Unit 4

What Do Banks Do?

• A bank is a financial intermediary 
• Uses liquid assets (i.e. bank deposits) to finance the investments of borrowers
• Process known as Fractional Reserve Banking 

• A system in which depository institutions hold liquid assets > the amount of deposits 

• Can take form of:  
• currency in bank vaults 
• bank reserves: deposits held at federal reserves  

 What Banks Do-Basic Accounting Review

• T-account (balance sheet): 
• statements of assets and liabilities 

• Assets(amounts owned): 
• items to which a bank holds legal claim 
• uses of funds by financial intermediaries

• Liabilities(amounts owed): 
• legal claims against a bank
• sources of funds for financial intermediaries  

Federal Reserve Bank :

Functions:

• Uses paper currency
• Holds reserves of the banks
• Lends money and charges interests 
• Check clearing service for the bank
• Personal bank for the government  
• Supervises members  of banks  
• Control money supply in economy  

Reserve Requirement: 

• federal requires bank to always have some money readily available to meet consumer's demand for cash 
• amount set by the federal is required reserve
• the required reserve ratio is the % of demand deposits (checking account balance) that must not be loaned out 
• typically it is 10% 

Three types of multiple deposit expansion question:

1. Calculate the initial change in excess reserves
2. Calculate the change in the money supply
3. Calculate the change in the money supply: sometime type 2 and type 3 will have the same result  (if no Fed involvement)

1) The Reserve Requirement:

• only a small % of your bank deposit is in the safe the rest of your money has been loaned out
• this is called "Fractional Reserve Banking"
• the FED sets the amount that banks must hold
• the reserve requirement (reserve ratio) is the % of deposits that banks must hold in reserve and not loan out
• when the FED increases the money supply it increases the amount of money held in bank deposits  

1. If there is a recession, what should the FED do to the reserve requirement?  

               decrease the RR 

1. Banks hold less money and have more ER
2. Banks create more money by loaning out excess 
3. Money increase, interest rates fall, AD goes up  

1.  If there is inflation what should the FED do to the reserve requirement, what should the FED do to the reserve requirement?  

 decrease the RR 

1.  Banks hold more  money and have less ER 
2. Banks create less money 
3. Money Supply decrease, interest rates rise, AD goes down   

 2) The Discount Rate:

• Discount Rate is  the interest rate that the FED charges commercial banks 
•  Ex: If the banks of America needs $10 million, they borrow it from the U.S Treasury (which the FED controls, but they must pay it back with interest)
•  To increase the Money Supply, FED should DECREASE the Discount Rate (Easy Money Policy)
• To Decrease the Money Supply, the FED should INCREASE the Discount Rate (Tight Money Policy) 

 3) Open Market Operations:

• FED buys/sell government bonds (securities)
• This is the most important and widely used monetary policy
• -To increase the MS, the FED should BUY government securities
• To decrease the MS, the FED should SELL government securities  

Monetary policy:

• Expansionary: buy bonds, decrease discount rate, decrease RR = increase in loan, AD increases, GDP increase, MS increases. interest rate decreases 
• Contractionary: sell bonds, increase discount rate, increase RR= loans decrease, AD decrease. GDP decrease, MS decrease, interest rate increases   

Federal Fund Rate: 
Where FDIC member bank loans each other overnight funds


Prime Rate: 
Interest rate that banks give to their most credit- worthy customers  

Unit 4: Money

Uses of Money: 

• Medium of exchange: Trade or barter
• Unit of account: Establishes economic worth in the exchange process 
• Store of value: Money has its value over a period of time, where products may not  

Types of Money: 

• Commodity money: Gets it value from the type of material from which it is made
• Representative money: Paper money backed up by something tangible that it gives it value 
• Fiat Money: Money because government says it is money and that is used in the U,S 

Characteristics of money: 

• portable 
• durable
• uniform
• scarce
• acceptable 
• divisible  

Money Supply:

• M1 money: Currency Examples: cash, coins, checkable deposits/ checking account, traveler's checks, and demand deposits) 
• M2 money: consists of M1 money  + savings accounts and deposits held by banks held outside of the U.S
• M3 money: consists of M2 money + certificates of deposits, known as CD's 
• 75% of money in circulation and it mostly liquid because it easy to convert to cash  

Time value of money:

1. Is a dollar today worth more than a dollar tomorrow?  Yes 
2. Why? Opportunity cost and inflation. This is the reason for changing and paying interest.

Formulas:

Simple interest formula: v=  (1+r)^n * p 

Compound interest formula: v= (1+r/k)^nk *p 

• V= future value of money
• P= present value of  money
• R= real interest rate (nominal rate- inflation rate) expressed as a decimal  
• N= years
• K= # of times interest is credited per year

1. What happened to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest rate assets instead of borrowed liabilities
2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increase, there is no incentive to convert cash into interest earning assets
3. What happens if price levels increase? 

   Money demand shifters:

   • Change in price level
   • Change in income 
   • Change in taxation that effects investments
4. How does money supply affect AD? 

money supply increases= decrease in interest rates, increase in investments, and decrease in AD

money supply decreases = increase in interest rate, decrease in investment, decrease in AD

Financial Assets vs Financial Liabilities 

• FA: assets such as stocks and bonds provide expected future benefits 
• FA:it benefits the owner, based upon the issue of the asset meeting certain obligations
• FL: liabilities incurred by financial asset to stand behind the issued asset  

Interest rate:

• price paid for a financial asset 

Stocks vs Bonds: 

Stocks: assets that convey ownership in a company(shareholder)

Bonds: promise to pay a certain amount of money + interest in the future

Monetary Policy