moneyandbanking 01-09 part1

8/14/2019 moneyandbanking 01-09 Part1

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MONEY & BANKINGTopics: Lesson 1 to 09Five Parts of Financial SystemFive Core Principles of Money & BankingMoney & Payment SystemOther Forms of Payment

Financial IntermediariesFinancial Instruments & MarketsThe Value of MoneyPresent Value Concepts

I. QUICK INTRODUCTION TO MONEY AND BANKING

Q: Why isn't it a good idea for me to try to pay my home heating bill by giving economicslectures to people at the power company?

A (the obvious answer, but not the full answer): The power company might not want mylecturing services. But, suppose for a minute that the company did. Then we'd have a "doublecoincidence of wants" - I want their heating services, and they want my lecturing services, and atrade could be arranged. Still, that probably wouldn't be very efficient, since I already have a joband not much free time. There's a much easier way to pay my bill - I can pay with money.--Paying with money is more convenient and less time-consuming.

MONEY (anything that is generally accepted as payment) is more efficient than BARTER(trading goods/services for goods/services). Barter requires a double coincidence of wants (youwant the good/service that the other guy has to offer, and he wants the good/service that you haveto offer); money does not , because everybody can find some use for money.

Q: Given that I'm paying the power company with money, why would it probably be a

waste of time to drive down to their office (which is 40 miles away) and pay in cash?A: Because it's inconvenient and I don't need to. It's much easier to write a check and mail it in,or to have money debited from my bank account (e.g., pay by phone, automatic monthly debit).-- Since the funds in your checking account balance are easily available for spending (through anATM withdrawal, a debit card, pay by phone, etc.), they count as money, too.

--BANK DEPOSITS, followed by CASH IN CIRCULATION, are the main form of moneyin our society.

---Banks make the monetary system a lot more efficient by reducing our need to carry a lot ofcash. People have long tended to use checks instead of cash for large purchases and bills.

Innovations in banking like debit cards, direct deposit, and automatic bill-paying reduce thatinconvenience even further, and also reduce such bank-related inconveniences of time spentstanding in line at the bank, writing checks, or visiting the ATM.----So, then, MONEY may be the common thread in our economy, but BANKS make the supplyof money a lot more plentiful than it would otherwise be. Banks also make the "paymentssystem" a lot more efficient.

Definition: A BANK is a financial institution that accepts deposits and makes loans.


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THE FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. TIME has value.a. Time affects the value of financial instruments.b. Interest payments exist because of time properties of financial instruments

A dollar today is worth more than a dollar a year from now. Why is this? (Several reasons:inflation erodes the buying power of money over time; having the money now means you canspend it now; having the money now means you can invest it and turn it into more money.) Later,we'll relate this principle to the concept ofpresent discounted value of future payments, or whatthey're worth today taking into account the interest you could be earning in the interim.--An important aspect of the time value of money is that interest compounds over time. Ex. inbook: a $10,000 car loan, at 6%. If you repaid the entire loan in one lump sum a year later, you'dpay $10,000 (original amount plus $600 interest). But in the example, the loan is to be paid off inmonthly payments over four years, or 48 monthly payments of $235, and the total repayment is$11,280. Why? Interest compounds, or accumulates, from month to month.

2. RISK requires compensation.a. In a world of uncertainty, individuals will accept risk only if they are compensated in some

form

For securities like stocks and bonds, the higher the risk, the higher the return has to be. Forindividuals, minimizing the risk of such things as accidents, illness, and theft is worth theexpense of monthly insurance premiums. (A note on usage: "Risk" refers to your potential losses,financial and otherwise, not merely to the probability of unwanted events. For example, fireinsurance might not reduce the likelihood of your house burning down, but it will compensateyou for the damage from your house burning down.)

3. INFORMATION is the basis for decisions.a. The collection and processing of information is the basis of foundation of the financial system

This rather general sentence relates to money, banking, and finance because we live in a world ofimperfect information. It is hard for financial transactions to take place when one or both partieslack adequate information about the other, because one party could easily end up getting burned.As a result, banks and other financial institutions that make loans gather a considerable amountof information about their potential borrowers before advancing them money. The collection and provision of company financial information by government agencies like the Securities andExchange Commission can aid the growth of financial markets by making them moretransparent, thus reducing the information barrier for potential investors. Recent advances in

computer and communications technology have greatly helped the spread of financialinformation, thereby paving the way for the growth of important new financial markets like thejunk-bond market.


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4. MARKETS set prices and allocate resources.a. The places where buyers and sellers meet are the core of the economic system

Financial institutions and markets, by connecting savers with borrowers, allow for people'sleftover money (savings) to be channeled into productive investment in capital (e.g., newtechnology, machinery, buildings). Financial markets for assets like stocks and bonds allow somecompanies, especially well-established companies, to obtain funds for new capital investmentmore cheaply than they could borrow from a bank.

5. STABILITY improves welfare (i.e., well-being).a. A stable economy reduces risk and improves everyone's welfare

-Imagine that your next job pays you $3,500 a month (or $42,000 a year). Now imagine that yourboss proposes to change your monthly pay to $1,000 times the roll of a die. That is, you'd havean equal chance of receiving $1,000, $2,000, $3,000, $4,000, $5,000, and $6,000, and the

average of those numbers (or the expected value of your monthly pay) would still be $3,500.Would you do it? Most people would say no way.--Real-life example: Professors at the college are officially paid on a nine-month schedule (i.e.,nothing in June, July, and August), but we have the option of being paid the same amountstretched out over 12 months. I don't know of a single person who chose the 9-month option.Even though it's not really risky, because the irregularity is known in advance, it could be hard tomanage.--In the interest of stability in the financial sector, governments have created central banks to tryto guard against bank failures and financial panics. The tasks of central banks have grown inrecent years, as they are now expected to keep inflation low and stable, and also to avoid orminimize recessions.

--Bank deposit insurance is another example of a government intervention for the sake offinancial and social stability.

A handy device for memorizing those five principles is the (inelegant) acronym "TRIMS" - for Time, Risk,Information, Markets, Stability. They're worth memorizing, as we will be returning to them again and againin this course.

Financial System Promotes Economic Efficiency

The Financial System makes it Easier to Trade

Facilitate Payments - bank checking accounts Channel Funds from Savers to Borrowers Enable Risk Sharing - Classic examples are insurance and forward markets


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1. Facilitate Payments - bank checking accounts

Cash transactions (Trade value for value). Could hold a lot of cash on hand to pay for things Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs Make transactions easier

2. Channel Funds from Savers to Borrowers Lending is a form of trade (Trade value for a promise) Give up purchasing power today in exchange for purchasing power in the future.

Savers: have more funds than they currently need; would like to earn capital income

Borrowers: need more funds than they currently have; willing and able to repay with interest inthe future.

WHY IT IS IMPORTANT?

Allows those without funds to exploit profitable investmentopportunities.

o

Commercial loans to growing businesses;o Student loans (investment in human capital)

Financial System allows the timing of income andexpenditures to be decoupled.

o Household earning potential starts low, grows and

decline with ageo Financial system allows households to borrow when young to prop up

consumption (house loans, car loans)

3. Enable Risk Sharing The world is an uncertain place. The financial system allows trade in risk. (Trade value for a

promise) Two principal forms of trade in risk are insurance and forward contracts. Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to

replace lost income to provide for their family.

What are your options to address this risk?

MONEY AND THE PAYMENT SYSTEM

The dictionary has several definitions of money. In ordinary conversation we commonly use theword money to mean income ("he makes a lot of money") or wealth ("she has a lot of money").In this course (and in macroeconomics courses in general), we use a different definition, namelythe one given in the chapter 1 notes:

money = anything that is generally accepted as payment

This is the (macro)economist's usage of the term money. And, to reiterate, in the context of thiscourse:


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Money is an asset that is generally accepted as payment for goods and services or repayment of debt.

MONEY is notthe same thing as INCOME or WEALTH

While money, income and wealth are all measured in some currency unit, they differ

significantly in their meaning. People have money if they have large amounts of currency or big bank accounts at a point in

time. (Stock variable) Someone earns income (not money) from work or investments over a period of time. (Flow

variable) People have wealth if they have assets that can be converted into more currency than is

necessary to pay their debts at a point in time. (Stock variable)

If money is something generally accepted as payment, then counts as money?

A: Obviously, cash -- dollar bills, coins -- is a form of money.

Q: Is there anything else that counts as money?

A: Checking account deposits. (And the broader measures of the money supply include allothertypes of bank accounts as well.)

Q: Are credit cards money?

A: No. They're not legal tender. What a credit-card purchases really represents is just anextremely convenient, pre-approved loan. It's only part of the transaction, since the merchantthen goes to the bank that issued the credit card to get money, and the bank sends you a billwhich must be paid with money.

Q: Are assets like stocks and bonds money?

A: No. They have value, but they are generally not used or accepted as payment. Financialinstruments are not money.

When economists talk about the "money supply," we mean something very different fromnational income (~GDP) or national wealth. The money supply is a lot smaller than nationalincome or national wealth. Generally speaking,money supply = cash in circulation + bank account deposits-- There are several measures of the money supply, or "monetary aggregates." The narrowest,and simplest, is "M1," or "transactions money," which corresponds closely to the things that aremost generally accepted as payment, namely cash (in circulation) and checking deposits. M2,which used to be called "broad money," includes most other bank account deposits as well as

money-market funds. We'll discuss them in more detail later in these notes.

CHARACTERITICS /FUNCTIONS OF MONEY

1. Means of payment (medium of exchange) -- Because money is a generally accepted form of payment,you can use it to buy things.

2. Unit of measurement (unit of account) --You can use it to price things, e.g., in dollars and cents. Ex.:new textbook is $120, Wall St. Journal (WSJ) subscription is $20, phone call on Sprint is 10 cents aminute. Quoting prices in terms of dollars, the American unit of account, is a lot easier than quoting prices


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in terms of other goods -- e.g., money & banking textbook = 6 WSJsubscriptions or 1,200 minutes oflong-distance calling; WSJ subscription = 1/6 textbook = 200 long-distance minutes; 1 long-distanceminute = 1/1200 textbook = 1/200 WSJsubscription. That's six barter prices to deal with, as comparedwith just three dollar prices. (The number of barter prices goes up exponentially as the number of goodsand services increases. If we added a fourth commodity -- say, pizza -- to the mix, there would be twelvebarter prices.)

3. Store of value -- an asset in its own right, and not a bad one -- while cash earns no interest, it'sperfectly liquid (convertible into cash) and has no default risk. Money in bank accounts earns someinterest and is guaranteed against default by Federal Deposit Insurance

THE EVOLUTION OF MONEY AND THE PAYMENTS SYSTEM

Money came into being thousands of years ago as a superior alternative to barter (trading goods andservices directly for other goods and services).

COMMODITY MONEY- money made up from precious metals or other commodities that haveINTRINSIC VALUE (are valuable in their own right).- Examples of commodity money could include gold, cows, and pretty shells.

COMMODITY-BACKED MONEYcame later. This is money that draws its value from a commodity (ex.:gold) but does not involve physically handling that commodity on a regular basis. An example is U.S.currency under the gold standard (~1873-1933), when people regularly used paper money that wasissued by banks but was redeemable for gold according to a fixed ratio of grams per dollar. People alsousedU.S. gold certificatesissued by the government, which also were paper notes redeemable for goldat a fixed ratio.

FIAT MONEY(most recently)- currency, usually paper currency, which by government decree (i.e., "by

fiat") is legal tender and which is not officially convertible into gold or other precious metal.

Fiat money is the type of money we have today. Although our dollar bills have greatvalue and are accepted all over the world, they do not have intrinsic value, becausethey are not really useful other than as money. Take away their monetary value(imagine, for example, that the government says they're no longer legal tender, orthat people lose their faith in U.S. dollars), and they become mere pieces of paper

Advantages of Fiat Money

Fewer resources are used to produce money. The quantity of money in circulation can be determined by rational human judgment rather than

by discovering further mineral depositslike gold or diamonds

Disadvantage

A corrupt or pressured government might issue excessive amounts of money, thereby unleashingsevere inflation.
http://en.wikipedia.org/wiki/Image:Goldcertificate.jpghttp://en.wikipedia.org/wiki/Image:Goldcertificate.jpghttp://en.wikipedia.org/wiki/Image:Goldcertificate.jpghttp://en.wikipedia.org/wiki/Image:Goldcertificate.jpg


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CHEQUESInstructions to the bank to take funds from your account and transfer those funds to the person or firmwhose name is written in the Pay to the Order of line

OTHER FORMS OF MONEY

A rapidly increasing share of our transactions in recent decades are electronic

transactions, such as credit-card transactions. Lately there has been the rise of E-MONEY (payment arrangments that exist only in electronic form and involvetransfers of money). Some forms of e-money:

* DEBIT CARD: works like a credit card but transfers funds from your personal bankaccount.* AUTOMATIC BILL-PAYING: whereby money is transferred straight from yourbank account to the phone company, the power company, the local tax collector,


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according to prior arrangements you have made. Pay-by-phone works similarly.* E-CASH: (like Paypal;) arrangement by which you set up an account on theInternet that is linked to your bank account. When you buy things on the Internetthrough this arrangement, your bank account is debited by the amount spent.*STORE VALUE CARDS:Retail businesses are experimenting with new forms of electronicpayment. Prepaid cellular cards, Internet scratch cards, calling cards etc

-- Are these money? Yes and no. All three provide access to your bank account,which is already in the money supply. These are really just more efficient andconvenient ways of making payments than the old ones.

MEASURING MONEY

a measure of the ease an asset can be turned into a means of payment (Money).

Different Definitions of money based upon degree of liquidity.

Federal Reserve System defines monetary aggregates.

The Fed used to keep track of a broader monetary aggregate, M3, which included

everything in M1 and M2 plus large CD's, institutionally-held money-market funds,


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and two key sources of borrowed funds for banks, term repurchase agreements

(repos) and term Eurodollars. The Fed stopped keeping track of M3 in late 2005,

after deciding that it contained no relevant economic information that was not

already in M2.
http://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htmhttp://www.federalreserve.gov/releases/h6/discm3.htm


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THE MONEY SUPPLY

Q: First, why should we care about the money supply?

A: The money supply (Ms) matters because it affects three very important things: the price level,

inflation, and economic recessions:

(1) Price level: higher levels of the Ms are a direct cause of higher price levels.-- Likewise, increases in the money supply tend to cause the general price level to increase.-- Inflation (an increase in the price level) is often described as "too much money chasing too few goods."When the money supply increases faster than the productive capacity of the economy, inflation is theusual result.

(2) Inflation: faster Ms growth rates tend to cause higher rates of inflation-- From international comparisons we see a tight relationship between money (M2) growth rates andinflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per month, or wellover 1000% per year) is impossible without extremely rapid money-supply growth.

---- [Refer to Cecchetti's Figure 2.4, which shows a graph of M2 growth rates and inflation rates for 1960-2004.M2 growth rates were highly correlated with inflation rates in 1960-1980; in 1990-2004, there is basically no

correlation, as inflation has been relatively low and stable. The low and stable inflation may owe something toslower M2 growth rates during that span and the preceding decade, as the public has come to trust the Fed to keep

money-supply growth and inflation at moderate levels.]

Q: Since money supply growth is inflationary, and perfect price stability (0% inflation) seems like an ideal,wouldn't we be better off keeping the money supply perfectly stable, and not increasing it at all?------ A: No. Money demand (people's demand for money for their transactions and savings) increasesvirtually every year as the volume of transactions (real GDP) increases, and if the money supply did notkeep pace with money demand, then the economy would run into serious problems -- cash shortages,sky-high interest rates, and probably recession. In general...


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(3) Recessions may be caused by steep declines in the Ms growth rate-- In the past 50 years, there have been eight recessions, and every single one of them was preceded bya notable decline in the money (M2) growth rate. Then again, not every decline in the M2 growth rate wasfollowed by a recession -- thus the old joke that "economists have predicted twelve of the last eightrecessions."

Q: Suppose that people transfer $100 million from checking accounts intomoney-market funds. How will M1 be affected? How will M2 be affected?

A: M1 will fall by $100 million. M2 will not be affected (because the $100 milliondrop in checking deposits is exactly offset by a $100 million increase in money-market funds).

PRICES AND INFLATION

Aggregate price level: an index of the average prices of goods andservices in the economy

1. Fixed-weight Index - CPIwhich measures the average price of a representative "basket" of consumer goodsand services,(Track changes in the typical households cost of living)

CPI in any month equals

The price level is an index, which has been set equal to 100 for a chosen base year, which we use as abasis for comparisons. Comparisons with a base of 100 are easy because the percent change calculationreduces to simple subtraction -- just subtract 100 from the current price level, and you've got the totalpercent change in prices since the base year.

-- Ex.: Currently the base year for the CPI is the average of three years, 1982-84. The CPI was about196 in December 2005, which means that consumer prices on average were 196% as high, or 96%higher, in December 2005 than they were in 1982-84.

Inflation A continual increase in price level

Deflation A continual decrease in price level

Inflation rate the yearly percent change in the price level

To calculate the inflation rate for a given year, from price-level figures for consecutive years (ormonthly figures that are twelve months apart):


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(Price level in that year) - (Price level in the previous year)Inflation rate = ----------------------------------------------------------------------------- (* 100%)

(Price level in the previous year)

(Price level in that year)OR { ------------------------------------------- - 1 } * 100%

(Price level in the previous year)

Ex.:Q: Suppose the Consumer Price Index was equal to 200 in 2004 and 206 in 2005. (If the base year is still1982-84, then prices were 100% higher in 2004 than in 1982-84 and 106% higher in 2005 than in 1982-1984. What was the inflation rate in 2005? A: Inflation rate = (206-200)/200 = 6/200 = 3/100 (*100%) = 3%.-- (Note: It is customary to report the inflation rate to one decimal place, so we'll report it as 3.0%.)

2. Deflator GDP or Personal Consumption Expenditure Deflator

which deals with the prices of goods and services in all the different components of GDP(consumption, business investment, government purchases, net exports) and is used to adjustmeasured GDP for inflation (i.e., to convert nominal GDP into real GDP).

also called the implicit price deflator for GDP, measures the price of output relative to its price in the baseyear. It reflects whats happening to the overall level of prices in the economy

GDP Deflator = (Nominal GDP / Real GDP) 100

moneyandbanking 01-09 part1

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