DSST Money and Banking cheat sheet

Money's three functions: medium of exchange, unit of account, store of value; a store of value must be liquid but need not be a medium of exchange.

M1 = currency held by the public + checkable (demand) deposits + traveler's checks; M2 = M1 + savings deposits, small time deposits, and retail money market mutual fund shares.

Commodity money has intrinsic value; fiat money is value by government decree and is a liability of no one, so its value rests on trust and scarcity.

Double coincidence of wants is the barter problem money solves; specialization and division of labor depend on a widely accepted medium of exchange.

Gresham's law: bad money drives out good when legal tender laws force acceptance at face value; debasement of coinage historically follows this pattern.

Money is the most liquid asset; liquidity is the ease of converting an asset to money at low cost and without loss of value.

Financial intermediaries reduce transaction costs, pool risk, and solve asymmetric information through screening (adverse selection) and monitoring (moral hazard).

Seigniorage is the revenue a government gains by issuing money; hyperinflation erodes money's store-of-value and unit-of-account roles first.

Bond price and yield move inversely; price = sum of coupon/(1+y)^t plus face/(1+y)^n, where y is yield to maturity.

Current yield = annual coupon / market price; for a discount bond the current yield overstates YTM if the bond is bought below par.

Fisher equation: nominal rate = real rate + expected inflation (approximately); the exact form is (1+r)(1+pi) - 1.

Term structure theories: expectations theory (long rates are averages of expected short rates), liquidity premium, and segmented markets.

A normal yield curve slopes upward; an inverted curve has occurred before most U.S. recessions and signals expected rate cuts.

Stock valuation: dividend discount model P = D1/(r - g), valid only when r > g; the Gordon growth model assumes constant growth.

Primary market is where securities are first issued (IPO); secondary market is where existing securities trade, providing liquidity and price discovery.

Money market instruments mature in one year or less: Treasury bills, commercial paper, negotiable CDs, and repurchase agreements; they are discounted, not coupon, instruments.

Depository institutions (commercial banks, thrifts, credit unions) issue deposits; nondepository institutions (insurance companies, pension funds, finance companies) do not.

Adverse selection occurs before a transaction (screening borrowers); moral hazard occurs after (monitoring how funds are used).

Banks earn the spread between asset yields (loans, securities) and liability costs (deposits, borrowings); net interest margin measures this spread.

Reserve requirements, deposit insurance, and capital requirements are the main tools that limit bank risk-taking and deposit runs.

Deposit insurance (FDIC) covers deposits up to a statutory limit per depositor per insured bank; it reduces runs but creates moral hazard.

A bank run is a coordination failure: each depositor withdraws because others are withdrawing; deposit insurance and a lender of last resort break it.

Nonbank financial intermediaries grew their share of credit after 2008; shadow banking uses short-term funding to hold longer-term assets without deposit insurance.

Insurance companies collect premiums and invest in bonds; pension funds hold long-horizon assets matched to long-dated liabilities.

The Federal Reserve System was created by the Federal Reserve Act of 1913 after the Panic of 1907; the Fed is the U.S. central bank.

Federal Open Market Committee (FOMC) sets the target federal funds rate; the Board of Governors sets reserve requirements and the discount rate (subject to Reserve Bank approval).

Twelve regional Federal Reserve Banks; the New York Fed executes open market operations and houses the Open Market Desk.

The Fed's dual mandate from Congress is maximum employment and price stability (2% inflation target adopted formally in 2012).

Open market operations: the Fed buys securities to add reserves and lower the funds rate; sells to drain reserves and raise it.

The discount rate is the rate Reserve Banks charge on loans to depository institutions; the interest rate on reserve balances (IORB) is a key administered rate.

The Fed's balance sheet expands when it buys assets; quantitative easing is large-scale asset purchases that push longer-term rates down.

Lender of last resort: the Fed can lend to solvent but illiquid institutions under Section 13(3) with Board approval in unusual circumstances.

Fed independence: governors serve 14-year terms, and monetary policy decisions do not require congressional or presidential approval.

Equation of exchange: M x V = P x Y; velocity V is nominal GDP divided by the money stock.

Quantity theory assumes V and Y are stable, so money growth translates one-for-one into inflation in the long run.

Money multiplier m = (1 + c)/(r + e + c), where c is the currency ratio, r the reserve requirement, and e the excess reserve ratio; m falls when c or e rises.

Monetary base (high-powered money) = currency in circulation + bank reserves; the money supply equals m times the base.

Expansionary policy: buy securities, lower the target funds rate, lower reserve requirements; contractionary policy does the reverse.

Lags matter: recognition, implementation, and impact lags make fine-tuning difficult; monetarists prefer rules over discretion.

Phillips curve trade-off is temporary; in the long run unemployment returns to the natural rate and only inflation changes.

Taylor rule: target funds rate = neutral real rate + inflation + 0.5(inflation gap) + 0.5(output gap).

Liquidity trap: nominal rates near zero make conventional policy ineffective, so central banks turn to quantitative easing and forward guidance.

Balance of payments: current account (goods, services, income, transfers) + capital/financial account + official reserves must sum to zero.

A current account deficit is financed by a capital/financial account surplus (net capital inflow) or reserve drawdown.

Nominal exchange rate is the price of one currency in another; appreciation raises the currency's value, depreciation lowers it.

Real exchange rate = nominal rate x (domestic price level / foreign price level); it measures competitiveness.

Purchasing power parity (PPP) predicts exchange rates equalize price levels in the long run; it fails in the short run because of nontradables and trade barriers.

Interest rate parity: higher domestic rates attract capital and tend to appreciate the currency in the short run; covered parity links forward premiums to rate differentials.

Fixed exchange rate regimes require the central bank to defend a peg with reserves or rate moves, sacrificing independent monetary policy (the trilemma).

Trilemma: a country cannot simultaneously have a fixed exchange rate, free capital flows, and independent monetary policy; it can choose only two.

A depreciation makes exports cheaper and imports dearer, improving the trade balance with a lag (J-curve).

Bank balance sheet: assets (reserves, securities, loans) = liabilities (deposits, borrowings) + equity capital.

Reserve ratio = reserves / deposits; required reserves = reserve requirement ratio x checkable deposits.

Capital adequacy: risk-based capital ratio = qualifying capital / risk-weighted assets; Basel III sets minimum common equity Tier 1 and buffers.

Liquidity management matches short-term deposit withdrawals with liquid assets; a bank can be solvent but illiquid and still fail.

Maturity mismatch: banks borrow short (deposits) and lend long (loans), exposing them to interest rate and liquidity risk.

Deposit insurance, capital requirements, and supervision are the three pillars of the bank safety net; moral hazard from insurance is offset by capital rules.

CAMELS ratings cover Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.

Glass-Steagall (1933) separated commercial and investment banking; it was largely repealed by the Gramm-Leach-Bliley Act of 1999.

Dodd-Frank (2010) created stress tests and the Consumer Financial Protection Bureau and designated systemically important institutions for stricter oversight.