_________________________________ BANKING & FINANCE CHAPTER 3 NAME “Money and Interest” 3.1 The Money Supply DEFINITIONS: Money Supply- The liquid assets held by banks and individuals (all the money in circulation and in banks) Liquidity- The measure of how quickly assets may be converted to something of value like cash Aggregate measures-a total measurement of the money supply M1- Money that can be easily spent- cash, checks, money in checking accounts M2- M1 plus short-term investments like savings/money market accounts (small accounts less than 100k) M3- M1 plus M2 and large bank deposits (over 100k) MZM- Money at zero maturity –a way of measuring the annual change in the money supply. 2 Types of Money: Commodity money-something of value like gold, stones, precious metals Fiat money- money that is deemed legal by the government (dollar bills, checks, etc)* not a commodity Fractional-Reserve System- only a fraction of currency is held on reserves for customers that deposit it, the other portion can be loaned out. This assumes only a small portion of customers will want their money back at the same time. Example: Customers deposit 100k, banks hold only 10k, and loan out the remaining 90k. THINK CRITICALLY PG. 67 Why are there more elements to the money supply than just the money that is actively circulating? Money held in savings accounts or short-term investments can easily be accessed and then would be in circulation Why do different parts of the money supply need to be measured differently? To understand how the varying degrees of liquidity impacts our economy 3.2 Money Creation and Circulation DEFINITIONS: Primary Reserves- consist of cash on hand, deposits that maybe due from other banks, and the percentage required by the Federal Reserve System Secondary Reserves- securities the bank purchases from the Federal government Multiplier Effect- Since banks can loan out up to 90% of their deposits, this essentially creates more future deposits (see below example) Ledger entries- A record of deposits and spending (money by entry, not cash that is moving) Example: Depositing or writing a check, using a debit card Treasury securities- Securities that the FED sells to the public to raise money (EE Savings Bonds) BANKING MATH QUESTION- MULTIPLIER EFFECT (fill in the blanks) Calculate the total amount of money “created from a deposit of $15,000 as it moves through four cycles of deposit. Assume a reserve rate of 10%. Solution: Deposit – Reserve = New Deposit Deposit #1: $ 15,000 - $ 1,500 = $13,500 ( .10 x $15,000 = $1,500) Deposit #2 $ 13,500 - $ 1,350 =_ $12,150 (.10 x $13,500 = $1,350)______________ Deposit #3 $12,150 - $1,215 (.10 x $12,150= $1,215) = $10,935 Deposit #4 $10,935 - $1,093.50 = $ 9,841.50 (.10 x $10,935 = $1,093.50) TOTAL DEPOSITS: =_46,426.50_______ What is the total amount “created” resulting from the four deposits, that is available for use in the money supply. THINK CRITICALLY (PG 73) Why can’t banks and the Federal Reserve just create money at will so that all people will have what they need? The more money that is printed the more it loses its value (scarcity gives it value) Why is the stability of the U.S. government such a large factor in the monetary system? The Government insures the banks (FDIC), sometimes funds the banks, and creates bonds/notes Why do some people say that money is “borrowed into existence”? Customers make deposits in banks, banks loan the money out, those people deposit that money then it is loaned out (process continues) 3.3 Interest and Interest Rates Define and Explain: Federal funds rate- the amount of interest charged for short-term, interbank loans Discount rate-the interest rate that the Federal Reserve sets and charges for loans to member banks Prime rate- the rate that banks charge their best and most reliable customers. THINK CRITICALLY (PG. 77) 1. Why do you think so many people believe that the Federal Reserve controls interest rates? When the discount rate changes the other rates soon follow to the same change The FEDS impact many policies that effect interest rates. 2. Why does the prime rate so often move up or down with the discount rate? The prime rate is set just a few points above the discount rate. If it costs more for banks to take loans from the FEDS then they passed that cost to their customers. ONLINE RESEARCH CH. 3 “MONEY & INTEREST” Research to find what the current interest is at: Federal funds rate_________________% Discount rate_____________________% Prime rate_______________________% What was the Fed Funds Rate in 1990? What was the Fed Funds Rate in 1980? What interest rate does the FEDERAL RESERVE control? Why does this impact other interest rates? Who is the Chairman of the FEDERAL RESERVE (FEDS)?