Textbook Media Press. CH 29 Taylor: Principles of Economics 1
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1 Textbook Media Press CH 29 Taylor: Principles of Economics 1
2 Money Defined Money is what people in a society regularly use when purchasing or selling goods and services. If money were not available, people would need to barter with each other, meaning that each person would need to identify others with whom they have a double coincidence of wants that is, each party has a specific good or service that the other desires. Textbook Media Press CH 29 Taylor: Principles of Economics 2
3 3 Functions of Money Money serves three functions: a medium of exchange a unit of account a store of value Textbook Media Press CH 29 Taylor: Principles of Economics 3
4 Measuring Money: Currency, M1, and M2 Money is measured with several definitions: M1 includes currency, traveler s checks, and money in checking accounts (demand deposits) M2 includes all of M1, plus savings deposits, small time deposits like certificates of deposit, and money market funds. Textbook Media Press CH 29 Taylor: Principles of Economics 4
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6 Banks as Financial Intermediaries Banks facilitate the use of money for transactions in the economy, since people and firms can use bank accounts when selling or buying goods and services, when paying a worker or being paid, and when saving money or receiving a loan. In the financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans. Textbook Media Press CH 29 Taylor: Principles of Economics 6
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9 A Bank s Balance Sheet A balance sheet (sometimes called a T-account) is an accounting tool which lists assets in one column and liabilities in another column. The liabilities of a bank are its deposits. The assets of a bank include its loans, its ownership of bonds, and its reserves (which are not loaned out). The net worth of a bank is calculated by subtracting the bank s liabilities from its assets. Textbook Media Press CH 29 Taylor: Principles of Economics 9
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11 How Banks Go Bankrupt Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans, or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low rate of interest on its long-term loans but must pay the currently higher market rate of interest to attract depositors. Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves. Textbook Media Press CH 29 Taylor: Principles of Economics 11
12 How Banks Create Money If banks hold only a fraction of their deposits as reserves, then the process of banks lending money, those loans being redeposited in banks, and the banks making additional loans will create money in the economy. Textbook Media Press CH 29 Taylor: Principles of Economics 12
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15 The Money Multiplier The money multiplier is defined as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves. Textbook Media Press CH 29 Taylor: Principles of Economics 15
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18 Cautions about the Money Multiplier The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. Much of the money in an economy is created by the network of banks making loans, people making deposits, and banks making more loans. Textbook Media Press CH 29 Taylor: Principles of Economics 18
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