Money Market

- demand for money has an inverse relationship between nominal interest rate and quantity of money demanded

Money Demand Shifters :

1. ∆ in PL
2. ∆ in income
3. ∆ in taxation that affects investment

- demand is always downward sloping

- FED increases Money Supply , temporary surplus of money will occur at 5 % interest

- Fed decreases Money Supply , temporary shortage of money will cause interest rate to rise to 10 %

Key Principles

- a single bank can create money ( through loans ) by the amount of excess reserves

- the banking system as a whole can create money by a multiple ( deposit or money multiplier ) of the initial excess reserves

- banks loan out all of their excess reserves

- loans are redeposited in checking accounts rather than taken in cash

Initial Deposit : Cash

• the only use of money created by the banking system
• Existing Money
• Bank Reserves , Income ( Liability )
• Immediate Change in Money Supply ?
• No, because the composition of money changes

Initial Deposit : FED Purchase of a Bond from the Public

• New Money
• Bank Reserves , Increase
• Immediate Change in Money Supply ?
• Yes, because money coming from the FED is new money in circulation

Initial Deposit : Bank Purchase of a Bond from the Public

• New Money
• Bank Reserves , Increase
• Immediate Change in Money Supply ?
• Yes, because money coming out of the bank reserves is new money

- Both FED and bank purchase of  bonds from the public can use initial deposit and money created by the banking system

Factors that Weaken the Effectiveness of the Deposit Multiplier :

1. if banks fail to loan out all of their excess reserves , this will cause the multipliers to be weak
1. Ex : FED can change the numbers of monetary multipliers
2. if bank customers take their loans in cash, rather than in new checking ( or checkable ) deposits, this creates cash or currency drain
3. 
   

Liabilities and Assets

• Bank Balance Sheet = Assets and Liabilities in a T-Account
• Liabilities = DD + Owner's Equity ( Stock Shares )
• Assets = RR , ER , Bank Properly , Securities , Loans
• Assets must equal Liabilities
• DD = RR + ER
• Money is created through the Monetary Multiplier
• ER x 1 / RR ( multiplier )
• this equals New Loans throughout the banking system
• Money Supply is affected ...
• cash from a citizen becomes DD , but does NOT change the Money Supply
• ER from this cash becomes "immediate" loan amount
• ER x Multiplier become
• new loans and DD changes the Money Supply
• The FED buying bonds
• creates new loans and changes the Money Supply
• IF the FED buys the bonds
• on the open market, this becomes a new DD amount
• IF the FED buys bonds
• from the account already held by a particular bank, then the amount only becomes new ER
• Bonds
• bond "prices" move opposite to the changes in interest rates
• the higher the interest rate will push bond prices down ( less money supply )
• the lower the interest rate will push bond prices up ( more money supply )

Three Types of Multiple Deposit Expansion Questions :

1. Type 1 
• Calculate initial change in excess reserves
• aka , the amount a single bank can loan from initial deposits
2. Type 2
• Calculate change in loans in the banking system ( money multiplier )
3. Type 3
• Calculate change in the money supply
• sometimes Types 2 and 3 will have the same results
• ex : no FED involvement
4. Type 4
• Calculate change in demand deposits
• cash, checking account

Liabilities :

1. Cash deposits from the public = DD
2. Owner's Equity or Stock Shares = values of the bank stocks as held by the public

Assets :

1. Required Reserves = the percentage of DD in the Vault = RR
2. Excess Reserves = the remaining % of DD , used for loans = ER
3. Banking Property Holdings = usually a statement of the bank's property values
4. Securities = previously purchased bonds held by the bank as investments
5. Customer Loans = previously loaned funds now owed back to the bank

REMEMBER THAT DD = RR + ER

Bonds can move in two ways

1. the FED sells to the banks and increases the amount
2. the FED buys from the banks and decreases the amount

Banks and the Money Supply

- the money multiplier process creates new money for the economy

• Scenario # 1 :
• A private citizen takes cash that they possess and put it into a bank account
• The cash placed into the bank is already part of the money supply
• the deposit is counted as a bank liability
• a percentage must be placed into required reserves
• the remainder is placed into excess reserves
• the bank will want to lend all of the excess reserve , if possible
• the amount in excess reserve is multiplied by the multiplier
• this will be assumed to become new loans in the banking system
• this will be counted as the change in the money supply
• Scenario # 2 :
• the FED buys bonds back from the public
• the public now has new cash
• this new cash is new loans
• assume that the public puts the cash into demand deposits
• a set percentage is placed into required reserves
• the remainder becomes excess reserves
• excess reserves are multiplied by the Money Multiplier ( 1 / RR )
• this amount becomes new loans and is new money supply
• the total change in the Mooney Supply is the amount of demand deposits plus the new loan amounts
• Scenario # 3 :
• the FED buys bonds back from the member banks
• the bank now has new excess reserve
• no money is needed to be placed into required reserves , since this is not owed to the public
• all of these excess reserves are multiplied by the multiplier
• this amounts becomes new loans
• this amounts is the change in the money supply

Cause and Effects of the Money Supply :

• changes in the MS will move the supply line on the Money Market Graph
• changes in the MS will change nominal interest rate
• changes in the MS can create inflation or dis-inflation
• change in inflation can change real wages
• changes in inflation rates also affect the international currency markets
• changes in interest rates affect the prices of bonds in an inverse relationship

Multiple Deposit Expansion and the Federal Reserve

Seven Functions of the FED

1. issues paper currency ( produced daily )
2. sets up reserve requirement and holds reserves of banks
3. lends money to banks and charges them interest
4. checks clearing service for banks
5. acts as a personal bank for the government
6. supervises member banks
7. controls money supply in the economy

Banks and the Creation of Money

• How do banks "create" money ?
• by lending out deposits that are used multiple times
• Where do the loans come from ?
• from depositors who take cash and place it in their banks
• How are the amounts of potential loans calculated ?
• using a bank balance sheet or a T - account that consists of assets and liabilities for the bank
• Bank Liabilities ( right side of T-Account Sheet )
• what you owe
1. Demand Deposits ( DD ) or checkable deposits
• cash deposits from the public
• liability because it belongs to the depositors
2. Owner's Equity ( stock shares )
• values of stocks held by the public ownership of bank shares
• Key Concepts of Liabilities
• demand deposit comes from someone's cash holdings, then DD is already part of the money supply
• DD comes in from purchase of bonds ( by the FED ) , this creates new cash and therefore creates new money supply ( MS )
• Bank Assets ( left side of T-Account Sheet )
• what you own
1. Required Reserves ( RR )
• percentages of demand deposits that must be held in the vault so that same depositors have access to their money
2. Excess Reserves ( ER )
• source of new loans
• the amount applied to the Monetary Multiplier or the Reserve Multiplier ( DD = RR + ER )
3. Banking Property Holdings ( buildings and fixtures )
4. Securities ( Federal Bonds )
• bonds purchased by the bank or new bonds sold to the bank by the Federal Reserves Bank
• bonds can be purchased from the bank, turned into cash that immediately becomes available as "excess reserve"
5. Customer Loans
• can be amounts held by banks from previous transactions, owed to banks by prior customers
• Money Creation ( Using Excess Reserves )
• banks want to create profit by lending ER and collecting interest
• loans will go out into customer's or business's accounts
• more loans created in decreasing amounts (because of RR)
• rough estimate of number of loan amounts created by any first loan is the "money multiplier"
• Monetary Multiplier ( aka )
• Checkable Deposits Multiplier
• Reserve Multiplier
• Loan Multiplier
• Formula :
• 1 / RR = Monetary Multiplier
• ex : RR = 10 %
• 1 / .1 = 10
• Excess Reserves are multiplied by the Multiplier
• to create create new loans for the entire banking system
• this creates new Money Suppyl

Investment

Investment
- redirecting resources that you would consume now for the future

• Financial Assets
• plans on property and income of the borrower
• Financial Intermediaries
• institution that channels funds from savers to borrowers
• Relationship between the two : savers to institution to investor

Three Purposes for Financial Intermediaries :

1. Share Risks
• diversification, spreading out your investment to reduce risk
2. Providing Information
• stock broker to help you in the market
• ex : facebook, teens attracted to it because of instagram
3. Liquidity, easily converted to cash
• Returns - money an investor receives above and beyond the sum of money that was initially invested
• the higher the risk, the higher the return

Bonds

- loans or I.O.U.s that represent a debt that the government or corporation must repay to an investor

- generally low risk investment

Three Components : 

1. Coupon Rate
• interest rate that a bond issuer will pay to a bond holder
2. Maturity
• time at which payment to a bond holder is due
3. Par Value
• amount that an investor pays to purchase a bond at that will be repaid to an investor at maturity

Yield

- annual rate of return on a bond if the bonds were held at maturity

• Bonds, YOU LOAN
• Stocks, YOU OWN

Time Value of Money

• Is the dollar today worth more than the dollar tomorrow?
• Yes
• Why?
• Opportunity cost and INFLATION

Formulas :

• v = future value of $
• p = present value of $
• r = real interest rate ( nominal - inflation rate ) [a decimal]
• n = years
• k = number of times interest is credited per year
• Simple Interest Formula
• v = ( 1 + r ) ^ n * p
• Compound Interest Formula
• v = ( 1 + r / k ) ^ nk * p

-Inflation expected at 3 %, nominal on simple interest is 1 %

Example Problems :

- Future Value of $1 After 1 Year :

• 1 - 3 = 2 % ( real interest )
• v = (1 + ( - 0.02 ) ) ^ 1 * 1 = $ 0.98

- Inflation 3 % , nominal 4 %

• 4 - 3 = 1 % → 0.01
• ( 1 + .01 ) ^ 2 * 1 = $ 1.01

- Inflation 2.5 % , nominal 5 % , years = 10 , future value = $1,000 , compound monthly

• ( 1 + .025 / 12 ) ^ 10 ( 12 ) * 1000
• ( 1 + 0.002083 ) ^120 * 1000 = $ 1,283.69

Monetary Equation of Exchange :

• MV = PQ
• M = money supply ( M1 or M2 )
• V = money's velocity ( M1 or M2 )
• P = price level ( P on AS / AD )
• Q = real GDP (Y on AS / AD )

How is Money created ?

• by banks ( fractional reserve banking )
• money is loaned into existence
• when it is paid back, there is no more money

Money

Money is any asset that can be easily used to purchase goods and services

Use of Money :

1. as a medium of exchange
• used to determine value
2. unit of account
• something that will compare cost
• ex : grocery shopping
3. store of value
• hiding money in a shoe box ( no interest )
• bank ( interest )

Types of Money :

1. Commodity Money
• has money value within itself
• ex : salt, olive oil, gold
2. Representative Money
• represents something of value
• I.O.U ( pay back, paper is worthless )
3. Fiat Money
• money because the government says so
• paper currency ( dollar / notes ), coins

"Currency is money, but money is not currency"

 Six Characteristics of Money :

1. Durability - how long it can last
2. Portability - can be taken anywhere
3. Divisibility - can be broken down
4. Uniformity - it all looks the same ( except with updated ones)
5. Limited Supply
6. Acceptability

Money is backed by Fiat Money

Money Supply :

- all of the available money in the economy

M1 Money :

• Liquid assets ( Liquidity )
• easily to convert to cash
• currency ( paper )
• coins
• checkable deposits / demand deposits ( checks )
• traveler's checks ( safe )

M2 Money :

• consist of M1 Money + Savings Account + Money Market Account
• Savings Account, not as easy to withdraw as M1 Money
• Money Market Account, if withdrawn, you will be penalized from your own account

Three Purposes for Financial Institution :

1. Store Money
2. Save Money
3. Loan Money
1. for credit cards
2. for mortgages

Four Ways to Save Money :

1. through savings account
2. through checking account
3. through money market account
4. through certificate of deposit ( CD )

• Number 3 and 4, these way gives higher interest rate

Loans :

- banks operate on a fractional reserve banking system, which means they keep a fraction of the funds and loan out the rest

- banks make money through loans

• Interest Rate
1. Principal - amount of money borrowed
2. Interest - price paid for the use of borrowed money
• Two Types of Interest :
1. Simple Interest - paid on the principal
• I = ( P * R * T ) / 100
• P = Principal
• R = Rate of Interest
• T = Time
2. Compound Interest - paid on the principal and accumulative interest
• Formulas :
• Time = ( I * 100 ) / P * R
• Principal = ( I * 100 ) / R * T
• Interest Rate = ( I * 100 ) / P * T

Types of Financial Institutions :

1. Commercial Banks
2. Savings and Loans Institutions
3. Mutual Savings Bank
4. Credit Unions
5. Finance Companies