Transcript Unit 4: Money, Banking, and Monetary Policy Financial Assets Financial Assets • Money at hand, or easily accessible, in the form of cash,

Unit 4: Money, Banking,
and Monetary Policy
Financial Assets
Financial Assets
• Money at hand, or easily accessible, in the
form of cash, deposits, loans, and
marketable securities (bonds, stocks, etc).
• Unlike physical assets, such as
machinery, financial assets are “intangible”
due to the fact that they regard monetary
values.
Financial Assets:
1. Stock: a claim on the ownership of the
firm and is exchanged in a stock market.
-In order to raise money for capital
investments, firms can issue and sell
stock.
-Equity Financing: avoids debt by
selling stock, but allows for small
control over management/ profits of the
firm.
Financial Assets:
2. Bonds: financial devices through which a
borrower (firm or government) is obligated
to pay the principal and interest on a loan
at a specific date in future.
-Firms want to raise money by
borrowing, which is why corporate
bonds are issued.
-Debt Financing: borrowing of funds in
order to finance a project.
Financial Assets:
• Video to explain stock and equity financing
vs. bonds and debt financing:
Bonds and Stock
Economic
Functions of
Money
Economic Functions of Money:
• Fiat Money: name given to paper and coin
money; due to the fact it has no intrinsic
value (like gold) and no value as a
commodity (like tobacco).
• However, it is serves as money because
the government declares it legal tender,
and assures us money performs three
general functions:
Function #1: Medium of Exchange
• Medium of Exchange: the most common
form, money, is used for buying and
selling goods and services.
• Helped to end the “barter system” in which
other goods and services were traded to
gain another good or service.
Example of Function #1:
You are employed at your local grocery
store, and are receiving $8.50/hr. Your
employer exchanges dollars for an hour of
your labor. You then exchange those
dollars for a grocer’s pound of bananas.
The grocer exchanges those dollars for a
banana plantation’s banana crop, and so
on.
Function #2: Unit of Account
• Unit of Account: money is considered a unit of
account.
-society uses monetary units to measure the
relative worth of goods and services.
-monetary units are beneficial because:
a) easily compare prices of
various goods.
b) easy to define debt obligations,
determine taxes owed, and
calculate nation’s GDP.
Example of Function #2:
Prior to the monetary system, bartering
was the way in which people gained the
goods and services needed. In this time
period, the price of cows was stated in
terms of corn, crayons, cranberries, etc.
Now, the monetary system allows for the
value of goods and services to be
compared by monetary value.
Function #3: Store of Value
• Store of Value: money serves as a “store of
value” by allowing people to transfer purchasing
power from the present to future.
• Money is stored in checking accounts and safes
to be used at a later date.
• Money is the preferred store of value for short
periods because it is the most liquid (spendable)
of all assets; long durations of time most be
analyzed considerably.
Example of Function #3:
You receive a paycheck of $1,000 for two
weeks of work at the local grocery store.
Instead of spending it, you decided to
store your money in a checking account to
use at a later time. A few weeks pass
before you decide that you would like to
purchase a new car. You have access to
the money, obtaining it instantly (liquid
asset), and buying the new car.
Problem with Function #3: Store of
Value
• Although money serves as a store of
value, money can lose its value over time.
• For example, think of a piece of cheese.
Over the course of time, this piece of
cheese becomes moldy and loses its
value. The same concept occurs with
money over long periods of time.
Time Value of Money,
Present and Future Value,
and Supply and Demand
of Money
Time Value of Money
• Time Value of Money- money may serve
as a store of value, but money does lose
its value over time
– It is the most important reason for paying
interest on savings and changing interest on
borrowing
Present and Future
Money
Present Value and Future Value
• Concept of Present and Future Values (in
non-Economic terms) :
- “If you wash the car, you can go to the
movies with your friends”
- Present: Costs (tuition, books, etc) Future:
valuable education, skills, etc.
Present and Future Values:
Basic Equation
• Dollars today are worth more than future dollars (due to
inflation that occurs)
• For this reason, we must convert present and future
dollars to same time period:
PARTS OF
EQUATION:
PV=present value
FV=future value
R= rate of interest
FV=PV*(1+r)
Present and Future Values:
Present Value
PARTS OF
EQUATION:
PV=present value
FV=future value
R= rate of interest
PV=FV/(1+r)
Present and Future Values:
PARTS OF
EQUATION:
PV=present value
FV=future value
R= rate of interest
n=number of years
FV=PV(1+r)2
Supply and Demand for
Money
Supply of Money:
Supply of Money:
• Government is trusted with keeping the value of
money as stable as possible.
-How is value guaranteed? stabilizing
money supply
• Money Supply: the total supply of money in
circulation in a country’s economy at a given
time.
-Important to note there are three parts to
money supply: M1, M2, and M3
-Liquidity: how easy assets can be converted
to cash.
Supply of Money: M1
M1: cash + coins + checking deposits +
traveler’s checks.
-most liquid of all the parts of money
supply
EXAMPLE: $5, already being cash, is as
liquid as it gets. It also falls under the M1
part of money supply.
Supply of Money: M2
M2: M1 + savings deposits + small (i.e.,
under $100,000 certificates of deposit)
time deposits + money market deposits +
money market mutual funds.
NOTE: M2 is slightly less liquid than M1
because converting these assets to cash
immediately would incur a penalty.
Supply of Money: M3
M3: M2 + large (over $100,000) time
deposits.
NOTE: M3 is the least liquid of all parts of
the supply of money because it takes even
longer to convert these time deposits (or
CDs) to instant cash.
• The supply of money is a
constant.
-implies that the
money supply curve
is VERTICAL
-when graphing
money supply, focus
on M1 (due to the
fact other measures
of money supply are
based on most
liquid)
Nominal Interest
Rate, i%
Graphing Money Supply:
MS
Money
Demand for Money:
Demand for Money:
• Demand for Money: the sum of money
demanded for transactions and money
demanded as assets.
• People demand money for two reasons:
1) money allows for them to
purchase goods/services that will
satisfy their wants.
2) money is also demanded as an
asset.
Demand for Money: Transaction
Demand
• Transaction Demand: the amount of
money people want to hold for use as a
medium of exchange; varies directly with
nominal GDP.
-if output INCREASES, then money
demanded INCREASES
-if price level INCREASES, then
money demanded INCREASES
• We assume that
Nominal Rate of
Interest does NOT
affect transaction
demand for money.
Therefore, this is
plotted on y-axis as a
constant.
Nominal Interest
Rate, i%
Demand for Money: Transaction
Demand
Money
Demand for Money: Asset Demand
• Asset Demand: the amount of money
people want to hold as a store of value;
varies inversely with the interest rate.
-if the interest rate on bonds
INCREASES, the asset demand
DECREASES
-if the interest rate on bonds
DECREASES, the asset demand
INCREASES
• demand for money in
terms of transactions
+ the demand for
money in terms of
assets.
• Downward sloping
curve:
-MD=MDt + MDa
Nominal Interest
Rate, i%
Total Demand for Money:
MD
Money
The Money Market
The Money Market
• Theory of liquidity preference- the
equilibrium price of money is the interest
rate where money supply intersects
money demand
How is the Money
Market Different from the
Market for Loanable
Funds?
1.Breadth of Scope
Money Market
• Includes savings,
currency, and checking
deposits
• Demand comes from
money used for
investment but also
consumption and from
holding an asset
• Broader and includes the
market for loanable funds
Loanable Funds
• Comes from national
savings
• Demand comes from
investment demand only
Example: a $100 bill in your wallet is part of the money supply curve, but not into
the supply of loanable funds
2.Different Philosophies
Classical Economists
• believe that the price
level is flexible and longrun GDP adjusts to the
natural rate of
employment
• For any level of GDP, the
interest rate adjusts to
balance the supply and
demand for loanable
funds and price level
adjusts to keep the
money market in
equilibrium
Keynesian Economists
• Believe that price level is
sticky
• For any price level, the
interest rate adjusts to
balance supply and
demand for money and
this interest rate
influences aggregate
demand and thus the
short run level of GDP
Graphing
• The vertical axis of the money market is labeled
with a nominal interest rate and the vertical
interest axis of the loanable funds market is
labeled with the real interest rate
• Changes in the money market can be viewed as
short-term changes and therefore the role of
inflation is negligible
• For investment and saving, the price of
investment does depend on inflation