Econ Midterm #2
3 purposes of money:
1. Medium of exchange – means by which you trade what you have for what you want
2. Astore of value – means of purchasing power for future needs or wants
3. Aunit of account – a basis for comparing apples and oranges, measuring GDP, etc.
Money should be durable, divisible, and limited in supply.
- Tobacco, cigarettes, and wampum have all been used as money
Why do people hold money?
- For ease in transactions, in anticipation of transactions to be made
- Precautionary: to meet anticipated near-term expenditures
- Store of wealth: to be able to act immediately if an investment opportunity arises
Liquidity – how easy it is to turn an asset into cash at a low cost
Portfolio theory – how people weigh risk, return, and liquidity in the management of their assets
At higher interest rates, people find that they can get by with less cash.
Commercial banks – business firms that earn a profit from providing people with services such
as receiving demand deposits and providing credit and loans
Banks earn their profit from the interest they charge on loans
Central banks – public institutions that are lenders of last resort and stabilizers of the economy
by controlling money and credit to pursue stable growth without inflation
Balance sheets balance the assets against the claims against them.Assets include reserves and
loans, and liabilities include demand deposits and net worth
- Net Worth =Assets – Liabilities
The money supply multiplier is equal to 1 over the reserve requirement
The banker has 3 objectives:
1. Profitability – putting the assets to work at interest and taking risks in hopes of higher
returns 2. Liquidity – the bank must have sufficient cash to be able to pay out deposits on demand.
They achieve liquidity by holding assets such as treasury bills that are easily converted to
3. Solvency – maintaining the value of assets above the liabilities
1913 – The Federal Reserve System emerged to serve as a lender of last resort. It now serves also
as a stabilizer to smooth out the swings of the business cycle
FDIC (Federal Deposit Insurance Corporation) – government corporation that insured bank
deposits up to a reasonable size.
BankingAct of 1933 (Glass-SteagallAct) – separated commercial banking from investment
banking, but it was repealed in 1999
Board of Governors – a group of 7 that are appointed by the President to 14 year terms
- Under them, there are 12 regional banks each with a president and committees of the
Open market economy – consists of 12 people (7 governors and 5 regional bank presidents
always including NY). They meet every 6 weeks to review economic conditions and decide
whether to ease or tighten money and credit.
- If we are entering a recession, the Fed would ease money and credit by buying US
government securities on the open market
When banks borrow from the Fed, they have a liability called owed to fed. This is an asset to the
Fed and a liability to the commercial bank.
Potential loans – money supply multiplier x excess reserves
If a bank has excess reserves, they will cut interest rates to encourage people to borrow, which
will stimulate investment spending, soAD will shift out.
Federal funds rate – the rate at which banks borrow from each other. It is technically the cost of
money to banks.
If there is rising inflation, then the Fed will sell government securities and take money out of the
system. Someone buys the securities, which takes money out of demand deposits at the
commercial banks, so they will now be short of reserves. They must now cut back on loans, so
they increase interest rates to discourage borrowers.
Discount rate policy – when the Fed lends reserves to member banks they charge an interest rate
known as the discount rate. If they raise it, it discourages banks from borrowing and holds down expansion of loans. To pump in money, they would cut the discount rate. This is usually used as
an emergency weapon.
- They keep the discount rate above the federal funds rate to encourage banks to borrow
from each other than the Fed.
Change in Reserve Requirements – righ