💸Principles of Economics Unit 27 – Money and Banking
Money and banking form the backbone of modern economies, facilitating transactions and shaping financial systems. This unit explores the functions of money, the role of banks as intermediaries, and the mechanisms of monetary policy implemented by central banks.
Students will learn about different types of financial instruments, the impact of interest rates, and the workings of financial markets. The unit also covers real-world applications, including inflation, exchange rates, and emerging trends in digital currencies and sustainable finance.
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Deposits can be withdrawn on demand or have specific maturity dates (certificates of deposit)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 (realinterestrate=nominalinterestrate−inflationrate)
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
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