What Do Banks Do?

• a bank is a financial intermediary

• uses liquid assets (i.e. Bank deposits) to finance the investments of borrowers

• process is known as Fractional reserve banking

• a system in which depository institutions hold liquid assets less than the amount of deposits 
• Can take the form of:

1. Currency in bank vaults 
2. Bank reserves- deposits held at the federal reserve 

• T-Account (balance sheet)

• statements of assets and liabilities

• assets ( amount owned)

• items to which a bank holds legal claim
• The use of funds by financial intermediaries 

• liabilities( amounts owed)

• the legal claims against a bank
• The sources of fund for financial intermediaries 

Federal reserve bank

• 12 district federal reserve banks
• Each are quasi-owned

• Functions of the fed

• issues paper currency 
• Sets reserve requirements and holds reserves of the bank 
• Lends money to the banks and charged them interest 
• They are a check clearing service for banks 
• Act as a personal bank for the government 
• Supervise member banks
• Control money supply in the economy 

Tools of Monetary Policy

3 tools of monetary policy

• the reserve requirement

• only small amount of deposit is in the safe. Rest is loaned out "fractional reserve banking"
• F'ed sets the amount banks must hold
• The rr (reserve ratio)is the %  of deposits that banks must hold in reserve and not loan out
• When f'ed increases ms it increases amount of money held in bank deposits 

1. If in recession what should fed do to reserve requirement 

Decrease reserve ratio

• banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall, AD goes up 

1. If in inflation what should fed to to reserve requirement

Increase reserve ratui

• banks hold more money and have less excess reserves
• Banks create less money 
• Money supply decreases, interest rates up, AD goes down

The discount rate

• the interest rate that the fed charges commercial banks

To increase the ms, the fed should decrease the discount rate( easy money policy)

To decrease the ms, the fed should increase the discount rate (contractionary policy)

Open market operations 

• the fed buys/ sells gov't bonds (securities) 
• Most important and widely used 

To increase the ms. The fed should buy gov't securities

To decrease the ms, the fed should sell gov't securities 

Federal funds rate is where FDIC meme we banks loan each other overnight funds 

Prime rate the interest rate banks charge their most credit worthy customers 

Money

I. What are the three uses of money?

1. A medium of exchange (to barter/ trade)
2. Unit of account (establishes economic worth in the exchange process)
3. Storage value (money holds its value over a period of time)

II. What are the three types of money? 

1. Commodity money (gets its value from the type of material from which it is made)
2. Representative money (paper money backed by something tangible that gives it value) 
3. Fiat money (type of money used in US. It is money because the government says so)

III. Characteristics of money

1. Portable 
2. Durable
3. Divisible 
4. Limited supply 
5. Acceptable 
6. Uniform

IV. Money supply 

• M1 money: consists of currency in circulation, checkable/ demand deposits (checking account), and travelers' checks. ( accounts for about 75%) held as a medium of exchange. "Most liquid" 
• M2 money: consists of M1 money, savings accounts, money market accounts, and deposits held by banks outside of the US
• M3 money: consists of M2, certificates of deposits

Time Value of Money

• is a dollar today worth more than a dollar tomorrow 

• yes

• why?

• Opportunity cost and inflation
• This is the reason for charging and paying interest 

• let v= future value of the dollar 
• P= present value of the dollar 
• r= real interest rate (nominal rate- inflation rate) expressed as a decimal 
• N= years 
• K= number of times interest is credited per year 

• simple interest formula 

• v=(1+r)^n*p

• the compound interest formula 

• V= (1+ r/k)^nk*p

Assume that inflation is to be 3% and the nominal interest rate on simple interest savings is 1%. Calculate the future value of the dollar after 1 yr.

• step one: calculate real interest rate

• -2%

•step two: Use the simple interest formula to calculate the future value

• $.98 

  

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

1. What happens to the quantity of money demanded when. Interest rates increase 

• quantify demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities 

1. What happens when interest rate decreases?

• Increases . There is no incentive to convert cash into interest earning assets

Financial institutions 

Financial assets v. Financial liabilities

Assets: stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain obligations 

Liabilities: liabilities incurred by the issuer of a financial asset to stand behind the issued asset 

Interest rate: the price paid for the use of a financial asset

Stocks v bonds

Stocks:financial asset that conveys ownership in a corporation 

Bonds: a promise to pay a certain amount of money plus interest in the future 

Relating the Money Market, Loanable Funds, and AD-AS

Summary:

Increase in government spending results in an increase in interest rates in the money market and loanable funds. This results in an increase in Aggregate Demand. Increasing Aggregate Demand increases price level and GDP. The Fisher Effect has a 1:1 ratio so that if the interest rate increases the price level must increase the same amount

Money Creation and Multiple Deposit Expansion

Summary:

Banks create money buy lending money. The initial loan multiplied by 1/ RR will give you the maximum amount of loans the bank can make. If any banks hold excess reserves it reduces the total amount of loans possible. The process of money being redeposited multiple times is Multiple Deposit Expansion.

Loanable Funds Market

Summary:

The supply of loanable funds depends on how much people have in banks. The more incentive people have to save, the more loanable funds there are. Increasing the demand for money in the money market increases the demand for loanable funds. An increase in the demand for loanable funds also increases the interest rate.

The FED- Tools of Monetary Policy

Summary:

The Reserve Requirement (RR) is the percentage of money from deposits that the bank must keep either as vault money or on reserve with a Fed branch. Altering the RR changes the money supply; the absence or lowering of the RR had a great impact on the cause of the Great Depression. Lowering the discount rate, or the interest rate the Fed charges commercial banks they have loaned money to, should increase the Fed’s loan activities. “Buy Bonds= Big Bucks”, if the Fed buys bonds, it means more money for the people which will ultimately raise the money supply.

Money Market

Summary:

Demand for money is downward sloping because as price level is higher, the quantity demanded is going to be lower. Increasing demand puts upward pressure on interest rate. Supply of money is not related to interest rate and is always constant; without a slope. Shifting the supply of money to the right, then they stabilize interest rate which is helpful in a recession.

Types and Functions of Money

Summary:

The most primitive type of money is commodity money. This is considered items used in place of money. Representative money is the type we use today and fiat money is like I.O.U. Money also has three functions. Money is a medium of exchange, a way for us to get things that we want. Money is also a unit of account in that we equate higher price to higher value or quality.