ab0901 jan 2012 lecture 9
TRANSCRIPT
McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved
AB0901 Principles of Economics Lecture 9
Capital Formation, Financial Markets and Money Supply
Prepared by Dr. Sng Hui Ying
Lecturer: Ng Beoy Kui
Tel: 63168958
McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved
Topics to Be Discussed
Saving, Wealth and National Saving
Investment and Capital Formation
Demand and Supply of Saving
Money and Its Uses
Commercial Banks and Money Creation
Central Bank and Money Supply
Money Demand and Money Supply
Ref: Frank and Bernanke, Chapters 20,21 & 24
20-3 LO 20 - 1
Savings and Wealth
Saving is current income minus spending on current
needs
Saving rate is saving divided by income
Wealth is the value of assets minus liabilities
Assets are the value that one owns
Liabilities are the debts one owes
Balance sheet is a list of assets and liabilities
20-4 LO 20 - 1
Flow Variables and Stock Variables
A flow variables is defined per unit of time
Income ■ Spending
Saving ■ Wage
A stock variable is defined at a point in time
Wealth ■ Debt
The flow of saving causes the stock of wealth to
change
Every dollar a person saves adds to his wealth
A high rate of saving today leads to an improved
standard of living in the future
20-5 LO 20 - 2
National Saving
National savings determines a country's ability to invest
in new capital goods
Consists of household saving, business saving and
government saving
Start with the definition of production and income for
the economy : Y = C + I + G + NX
Y = aggregate income
C = consumption
expenditure
G = government
purchases of goods
and services
I = investment spending NX = net exports
20-6 LO 20 - 2
Calculate National Savings
Assume NX = 0 for simplicity
National savings (S) is current income less spending on
current needs
Current income is GDP or Y
Spending on current needs
Exclude all investment spending (I)
Most consumption and government spending is for
current needs
For simplicity, we assume all of C and all of G are
for current needs
S = Y – C – G
20-7 LO 20 - 2
Private Saving
Private saving is household plus businesses saving
Household's total income is Y
Households pay taxes from this income
Government transfer payments increase household
incomes
Transfer payments are made by the government to
households without receiving any goods in return
Interest is paid to government bond holders
T = Taxes – Transfers – Government interest payments
20-8 LO 20 - 2
Private Saving
Private saving is after-tax income less consumption
SPRIVATE = Y – T – C
Private saving is done by households and businesses
Household saving or personal saving is done by
families and individuals
Business saving makes up the majority of private
saving in the US
Business saving is revenues less operating costs
less dividends to shareholders
Business saving can purchase new capital
equipment
20-9 LO 20 - 2
Public Saving and National Saving
Public saving is the amount of the public sector's
income that is not spent on current needs
Public sector income is net taxes
Public sector spending on current needs is G
SPUBLIC = T – G
National saving (S) is private savings plus public
savings
SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)
S = Y – C – G
20-10 LO 20 - 2
The Government Budget
Balanced budget occurs when government spending
equals net tax receipts
Government budget surplus is the excess of
government net tax collections over spending (T – G)
Budget surplus is public savings
Government budget deficit is the excess of
government spending over net tax collections
Budget deficit is public dissaving
20-11 LO 20- All
Three Reasons for Household Saving
1. Life-cycle saving is to meet long-term objectives
Retirement ■ Purchase a home
Children's college attendance
2. Precautionary saving is for protection against
setbacks
Loss of job ■ Medical emergency
3. Bequest saving is to leave an inheritance
Mainly higher income groups
20-12 LO 20 - 3
Saving and the Real Interest Rate
Savings often take the form of financial assets that pay
a return
Interest-bearing checking ■ Bonds
Savings ■ CDs
Mutual funds ■ Stocks
The real interest rate (r) is the nominal interest rate (i)
minus the rate of inflation ()
The increase in purchasing power from a financial
asset
Marginal benefit of the extra saving
20-13 LO 20 - 3
Explaining US Household Savings Rate
Savings rate may be depressed by
Social Security, Medicare, and other government
programs for the elderly
Mortgages with small or no down payment
Confidence in a prosperous future
Increasing value of stocks and growing home values
Readily available home equity loans
Demonstration effects and status goods
20-14 LO 20 - 4
Investment and Capital Formation
Investment is the creation of new capital goods and
housing
Firms buy new capital to increase profits
Cost – Benefit Principle
Cost is the cost of using the machine or other capital
Benefit is the value of the marginal product of the
capital
20-15 LO 20 - 4
The Investment Decision
Two important costs
Price of the capital goods
Real interest rates
Opportunity cost of the investment
Value of the marginal product of the capital is its benefit
Net of operating and maintenance expenses and of
taxes on revenues generated
Technical innovation increases benefits
Lower taxes increase benefits
Higher price of the output increases benefits
20-16 LO 20 - 5
Saving, Investment, and Financial Markets
Supply of savings (S) is the amount of savings that
would occur at each possible real interest rate (r)
The quantity supplied increases as r increases
Demand for investment (I) is the amount of savings
borrowed at each possible real interest rate
The quantity demanded is inversely related to r
20-17 LO 20 - 5
Financial Market
Equilibrium interest rate
equates the amount of
saving with the
investment funds
demanded
If r is above
equilibrium, there is a
surplus of savings
If r is below
equilibrium, there is a
shortage of savings Saving and investment
Re
al in
tere
st ra
te (
%)
Investment I
Saving S
S, I
r
20-18 LO 20 - 5
Technological Improvement
New technology raises
marginal productivity of
capital
Increases the demand
for investment funds
Movement up the
savings supply curve
Higher interest rate
Higher level of savings
and investment Saving and Investment
Real in
tere
st
rate
(%
)
I
r E
S
r'
I'
F
A' A
20-19 LO 20 - 5
Government Budget Deficit Increases
Government budget
deficit increases
Reduces national
saving
Movement up the
investment curve
Higher interest rate
Lower level of savings
and investment
Private investment is
crowded out
I
Saving and investment
Real in
tere
st ra
te (
%)
S
r
E r'
F
S'
A A'
20-20 LO 20 - 5
Increase National Saving
Policymakers know the benefits of increased national
saving rates
Reducing government budget deficit would increase
national saving
Political problems
Increase incentives for households
Federal consumption tax
Reduce taxes on dividends and investment income
Higher national saving rate leads to greater investment
in new capital goods and a higher standard of living
20-21 LO 20 - 5
Singapore: Output, Saving and Investment
20-22 LO 20 - All
Financial System and Allocation of Saving
A successful economy uses its savings for investments
that are likely to be the most productive
The interest on deposits is one important reason
people put savings in banks
The financial system improves the allocation of saving
Provides information to savers about the possible
uses of their funds
Help savers share the risks of individual investment
projects
Risk sharing makes funding possible for projects
that are risky but potentially very productive
20-23 LO 20 - All
Financial Intermediaries and Banking System
Financial intermediaries are firms that extend credit
to borrowers using funds raised from savers
Commercial banks accept deposits from individuals
and businesses and make loans
Banks gather information, evaluate potential
investments, and direct savings to higher-return, more
productive investments
Banks provide access to credit for small businesses
and homeowners
When banks make loans, they earn interest which, in
turn, is paid to the bank's depositors
20-24 LO 20 - All
Bonds
A bond is a legal promise to repay a debt
Each bond specifies
Principal amount, the amount originally lent
Maturation date, the date when the principal amount
will be repaid
The term of a bond is the length of time from issue
to maturation
Coupon payments, the periodic interest payments
to the bondholder
Coupon rate, the interest rate that is applied to the
principal to determine the coupon payments
20-25 LO 20 - All
Bonds
Corporations and governments issue bonds
The coupon rate depends on
The bond's term
30 days to 30 years; longer term, higher coupon
rate
The issuer's credit risk
Probability the issuer will default on repayment
Higher risk, higher coupon rate
Tax treatment for the coupon payments
Municipal bonds are free from federal taxes
Lower taxes, lower coupon rates
20-26 LO 20 - All
Bond Market
Bonds can be sold before their maturation date
Market value at any time is the price of the bond
Price depends on the relationship between the
coupon rate and the interest rate in financial markets
A two-year government bond with principal $1,000 is
sold for $1,000, 1/1/09
Coupon rate is 5%
$50 will be paid 1/1/10
$1,050 will be paid 1/1/11
Bond's price on 1/1/10 depends on the prevailing
interest rate
20-27 LO 20 - All
Selling a Bond
Offer for sale: a government bond with payment of
$1,050 due in one year
The competition: a new one-year bond with principal of
$1,000 and coupon rate of 6%
Pays $1,060 in one year
Year-old bond with 5% coupon rate is less valuable
than the new bond
Price of the used bond will be less than $1,000
(Bond price) (1.06) = $1,050
Bond price = $991
Bond prices and interest rates are inversely related
20-28 LO 20 - All
Stocks
A share of stock is a claim to partial ownership of a
firm
Receive dividends, a periodic payment determined
by management
Receive capital gains if the price of the stock
increases
Prices are determined in the stock market
Reflect supply and demand
20-29 LO 20 - All
FortuneCookie.com
New company with estimated dividend of $1 in 1 year
Selling price of stock will be $80 in 1 year
Interest rate is 6%
Value of the new stock is $81 in 1 year
(Stock price) (1.06) = $81
Stock price = $76.42
Value would be higher if
Dividend were higher
Price of stock in one year were higher
Interest rate were lower
20-30 LO 20 - All
Risk Premium
Risk premium is the difference between the required
rate of return to hold risky assets and the rate of return
on safe assets
Suppose interest on a safe investment is 6%
FortuneCookie.com is risky, so 10% return is
required
Stock will sell for $80 in 1 year; dividend will be $1
(Stock price) (1.10) = $81
Stock price = $73.64
Risk aversion increases the return required of a risky
stock and lowers the selling price
20-31 LO 20 - All
Bond Markets and Stock Markets
Channel funds from savers to borrowers with
productive investment opportunities
Sale of new bonds or new stock can finance capital
investment
Like banks, bond and stock markets allocate savings
Provision of information on investment projects and
their risks
Provide risk sharing and diversification across
projects
Diversification is spreading one's wealth over a
variety of investments to reduce risk
20-32 LO 20 - All
Benefits of Diversification
Vikram has $200 to invest in stocks, each $100
Buy 2 shares of either stock
50% chance of $20 gain and 50% chance of $0
Diversify and buy 1 share of each
One stock will be worth $100 and the other will be
worth $110
Return is $10 with no risk
Increase in Stock Price per Share
Actual Weather Smith Umbrella Jones Suntan Lotion
Rainy (50%) +$10 $0
Sunny (50%) $0 +$10
20-33 LO 20 - All
Stock and Bond Markets
Savers can put savings into a variety of financial assets
Diversification makes risky but potentially valuable
projects possible
No individual saver bears the whole risk
Society is better off
A mutual fund is a variety of financial assets sold to the
public as shares in a single financial intermediary
Diversified asset for the saver
Less costly than buying many stocks and bonds
directly
20-34 LO 20 - All
Money
Money is any asset that can be used in making
purchases
Examples include coins and currency, checking
account balances, and traveler's checks
Shares of stock are not money
Money has three principal uses
1. Medium of exchange
2. Unit of account
3. Store of value
Money makes barter unnecessary
Barter is trading goods directly
20-35 LO 20 - All
Measuring Money
Definitions of money range from narrow to broad
M1 ($B) $1,364.7
Currency $758.1
Demand deposits 292.5
Other checkable deposits 307.9
Traveler's checks 6.2
M2 ($B) $7,498.7
M1 $1,364.7
Savings deposits 3,903.4
Small-denomination time notes 1,224.4
Money market mutual funds 1,006.1
20-36 LO 20 - All
Commercial Banks Create Money
Republic of Gorgonzola begins with no banking system
Government issues 1 million guilders
Banks are created to store cash
Payments are made by withdrawing cash or writing
checks
Checks tell bankers of change in ownership of the
specified number of guilders
Without interest, banks earn profits by charging
depositors fees
20-37 LO 20 - All
Consolidated Bank Balance Sheet – Part 1
All guilders (g) are deposited
Bank reserves are cash or similar assets held by
banks
Used to meet depositors' withdrawals and payments
Gorgonzola's banks have 100% reserves
100% reserve banking is when banks' reserves
equal 100% of their deposits
Assets Liabilities
Currency 1,000,000 g Deposits 1,000,000 g
20-38 LO 20 - All
Bank Reserves
Cash in a bank's vault is not part of the money supply
Unavailable for payments
Bank deposits available for use in transactions are
part of the money supply
Depositing a $100 bill in your checking account
does not change the money supply
Bankers realize that inflows and outflows from vaults
leave some guilders unused
Only 10% of deposits are needed for transactions
90% can be lent to borrowers for a fee -- interest
20-39 LO 20 - All
Consolidated Bank Balance Sheet – Part 2
Currency held in the vault is the bank reserves
The reserve – deposit ratio is bank reserves divided
by total deposits
Fractional reserve banking system holds less bank
reserves than deposits
The reserve – deposit ratio is less than 100%
Assets Liabilities
Currency 100,000 g Deposits 1,000,000 g
Loans 900,000 g
20-40 LO 20 - All
Consolidated Bank Balance Sheet – Part 3
Farmers borrow 900,000 guilders to buy supplies
Farmers spend the 900,000 guilders which are then
deposited in the banks
Bank deposits are the entire money supply
Loan of 900,000 guilders increased the money
supply by 900,000 guilders
Banks are again holding excess reserves on deposits
of 1,900,000 guilders
Assets Liabilities
Currency 1,000,000 g Deposits 1,900,000 g
Loans 900,000 g
20-41 LO 20 - All
Consolidated Bank Balance Sheet – Part 4
With deposits of 1,900,000 guilders and a reserve –
deposit ratio of 10%, banks want only 190,000 guilders
in reserves
Currently holding 1,000,000 guilders
Loan 810,000 guilders
Loan are spent and re-deposited
Excess reserves are created and re-loaned
Assets Liabilities
Currency 1,000,000 g Deposits 2,710,000 g
Loans 1,710,000 g
20-42 LO 20 - All
Consolidated Bank Balance Sheet – The End
Expansion of loans and deposits stops when reserves
are 10% of deposits
1,000,000 guilders available as reserves
Deposits stabilize at 10,000,000 guilders
Beginning with 1,000,000 guilders in cash, the money
supply is now 10,000,000 guilders
Assets Liabilities
Currency 1,000,000 g Deposits 10,000,000 g
Loans 9,000,000 g
20-43 LO 20 - All
Money Creation
With 10% reserves, each guilder supports 10 guilders
in deposits
The general case of money creation with fractional
reserve banking is
Solving for bank deposits we get
Bank reserves
Bank deposits = Desired reserve – deposit ratio
Bank reserves
Desired reserve – deposit ratio Bank deposits =
20-44 LO 20 - All
Money Supply with Currency and Deposits
Gorgonzola residents hold 500,000 guilders as
currency
Deposit 500,000 guilders in the banks
Reserve-deposit ratio = 10%
Bank deposits = 500,000 / 0.10 = 5,000,000 guilders
Money supply = 500,000 cash + 5,000,000 deposits
= 5,500,000 guilders
Money supply = Currency held by public +
Bank reserves
Desired reserve – deposit ratio
20-45 LO 20 - All
Money Supply at Christmas
Suppose banks hold $500 billion in reserves and the
public hold $500 billion in cash
Reserve-deposit ratio = 0.20
Money supply = $500 + (500 / 0.20) = $3,000
As Christmas approaches, consumers reduce bank
deposits by $100 billion
Banks have $400 billion in reserves; public holds
$600 billion cash
Money supply = $600 + ($400 / 0.20) = $2,600
Reducing bank deposits reduces the money supply
20-46 LO 20 - All
Singapore: Money Supply
20-47 LO 20 - All
Increasing the Money Supply
An economy has 1,000 shekels in currency and bank
reserves of 200 shekels
Reserve-deposit ratio = 0.2
Money supply = 1,000 + (200 / 0.2) = 2,000 shekels
Central bank pays 100 shekels for a bond held by the
public
Assume that all 100 shekels are deposited
Money supply = 1,000 + (300/ 0.2) = 2,500 shekels
100 shekel increase in reserves leads to a 500
shekel increase in the money supply
20-48 LO 20 - All
Money and Prices
In the long run, the amount of money circulating and
the level of prices are closely linked
Sustained high inflation rates occur with a
comparably high growth rate of the money supply
20-49 LO 20 - All
Money and Inflation in the Long Run
Quantity equation states (M) (V) = (P) (Y)
Restatement of the velocity definition
The quantity equation relates the money supply to price
levels
Suppose velocity and real GDP are constant
The quantity equation becomes
An increase in the money supply by a given
percentage would increase prices by the same
percentage
V and Y, respectively
M V = P Y
20-50 LO 20 - All
Demand for Money
The demand for money is the amount of wealth held
in the form of money
Demand for money is sometimes called an individual's
liquidity preference
The Cost – Benefit Principle indicates people will
balance the marginal cost of holding money versus
the marginal benefit
Money's benefit is the ability to make transactions
Quantity of money demanded increases with income
Technologies such as online banking and ATMs have
reduced the demand for money
20-51 LO 20 - All
Demand for Money
The marginal cost of holding money is the interest
foregone
Most forms of money pay little or no interest
Assume the nominal interest rate on money is 0
Alternative assets such as stocks or bonds have a
positive nominal interest rate
The higher the nominal interest rate, the smaller the
quantity of money demanded
Business demand for money is similar to individuals'
Businesses hold more than half of the money stock
20-52 LO 20 - All
Demand for Money
Demand for money depends on
Nominal interest rate (i)
The higher the interest rate, the lower the quantity
of money demanded
Real income or output (Y)
The higher the level of income, the greater the
quantity of money demanded
The price level (P)
The higher the price level, the greater the quantity
of money demanded
20-53 LO 20 - All
The Money Demand Curve
Interaction of the aggregate demand for money and the
supply of money determines the nominal interest rate
The money demand curve shows the relationship
between the aggregate quantity of money demanded,
M, and the nominal
interest rate
An increase in the
nominal interest rate
increases the
opportunity cost of
holding money
Negative slope Money (M) Nom
ina
l in
tere
st
rate
(i)
MD
20-54 LO 20 - All
The Money Demand Curve
Changes in factors other than the nominal interest rate
cause a shift in the money demand curve
An increase in demand for money can result from
An increase in output
Higher price levels
Technological advances
Financial advances
Foreign demand for
dollars
Money (M) No
min
al in
tere
st
rate
(i)
MD MD'
20-55 LO 20 - All
Supply of Money
The central bank controls the supply of money with
open-market operations
An open-market purchase of bonds by the central
bank increases the money supply
An open-market sale of
bonds by the central bank
decreases the money
supply
Supply of money is vertical
Equilibrium is at E
Money (M)
MD
E
MS
M
i
Nom
inal in
tere
st ra
te (
i)
20-56 LO 20 - All
Equilibrium in the Money Market
Bond prices are inversely related to the interest rate
Suppose the interest rate is at i1, below equilibrium
Quantity of money demanded is M1, more than the
money available
To get more money, people
sell bonds
Bond prices go down,
interest rates rise
Quantity of money
demanded decreases
from M1 to M
Money (M)
MD
E
MS
M No
min
al in
tere
st ra
te (
i)
M1
i1 i
20-57 LO 20 - All
Central Bank Controls the Money Supply
Initial equilibrium at E
Central bank increases the money
supply to MS'
New equilibrium at F
Interest rated decrease to i'
to convince the market
to hold the new, larger
amount of money
Money (M)
MD
MS
M
E i
Nom
inal in
tere
st
rate
(i)
F i'
M'
MS'
20-58 LO 20 - All
Additional Controls over the Money Supply
Open market operations are the main tool of money
supply
Fed offers lending facility to banks, called discount
window lending
If a bank needs reserves, it can borrow from the Fed
at the discount rate
The discount rate is the rate the Fed charges
banks to borrow reserves
Lending increases reserves and ultimately increases
the money supply
Changes in the discount rate signal tightening or
loosening of the money supply
20-59 LO 20 - All
Additional Controls over the Money Supply
The central bank can also change the reserve
requirement for banks
The reserve requirement is the minimum
percentage of bank deposits that must be held in
reserves
The reserve requirement is rarely changed
The central bank could increase the money supply by
decreasing the reserve requirement
Banks would have excess reserves to loan
The central bank could decrease the money supply by
increasing the reserve requirement
20-60 LO 20 - All
Singapore: Interest Rates
20-61 LO 20- All
References
Frank, R. H., B. S. Bernanke, L. Gan, Chen Kang,
Asian Edition, Chapter 20, 21 & 24.