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A Closer Look At The Financial Markets
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An Overview of MoneyWhat is Money? Money is a means of payment what sellers / buyers accept
to pay for goods and services
Money is a store of value an asset that can be used totransport purchasing power from one time period to another
- it is convenient- it is portable- it is easily exchanged for goods
Money is a unit of account - a consistent way of quotingprices
liquid
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An Overview of Money
These three features are so important though we maytake them for granted that we are willing to incur acost to hold currency. The sacrifice in interest thatcould be earned by holding money rather than a
riskier, less liquid financial asset is calledopportunity cost of holding money
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An Overview of MoneyCommodity Money and Fiat Money
1. Commodity Money items designated as moneywith intrinsic value like gold and other preciousmetals
2. Fiat Money items designated as money with nointrinsic value other than what the Governmentdeclares it to have
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A Brief History of Money
Mr. GoldsmithMr. Richman
goldsafety
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A Brief History of Money
Mr. GoldsmithMr. Richman
assurancesafety
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A Brief History of Money
Mr. RichmanMr. Artist
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A Brief History of Moneyand
Banking
Mr. Goldsmith
interest
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The Creation of Money Like the goldsmith, banks today earn income by
lending money at a higher interest rate than what theypay their depositors for the use of their money
Banks and similar institutions who act as linksbetween those who have money to lend and those who
need money to borrow are called financialintermediaries
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The Creation of MoneyConsider Bank A
Bank A would have a value equal to:
Assets Liabilities = Net Worth
OR
Assets = Liabilities + Net Worth
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In Accounting terms, we could see Bank As value thru:
Assets Liabilities
Net Worth
The Creation of Money
Debit Credit
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We can define Bank As assets and liabilities thru:
Reserves 20 100 DepositsLoans 30
Investments 100
50 Net Worth
TOTAL 150 150 TOTAL
The Creation of Money
Assets Liabilities
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We can define Bank As assets and liabilities thru:
Reserves 20
Loans 30Investments 100
TOTAL 150
The Creation of Money
Assets
Reserves are cash on hand and depositsthat Bank A holds at the Central Bank
Loans and Investments are assets of Bank Athrough which they earn their income
The Central Bank requires a fixedpercentage of all Deposits as reserve
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We can define Bank As assets and liabilities thru:
100 Deposits
50 Net Worth
150 TOTAL
The Creation of Money
Liabilities
Deposits are debts /obligationsowed to depositors
The Central Bank requires a fixedpercentage of all Deposits as reserveThis percentage is called the
required reserve ratio
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So, how do banks create money?
Lets begin with Bank A and a deposit of $ 1,000
The Creation of Money
Bank A
Reserves 1,000 Deposit 1,000
Central Bank
Reserves 1,000 Deposit 1,000
BEGINNING MONEY POSITION
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Lets assume the Central Bank (CB) puts a 10 % reserverequirement rate. Then Bank A will be required toleave $ 100 with the CB, and will have $ 900 to loan out
The Creation of Money
Bank A
Reserves 100Loans 900
Deposit 1,000
Central Bank
Reserves 100(From Bank A)
Deposit 100
SECONDARY MONEY POSITION
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Assume Mr. M borrowed the $ 900, and deposited it toBank B, then Bank Bs account will be below, and theCB will be
The Creation of Money
Bank B
Reserve 90Loans 810
Deposit 900
THIRD MONEY POSITION
Central Bank
Reserves 100(From Bank A)
Deposit 100Deposit 90
(from Bank B)
Reserves 90(From Bank B)
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If we repeat this cycle with Mrs C who borrows Bank Bs$ 810 and deposits it to Bank C, then Bank C and theCB will be
The Creation of Money
Bank C
Reserve 81Loans 729
Deposit 810
FOURTH MONEY POSITION
Central Bank
Reserves 100(From Bank A)
Deposit 100Deposit 90
Deposit 81(from Bank B)Reserves 90
(From Bank B)
Reserves 81(From Bank C)
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The Creation of MoneyIf we tally the actual value of each Banks balance, we
will have:
Deposit Loans Reserves
Bank A 1,000 900 100
Bank B 900 810 90
Bank C 729 656.10 72.90
And so on and so forth
Total for all Banks 10,000 9,000 1,000
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The Creation of MoneyAs you can see, from an INITIAL deposit of S 1,000, the
new total deposit has ballooned to
Deposit Loans Reserves
Total for all Banks 10,000 9,000 1,000
The entire banking system can transform an initialincrease in the reserves into a multiplied anoubt ofnew deposits or bank money
The value of the new total of deposits is given as theproduct of 1/ reserve requirement rate and the initial
deposit
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The Creation of MoneyIn our example, given the initial deposit of $ 1,000 and
the reserve requirement rate of 0.10 ( 10%), then
1
The product of the money supply multiplier and theinitial deposit is the total new value of all deposit
10 x $ 1,000 = $ 10,000
0.10
= 10 10 is the money suppy multiplier
and
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The Demand for Money The demand for money is a demand for liquidity. The
quantity/amount of money we can hold is directlyproportional to our income (nominal).
The demand for money also depends on theopportunity cost of holding money. The relationship is
negative, so the higher the opportunity cost, the lesswe want to hold money
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The Demand for MoneyThese relationships are summarized in the function
below:
Md=f$Y(-i)
Where Md= demand for money
$ Y = nominal income , positive relation
- I = interest rate, negative relation
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The Demand for Money
i
In
terestrate
i
Money, M
M M
Md1Md2
At a constant Ian increasein nominal income shiftsthedemand for money curve tothe right
At a constant Mda decreasein the interest rate movesthe demand for money to the
right
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The Supply of MoneyHOW THE CENTRAL BANK AFFECTS THE MONEY SUPPLY
As seen in the previous section, the supply of money can be affected by
the level ofreserve requirement rate.
The money supply can also be influenced by the discount rate , theinterest rate banks pay the Central Bank to borrow from it
The money supply can also be influenced when the Central Bank decidesto engage in open market operations the buying and selling ofbonds
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The Supply of MoneyAs can be seen from the way the Central Bank can affect
the supply of money in the economy, interest plays akey role.
And yet, when we look at the interaction between theSupply and Demand for Money, we will treat the
Supply of Money as an exogenous variablefor now.
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The Supply of Money
In
terestrate
i
Money Supply, M
Ms
Assuming that the interest ratedoes not influence the money supply,
then the Money Supply Ms is avertical line
Ms
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Money Market Equilibrium Rate
In
terestrate
i
Money, M
M
Md Money Demand
Ms Money Supply
iA
Equilibrium A is where theDemand for Money equalsSupply for Money
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Money Market Equilibrium Rate
In
terestrate
i
Money, M
M
Md1
Ms Money Supply
i2
A
Equilibrium B is where theDemand for Money equalsSupply for Money, but withhigher interest rates
Md2i
B
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Money Market Equilibrium Rate
In
terestrate
i
Money, M
M
Md1
Ms1
i3
A
Equilibrium C is where theDemand for Money equalsSupply for Money, but withlower interest rates
i
Ms2
C
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Notes on Monetary PolicyWhen the Central Bank increases the Money Supply, it
engages in expansionary monetary policy
When the Central Bank decreases the Money Supply, itengages in contractionary monetary policy
Affecting the Money supply via open market operations
involve the Central Bank selling and buying ofgovernment securities, Treasury bills, and similarinstruments.
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Notes on Monetary PolicyThere is an inverse relationship betweenBond Prices and the Interest Rate
Bond Price Interest Rate
Bond Price Interest Rate
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SummaryEquilibrium interest rate is determined by the
equilibrium between the supply and demand formoney.
The Central Bank can affect the supply of Money by theRRR, discount rate, and the open monetary
operations.
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