Functions of Money by BrittanyGibbons

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									Unit 9

Functions of Money
1. Functions of Money
Money, which exists and has existed in many different forms (e.g. salt, tobacco leaves, and gold in the olden days, and coins, paper bills, and electronic signals in today’s world), serves three main functions: A Medium of Exchange – Instead of exchanging potatoes or leather shoes directly (barter), one can exchange the potatoes for money (i.e. coins) and use the coins to buy leather shoes. It saves the potato supplier to have to look for someone who not only wants to buy potatoes, but also wants to sell leather shoes. Money, in this sense, encourages and speeds up trade. A Standard of Value – How many potatoes are worth one pair of leather shoes? Without money it is difficult to reach an agreement every time you enter into a trade like that. Money allows us to put values on the goods, and services we sell. For example, if a pound of potatoes sells for $1.and a pair of leather shoes costs $8.-, then 8 pounds of potatoes would be worth one pair of leather shoes. A Store of Value – By exchanging goods and services for money, you can accumulate money and increase your wealth. Without money, a surplus of potatoes each month would go a long way towards smelling up your house, but it wouldn’t allow you to store any of the surplus production.


Money Supply Measures
Our monetary authorities (The Federal Reserve System) use a number of different measures to quantify the amount of money which exists in our economy. The narrowest definition, M-1, contains the most liquid forms of money: M-1 = All coins and currency in circulation with the public + money in checking or transactions accounts (demand deposits, NOW accounts, etc.) + traveler’s checks. Characteristic of these forms of money is that you can easily use these to directly purchase goods and services. Another definition of the money supply frequently used by government agencies is M-2. M-2 = Includes everything in M-1 plus the following: Savings deposits (amounts less than $100,000) + money market mutual funds + money market deposit accounts + other short-term money market investments. Recently,

Unit 9 – Functions of Money


government policy makers have shifted their focus on watching M-2 more than M-1. The deregulation of the banking industry has made the components in M-2 more liquid and more people use funds within M-2 to purchase goods and services. The Fed also defines M-3 and L; which include forms of money which are progressively less liquid (not easily exchanged for cash).


The Federal Reserve System
The Federal Reserve Board, a group of seven monetary experts is the monetary power in our country. These Board governors (no relation to state governors) have a great amount of economic power in this country. Each governor is appointed by the President of the United States with approval from Congress. One new member gets appointed at least every two years to serve a fourteen-year term. The Federal Reserve Board governors, once appointed, act completely independently from Congress and the White House. Any decision they make does not have to be approved by politicians. The seven Fed governors are assisted by a committee called the Federal Open Market Committee (FOMC). The FOMC consists of the seven board governors as well as five of the twelve central bank presidents. An advisory body is the Federal Advisory Council. The council includes government economists and bankers.


Federal Reserve System Organization
At the head of our banking system are 12 central banks (and 25 of their branches) whose policies are determined by the Fed. In each of the 12 financial districts commercial banks serve customers like you and moi. These banks in turn have their own accounts with a Federal Reserve Bank or branch bank in their district. The central bank holds the member banks’ required reserves, loans money to the commercial banks, supervises them, and clears their checks.


Federal Reserve Tools To Change the Money Supply
How does the Fed accomplish this change in the money supply? Of the three methods the Fed applies to change reserves in the economy, open market operations is the most important and most frequently used. The term refers to the Fed’s activity of buying and selling government securities (bonds). Bonds are pieces of paper (certificates) which are proof that you have lent money to someone. Government bonds are first issued by Congress and the White House to help finance expenses on defense, roads, social security, etc. The Fed does not issue these bonds, but only trades them to fine tune the money supply. To put more money into circulation, the Fed buys bonds from people, businesses or banks who hold them. These groups would receive cash in exchange for the bond, which puts funds in circulation and increases the money supply. The reverse occurs when the Fed sells bonds. This takes funds out of circulation and decreases the money supply. When the Fed increases the reserve requirement (the amount a bank is required to keep on hand as a percentage of its deposits) it forces banks to make fewer loans. This causes a drop in the money supply (and vice versa). The discount rate is the interest rate which a bank must pay the Fed when the bank borrows money from the Fed. The more money a bank borrows, the more it can loan out and the more it increases the money supply. If the Fed decreases the discount rate more banks will want to


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borrow money, thus increasing the money supply. The reverse is true when the Fed decides to increase the discount rate.


Balance Sheets
A bank’s balance sheet includes entries for assets, liabilities and net worth. Assets are investments and properties which the bank owns and liabilities are funds which the bank owes. For our purposes, it is sufficient to consider a balance sheet, or T-account, which includes only these assets: total reserves (divided into required and excess reserves) and loans. On the liability side we will only look at demand and other checkable deposits (funds deposited by the bank’s clients into their transaction accounts). The following balance sheet shows a bank with $4000 of deposits, $1000 in total reserves and $3000 in loans. Assets
Total Reserves Loans $1000 $3000 Demand Deposits



Fractional Reserve Banking
In the example above, the bank received $4000 from one or more customers and loaned $3000 of it out. The other $1000 the bank keeps on hand in case the customer(s) want(s) a portion of his/her money back within a short period of time. By law, a bank is required to keep at least a fraction of customers’ deposits on hand in the form of cash (total reserves). This concept is called “fractional reserve banking.” You might wonder what would happen if this bank’s customers decided to not just withdraw a portion of their deposits the next day, but all of it! This would indeed cause the bank to be in big trouble. After all, it has loaned out $3000 of the deposited money. Such a “run” on the bank would force the bank to go bankrupt, unless it receives help. Our system of fractional reserve banking is built on the assumption that on any given day at most ten or fifteen percent of all deposits is withdrawn by customers. Experience does back this up, except in cases where the customers lose trust in the bank and withdraw all their deposited money at once.


Required and Excess Reserves
A bank’s total reserves (cash) can be broken down into two kinds: A. required reserves, and, B. excess reserves. Required reserves are the funds which the bank legally must (is required) to keep. Excess reserves is cash which it has as extra and could choose to loan out. In the above example, the bank has $1000 in total reserves. Let’s say that the government (the federal reserve) requires banks to keep 20% of their deposited money. Demand deposits were $4000, so the bank is required to keep 20% of that, or $800. How much does it have in excess reserves in this case?

Unit 9 – Functions of Money


Answer: $200. ($1000 - $800). In other words the bank still has maximally $200 which it can loan out.


Describe the significance of the Federal Deposit Insurance Corporation (F.D.I.C.)
The F.D.I.C.’s main function is to discourage people from withdrawing all their money when they suspect that their bank is in trouble. As you know, a run on the bank is fatal for the bank as it does not have all the money which has been deposited. Minor problems could then turn into a disaster for the bank. In some instances, banks never did have problems, but were perceived to not do well. This perception could then turn real if peoples’ reaction is to storm the bank. The F.D.I.C.’s strength is to guarantee to people that their money will always be there, so that a run can be prevented. Recently it has been the F.D.I.C. itself which has been in trouble. To maintain stability in the banking system and to avoid another banking crisis, the federal government has decided to support the agency by supplying it (and other overseeing agencies) with funds to bail out insolvent banks.


Money Creation
An initial deposit of $1000 enables a bank to loan out $800 (assuming a required reserve ratio of 20%). This $800 will be spent and deposited into bank B, which in turn can loan out 80%, or $640. Analogously, bank C can loan out 80% of $640, or $512, etc., etc. The initial $1000.- has created demand deposits of an additional $800 plus $640 plus $512, etc. The total increase in the money supply amounts to $5000.- in the above example. Mathematically, the increase in the money supply can be calculated as follows: Change in M = deposit multiplier x the initial deposit, where the deposit multiplier equals: dm = 1/required reserve ratio. In the above example: $5000 = 5 x $1000. The above process can be illustrated through the following T-charts: Bank A receives a (new) deposit of $1000:

BANK A Assets
Total Reserves Loans $1000 $0 Demand Deposits


Note that of this $1000 in total reserves, the bank is required to keep 20% or $200 and it can loan out the other 80% or $800. Let’s say the bank decides to do so the next day. It shows the following balance sheet:


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BANK A Assets
Total Reserves Loans $200 $800 Demand Deposits


The $800 loan is taken out by business Z, which spends the money on, say tickets to Orioles games. The Orioles franchise is happy to receive the money and deposits the revenue in its account with bank B: BANK B Assets
Total Reserves Loans $800 $0 Demand Deposits


And bank B’s next day balance sheet will be as follows: BANK B Assets
Total Reserves Loans $160 $640 Demand Deposits


The $640 in loan money is accepted by business XYZ, which spends it on a trip to California through airline KLM. Airline KLM then deposits the $640 in its account with bank C, etc. As you can see, the total accumulation of money in the form of demand deposits (checking accounts), an important component of M-1, equals $1000 + $800 + $640 + $512 + … = $5000. The multiplier in the above example, 1/required reserves, equals 1/.20, or 5. This number, as we concluded above, leads to an expansion of the nation’s money supply of five times the change in the initial change in reserves. The factor 5 assumes that banks’ reserve requirements are 20%. In reality, banks’ required reserves are not this high. For many banks the percentage equals 10 for most transaction accounts, but does vary depending on the nature of the account and the size of the bank. Some required reserves ratios are as low as 3%. The lower (20%) reserve requirement means that the multiplier is larger. However, banks do not always loan out all that they can. This in turn lowers the value of the multiplier. Additionally, the public does not always deposit all the money it receives (it holds currency) and this lowers the real world multiplier further.


The Velocity of Circulation of Money
Velocity, V, represents the average number of times a unit of the money supply is spent during a certain period. For example, the money supply at this time is approximately $1350 billion. The Gross Domestic Product, the most common measure of spending in our economy, will be approximately $7200 billion this year. Therefore, the average number of times a dollar is spent on goods and services included in GDP is about 5.40.

Unit 9 – Functions of Money


Velocity is determined by various factors, among others: 1. The stability of the value of money. If the value of money decreases (inflation) then people will be more likely to spend it more quickly and raise the velocity. The spending is mostly on consumer goods as opposed to capital goods though, because as inflation accelerates businesses know that any future earnings will have less value and they will be more reluctant to invest. Therefore, a greater velocity as a result of higher inflation is not desirable. Transportation and technology advances. As it becomes easier to transfer and transport money, the money is more quickly available to re-spending and therefore the velocity increases. This increase in velocity is desirable, because it is accompanied by a process which increases the physical ability of businesses to produce. The ability for people to save. When people have a greater ability to save (through banks and other financial institutions), and not hoard their money, the money becomes available to businesses and consumers (who borrow the money) for re-spending. In this case again, especially as the savings are used by businesses for production purposes, the higher velocity leads to greater economic activity.




The Quantity Theory of Money
Velocity was defined as: V = GDP/Money Supply Measure or: V = GDP/M. Using cross multiplication, this equation can be rewritten as: V x M = GDP GDP is the quantity (supply) of goods times their prices, so: GDP = P x Sc. Substituting this into the equation we get: V x M = P x Sc. This equation is also called the equation of exchange, because the left side represents the volume of money which is used (exchanged) to pay for the right side, the volume of goods. The quantity theory of money states that without any increase in Sc, and no or only small fluctuations in V (a realistic assumption), any increase in the money supply will translate into an equal increase in the price level. This is the same conclusion we reached in the chapter on inflation, i.e. that the only lasting cause of an increase in the general price level is an increase in the money supply.


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