Money, Credit and Banking

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Currency:

Function:

Medium of exchange, (portable, durable. Divisibility, non-counterfeitable)

store of value,

Unit of account,

Social memory (longer): keeps track of socially desirable gifts

Evolution

Commodity Money：Gold/silver, etc

Fiat money: paper

Problems

Zero nominal interest

Crime (currency is hard to trace)

Evolution of the payments system

Checks

Electronic Payment

E-Money

Broader notion of Money

Monetary Base-- refers to the sum of bank reserves (deposits held by banks at the federal Reserve) and currency

Quantity Theory

Inflation: rate of increase of the price level

Price level: relative price of goods and services to dollars.

Quantity Theory----Inflation should be shaped by relative supplies of money to goods (by amount of “money” held by spenders)(Money supply grows a lot, inflation should rise)

Fail?

Monetary base grew a lot, but money demand grew at the same time---no inflationary pressure

Bank were willing to hold growing reserves since anticipated that after economy improved, FED would either pay higher interest rate on reserves or buy back the reserves using gov’t assets.

M1 money stock (most liquid assets)= currency(outside of banks)+ traveler’s checks+ demand deposits= other checkable deposits

M2 money stock= M1+small denomination time deposits + savings deposits and money market deposit accounts+ money market mutual fund shares

Less liquid than M1 but are still quickly accessible by householders

Quantity theory does not work well in M1 and M2 (likely because ir is low)

The federal reserve’s Monetary aggregates

M1 and M2 can move in different directions in the short run

The behavior of the quantity of the money depends on the choice of monetary aggregate

Use M3 = form of privately created money used by financial institutions (mattered a lot in financial crisis)

Yield to maturity of a debt instrument is defined to be the interest rate such that the present value of cash flow payments from the instrument, calculated using YTM equals the price of the debt instrument.

Four types of credit market instruments:

Simple loan

Fixed payment loan

Coupon bond (will pay principle/face value)

Perpetual coupon bond(consol/perpetuity): a bond with no maturity date that does not repay principle but pays a fixed coupon payment forever

YTM*PC=C

discount bond

Pays no coupons, only a face payment in N years

P= F/ (1+YTM)N

Nominal interest rate: make no allowance for inflation

Real interest rate : adjusted for changes in price level so it more accurately reflects the cost of borrowing.

Ex ante real interest rate is adjusted for expected changes in price level.

Ex post real interest rate is adjusted for actual changes in price level.

Fisher Equation: rexp(EX-ANTE REAL INTEREST RATE)=(1+R)/(1+infexp)-1≈R-infexp(expected inflation)