Money

• In modern day economics, (fiat) money is valued because of society’s shared trust and agreement that it has value and can be used for transaction
• The quantity of money in an economy is closely linked to the quantity of lending or credit in the economy

Monetary Systems §

• Economies without money operate on a barter system

  • Bartering is inefficient for coordinating trade.
  • Bartering entails a double coincidence of wants where both parties must have something the other wants.
  • Bartering does not allow us to easily enter into future contracts
  • It does not allow for an economy to grow because people will have to interact with the complex system of bartering for goods.

• Money fulfills several functions in the economy

  • It is a medium of exchange that acts as an intermediary between buyer and seller as both accept money as payment.
  • It is a store of value because it is non-perishable and it retains its value as money.
  • It is a unit of account which serves as a way to measure the value of goods and services. It simplifies evaluating transactions.
  • It is a standard of deferred payment which makes it acceptable to have transactions where the buyer pays in the future.

• Commodity Money pertains to things which act as money but also as things with value or utility beyond being money.

• Commodity-backed Currency pertains to currency backed up by commodities held at a bank.

• Fiat Money - money that has no intrinsic value beyond being an accepted standard by all involved parties for use as legal tender.

• Liquidity - refers to how quickly a financial asset can be used to buy a good or service.

  • The M1 Money Supply includes monies that are very liquid
    • Cash including all currency in circulation.
    • Checkable Deposits - amounts held in checking accounts and where the bank can give money on demand
    • Savings Deposits - bank accounts from which money can be withdrawn at an ATM rather than through check.
  • The M2 Money Supply includes M1 plus monies that are less liquid
    • Money market funds - pools of deposits from many investors.
    • Time Deposits - accounts that the depositor has committed to leaving in the bank for a certain period of time in exchange for high interest.

• A debit card is an instruction to the user’s bank to transfer money directly and immediately from the bank account to the seller.

• A credit card is an instruction to transfer money directly from the credit card company to the seller but where the buyer is treated as “borrowing” money from the credit card company.

• A smart card is used to store a certain value of money on the card and use it to make purchases.

Banks §

• Banks act as financial intermediaries from which people can store money in an account so that they no longer have to carry all the cash on hand.
  • A financial intermediary is an institution (typically a bank) that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank.
  • All the money in the bank from all its savers are pooled together, and it is from this pool that the bank takes from to lend.
• Banks lower transaction costs since people can go directly to the bank for cash.

Bank Capital §

• A balance sheet lists assets and liabilities. Assets are things owned and used to produce something; Liabilities are things owed and considered debt.

• Net Worth is calculated as the total value of Assets minus the total value Liabilities. A positive net worth is indicative of a healthy business. A negative net worth means the business is bankrupt.

• The bank capital is the bank’s net worth.

  • Deposits are viewed as liabilities from the perspective of the bank since the bank is borrowing the saver’s money
  • Withdrawals are viewed as assets from the perspective of the bank since the bank is lending money to the borrower.

• The primary loan market is the market where financial institutions make loans to borrowers

• The secondary loan market is the market where financial institutions buy and sell loans.

• Banks can go bankrupt when the number of loan defaults (loans unpaid) is greater than expected. ¹

  • This is especially apparent due to asset-liability time mismatch. Borrowers can withdraw money quickly (short term) but many of the bank’s assets will only be repaid over years (long term)
  • Like in the Financial Market, banks can diversify its loans. However, this will not help during a recession that touches many sectors.

• The willingness of the bank to give a loan is dependent on the riskiness of the loan (higher risk = lower likelihood of paying to acquire the loan.

• Another factor is interest rate. Higher interest rate relative to market rates = higher likelihood of paying to acquire the loan.

• Aside from bank loans, a bank has bonds and reserves that act as assets.

• Banks make money through loans. In particular, if there are multiple banks, they are only required to hold a fraction of their deposits as reserves. The loan of one bank can then become deposits other banks which increases the money supply

• The money multiplier formula says how many rounds of lending in a banking system there are.

• The total change in the M1 money supply (and the amount made by the bank) are given us
• Banks make money by allowing money to circulate.

Exchanging Money §

• The presence of many internationally recognized currencies means that there is a need to establish rules for exchanging between them.

• The exchange rate is the price of one currency in terms of another.. This can be treated with respect to supply and demand.

  • When the exchange for a currency rises so that the currency exchanges more for other currencies, it is appreciating.
  • Otherwise, when it is weakening, it is depreciating
  • The appreciation of one currency means the depreciation of another.

• The foreign exchange market is the market where entities use one currency to purchase another

  • We buy from the foreign exchange market at a price dictated by the exchange rates
  • We sell to the foreign exchange market at a price lower than that dictated by the exchange rate. This scheme allows the foreign exchange market to be profitable
  • In this market, entities are both demanders (of foreign currency) and suppliers (of domestic currency). Common entities involved are

	Supplies	Demands
Firms involved in international markets	Currency of nation where they sell their products	Currency of nation where they produce products
Tourists	Currency of nation where they came from	Currency of tourist destination
Investments (FDI and Portfolio)	Currency of nation where they are from	Currency of nation they are investing to

• Foreign direct investment - purchasing a firm in another company or starting up a new enterprise in a foreign company

• Portfolio investment - involves a financial investment that does not entail ownership

  • This entails not only betting on profitable exchange rates but also protecting oneself from volatile exchange rates
  • Hedging - using a financial transaction to protect oneself against a risk from one of the investments. In exchange for a fee, any conversions for an investment is guaranteed a fixed exchange rate.
  • Portfolio investments contribute a lot to the foreign exchange market

• Appreciating currency benefits the suppliers. Depreciating currency benefits the demanders.

• Dealers, which are banks or firms, facilitate foreign exchange in the interbank market.

Supply and Demand §

• In the foreign exchange market Supply and Demand move at the same time.

• Predicted appreciation of value of = Demand for increases = Supply of decreases .

• If a county’s rate of return on investment is high, then Demand for the county’s currency increases and supply of decreases.

• If a county is at a high inflation rate, then there is less demand for its currency due to the low purchasing power. The supply of increases.

• If at a certain exchange rate it was much cheaper to buy internationally traded goods in a country with currency than in other currencies, then demand for increases and supply of decreases.

  • Arbitrage - the process of buying and selling goods across international borders at a profit
  • Over time, arbitrage forces prices and exchange rates to align so that the price of internationally traded goods is similar in all countries. The exchange rate in this scenario is the Purchasing Power Parity Exchange Rate
    • The PPP Exchange Rate tends to stay constant or fluctuate only slightly. Thus, we can use it to compare GDP
    • The PPP also allows for tracking exchange rate relationships
    • A country experiencing hyperinflation is less likely to be at its PPP Exchange Rate since hyperinflation induces depreciation of the currency.

• Movements in exchange rates will affect Aggregate Supply and Demand.

  • It can incentivize Trading behavior.
    • Stronger exchange rate = trade deficit or reduced trade surplus
    • Weaker exchange rate = trade surplus or reduced trade deficit.
  • Appreciating domestic currency means a reduction of exports and addition of more imports. However, this does not mean that exports are always good since the money will eventually circulate back to its country of origin.
  • Sharp movements in exchange rates can lead to dramatic changes in profits and losses.
  • Borrowers of will benefit when appreciates and will suffer losses when depreciates. This happens because the change in exchange rate means that they would have to pay a larger or smaller amount than what they otherwise would have paid to foreign lenders.

• Weaker exchange rates can stimulate aggregate demand and reduce a recession

• Stronger exchange rates stimulate aggregate supply and reduce inflation.

Links §

• Shapiro, MacDonald and Greenlaw - Ch. 27, 29

Footnotes §

1. For example, during a recession. ↩