Final ExamFinal Exam

Exam Date: May 6, 2006Exam Date: May 6, 2006 Exam Time: 2:00-4:00pmExam Time: 2:00-4:00pm Room: Terrill Hall 121Room: Terrill Hall 121

Request to Reschedule Final ExamRequest to Reschedule Final Exam

Taking both 1100 and 1110Taking both 1100 and 1110 3 or more finals scheduled for that day3 or more finals scheduled for that day Religious reasonsReligious reasons Other? (appropriate documentation)Other? (appropriate documentation) All requests must be submitted to Kari All requests must be submitted to Kari

Battaglia, by Monday, May 1Battaglia, by Monday, May 1stst

NATURE OF MONEYNATURE OF MONEY

widely acceptable in exchange for goods widely acceptable in exchange for goods and servicesand services

acceptable as payment for debtsacceptable as payment for debts

MONEY vs. BARTERMONEY vs. BARTER

Money is more efficient than barter because Money is more efficient than barter because itit– decreases transaction timedecreases transaction time– increases the number of transactionsincreases the number of transactions

Exchange is easier and less time-consuming in Exchange is easier and less time-consuming in a money economya money economy

PHYSICAL PHYSICAL CHARACTERISTICSCHARACTERISTICS

OF MONEYOF MONEY portableportable divisibledivisible RecognizableRecognizable

Money is any good that is widely accepted for Money is any good that is widely accepted for purposes of exchangepurposes of exchange

WHAT GIVES MONEY WHAT GIVES MONEY VALUE?VALUE?

no longer backed by goldno longer backed by gold ““fiat money” backed by the governmentfiat money” backed by the government value lies in peoples trust in the government value lies in peoples trust in the government

and their willingness to accept it for G & S.and their willingness to accept it for G & S.

Three Functions of MoneyThree Functions of Money

Medium of exchangeMedium of exchange money is the medium through which exchange money is the medium through which exchange

occursoccurs Unit of accountUnit of account a common measure in which values are a common measure in which values are

expressedexpressed Store of valueStore of value ability to maintain its value over timeability to maintain its value over time

Three Functions of Money Three Functions of Money (cont.)(cont.)

A pizza maker lists the price of pizza A pizza maker lists the price of pizza as $10as $10

A $50 traveler’s checkA $50 traveler’s check A $10 food stampA $10 food stamp A vacation home in the CaribbeanA vacation home in the Caribbean

M1M1NARROWLY DEFINED NARROWLY DEFINED

MONEYMONEY currencycurrency checkable depositscheckable deposits traveler’s checkstraveler’s checks

CURRENCYCURRENCY

coins and billscoins and bills currency in circulation and currency held currency in circulation and currency held

outside the bank are equivalentoutside the bank are equivalent

CHECKABLE DEPOSITSCHECKABLE DEPOSITS

all checkable deposits whether at a bank, all checkable deposits whether at a bank, savings and loan, or credit union.savings and loan, or credit union.

also called transactions accounts and also called transactions accounts and demand depositsdemand deposits

debit cards that draw directly from your debit cards that draw directly from your account are includedaccount are included

Exhibit 1 The Components of M1

SOURCE: Board of Governors of the Federal Reserve System.

MONEY SUPPLYMONEY SUPPLY

checkable deposits are the largest checkable deposits are the largest component of M1 (almost 70%)component of M1 (almost 70%)

the term Money Supply refers to M1 unless the term Money Supply refers to M1 unless otherwise notedotherwise noted

M2M2BROADLY DEFINED MONEYBROADLY DEFINED MONEY

M1M1 small time depositssmall time deposits savings depositssavings deposits money market deposit accounts (MMDA)money market deposit accounts (MMDA) money market mutual fund (MMMF)money market mutual fund (MMMF)

M3 and LM3 and L

M3 and L add less liquid assets such asM3 and L add less liquid assets such as– large time deposits (M3)large time deposits (M3)– bankers acceptances (L)bankers acceptances (L)

Money supply measures, Money supply measures, April 2002April 2002_Symbol_Symbol Assets includedAssets included Amount (billions)_Amount (billions)_

CC CurrencyCurrency $598.7$598.7

M1M1 C + demand deposits,C + demand deposits, 1174.01174.0 travelers’ checks, travelers’ checks, other checkable deposits other checkable deposits

M2M2 M1 + small time deposits,M1 + small time deposits, 5480.15480.1 savings deposits, savings deposits, money market mutual funds, money market mutual funds, money market deposit accounts money market deposit accounts

M3M3 M2 + large time deposits,M2 + large time deposits, 8054.48054.4 repurchase agreements, repurchase agreements, institutional money market institutional money market mutual fund balances mutual fund balances

CREDIT CARDSCREDIT CARDS

Credit cards are NOT moneyCredit cards are NOT money Credit cards are short term loans - you Credit cards are short term loans - you

borrow from the bank and then must repay borrow from the bank and then must repay that loan.that loan.

The existing money is shifted around but The existing money is shifted around but Ms does not changeMs does not change

100-PERCENT-RESERVE 100-PERCENT-RESERVE BANKINGBANKING

All deposits are held as reservesAll deposits are held as reserves Banks accept deposits, place the money in Banks accept deposits, place the money in

reserve, and leave the money there until the reserve, and leave the money there until the

depositor makes a withdrawaldepositor makes a withdrawal

FRACTIONAL RESERVE FRACTIONAL RESERVE BANKINGBANKING

Banks are not required to keep every dollar Banks are not required to keep every dollar that you deposit on reserve.that you deposit on reserve.

The Federal Reserve sets the required The Federal Reserve sets the required reserve ratio which determines the reserve ratio which determines the percentage of deposits that must be held.percentage of deposits that must be held.

BANK RESERVESBANK RESERVES

TOTAL RESERVES - cash in the vault and TOTAL RESERVES - cash in the vault and bank deposits at the Fed.bank deposits at the Fed.

REQUIRED RESERVES - total deposits X REQUIRED RESERVES - total deposits X required reserve ratio required reserve ratio

EXCESS RESERVES - total reserves - EXCESS RESERVES - total reserves - required reservesrequired reserves

ExamplesExamples

Calculate required reserves (RR) when total Calculate required reserves (RR) when total deposits are $80,000 and the required-reserve ratio deposits are $80,000 and the required-reserve ratio is is r r = 20%= 20%

What is the required-reserve ratio if banks are What is the required-reserve ratio if banks are required to hold $100 in reserves to support $500 required to hold $100 in reserves to support $500 in deposits?in deposits?

Calculate deposits if required reserves are $150 Calculate deposits if required reserves are $150 and the required-reserve ratio is and the required-reserve ratio is r r = 20%= 20%

ExamplesExamples

What are excess reserves if $40 of the $100 What are excess reserves if $40 of the $100 in total reserves held by banks are required in total reserves held by banks are required reserves?reserves?

How much do banks have in excess How much do banks have in excess reserves if total reserves are $400, deposits reserves if total reserves are $400, deposits are $2,000 and the required-reserve ratio is are $2,000 and the required-reserve ratio is 20%?20%?

BANK ACTIVITIESBANK ACTIVITIES

Banks accept deposits and offer checking Banks accept deposits and offer checking servicesservices

Banks keep a percentage of the deposits on Banks keep a percentage of the deposits on reservereserve

Excess reserves are available to be loaned Excess reserves are available to be loaned outout

Banks earn money from loansBanks earn money from loans

Exhibit 3 The Money Supply Expansion and Contraction Processes

T - AccountsT - Accounts

BANK TWOBANK TWO

AssetsAssets LiabilitiesLiabilities

Total ReservesTotal Reserves Demand DepositsDemand Deposits

LoansLoans

MONEY EXPANSIONMONEY EXPANSION

When banks make loans they create moneyWhen banks make loans they create money When the loans are spent, it finds its way When the loans are spent, it finds its way

into other banks.into other banks. These banks keep a portion of these These banks keep a portion of these

deposits on reserve and then loan the rest deposits on reserve and then loan the rest out.out.

BANK TWOBANK TWOr = .10r = .10

AssetsAssets LiabilitiesLiabilities

Reserves 100 Demand Deposits 1,000

Loans 900

BANK TWOBANK TWOr = .10r = .10

(fully loaned up)(fully loaned up)AssetsAssets LiabilitiesLiabilities

Reserves 100 Demand Deposits 1,000

Loans 900

RR 100

ER 0

BANK TWOBANK TWOr = .10r = .10

AssetsAssets LiabilitiesLiabilities

Reserves 200 Demand Deposits 1,000

Loans 800

RR 100

ER 100

(1)BANK

(2)NEW DEPOSITS(new reserves)

(3)NEW REQUIRED

RESERVES

(4)CHECKABLE DEPOSITS CREATED

BY EXTENDING NEW LOANS(equal to new excess reserves)

$1,000.00

900.00

810.00

729.00

656.10

$100.00

90.00

81.00

72.90

65.61

$900.00

810.00

729.00

656.10

590.49

A

B

C

D

E

.

.

.

.

.

.

.

.

.

.

.

.

TOTALS (rounded) $10,000 $1,000 $9,000

ExamplesExamples

By how much can the banking system By how much can the banking system expand deposits if total reserves are $600, expand deposits if total reserves are $600, deposits are $2,500 and the required-reserve deposits are $2,500 and the required-reserve ratio is 20%?ratio is 20%?

Money ExpansionMoney Expansion When banks make loans they increase the money When banks make loans they increase the money

supply (M1)supply (M1) The maximum change in checkable deposits is The maximum change in checkable deposits is

( 1/r x change in reserves )( 1/r x change in reserves ) simple deposit creation multiplier = 1/rsimple deposit creation multiplier = 1/r Reasons actual creation may be less than the Reasons actual creation may be less than the

maximummaximum– cash leakagescash leakages– nonzero excess reservesnonzero excess reserves

SIMPLE DEPOSIT SIMPLE DEPOSIT MULTIPLIERMULTIPLIER

If r = .10 then the simple deposit multiplier If r = .10 then the simple deposit multiplier is 10is 10

If r = .15 then the simple deposit multiplier If r = .15 then the simple deposit multiplier is 6.67is 6.67

If r = .20 then the simple deposit multiplier If r = .20 then the simple deposit multiplier is 5is 5

MONEY DESTRUCTIONMONEY DESTRUCTIONcontractionary policycontractionary policy

The FED can also choose to remove money The FED can also choose to remove money from the economyfrom the economy

When the FED reduces the amount of money When the FED reduces the amount of money in circulation this impacts banksin circulation this impacts banks

as bank deposits fall, banks are forced to as bank deposits fall, banks are forced to reduce the amount of loans (call in loans)reduce the amount of loans (call in loans)

The decrease in loans reduces the money The decrease in loans reduces the money supplysupply