AP Macroeconomics Unit 4
Unit 4 Lesson 1 • Money • hw: read ch 16
I. Money • 3 Functions of Money: • Medium of exchange: use it to buy stuff • Unit of measure: use it to measure worth • Store of value: use it to hold value
I. Money • Money in Early Societies: • Barter requires double coincidence of wants. • Compressed tea leaves & gold schillings are commodity money. • Fiat money is made valuable by gov’t decree.
I. Money • Characteristics of: • Portable • Durable • Divisible • Limited Supply (to retain value) Some islanders in Micronesia used these carved stones called “Vai” as currency .
I. Money • A monetary standard is a system that makes sure currency has the characteristics of money. • The Constitution gave the federal gov’t the power to coin money, not the states. • But, private banks could issue paper money (bank notes). • This resulted in counterfeiting problems. Remember 4 Char. Of $: -Portable -Durable -Divisible -Limited Supply
I. Money • The Inconvertible Fiat Money Standard • Since 1934. • Money supply is managed by gov’t. • Tangible component: coins/bills • Intangible component: checks/bank accounts.
I. Money • Measures of the Money Supply: • M1: Currency + Checkable Deposits • Checkable deposits make up +/- 70% of M1 • M2: M1 + Savings Deposits + Small Time Deposits + Money Market Mutual Funds + Money Mkt Deposit Accounts • M3: M1 + M2 + large time deposits (>$100k)
I. Money • The velocity of money (V) is the number of times in a year that a typical dollar bill is used to pay for a new good/service. • V = (PY)/M, Note** V=GDP/M • so, MV = PY • This quantity equation relates the quantity of money (M) to the value of output (PY). • Usually, velocity is relatively stable.
I. Money • MV = money spent • PQ = money received by sellers
I. Money • The Federal Reserve System • Nation’s central bank. • Lends $ to private banks. • Is set up like a corporation, but banks are stockholders. • Privately owned, but publicly controlled. • The president appoints board of governors.
I. Money • FDIC • Federal Deposit Insurance Corporation • Insures customer deposits in event of bank failure. • Coverage has historically been $100,000 per account type, per owner.
I. Money • Other Financial Institutions • Savings & Loan Association – invests majority of its funds in home mortgages. • Credit Union – nonprofit cooperative, owned by & operated for the benefit of its members.
II. Financial Assets & Balance Sheets/ T-Accounts • Assets are claims on a borrower. • Liabilities are obligations/ things borrowed • One entity’s asset is another entity’s liability. • Balance sheets, or T-Accounts must balance.
II. Financial Assets & Balance Sheets/ T-Accounts • Banks assets include • accounts at the Federal Reserve District Bank • Treasury securities owned by the bank • loans to customers • Liabilities are deposits • Net Worth=assets minus liabilities
II. Financial Assets & Balance Sheets/ T-Accounts • Let’s start a bank. • We will sell $250k in stock. • How should this be entered in our T-Account?
II. Financial Assets & Balance Sheets/ T-Accounts • Now, we need a building. • We decide to build a $220k building and buy $20k in equipment. • What does our balance sheet look like now?
II. Financial Assets & Balance Sheets/ T-Accounts • For simplicity’s sake, ignore our last balance sheet. We’ll go back to having $250k cash assets & $250k stock liability. • Let’s start taking deposits. • We take in $100k in deposits. • Implications for M1? • What should we do with this money?
II. Financial Assets & Balance Sheets/ T-Accounts • Reserves = money in the vault + money deposited at the Fed • Required reserves = dollar amount banks must have in vault cash & Fed account. • Reserve ratio = % of deposits banks are required to hold in reserve. • Excess reserves = actual reserves - required reserves
II. Financial Assets & Balance Sheets/ T-Accounts • Clearing a check. • One of our customers writes a check for $50,000 to someone.
II. Financial Assets & Balance Sheets/ T-Accounts • Let’s make some loans. • This is a Fractional Reserve Banking System b/c reserves < deposits. • The Fed currently mandates a reserve ratio of 10%, so we can loan out… • ...90% of our reserves. • We decide to loan someone $50k.
II. Financial Assets & Balance Sheets/ T-Accounts • How could a bank find itself holding less in reserves than the reserve ratio specifies? • How does the bank correct for this? • The bank borrows money from either the Fed or other banks.
II. Financial Assets & Balance Sheets/ T-Accounts • What does the T-Account look like if the loan recipient pays the $50k to a contractor who deposits the $ into our bank? • The bank has just created $50k of new money. • What is the most we could loan out?
II. Financial Assets & Balance Sheets/ T-Accounts • What does the T-Account look like if the loan proceeds go to another bank? • What if the recipient come in the next day and pays off the loan in full?
Hw: • ch 16 pa 2,4,5
III. Saving & Capital Formation • Saving money makes economic growth possible. • One person’s savings is another person’s loan. • Savings make investments possible.
III. Saving & Capital Formation • PPF: consumer goods, capital goods
IV. Financial Assets & the Financial System • Financial assets (savings accounts, bonds…) are claims on a borrower. • Intermediaries bring savers and borrowers together. • The interest a bank pays on its savings accounts is always lower than the interest it earns from loans. • The difference is called the SPREAD.
IV. Financial Assets & the Financial System • A bank pays 5% interest on its savings account. • The bank takes some of the money deposited in savings accounts, & loans that money out in the form of mortgages, car loans, consolidation loans, etc. • On average, the bank charges 10% on its loans. • What’s the spread? Why does the bank do this?
IV. Financial Assets & the Financial System • The Money Multiplier: • The Fractional Reserve System allows banks to “create” money, but how much is created? • Remember the multiplier effect on AD: 1/(1-MPC) or 1/MPS • The money multiplier = 1/reserve requirement
IV. Financial Assets & the Financial System • The money multiplier = 1/reserve requirement • This gives you the maximum size the money supply could reach as a result of the deposit. • Note the difference between size of money supply and the amount of new money created.
IV. Financial Assets & the Financial System • Leakages prevent the money supply from reaching levels indicated by multiplier: • Currency Drain-$ that leaves the banking system • Excess Reserves-Banks don’t always loan out all available reserves
IV. Financial Assets & the Financial System • The money multiplier can also be used to determine amount of new loans or additional $. • Instead of multiplying initial deposit by multiplier, multiply excess reserves by multiplier.
V. Money, the Interest Rate & Loanable Funds • Money Demand • The value of money is determined by the forces of supply and demand. • The Quantity Theory of Money states that, quote, “Mo’ money equals... • mo’ inflation… • in the long-run.” Value of Money Quantity of Money
V. Money, the Interest Rate & Loanable Funds • Money Market • The (nominal) interest rate adjusts to balance the supply of and demand for money. Interest Rate (i) Quantity of Money
V. Money, the Interest Rate & Loanable Funds • Loanable Funds Market • The real interest rate adjusts to bring the S & D of loanable funds to equilibrium. Real Interest Rate (r) Q of Loanable Funds
V. Money, the Interest Rate & Loanable Funds • Lower i and/or r chiefly spurs I, which increases AD.
VI. Nonbank Financial Intermediaries • Life insurance companies invest the premiums they charge. • Finance companies: • -make (usually high interest) loans to customers • -offer loans through businesses (boat, furniture, & jewelry stores)
VI. Nonbank Financial Intermediaries • Mutual funds are corporations that buy stock in other corporations. • Employers put $ in pension funds that invest in stocks & provide retirement income. • Real estate investment trusts borrow $ from banks & lend to construction companies.
VII. Basic Investment Considerations • Low-risk investments pay low returns. • Consistent investing can yield large returns because of compound interest. • Investors should avoid complex investments they don’t understand. • The Time Value of Money • value of money with a given interest rate over a given time • FV = PV + (r * PV) • PV = FV / (1 + r) • Remember: r = i - π
VII. Basic Investment Considerations • r = i - π • What happens to r if: • i increases & π decreases? • i decreases & π increases? • i increases & π increases? • i decreases & π decreases? • The Fisher Effect • In the long-run, an increase in Sm will result in an increase in π and i, but r is unaffected.
VII. Basic Investment Considerations The Relationship Between Risk & Return Stocks Bonds Stock Based Mutual Funds Bond Based Mutual Funds Risk CD’s Savings Accounts Return
VIII. Insurance • You pay a premium to receive coverage. • Types: • Life: upon your death, beneficiary receives a check • Health: pays some or all of your medical expenses • Property: compensates you for loss of property through fire, theft, etc. as specified • Car: Liability covers damage you cause to someone else. Full also covers damage to you/your car. • Unemployment, Disability, Vacation, Dental
IX. Looking At a Budget • Variable expenses can change (food, entertainment). • Fixed expenses-same every mo. (water bill). • Subtract expenses & deductions from income, to determine what’s left over.
X. Simple vs Compound Interest • Simple interest is a flat percentage. • If you’re paying 10%simple interest on a $1,000 loan, you’ll pay $100 in interest. • If you’re paying 10% compound interest, you pay more.
XI. Loans • Longer time = higher interest rate • The minimum most banks will loan is $3-$5k.
XI. Loans - Continued • Lowest Highest • Credit Union-Bank-Finance Co.- Credit Card- Payday Advance Interest Rates Charged