AP Macro Notes Unit 4

Money has been around forever.
Barter system: Problem with Barter system is double coincidence of wants. You have to want what I have and vice versa. We would have to spend time searching for others to trade with. Huge waste of time!

Functions of Money:
1) Medium of Exchange: It must be able to be used to buy goods and services.
That way I do not have to trade Bonsai for hamburgers.

2) Measure of Value: It must be capable of being a measurement as to the relative worth of a good or service.
Which is worth more a Bonsai or a hamburger?

3) Store of Value: You can hold it without worrying about it spoiling.

Three definitions of money

M1 = Currency + Checkable Deposits

Currency: Coins and Paper Money
Coins are token money because the value of the metal is not worth what the actual coins represents.
Paper money is actually Federal Reserve Notes.
plus

Checkable Deposits: (the largest component of M1 (It constitutes around 70%))
Checking accounts are a way of transferring money from one account to another. They can be easily converted into liquid cash.

*** Notice that M1 must be in the hands of individuals. Not in the hands of the treasury or the banks. This avoids double counting money. (Your money is in your checking account but it is yours. It is counted as part of yours. It is not counted as part of the banks money.)

M2 = M1 + savings accounts + small time deposits + money market deposit accounts + money market mutual funds

Savings accounts: you can readily convert this to cash. (Sometimes called near money)

Time deposits: money that can only be gotten when they mature. (C.D.'s of less than $100,000...)

Money Market Deposit Accounts: you buy shares in a money market. This money is then used by the bank to make large loans. You get a larger rate of return.

Money Market Mutual Funds: This money us use to buy short-term securities such as T bills (treasury bills).

M3 = M1 + M2 + large time deposits

Large Time deposits: These are usually held by business.

For the most part M1 is a good definition of money. Other times we will use M2. Rarely will economist use M3 because it is so broad. No matter what the definition the models work.

Credit cards are not included because they do not represent money. Instead, they are short term loans from the creditor.

Unit 4 Lesson 2, Day 1

Equation of Exchange
MV = PQ
M = supply of money
V = velocity of money (number of times a year that a dollar is spent on final G & S.
P = price level (average price of each unit of output)
Q = physical volume of G & S produced.

MV is the amount spent by consumers This is the same as the total C + I + G + Xn
PQ is the amount received by sellers. This is the same as nominal GDP (current output at current prices)

What happens if M changes? When M increases you have to look to see if the economy is in full capacity. If it is not then Q increase. If it is then P increases.

One argument about V is that it is determined by people’s willingness to hold money in a non interest bearing form. If the interest rates go way up people are willing to hold less money. This means that the money they are holding must turn over quicker so V increases.


V is actually fairly stable.
Unit 4 Lesson 3 Days 2 and 3

Balance Sheet: a statement of assets and claims summarizing the financial position of a firm or bank at some point in time.

A balance sheet must always balance. Every asset is claimed by someone.

net worth: the claims of the owners against the firm’s assets

liabilities: claims of the non-owners.

Assets = net worth + liabilities

In the beginning people would not want to carry around large sums of gold. They would therefore bring the gold to goldsmiths who would issue them receipts. Eventually people found it easier to trade receipts rather than gold. They knew that they could get the gold if they wanted to. The receipt was backed by gold.

Soon the goldsmiths saw that more gold was deposited than taken out. They decided to issue receipts that was not backed by gold. They did this in the form of loans.

The fractional reserve system of banking was started. Only a fraction of the receipts were covered with gold.

The goldsmiths created money. Today the same thing occurs. Banks make loans based on an amount that the Federal Reserve requires them to keep in reserve.
legal reserve (reserve): an amount of funds equal to a specified percentage of its own deposit liabilities which a member bank must keep on deposit with the Federal Reserve Bank in its district or as vault cash.

reserve ratio: this is the specified percentage of its demand liabilities, which the commercial bank must keep as reserves.

Reserve ratio = banks required reserves / banks demand-deposit liabilities.

EX: 10% = 10,000/100,000

From here on we will for simplicity reasons assume a rate of 20%.
Notice the amount by which the banks actual reserves exceed its required reserves is called excess reserves.

actual reserves - required reserves = excess reserves.
110,000 - 20,000 = 90,000

**** It is very important that you understand this concept. You must be able to compute all of these numbers. It is the excess reserves that allow a bank to create money. ****

This is called the Fractional Reserve Banking System: A system in which depository institutions hold reserves that are less than the amount of total deposits.

The required reserves are not there for the banks to draw on if a run occurs. Instead the required reserves are there so that the Fed can control the amount of money the bank lends.

When the bank puts its reserves in the Fed what does this represent for the Fed? a liability for the Fed.

Lets look and see what happens if one of our banks customers writes a 50,000 dollar check. This check will go through another bank. This bank will credit the account of the person that our customer paid.

The other bank will now send the check to the Fed. (This actually happen electronically now.) The Fed will take this check and increase the other banks reserves by 50,000.

It will then take 50,000 out of our reserves. The check will then be sent to us. We will then take the money out of our customer’s account (reducing our demand deposit by 50,000 and reduce our reserves by the 50,000.