Chapter 9

The Nature and Creation of Money

Hossain: MSMC

Definition Money is anything that serves as a

medium of exchange This means it is accepted as a

means of payment Therefore,

Cash Coin Credit card Checks

All can be considered as Money

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Functions Three functions of money are: Medium of Exchange: Purchasing

goods and services Unit of Account: A consistent means

of measuring value of goods and services

Storage of Value: An item that holds value over time and therefore, expands the consumption horizon.

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Exchange without Money Without money goods and services can be

exchanged for other goods and services If you have Oranges and want Apples you

must know the Price of Apples in terms of Oranges

Say 1 pound of Apple = 2 pounds of Oranges = 1 gallon of Milk

This is known as Barter In a Barter economy, there will be millions of

price for one pound of Apple We will also need double coincidence of

wants

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Types of Money Two types of money are: Commodity Money:

Money that has its value or use apart from its use as money

Gold or Silver coins Cigarettes in WWII prisons

Fiat Money: Fiat money has no intrinsic value It has value because government stands

behind its value as a medium of exchange This note is legal tender for all debts

public or privateHossain: MSMC 5

Measuring Money Money Supply: Total quantity of money

in an economy at any given time Liquidity:

Not all assets are equal in terms of how quickly and easily they can be converted to currency

Liquidity is the ease with which an asset can be converted into currency

Clearly, currencies are most liquid A U.S. treasury bond will be a little less

liquid Your home will be even less liquid

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Measuring Money Based on liquidity, money supply is

measured in two forms. M1 Money Supply:

The most narrowest definition of money supply by Federal Reserve or the U.S. Central Bank

It is also more liquid than M2 definition It includes:

Currency: Cash and Coins Checkable Deposits Traveler’s Check

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Measuring Money M2 Money Supply:

A more broader definition of money supply

It includes M1 plus several other types of deposits including All of M1 Savings account deposit Small denomination time deposit Money market mutual fund

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M1 and M2 in December 2008

Financial Intermediary Financial Intermediary

An institution that accepts funds from one group (the savers) and provides funds to another group (the borrowers) who has a better and more productive use of funds

In doing so intermediaries Allocates resources to its best use Reduce risks through diversification Reduce transaction cost through

specialization Examples include Banks, Insurance

company, Mutual funds, Pension funds, Investment banks.

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Financial Intermediary Banks

A financial intermediary that accepts deposits, offer checking account services and make loans.

Balance Sheet A financial statement that shows an

institution’s assets, liabilities and net worth. Asset: Anything of value. For banks, loans,

mortgages, cash, reserves are assets Liability: Obligations to other parties. For

banks, deposits, loans from other banks are liabilities

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Financial Intermediary Balance Sheet

Net worth: Refers to assets less liabilities

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Assets Liabilities and Net Worth

Reserves $300.0 Checkable deposits $604.5

Other assets 1,357.8 Other deposits 6,306.7

Loans 6,903.4 Borrowings 2,322.1

Securities 2,466.9 Other liabilities 6,576.6

Total assets $11,928.1 Total Liabilities 9,890.9

Net worth 1,137.2

Financial Intermediary Reserves

Bank’s assets in the form of vault cash and deposits with Federal Reserve in called reserve.

Reserve = Cash + Deposit with Fed

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Financial Intermediary Required Reserve

Quantity of reserve banks are required to hold.

Required reserves cannot be loaned out.

It is usually a certain percentage of banks’ primary liability (checkable deposits)

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Financial Intermediary Required Reserve Ratio

Ratio of reserve to checkable deposits that all bank must maintain

For example, required reserve ratio is .10 or 10%

If Bank of America has 500 m checkable deposits, it must hold 50m worth of reserve (cash or deposit with Federal Reserve Bank)

Since reserve earns no interest, most banks maintains just the required reserve

Keep assets in the form of loans and securities.

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Required Reserve Ratio (rrr)

Ratio of reserve to checkable deposits that all bank must maintain

Mathematically,rrr = R / D

For Bank of Americarrr = 50m/500m = .10 or

10% If rrr rises to 12%, compute the

required reserve for the Bank of America.

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Here, R= Required ReserveD = checkable deposits

Financial Intermediary Excess Reserve

Reserve that are in excess of the required reserve

For example, required reserve ratio is .10 or 10%

If Bank of America has 500 m checkable deposits, it must hold 50m worth of reserve

However, if it has 60m reserve at hand, then what is the excess reserve.

Excess Reserve=Actual Reserve – Required Reserve

60m – 50m = 10mHossain: MSMC 17