Chapter 25 Summary

A. Money and Interest Rates 1. Money is anything that serves as a commonly accepted medium of exchange or means of payment. Money also functions as a unit of account and a store of value. Before money came into use, people exchanged goods for goods in a process called barter. Money arose to facilitate trade. Early money consisted of commodities, which were superseded by paper money and then bank money. Unlike other economic goods, money is valued because of social convention. We value money indirectly for what it buys, not for its direct utility. 2. Two definitions of money are commonly used today. The first is narrow (or transactions) money (M1) - made up of currency and checking deposits. The second important concept is broad money (M2), which includes M1 plus highly liquid near-monies like savings accounts. The definitions of the M's have changed over the last two decades as a result of rapid innovation in financial markets. 3. Interest rates are the prices paid for borrowing money; they are measured in dollars per year paid back per dollar borrowed or in percent per year. People willingly pay interest because borrowed funds allow them to buy goods and services to satisfy consumption needs or make profitable investments. 4. We observe a wide variety of interest rates. These rates vary because of many factors such as the term or maturity of loans, the risk and liquidity of investments, and the tax treatment of the interest. 5. Nominal or money interest rates generally rise during inflationary periods, reflecting the fact that the purchasing power of money declines as prices rise. To calculate the interest yield in terms of real goods and services, we use the real interest rate, which equals the nominal or money interest rate minus the rate of inflation. The U.S. government recently issued inflation-indexed bonds, which guarantee a fixed real return on investments. 6. The demand for money differs from that for other commodities. Money is held for its indirect rather than its direct value. But money holdings are limited because keeping funds in money rather than in other assets has an opportunity cost: we sacrifice interest earnings when we hold money. 7. People hold money primarily because they need it to pay bills or buy goods. Such transactions needs are met by M1 and are chiefly related to the value of transactions or to nominal GDP. Economic theory predicts, and empirical studies confirm, that the demand for money is sensitive to interest rates; higher interest rates lead to a lower demand for M. B. Banking and the Supply of Money 8. Banks are commercial enterprises that seek to earn profits for their owners. One major function of banks is to provide checking accounts to customers. Modern banks gradually evolved from the old goldsmith establishments in which money and valuables were stored. Eventually it became general practice for goldsmiths to hold less than 100 percent reserves against deposits; this was the beginning of fractional-reserve banking. 9. If banks kept 100 percent cash reserves against all deposits, there would be no creation of money when new reserves were injected by the central bank into the system. There would be only a 1-to-1 exchange of one kind of money for another kind of money. 10. Today, banks are legally required to keep reserves on their checking deposits. These can be in the form of cash on hand or of non-interest-bearing deposits at the Federal Reserve. For illustrative purposes, we examined a required reserve ratio of 10 percent. In this case, the banking system as a whole - together with public or private borrowers and the depositing public - creates bank money 10 to 1 for each new dollar of reserves created by the Fed and deposited somewhere in the banking system. 11. Each small bank is limited in its ability to expand its loans and investments. It cannot lend or invest more than it has received from depositors; it can lend only about nine-tenths as much. Although no bank alone can expand its reserves 10 to 1, the banking system as a whole can. Each bank receiving $1000 of new deposits lends nine-tenths of its newly acquired cash on loans and investments. If we follow through the successive groups of banks in the dwindling, never-ending chain, we find for the system as a whole new deposits of $1000 + $900 + $810 + $729 + ... = $1000 × [1 + 9/10 + (9/10)2 + (9/10)3 + @ @ @ ] = $1000(1/(1 - 9/10)) = $1000(1/0.1) = $10,000 More generally: Money-supply multiplier = (change of money)/(change of reserves) = 1/(required reserve ratio) 12. There may be some leakage of new cash reserves of the banking system into circulation outside the banks and into assets other than checking accounts. When some of the new reserves leak into assets other than checking deposits, the relationship of money creation to new reserves may depart from the 10-to-1 formula given by the money-supply multiplier. C. A Tour of Wall Street 13. Households own a variety of financial assets. The most important are money, savings accounts, government securities, equities, and pension funds. 14. Assets have different characteristics, the most important being the rate of return and the risk. The rate of return is the total dollar gain from a security. Risk refers to the variability of the returns on an investment. Because people are risk-averse, they require higher returns to induce them to buy riskier assets. 15. Stock markets, of which the New York Stock Exchange is the most important, are places where titles of ownership to the largest companies are bought and sold. The history of stock prices is filled with violent gyrations, such as the Great Crash of 1929. Trends are tracked by the use of stock-price indexes, such as the Standard and Poor's 500 or the familiar Dow-Jones Industrial Average. 16. Modern economic theories of stock prices generally focus on the role of efficient markets. An efficient market is one in which all information is quickly absorbed by speculators and is immediately built into market prices. In efficient markets, there are no easy profits; looking at yesterday's news or past patterns of prices or elections or business cycles will not help predict future price movements. Thus, in efficient markets, prices respond to surprises. Because surprises are inherently random, stock prices and other speculative prices move erratically, as in a random walk. 17. Implant the five rules of personal finance firmly in your long-term memory: (a) Know thy investments. (b) Diversify, diversify, that is the rule of the prophets of finance. (c) Consider common-stock index funds. (d) Minimize unnecessary costs and taxes. (e) Match your investments to your risk preference.