💸Principles of Economics Unit 27 – Money and Banking

What's Money All About?

• Money serves as a medium of exchange facilitates transactions by eliminating the need for direct barter
• Acts as a store of value allows individuals to save and accumulate wealth over time
• Functions as a unit of account provides a standard measure for comparing the value of goods and services
  • Enables price comparisons across different products and markets
  • Simplifies financial record-keeping and accounting practices
• Money supply consists of currency in circulation and various types of bank deposits (checking accounts, savings accounts)
• Fiat money is not backed by a physical commodity derives its value from government decree and public trust
• Commodity money has intrinsic value based on the material it is made from (gold coins, silver certificates)
• Liquidity refers to the ease with which an asset can be converted into cash without significant loss of value

Banking Basics

• Banks act as financial intermediaries connecting savers with borrowers and facilitating the flow of funds in the economy
• Commercial banks accept deposits from customers and use these funds to make loans to individuals and businesses
  • Deposits can be withdrawn on demand or have specific maturity dates (certificates of deposit)
  • Loans include mortgages, car loans, personal loans, and business loans
• Banks earn profits by charging higher interest rates on loans than they pay on deposits (net interest margin)
• Fractional reserve banking allows banks to lend out a portion of their deposits while keeping a fraction in reserve to meet withdrawal requests
• Bank reserves are held as cash in bank vaults or as deposits with the central bank
• Capital requirements regulate the amount of equity banks must hold relative to their assets to ensure financial stability
• Banks manage risk by diversifying their loan portfolios and implementing credit assessment procedures

How Money Moves

• Payments systems facilitate the transfer of funds between individuals, businesses, and financial institutions
• Cash transactions involve the physical exchange of currency and are settled immediately
• Checks are written orders instructing a bank to pay a specified amount from the account holder's account to the payee
  • Check clearing process involves the transfer of funds from the payer's bank to the payee's bank
• Electronic fund transfers (EFTs) move money electronically between bank accounts (direct deposit, online bill payments)
• Credit card transactions allow consumers to make purchases using borrowed funds repaid over time with interest
• Debit card transactions directly deduct funds from the cardholder's bank account at the time of purchase
• Wire transfers facilitate the rapid movement of large sums of money between banks domestically and internationally
• Automated clearinghouse (ACH) processes batches of electronic payments, such as payroll deposits and recurring bills

Central Banks and Monetary Policy

• Central banks are responsible for conducting monetary policy to achieve economic goals (price stability, full employment)
• Federal Reserve System (Fed) serves as the central bank of the United States consists of the Board of Governors and 12 regional Federal Reserve Banks
• Open market operations involve the buying and selling of government securities to influence the money supply and interest rates
  • Buying securities injects money into the economy, while selling securities removes money from circulation
• Discount rate is the interest rate charged by the central bank when lending to commercial banks affects the cost of borrowing and credit availability
• Reserve requirements set the minimum amount of reserves banks must hold against their deposits influences banks' lending capacity
• Quantitative easing (QE) is an unconventional monetary policy tool used to stimulate the economy by purchasing long-term securities
• Forward guidance communicates the central bank's future policy intentions to shape market expectations and influence long-term interest rates
• Central bank independence ensures that monetary policy decisions are made based on economic considerations rather than political pressures

Interest Rates and Their Impact

• Interest rates represent the cost of borrowing money and the return on savings
• Nominal interest rates are the stated rates without adjusting for inflation
• Real interest rates account for inflation and reflect the true cost of borrowing or return on savings ($real interest rate = nominal interest rate - inflation rate$)
• Prime rate is the interest rate banks charge their most creditworthy customers influences other lending rates in the economy
• Yield curve depicts the relationship between bond maturities and their corresponding interest rates (yields)
  • Normal yield curve has higher interest rates for longer maturities, reflecting higher risk and time value of money
  • Inverted yield curve has lower interest rates for longer maturities may signal economic uncertainty or expectations of future interest rate cuts
• Higher interest rates encourage saving and discourage borrowing, while lower interest rates stimulate borrowing and spending
• Interest rates affect the cost of financing for businesses and consumers (mortgages, car loans, credit card debt)
• Changes in interest rates can impact asset prices (bonds, stocks, real estate) and currency exchange rates

Financial Markets and Instruments

• Financial markets facilitate the buying and selling of financial assets and the allocation of capital in the economy
• Capital markets enable long-term financing through the issuance and trading of stocks and bonds
  • Stock markets (equity markets) allow companies to raise funds by selling ownership shares to investors
  • Bond markets (debt markets) enable companies and governments to borrow money by issuing fixed-income securities
• Money markets facilitate short-term borrowing and lending with maturities of one year or less (Treasury bills, commercial paper)
• Derivatives markets involve contracts whose value is derived from an underlying asset (options, futures, swaps)
• Primary markets are where new securities are issued and sold to investors (initial public offerings, bond issuances)
• Secondary markets provide liquidity by allowing investors to buy and sell previously issued securities (stock exchanges, over-the-counter markets)
• Market efficiency refers to the degree to which asset prices reflect all available information
• Regulation aims to ensure fair and transparent market practices, protect investors, and maintain financial stability (Securities and Exchange Commission)

Money in the Real World

• Inflation occurs when the general price level of goods and services increases over time erodes the purchasing power of money
  • Measured by the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) index
  • Caused by factors such as increased money supply, rising production costs, or higher demand relative to supply
• Deflation is a sustained decrease in the general price level can lead to delayed spending and economic contraction
• Hyperinflation is an extremely high and rapid rate of inflation (usually over 50% per month) can cause severe economic and social disruption (Venezuela, Zimbabwe)
• Exchange rates determine the value of one currency in terms of another affect international trade and investment flows
  • Appreciation occurs when a currency increases in value relative to other currencies makes exports more expensive and imports cheaper
  • Depreciation occurs when a currency decreases in value relative to other currencies makes exports cheaper and imports more expensive
• Monetary policy decisions impact borrowing costs, investment decisions, and overall economic activity
• Financial crises, such as the 2008 global financial crisis, highlight the importance of stable financial systems and effective regulation
• Cryptocurrencies, like Bitcoin, have emerged as digital alternatives to traditional fiat currencies but face challenges in widespread adoption and regulatory oversight

Key Takeaways and Future Trends

• Money serves multiple functions in the economy, facilitating transactions, storing value, and providing a unit of account
• Banks play a crucial role as financial intermediaries, accepting deposits and making loans to support economic growth
• Central banks conduct monetary policy to achieve price stability and promote economic growth using tools such as open market operations and interest rate adjustments
• Interest rates influence borrowing and saving decisions, affect asset prices, and shape economic activity
• Financial markets enable the allocation of capital and provide liquidity for investors through the trading of various financial instruments
• Inflation and exchange rates have significant impacts on the purchasing power of money and international economic relationships
• Effective regulation and oversight are essential for maintaining the stability and integrity of the financial system
• Technological advancements, such as digital payments and cryptocurrencies, are transforming the financial landscape and presenting new opportunities and challenges
• Financial inclusion efforts aim to expand access to financial services for underserved populations and promote economic empowerment
• Sustainable finance and environmental, social, and governance (ESG) considerations are gaining prominence in investment decisions and financial market practices