Unit IV: Money

There are three functions of money: medium of exchange, store of value, and unit of account.

• Medium of Exchange
• it serves to trade one product for another
• Store of Value
• where money holds its value over a period of time
• Unit of Account
• establishes economic worth

There are three types of money: commodity money, representative money, and fiat money.

• Commodity Money
• gets its value from the type of material from which it is made
• examples are gold and silver in products
• Representative Money
• paper money backed by something tangible that gives it value
• examples are gold-or-silver-backed money and IOUs
• Fiat Money
• money because the government says so

There are seven characteristics of money:

• Durability
• Portability
• Divisibility
• Uniformity
• Scarcity
• Acceptability
• Limited Supply

Money supply consists of M1 money, M2 money, and M3 money.

• M1 Money
• consists of currency in circulation, which can be:
• currency, which consists of cash and coins
• checkable deposits (CD), which are also known as demand deposits (DD) and checking accounts
• traveler's checks
• liquidity means it is easy to convert checkable deposits and traveler's checks to cash
• M2 Money
• consists of M1 money + savings accounts + money market accounts
• savings accounts - a bank account where you can store money you don't need right away but still keep it easily accessible
• money market accounts - savings account with some checking features; they typically come with checks or a debit card and allow a limited number of transactions each month; traditionally, they've also offered higher interest rates than regular savings accounts
• M3 Money
• consists of M2 money + certificates of deposits (CD)

Time Value of Money

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

Balance Sheet

• Summarizes the financial position of a bank at a certain time.
• The value of assets must equal the value of claims.
• Claims on a balance sheet are divided into two groups.
• Assets, or credit, include
• required reserves (RR)
• excess reserves (ER)
• loans
• property
• bonds (securities)
• Liabilities, or debit, include
• demand deposits (DD) a.k.a. checkable deposits (CD)
• owner's equity
• owning stock in something; investing in something
• net worth

The Federal Reserve

• Fractional Reserve Banking System
• The banks have to hold a fraction of the total money supply as currency
• Money Creation
• Putting new money into circulation using two methods:
• when the federal reserve bank buys bonds from the people or financial institutions (open market operation or OMO)
• when banks make loans to the public
• The money supply is increased when banks make loans
• The more loans banks make, the more money that is in circulation
• A bank can loan any amount that is in excess of its required reserves
• The banking system can create loans in multiples of an original loan
• Reserves or Total Reserves
• The amount of deposits that a bank has accepted but not loaned out
• Required Reserves (RR)
• The amount of money a bank must keep on hand by law
• Excess Reserves (ER)
• Whatever the bank has over and above the required reserves
• The required reserve ratio (RRR) determines this amount
• Total Expansion of the Money Supply
• loans x money multiplier
• money multiplier = 1/RRR
• Total Money Supply
• money in circulation + money in demand deposits

The Federal Reserve System

• Functions of the Fed
• Issues paper currency
• Sets reserve requirements and holds reserves of banks
• Lends money to banks and charges them interest
• They are a check clearing service for banks
• Acts as a personal bank for the government
• Supervises member banks
• Controls the money supply in the economy

There are four types of multiple deposit expansion questions:

• Type 1: Calculate the initial change in excess reserves (ER)
• a.k.a. the amount a single bank can loan from the initial deposit
• Type 2: Calculate the change in loans in the banking system
• Type 3: Calculate the change in the money supply
• sometimes type 2 and type 3 will have the same result (i.e. no Fed involvement)
• Type 4: Calculate the change in demand deposits (DD)

For more information, please refer to these videos on Khan Academy:

Money supply: M0, M1, and M2: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/definition-measurement-and-functions-of-money-ap/v/money-supply-m0-m1-and-m2?modal=1

Functions of money: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/definition-measurement-and-functions-of-money-ap/v/functions-of-money?modal=1

Commodity money vs. Fiat money: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/definition-measurement-and-functions-of-money-ap/v/commodity-money-vs-fiat-money?modal=1

Bank balance sheets in a fractional reserve system: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/banking-and-the-expansion-of-the-money-supply-ap/v/bank-balance-sheets-in-a-fractional-reserve-system?modal=1

Money creation in a fractional reserve system: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/banking-and-the-expansion-of-the-money-supply-ap/v/money-creation-in-a-fractional-reserve-system-ap-macroeconomics-khan-academy?modal=1

Bank balance sheet free response question: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-financial-sector/banking-and-the-expansion-of-the-money-supply-ap/v/bank-balance-sheet-free-response-question?modal=1