Macro Money and Banking Essentials WCC

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1 Macro Money and Banking Essentials WCC Barter - a system of exchange in which people directly exchange one good for another without any intermediate step Barter relies on the double coincidence of wants both parties have to happen to have the good the other party wants rather clumsy, lots of time and energy go into arranging trades barter transactions exhibit high transaction costs Transaction costs - the costs associated with getting the deal done. They include the time effort and energy needed to make the transaction happen. An alternative to barter It would be so much more convenient if a single good existed which everyone accepted in exchange for other goods and services. This good does exist; it is referred to as money. Money "greases the wheels of trade". It reduces transaction costs. Why money is such a great invention Reducing transaction costs reduces barriers to exchanges. Each exchange creates value for society since both parties benefit from voluntary transactions. To the extent that money allows for more transactions to take place, money is increasing happiness for society. Note: Money, wealth, and income are not necessarily the same thing. Wealth - is an accumulation of assets Money may account for part of your wealth, but stocks, bonds, your car, and your house are all part of your wealth. They are not widely accepted in exchange for other goods and services though, so they are not money.

2 Income - is a flow of purchasing power that you receive over time. Income is usually received in the form of money, but it could be anything of value received in return for services. Money is the good that everyone accepts in exchange for other goods and services Rather than make a list of items that are considered to be money, we tend to define money by the functions we want it to carry out for us. Anything that then fulfills these functions can be considered money. Functions of Money 1) Medium of exchange - the good everyone accepts 2) Unit of account - standard unit for quoting prices 3) Store of value - value doesn't erode, except via inflation 4) Standard of deferred payment agreed upon future yardstick We haven t always used green pieces of paper with dead white guys as money. Historical examples of money Salt source of the word salary Wheat Gold and precious metals Cigarettes - see The Shawshank Redemption Wampum - American indian currency composed of shells and beads Large stone wheels - see the Yap Islands Commodity money - a medium of exchange which has a significant nonmonetary use Fiat money - a medium of exchange which has no significant nonmonetary use

3 What makes a good money Durable Divisible Acceptable Portable Uniform Optimally scarce o Difficult to counterfeit Problems with commodity monies A significant nonmonetary use, also means that there is a significant OC to using a commodity as money. o If you use wheat as money then you can t use it to bake bread. It is hard to control the size of the money supply when you use a commodity money. o If you use wheat as money, a good harvest leads to significant inflation as the money supply expands o If your money supply is backed by gold, you can t expand the money supply unless you find more gold. See The Wizard of Oz Commodities are often not uniform from unit to unit, making it hard to establish a value Gresham s Law Good money drives out bad. People will keep the best versions of a nonuniform commodity money for themselves and try to use the poorer examples of the commodity money in exchange. Since people don t really want the poorer examples of money, they don t work very effectively as money. What backs the money supply? It s certainly not gold or silver. Nixon ended the Bretton Woods agreement and took the U.S. off the gold standard in 1971 People accept currency for a simple reason. They accept our currency in return for their goods and services because they are reasonably certain they can turn around and use it to buy goods and services.

4 Faith in that ability to get goods and services backs the money supply. Anything that shakes that faith, shakes the reduces the value of that money. How large is the money supply? That depends on what is meant by the money supply. Some forms of money fulfill some of the Functions of Money better than others M1 includes those items that function primarily and directly as a medium of exchange. M1 Components Currency & Coin in Circulation ,148 1,512.4 Checking Deposits ,499.4 Other Checkable Deposits Traveler s Checks M1 $1,369.1 $2,551 $3,594.6 M2 Includes those items that function as a store of value. M1 + savings deposits, small time deposits, money market mutual funds, other items, approximately $6,939.3 billion circa 2007, $10,919 billion in 2013, and $13,747 in 2017

5 M2 Components 2017 M1 3,594.6 Savings Deposits 9,052.4 Small Time Deposits Money Market Mutual Funds M2 $13,747 M3 = M2 + institutional funds, large time deposits, repurchase agreements, eurodollars From an old Federal Reserve announcement "On March 23, 2006, the Board of Governors of the Federal Reserve System will cease publication of the M3 monetary aggregate. The Board will also cease publishing the following components: large-denomination time deposits, repurchase agreements (RPs), and Eurodollars. The Board will continue to publish institutional money market mutual funds as a memorandum item in this release. M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits." Liquidity - refers to the ease with which a an asset can be converted to cash. Near moneys - liquid assets that are close substitutes for money.

6 Credit cards - generally speaking, credit cards are not considered money. They themselves are not payment, rather they simply defer payment. Credit cards are short term loans. They do reduce need for money. Fractional Reserve Banking is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit. Facts about banks 1) Banks are in business to make a profit. 2) Banks make money by loaning out deposited funds at a higher rate than they pay the depositors. 3) Banks' regarding loans affect our money supply. 4) Banks must always be concerned with the possibility of a run. Demand deposits are available on demand. Lower level reserves equal higher profits. However, lower level reserves also equal higher risk of bankruptcy. Other protections Deposit insurance Bank examinations and audits Restrictions on investments Required reserves - only of minimal importance here Deposit insurance - guarantees that depositors will get their money back if the bank goes bankrupt Deposit insurance is provided by FDIC. It is paid for by bank premiums. Deposit insurance introduces moral hazard. Required reserves are the minimum amount of demand deposits that must be kept on hand as vault cash or on deposit with the Fed. To determine the health of a bank, we need to examine its financial statements, particularly it balance sheet.

7 Assets are items of value which someone owes to you. Liabilities - are items of value which you owe to someone else. Net Worth = Assets Liabilities