Understand How and Why Money Is Used Instead of Barter

MONEY

Expectations:

What is money?

What are the functions of money?

Understand how and why money is used instead of barter

Understand why credit cards are not a component of the basic money supply.

Definition: assets people use to purchase goods and services from other people. Serves as a medium of exchange, store of value and unit of account.

Types of money

Commodity money: money that can be exchanged for gold, silver, or some other valuable commodity.

Fiat money: money that is by decree worth something. (US $ is fiat money.)

Categories of money:

M1 -- cash (only 30%) of liquid money, M1. Wheres the rest of the money? Checking account balance sheets.

M2 – M1 plus money market mutual funds, certificates of deposit, less liquid

M3 – M2 plus large time deposits

“We use credit cards to make purchases, just like cash and checks. Why aren’t credit cards counted as part of the money supply?”

* Because they represent a loan being made to the user, credit cards do not satisfy the store of value function of money.

Functions of money.

* Medium of exchange – buyers give to sellers

* Unit of account – a yardstick

* Store of value – transfer purchasing power to the future.

What if we didn’t have money? Life would be pretty inconvenient.

How your money can grow over time: when money is invested and an interest rate is applied, it compounds over time.

If the principle investment is $10,000 and the interest rate remained constant at 5%, at the end of the first year you would have:

$10,000 x 1.05 = $10,500

At the end of the second year, you would have:

$10,500 x 1.05= $11,025

For more understanding of money and banking institutions, see Carbaugh or Mankiw (on reserve).

So, how is it that banks circulate money, and how does money multiply through the economy?

FIRST NATIONAL BANK

AssetsLiabilities

Reserves $100Deposits$100

Now let’s say that banks only have to keep a fraction of reserves on the books, what do they do?

FIRST NATIONAL BANK

AssetsLiabilities

Reserves $10Deposits$100

Loans$90

The banks make loans, which are then held in other banks.

SECOND NATIONAL BANK

AssetsLiabilities

Reserves$9Deposits$90

Loans $81

So, the money multipler is 1/reserve ratio.

I show you this, just so that it will make understanding of monetary policy easier.

Where do you keep your money? Not a lot of difference now…

* under the mattress?

* commercial banks (private stockholder held, full service)

* S&L (used to be for needy borrowers, now more specialized/ mortgage loans)

* mutual savings bank (households with small savings)

* credit union (cost advantages)