Money and Banking: Functions of Money

• Money and banking are integral parts of modern economies, facilitating transactions, savings, and investments
• The study of money and banking involves understanding the functions of money, the structure of financial institutions, and the role of central banks in influencing economic activity.

Functions of Money

• Money serves as a medium of exchange, a unit of account, and a store of value.
• As a medium of exchange, money eliminates the need for barter by providing a universally accepted means of payment.
• As a unit of account, money provides a common measure of the value of goods and services, making it easier to compare relative prices.
• As a store of value, money allows individuals to save purchasing power for future use.
• To be effective, money should be durable, portable, divisible, uniform, and have a stable value.
• Different forms of money have evolved over time, including commodity money, representative money, and fiat money.
• Commodity money has intrinsic value (e.g., gold coins).
• Representative money is backed by a commodity (e.g., silver certificates).
• Fiat money is declared legal tender by the government and is not backed by any physical commodity.

Financial Institutions

• Financial institutions act as intermediaries between savers and borrowers, facilitating the flow of funds in the economy.
• Commercial banks accept deposits and make loans, playing a key role in the money creation process.
• Investment banks underwrite securities and advise corporations on mergers and acquisitions.
• Insurance companies provide risk management services, pooling premiums to cover potential losses.
• Pension funds manage retirement savings, investing in a variety of assets to generate returns for future payouts.
• Credit unions are cooperative financial institutions owned and controlled by their members.
• Other financial institutions include finance companies, hedge funds, and private equity firms.

The Money Supply

• The money supply is the total amount of money available in an economy at a specific time.
• The most common measures of the money supply are M1 and M2.
• M1 includes currency in circulation, checkable deposits, and traveler's checks.
• M2 includes M1 plus savings deposits, money market accounts, and small-denomination time deposits.
• The money supply is influenced by the actions of the central bank and the behavior of commercial banks and the public.
• The money multiplier measures the maximum amount of money that can be created by a given increase in the monetary base.
• The money multiplier is affected by the reserve requirement, the currency ratio, and the excess reserve ratio.

The Federal Reserve System (The Fed)

• The Federal Reserve System is the central bank of the United States, responsible for conducting monetary policy and regulating the banking system.
• The Fed was created in 1913 in response to financial panics and the need for a more stable monetary system.
• The Fed is governed by a Board of Governors, whose members are appointed by the President and confirmed by the Senate.
• The Federal Open Market Committee (FOMC) is responsible for making decisions about monetary policy.
• The Fed's main tools for influencing the money supply and credit conditions include open market operations, the discount rate, and reserve requirements.
• Open market operations involve the buying and selling of government securities in the open market.
• The discount rate is the interest rate at which commercial banks can borrow money directly from the Fed.
• Reserve requirements are the fraction of deposits that banks are required to hold in reserve.
• The Fed also plays a role in supervising and regulating banks, providing financial services to the government and banks, and promoting financial stability.

Monetary Policy

• Monetary policy refers to actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
• The goals of monetary policy typically include price stability, full employment, and economic growth.
• Expansionary monetary policy involves increasing the money supply and lowering interest rates to stimulate economic activity.
• Contractionary monetary policy involves decreasing the money supply and raising interest rates to restrain inflation.
• The Fed uses a variety of tools to implement monetary policy, including open market operations, the discount rate, and reserve requirements.
• The effectiveness of monetary policy can be affected by factors such as lags, expectations, and the state of the economy.
• There are different views on the appropriate role of monetary policy, including rules-based versus discretionary approaches.
• Taylor's rule is a formula that suggests how the central bank should set the federal funds rate based on inflation and output gap.

The Banking System

• The banking system is a critical component of the financial system, providing essential services such as deposit taking, lending, and payment processing.
• Banks generate profits by charging higher interest rates on loans than they pay on deposits.
• Banks must manage liquidity risk, credit risk, and interest rate risk to ensure their solvency and profitability.
• Liquidity risk is the risk that a bank will be unable to meet its obligations when they come due.
• Credit risk is the risk that borrowers will default on their loans.
• Interest rate risk is the risk that changes in interest rates will adversely affect a bank's earnings or capital.
• Banks are subject to regulation and supervision to ensure the safety and soundness of the banking system.
• Deposit insurance protects depositors from losses in the event of a bank failure.
• Capital requirements require banks to hold a certain amount of capital relative to their assets, providing a buffer against losses.

Financial Markets

• Financial markets are markets where financial assets, such as stocks, bonds, and derivatives, are traded.
• Financial markets play a crucial role in allocating capital, facilitating risk transfer, and providing information about asset prices.
• Stock markets allow companies to raise capital by issuing shares of ownership to investors.
• Bond markets allow governments and corporations to borrow money by issuing debt securities.
• Derivative markets allow investors to manage risk or speculate on future price movements.
• The efficient market hypothesis (EMH) states that asset prices fully reflect all available information.
• There are different forms of the EMH, including the weak form, the semi-strong form, and the strong form.
• Behavioral finance challenges the EMH by arguing that psychological factors can influence investor behavior and lead to market inefficiencies.

International Finance

• International finance involves the study of financial transactions and investments that cross national borders.
• Exchange rates determine the relative value of different currencies.
• A fixed exchange rate system is one in which exchange rates are fixed by government policy.
• A floating exchange rate system is one in which exchange rates are determined by market forces.
• The balance of payments (BOP) is a record of a country's transactions with the rest of the world.
• The current account measures the flow of goods, services, and income between a country and the rest of the world.
• The capital account measures the flow of financial assets between a country and the rest of the world.
• International capital flows can have significant effects on exchange rates, interest rates, and economic activity.

Financial Crises

• Financial crises are disruptions to the financial system that can have severe consequences for the economy.
• Financial crises can be caused by a variety of factors, including excessive leverage, asset bubbles, and regulatory failures.
• The global financial crisis of 2008 was triggered by the collapse of the U.S. housing market and the subsequent failure of several large financial institutions.
• Financial crises often lead to sharp declines in economic activity, increases in unemployment, and government bailouts of financial institutions.
• Regulatory reforms have been implemented to reduce the risk of future financial crises.
• Macroprudential regulation focuses on the stability of the financial system as a whole, rather than individual institutions.