Chapter 14

M2 money supply

- M1, saving account balances, small time deposits, balances in money market deposit accounts in banks, and non institutional money market fund shares.

security

- a financial asset that can be bought and sold in the financial market.

bank balance sheets

- a firms assets are listed on the left and its liabilities are listed on the right. - the largest liabilities are their deposit accounts (the money they owe to their depositors)

commodity money

- a good used as money that also has value independent of its use as money

the double coincidence of wants

- a major shortcoming of barter economies is that in order for barter to occur, each person just want what the other person has

T-account

- a stripped down version of a balance sheet, showing only how a transaction changes a banks balance sheet

what are the requirements for a suitable medium of exchange?

- acceptability - standardized quality - durability - value to relative to weight - divisibility

Lehman Brothers collapse

- after Lehman Brothers failed, a panic started, with many investors withdrawing their funds. - securitization ground to a halt; with banks unable to resell their loans, they stopped making as many. - the resulting credit crunch significantly worsened the recession.

money

- assets that people are generally willing to accept in exchange for goods and services or for payment of debts - eliminates the problems associated with barter economies and allows people to specialize by making the exchange of goods and services easier

required reserve ratio

- at least 10% of checking account deposits above some threshold level. - the minimum fraction of deposits banks are required by law to keep as reserves.

fractional reserve banking system

- banks keep less than 100% of deposits as reserves

excess reserves

- banks might choose to hold reserves over the legal limit

investment banks

- banks that do not typically accept deposits from or make loans to households; they provide investment advice, and engage also engage in creating and trading securities such as mortgage-backed securities.

quantity theory of money

- based on QTM there should be a predictable, positive relationship between the annual rates of inflation and growth rates of the money supply. - there is a positive relationship,but not the consistent relationship implied by a constant velocity of money. - although the relationship is not entirely predictable, countries with higher growth in the money supply do have higher rates of inflation. - the money supply grows faster than real GDP

the shadow banking system

- brought increasing importance of non-bank financial firms including: - investment banks - money market mutual funds - hedge funds - these are quite vulnerable to bank runs.

central bank

- can help to prevent bank runs and panics by acting as a lender of the last resort, promising to make loans to banks in order to pay off depositors. - this assurance helps make people confident in being able to eventually receive their money and prevents the panic. - the Federal Reserve is an example of this.

the Federal Reserve System

- congress divided the country into 12 Federal Reserve districts, each of which provides service to banks in the district - the Board of Governors consists of 7 meters, each appointed by the president to 14 year, non-renewable terms. - one of the 7 board members is appointed to be chairman for a 4 year, renewable term.

Federal Deposit Insurance Corporation (FDIC)

- congress established this as a response to the Great Depression - bank runs are still possible

real world deposit multiplier

- consumers keep some currency out of the bank, that currency cannot be used as required reserves

reserves

- deposits that a bank keeps as cash in its value of on deposit with the Federal Reserve. - the bank does not keep enough deposits on hand to cover all its deposits - an initial decrease in a banks reserves will decrease checkable deposits by an amount greater than the decrease in reserves. - an initial increase in a banks reserves will increase checkable deposits by an amount greater than the increase in reserves.

barter economies

- economies where goods and services are traded directly for other goods and services

hedge funds

- funds that raise money from wealthy investors and make "sophisticated" (often non-standard) investments.

money market mutual funds

- funds that sell shares to investors and use the money to buy short-term Treasury bills and commercial paper (loans to corporations).

advantages of fiat money

- governments do not have to be willing to exchange it for gold or some other commodity on demand - it makes central banks more flexible in creating money

the nonbank public

- households and firms decide how much money to hod as deposits in banks. the more deposits, the more loans banks can make and the greater effect on the money supply

in addition to the Federal Reserve Bank, what other economic factors influence the money supply?

- households, firms, and banks

commercial banks

- its primary role is to accept funds from depositors and make loans to borrowers.

how do banks make a profit?

- lending out our investing money deposited with it

anything used as money should fulfill what functions?

- medium of exchange - unit of account - store of value - standard of deferred payment

fiat money

- money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money - an example of this is the US Dollar

credit cards

- not included in M1 or M2 - they do not represent money

how does the Federal Reserve manage the money supply?

- open market operations (most common) - discount policy - reserve requirements

Troubled Asset Relief Program

- providing funds to banks in exchange for stock - offering discount loans to previously ineligible investment banks - buying commercial paper for the first time since the 1930s

what are the benefits of using money?

- reduces the transaction costs of exchange - eliminates the double coincidence of wants - allows for greater specialization

open market operations

- refers to the buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.

reserve requirements

- the Federal Reserve can alter the required reserve ratio - a decrease would result in more loans being made, increasing the money supply (also works adversely)

americas monetary policy

- the actions the federal reserve takes to manage the money supply and interest rates to persue macroeconomic policy objectives - the Federal Open Market Committee (FOMC) conducts this

velocity of money

- the average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

required reserves

- the bank must keep some cash available for its depositors - it does this through a combination of vault cash and deposits with the Federal Reserve - banks in the US are legally required to hold reserves based on its checking deposits

stockholders equity

- the difference between a banks assets an liabilities

discount policy

- the discount rate is the interest rate paid on money banks borrow from the Federal Reserve. - by lowering the discount rate, the Federal Reserve encourages banks to borrow more money, increasing the money supply (also works adversely)

inflation

- the growth rate of the money supply, the growth rate of real output - if the money supply grows faster than real GDP, there will be inflation - if the money supply grows slower than real GDP, were will be deflation - if the money supply grows at the same rate as real GDP, there will be neither inflation nor deflation, the price level will be stable.

calculating the velocity of money

- the money supply=M (M1) - the price level=P (GDP deflator) - level of real output=Y (real GDP) - assumes that the velocity of money is constant - M x V = P x Y - growth rate of M1 + growth rate of V = growth rate of P + growth rate of Y - Inflation rate = growth rate of M1 - growth rate of real GDP

securitization

- the process of transforming loans or other financial assets in to securities.

simple deposit multiplier

- the ratio of the amount of deposits created by banks to the amount of new reserves - 1/RR

M1 money supply

- the sum of currency in circulation, checking account deposits in banks, and holdings of travelers checks - we use M1 more

liabilities

- the value of anything that the bank owes

banks

- there is more money held in checking accounts that there is actual currency in the economy. - somehow money is being created by banks - banks are generally profit making private firms, their activities are designed to allow themselves to make a profit - banks use money deposited with them to make loans and by securities (investments)

why is the shadow banking system different from commercial banks?

- these firms were less regulated by the government, including not being FDIC-insured. - these firms were highly leveraged, relying more heavily on borrowed money; hence their investments had more risk, both of gaining and losing value.

disadvantages of fiat money

- this is only acceptable as long as households and firms have confidence that if they accept paper dollars in exchange for goods and services, the dollar will not lose much value during the time they hold them. - if people stop believing in the fiat money, it will no longer be useful

hyperinflation

- very high rates of inflation—in excess of 100 percent per year - results when central banks increase the money supply at a rate far in excess of the growth rate of real GDP. - this might happen when governments want to spend much more than they raise through taxes, so they force their central bank to "buy" government bonds. - tends to be associated with slow growth, if not severe recession

assumptions of the deposit multiplier

- we assume that banks keep the absolute minimum amount on reserve - we assume that individuals always deposit the entire check, and don't hold any in cash.

banks and money supply

- when banks gain reserves, they make new loans, and the money supply expands. - when banks lose reserves, they reduce their loans, and the money supply contracts.

bank run

- when depositors lose confidence in the bank - involves one bank - a bank panic may simultaneously occur, which involves many banks.

relationship between money supply growth and inflation

There is not an exact relationship between money supply growth and inflation, but countries such as Bulgaria, Turkey, and Ukraine that had high rates of money supply growth had high inflation rates, and countries such as the United States and Japan had low rates of money supply growth and low inflation rates.

asset

anything of value owned by a person or a firm

Zimbabwe

recently experienced very high hyperinflation