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Money, Banking, and Monetary Policy

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Michael Gallego

on 22 April 2014

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Transcript of Money, Banking, and Monetary Policy

Money, Banking, and Monetary Policy
Functions of Money
In reality, paper money and coin money has no value. It serves as money because the government declares it to have value and to perform the three functions of money.
Medium of Exchange: money is accepted to all types of sellers; if I would want to buy a guitar, I would give him the correct amount of dollars. If the guitar seller wanted to buy some doughnuts, he would give dollars to the doughnut seller and so on.
Unit of Account: This makes it easier to know the value of a good or service, compared to the old barter system where a sword would equal to five iron bars, or two shields, etc.
Store of Value: This makes it easier to store places and wouldn't deteriorate easily. For example I can put fiat money under a mattress or in bank or wallet and it wouldn't lose its value until a long period of time, compared to back then when people bartered stuff, their goods had to stay fresh before it loses its value.
Formulas of Present Value and Future Value
If I lent you 100 dollars and you are going to pay me back in one year, assuming that there is no inflation, the nominal interest rate is equal to the real interest rate. The interest rate is 10 percent. The formula below shows what the future value of the 100 dollars after a year has passed:
FV = PV X (1+r).....Future Value = $100 X (1.10) = $110
You can also find the present value by inversing the formula
PV = FV/(1+r)...Present Value = $110/(1.10) = $100
If you want to find the future value of a good after two years have passed, just square the the interest rate.

M1, M2, and M3. What are they???
The order of the "M" tells how much "liquid" it is. Liquidity, related to macroeconomics, refers to how easily an asset can be converted into cash.
M1 = Cash + Coins + Checking deposits + Traveler's Checks.
M2 = M1 + Savings deposits + Small time deposits + Money market deposits + Money market mutual funds. Slightly less liquid than M1 because the holder of the asset would likely incur a penalty if they wished to immediately convert the asset to cash.
M3 = M2 + Large time deposits.
Financial Assets
Although people assume that money is the only financial asset, there are, in fact, more financial assets such as stocks and bonds.
Stocks: They are an investment in a firm that is then exchanged in a stock market. You may ask yourself, "Why would a company want to share its assets with people?" The reason is because the company want to raise money. One way is Equity Financing, also known as selling stocks.
Bonds: Another way businesses can make money is buy borrowing money, also known as debt financing. The catch of borrowing money is to pay the bondholder an additional interest. Like stocks, bonds can also be bought and sold in a secondary market. In my opinion I think this method is a bit risky because if your company fails, you would have a big debt to clean up.
The Money Market
What is the Money Market???
The Money Market is a model showing the total supply of and demand for money in a nation.
Money Supply: The money supply is fixed and determined by central bank policy. The printers are by the Treasury of the United States, which is a branch of government.
Money Demand: The asset demand for money is inversely related to the nominal interest rate. At higher interest rates, the Quantity demanded of money is lower and at lower interest rates the Quantity demanded of money is higher. The demand for money is also determined by the level of output and income in the economy. At higher income levels, the demand for money increases, and at lower income levels the demand for money decreases.
When the supply of money decreases, the central bank uses the contractionary monetary policy because nominal interest rates will rise, causing aggregate demand to decrease, making our level of output to decrease. This method is used to avoid inflation in the economy.
When the supply of money increases, the central bank uses the expansionary monetary policy because nominal interest rates will decrease, causing aggregate demand to increase, making our level of output to increase. This method is used to expand our economy when in a recession and lower our unemployment rate.
Reserved Ratio
The fraction of total deposits kept on reserve is called the Reserve Ratio.
Reserve ratio = Cash Reserves/Total Deposits
Asset: Anything owned by the bank or owed to the bank is an asset of the bank. Cash on reserve is an asset, and so are loans made to citizens.
Liability: Anything owned by depositors or lenders to the bank is a liability. Checking deposits of citizens or loans made to the bank are liabilities to the bank.
The Money Multiplier
The point of the money multiplier is to create money by loaning excess reserves.
M = 1/(Reserve ratio) = 1/rr

If you were to deposit something and withdraw the same amount you deposited, this would be called money destruction because there wouldn't be money to loan out.
Question 1: Which function of money best defines $1.25 as the price of a 20-ounce bottle of pop?
A. Medium of Exchange
B. Unit of Account
C. Store of Value
D. Transfer of Ownership
E. Fiat Money

Question 2: If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves?
A. 10 percent, $450 in excess reserves
B. 90 percent, $50 in excess reserves
C. 90 percent, $450 in excess reserves
D. 10 percent, $50 in excess reserves
E. 10 percent, $500 in excess reserves
Question 3: If the money supply increases, what happens in the money market (Assuming money demand is downward sloping)
A. The nominal interest rates rise
B. The nominal interest rates fall
C. The nominal interest rates does not change
D. Transaction demand for money falls
E. Transaction demand for money rises.
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