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CFA Level I - Reading 24 - Money, U.S. inflation
Functions of money
1. Settling a debt
2. Medium of exchange.
3. Unit of account
4. Store of value
Medium of exchange
Without money, goods and services, needs to be exchanged with other goods and services aka Bartering system.
Unit of account
Agreed measure for stating the prices of goods and services. Example: Movie ticket vs can of soda.
When one unit is quoted in another, is called opportunity cost. An example would be opportunity cost of a movie ticket is 10 magazines.
Store of value
Money is a store of value. It can stored and exchanged later for goods and services.
Deposits vs checks
Deposits are money but not checks. Checks are information to the bank, to transfer money from one account to another account.
A firm that holds the deposits and makes loans to other households is known as Depository institution.
Types of depository institution
1. Commercial banks.
2. Thrift institutions.
3. Money market mutual funds.
One that takes deposits and makes loans. They are authorized by Comptroller of the currency.
How banks make money?
By providing deposits at a lower rate and charging loans at a higher rate. The difference is their profit.
Security to depositors
A bank keeps its cash in vault and reserves in federal reserve bank.
Assets of bank
1. Liquid assets. (U.S. Treasury bills and commercial bills)
2. Investment securities. (Long term U.S. Government bonds)
3. Loans made to others by bank.
Savings and loan associations
Money market funds
They are mutual funds operated by financial institutions. The assets are held in U.S. treasury bills and short term commercial bills.
Four roles of depository institutions
1. Creating liquidity.
2. Minimizing cost of obtaining funds.
3. Minimizing the cost of monitoring borrowers.
4. Pooling risk.
By borrowing short and lending long. All depository institutions borrows from the depositors and makes a loan commitment for the longer duration.
Pooling the risk
When money is lent to a borrower, if the default happens, then the risk is pooled among all depositors instead of one. This lowers the risk for depositors.
The process of developing new financial products and earn profits from it, by the financial institutions is known as 'Financial innovation'.
Reasons for financial innovation
1. Economic environment
High inflation in 1990s, brought variable interest rate mortgages to avoid banks paying higher interest on deposits with a lower mortgage income.
Money consists of currency and deposits in banks.
M1 and M2
M1 = All cash , traveler's check and money in checking account held by individuals and businesses.
M2 = M1 + Deposits in savings, time deposits and money market in institutions.
Immediate liquidity. Money from M1 can be transferred from X to Y in no time.
Short term liquidity includes time deposists
Deposits that are made with a fixed time frame like Certificate of deposits.