Money, Banking and Financial System
Ch. 12, Macroeconomics, Roger A. Arnold
12-1 All About Money Money: Any good that is widely accepted for purposes of exchange and the repayment of debt Functions of money: Medium of exchange (reduces transaction costs of exchanges) Unit of account (Values of goods are expressed in money; we can determine relative prices) Store of value (The ability of an item to hold value over time; we can keep money until we decide how to spend it)
Barter Economy VS Money Economy
In a barter economy transaction costs are higher because of double coincidence of wants i.e. a trader must find another trader who at the same time is willing to trade what the first trader wants and wants what the first trader has. In a money economy transaction or trade takes less time since double coincidence of want is unnecessary. People can use the extra time to work and/or for leisure. Hence a money economy is likely to produce a greater amount of output and people are likely have more leisure time. Hence, the standard of living of the average person in the money economy is likely to be higher.
Defining The Money Supply
Two frequently used definitions of money supply are M1 and M2 M1 : narrow definition of money supply or transactions money M1 = Currency (coins and paper money) held outside banks + checkable deposits (deposits on which checks can be written) + traveller’s checks (a check for a fixed amount that can be cashed or used as payment abroad) M2: Broad definition of the money supply M2 = M1 + Savings deposits + time deposits + Money market mutual funds
Savings deposits: An interest earning account at a commercial bank
Savings deposits: An interest earning account at a commercial bank. Usually, checks cannot be written on savings deposit and the funds may be withdrawn at any time without a penalty payment. Time deposit: An interest earning deposit with a specified maturity date (hence checks cannot be written). Time deposits are subject to penalties for early withdrawal. Money Market Mutual Fund: An interest earning account at a mutual fund company, where a minimum balance is usually required and most of which offer limited check-writing privileges.
12-3 Fractional Reserve Banking System
Fractional Reserve Banking: A banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities Banks usually have an account with the central bank (Bangladesh Bank or The Fed in USA). This is referred to as a reserve account. Banks also have currency in their vaults – called vault cash. Reserves = reserve account + vault cash
Continued… The central bank mandates that member commercial banks must hold a certain fraction of their checkable deposits in reserve form. This fraction is referred to as the required reserve ratio (r). Required Reserves: The minimum dollar amount of reserves that a bank must hold against its checkable deposits, as mandated by the central bank. Required reserves = r x Checkable deposits The amount of required reserves that must be maintained by commercial banks as mandated by the central bank is called the Reserve Requirement Excess Reserves: Any reserves held beyond the required amount, the difference between total reserves and required reserves
The Financial System A financial system gets together people with surplus funds (lenders) with people who have a shortage of funds. Direct Finance: Borrowers and lenders meet in a market setting, such as the bond market. E.g. the buyer of a bond is a lender and the seller the borrower Indirect Finance: Funds are loaned and borrowed through a financial intermediary (e.g. commercial banks) Financial Intermediary: A financial intermediary transfers funds from those wo want to lend funds to those who want to borrow them
Adverse Selection and Moral Hazard Problems
Both the problems arise due to asymmetric information – Relates to an economic agent on one side of a transaction having information that an economic agent on the other side of the transaction does not have. Adverse selection: A phenomenon that occurs when the parties on one side of the market, who have information not known to others, self-select in a way that adversely affects the parties on the other side of the market. Occurs before a loan is made. Moral Hazard: A condition that exists when one party to a transaction changes his or her behaviour in a way that is hidden from and costly to the other party. Occurs after a loan is made. Financial intermediaries can solve / reduce both the problems
The Bank’s Balance Sheet
Balance Sheet: A record of liabilities and assets of a bank Asset: Anything of value that is owned or that one has claim to (e.g. reserves that bank holds and loans that bank has made to the borrowers) Liability: Anything that is owed to someone else (e.g. checkable deposits and any loans the bank has taken out) A bank’s business: Turning liabilities (deposits) into assets (loans made to borrowers) Bank Capital = Assets – Liabilities and Insolvency -> liabilities > assets
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