Monetary System Flashcards
What is money
1) set of assets in economy that people regularly use to buy goods + services from one another
2) means that stocks not considered money bc you need to liquidate them before you can actually buy stuff
Three functions of money
1) Medium of exchange
2) unit of account
3) store of value
Purpose of $: Medium of exchange
1) item buyers give to sellers when purchasing goods/services
Purpose of $: unit of account
1) yardstick people use to post prices and record debts
2) money is used to measure + record economic value (you won’t said that shirt is worth 10 hotdogs for example)
Purpose of $: store of value
1) people use to transfer purchasing power from present to future
2) transfer wealth to future by holding nonmonetary assets like stocks/bonds
Liquidity
1) ease by which asset can be converted into money
Kinds of money
1) Commodity money = holds intrinsic value even if not used as money (gold)
2) Fiat money = declared to have value by government decree (modern paper currency)
Money Stock
1) Quantity of money circulating in economy
2) includes currency, demand deposits
What is the difference between M1 and M2 money stocks
1) M1 = includes currency, travelers checks, demand deposits at banks, liquid deposits like savings account
2) M2 = includes everything in M1 + small time deposits + money market funds
What is the fed’s dual mandate
1) Stable prices
2) maximum sustainable employment
How does the fed achieve its dual mandate
1) Regulate banks + ensure health of banking system –> does this by clearing checks + acting like a bank’s bank (lender of last resort)
2) Controls money supply –> controls interest rates
What is open-market operation
1) Purchase/sale of govt bonds to either increase or decrease money supply
2) Increase –> Fed will buy more bonds with newly minted money
3) Decrease –> Fed will sell more bonds which people will buy with old money thus reducing money supply
What happens if banks hold all deposits in reserve
1) Do not influence supply of money
2) Each deposit reduces currency BUT increases demand deposits by same amount
Fractional-reserve banking + reserve ratio
1) Fractional-reserve banking: only keeps a fraction of deposits in reserve
2) Reserve ratio = ratio of money that needs to be held by bank (reserves) to amount that can be lended out –> determined by govt + fed
What happens when banking systems lease money?
1) Essentially CREATE money
2) ex: 100 in reserve BUT 1/10 ratio so bank loaned out 90, so there is a surplus of 90 compared to 100 in reserve + 100 reduced from money supply
Economy is more liquid BUT not wealthier bc eventually need to pay loans back
Calculating Money multiplier
1) Money multiplier = amount of money that results from each dollar of reserves
2) Equals reciprocal of reserve ratio
Relationship btwn money multiplier + reserve ratio
1) Higher reserve ratio –> less money loaned out –> lower money multiplier
Bank capital
1) Resources bank obtains from issuing equity to its owners –> uses it to buy financial securities like stocks/bonds
Leverage + leverage ratio
1) Leverage = use of borrowed money to supplement existing funds to invest
2) Leverage ratio = ratio of bank’s total assets to bank capital
Problem with bank leverage
1) Can increase bank capital + owner equity when the securities rise
2) BUT if the securities fall then owner’s equity can reduce –> bank become insolvent (unable to pay debt holders/depositors in full)
What is capital requirement
1) Bank regulators require banks to hold certain amount of capital –> ensures that bank can pay off depositors
Bank has capital of $200 and a leverage ratio of 5. If the value of the bank’s assets declines by 10 percent, then its capital will be reduced to
Leverage ratio = Assets/capital
Assets = Leverage ratio * capital = 200 * 5 = 1000
Liabilities = Assets - Capital = 1000 - 200 = 800
10% decrease in assets –> loss of 100 BUT liabilities don’t change, only capital does SO capital reduces by 100
How can fed influence quantity of reserves
1) Open market operations: Sell bonds to reduce money supply, buy bonds to increase
2) Fed loans money to banks as a last resort SO if it increases its discount rate (interest for loan to bank) then it reduces reserves BUT if it decreases discount rate then it increases reserves
How does the fed influence the reserve ratio
1) Reserve requirements: changing min amount of reserves banks must hold against their deposits (increasing requirement reduces banks’ ability to make loans + make money –> reducing money supply)
2) Interest on reserves: Fed pays banks interest on reserves they give to fed –> SO if fed increases interest rates on reserve more banks want to increase their reserves –> reducing money supply
