Money and Banking: A Macroeconomics Overview PDF

# Money and Banking: A Macroeconomics Overview ## Barter vs. Money * **Barter:** Exchange of goods and services for other goods and services. * Requires a "double coincidence of wants," meaning both parties must want what the other has. * Difficult and inefficient. * **Money:** A...

# Money and Banking: A Macroeconomics Overview ## Barter vs. Money * **Barter:** Exchange of goods and services for other goods and services. * Requires a "double coincidence of wants," meaning both parties must want what the other has. * Difficult and inefficient. * **Money:** Anything generally accepted as a medium of exchange in a market. * **Liquidity:** How easily an asset can be converted into cash. * **Less Liquid:** House, Car * **More Liquid:** Dollar, Cash ## Properties of Money * **Liquidity:** Easily converted into cash. * **Medium of Exchange:** Used to purchase goods and services. * **Unit of Account:** A standard unit for measuring value (a yardstick) * **Store of Value:** Preserves value over time. ## Types of Money * **Commodity Money:** Has intrinsic value based on the value of the underlying commodity. * Examples: Gold, Cigarettes * **Digital Money:** Represents a claim to a digital asset. * Example: Bitcoin. * "Mining" validates transactions and secures the network. * **Fiat Money:** Has no intrinsic value and is backed by government decree. * Examples: The US Dollar, The Euro. ## Money Stock and Money Supply * **Money Stock:** The total amount of money in circulation. * **M1:** Most liquid form of money (demand deposits, traveler's checks). * **M2:** Less liquid form (savings deposits, small time deposits). * **Currency:** Coins and paper bills. * **Central Bank:** Manages the country's money supply and banking system. * **The Federal Reserve (Fed):** The central bank of the United States, established in 1913 to prevent financial panics like the one in 1907 and ensure the health of the nation's banking system. ## The Federal Reserve (Fed) * **Board of Governors:** * 7 members * 14-year terms * Current chairman: Jerome Powell * Testifies about Fed policy. * **12 Regional Banks:** * Located throughout the US. * **The Fed's Jobs:** * **Regulate Banks:** Ensure the safety and soundness of the banking system. * **Monitor Financial Condition:** Assess the health of individual banks. * **Dual Mandate:** * Full Employment: Maintain a low unemployment rate. * Price Stability: Control inflation. * **Inflation Target:** 2% annually * **Key Tool: Money Supply:** The Fed controls the amount of money in circulation. * **Federal Open Market Committee (FOMC):** Sets monetary policy. * Includes 7 members of the Board of Governors and 5 of the 12 bank presidents. * Only 5 vote at each meeting. * The New York Federal Reserve President always votes. * **Open Market Operations:** The Fed buys or sells US government bonds (T-Bills) to increase or decrease the money supply, respectively. * **Purchase:** Increases the money supply. * **Sale:** Decreases the money supply. * **T-Bills:** Are short-term debt instruments backed by the Treasury. * **Money:** Consists of currency and demand deposits. ## The Banking System * **Behavior of Banks:** Banks influence the amount of money in circulation (demand deposits) by lending a portion of their deposits to borrowers. * **Reserve Requirement:** Banks are required to hold a minimum percentage of their deposits in reserve. * *Loaned Out Deposits:* The portion of deposits that banks have received but haven't lent. * *100% Reserve Banking:* All deposits would be held in reserve and no money could be loaned out. * **Banks Do Not Influence Money Supply:** Banks simply act as intermediaries to create money by extending loans, but they do not actually create money. * **Influence on Spending and Prices:** * **Increase in Money Supply:** Increases spending, raises prices, and lowers unemployment. * **Decrease in Money Supply:** Decreases spending, lowers prices, and raises unemployment. * **Fractional Reserve Banking:** Banks are required to hold a minimum amount of deposits. * *Need to Meet Every Night:* This requires additional reserves on top of the minimum reserve amount, which may change every day. * **Excess Reserve:** Excess funds held by banks above the legal minimum. * **Banks Create Money in a Fractional Reserve System:** When banks extend loans (assets), they add this loan amount to their money supply. * **Money Multiplier:** The amount of money created for each dollar of reserves held by banks. The higher the amount of reserves, the smaller the money multiplier. * **Reserve Requirement:** Was set to 0% during the pandemic to encourage banks to increase economic activity. * **Bank Capital:** Reserves retained by banks to increase profits and minimize losses. Banks need capital to operate. * **Leverage:** Borrowed funds can be used to supplement existing resources. * **Amplifies Gains and Losses:** Increases both the potential for profits and the risk of losses. * **Leverage Ratio:** The ratio of a bank's total assets to its capital. * **Capital Requirement:** The minimum amount of capital that banks are required to hold. * **Ratio > Leverage:** Increases the possibility of a gain. * **Ratio < Leverage:** Increases the possibility of losses and potential bankruptcy. * **The 2008 Financial Crisis:** Banks experienced losses on their assets, which lowered their capital, stopped them from extending credit, and contributed to a recession. * **Government Intervention:** The US Treasury and Fed pumped money into the banking system to increase bank capital and encourage lending. * **Open Market Operations:** The Fed buys or sells bonds to influence the money supply. * **Reserve Requirements:** The Fed adjusts the minimum amount of reserves banks are required to hold. * **Interest Rate Controls:** The Fed also influences the money supply by setting interest rates on reserves. * **Open Mark Operations:** The Fed's primary tool to control the money supply. * **Purchase of Bonds:** Increases the money supply. * **Sale of Bonds:** Decreases the money supply. ## Interest Rates * **Federal Funds Rate:** The interest rate at which banks lend reserves to each other overnight. * **Lender:** Has excess reserves. * **Borrower:** Needs reserves. * **The Fed Targets the Federal Funds Rate:** The Fed uses open-market operations to influence the federal funds rate, and it has a significant impact on other interest rates in the economy. * **Bank Runs:** Depositors withdraw their money from a bank, fearing its solvency. * The Silicon Valley Bank collapse in 2023 was an example of a bank run. * **Deposit Insurance:** The government guarantees the safety of deposits in banks to prevent future bank runs. ## Hyperinflation * A rapid and out-of-control rise in prices. * Examples: Venezuela, Zimbabwe, and Ecuador ## Classical Theory of Money * **Money Demand:** Depends on: * *How Much Wealth People Want to Hold Liquid:* Higher prices make people want to hold less money. * **Value:** The value of money is inversely related to the price level. * **Quantity Theory of Money:** Changes in the money supply have a proportional effect on the price level. * *Growth Rate of Money Supply:* Determines inflation rate. * **Velocity of Money:** The number of times a unit of money is spent per year. Assumed to be stable over time. * **Classical Equation of Exchange:** MV = PY * *M:* Money supply * *Y:* Real GDP * *P:* Price level * *V:* Velocity * The formula states that the total amount of money spent (the product of the money supply and the velocity) equals the total value of goods and services purchased (the product of the price level and real output). * **Adjusting to Price Level Changes:** * **Short-Run:** Prices and wages adjust more slowly. * **Long-Run:** Prices and wages adjust more quickly. ## Hyperinflation * The inflation rate reaches 50% or higher per month. * Increases when the money supply grows rapidly compared to real GDP. * *The Fed Printing Too Much Money:* Can lead to high inflation in the short run. * Can be triggered by: * **A rapid increase in the money supply.** * **A decline in the value of the currency.** * **A loss of confidence in the central bank.** ## Key Takeaways * Money plays a vital role in a modern economy, serving as a medium of exchange, a unit of account, and a store of value. * The Fed controls the money supply through open market operations and by setting interest rates. * Inflation is a major economic problem that can be caused by a rapid increase in the money supply. * The central bank plays a critical role in managing the economy, and its policies can have a significant impact on inflation, unemployment, and economic growth.