Unit IV The Financial Sector Objectives: The functions of money Definition of Money Supply Financial assets The concept of time value of money

What are the characteristics of a dollar bill that makes it a good form of money? 1. Portable 2. Stable 3. Acceptable 4. Durable 5. Divisible 6. Valuable 7. Uniform 8. Difficult to counterfeit

Barter: What’s the weakness? Inefficient Double coincidence of wants required for effective bartering Trade requires people to find someone who wants what they have and has what they want.

Money facilitates trade Three functions of money in an economy: 1. Median of Exchange= any items that sellers accept as payment. 2. Standard of Value ( or unit of account)= a way to measure the relative value of goods by comparing their prices; make economic decisions 3. Store of Value= it can be saved, or stored for later use; holds purchasing power

Sources of Money’s Value Commodity money: An item used as money that also has value of its own (like gold, silver or tobacco ). Representative money: An item that has value because it “represents” something else; can be exchanged for that something else. (A sheet of paper that can be redeemed for currency.) Fiat money: this money has value because a government “fiat”, or decree states that it has value (like currency= coins and paper bills). U.S. dollars are fiat money and are not backed by gold, silver or any commodity.

Definition of Money Difficult to define because anything that serves the function of money, can be considered money. U.S. gov. defines what is included in money when it measures the Supply of money in the economy. Monetary Aggregates: M0 M1 M2 tobacco

Definition of Money Liquidity refers to how easy it is to convert an asset into cash. M0- most liquid M2-least liquid

Definition of Money M0: Coins and paper money, already CASH, most liquid. MI: All of M0 plus demand deposits; checking accounts, traveler’s checks Checks can be paid “on demand” at any time. M2: Includes M1 and near money, assets that can easily be converted into cash when needed, like savings accounts and small time deposits, money market shares

Financial Markets Facilitate the flow of funds from lenders to borrowers Households invest their savings in financial assets, which provide funds for investment spending The financial system is important to the econ: makes savings available for investment which leads to long-run growth.

Financial Markets Transaction costs Risk liquidity The financial system addresses three problems: Transaction costs Risk liquidity

What are financial assets? Any paper claim that entitles the buyer to future income from the seller. 4 types Loans Stocks Bonds Bank deposits Activity 4.1

A dollar today or a dollar next year? Why? Money today may be put in the bank and earn interest for a year. So dollar today is worth more than the dollar next year. Money has time value because interest rates are positive.

Time value of money Let’s say you earn 5% per year on your savings account. $1 will grow to $1.05 after one year. Since the present value of $1.05 to be received one year from now ( if interest rates are 5%) is $1, then the present value of $1 to be received one year from now (again if interest rates are 5%)must be some value less than $1.00 The present value :PV=FV/(1+r) n

present value :PV=FV/(1+r) PV is present value FV is future value R is the rate of interest per period n is the number of compounding periods (per year) Therefore, PV=$1.00/ (1.05) PV= $0.95 Today’s value of $1.00 to be received one year from now is the interest rate is 5%, is $0.95 Activity 4.2 1