the financial sector and the...

The Financial Sector and

the Economy

The peculiar essence of our banking system

is an unprecedented trust between man and

man; and when that trust is much weakened

by hidden causes, a small accident may

greatly hurt it, and a great accident for a

moment may almost destroy it.

— Walter Bagehot

CHAPTER 30

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Monetary Policy

There have been three great inventions since the beginning of

time: fire, the wheel and central banking.

— Will Rogers

CHAPTER 31

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

The Financial Sector andthe Economy 30

Money

McGraw-Hill/Irwin Colander, Economics 3


The Definition and Functions of Money

• Money is anything that is generally accepted as payment for goods or services

• Money is a highly liquid financial asset —it is easily changeable into another asset or good

30-4


The Definition and Functions of Money

• Commodity money: something that performs the function of money and has alternative uses

• Examples: Gold, silver, cigarettes, etc.

• Fiat money: Something that serves as money but has no other important uses

• Examples: Paper money and coins



The 3 Functions of Money• Medium of exchange

• Money can easily be used to buy goods and services without bartering

• Unit of account (measure of value)

• Money measures the value of all goods and services

• Store of wealth

• Money allows you to store purchasing power for the future



Alternative Measures of Money

• M1 and M2

• M1: consists of coins and currency plus checking accounts (checkable deposits) and traveler’s checks

30-7


Alternative Measures of Money

• M2 consists of M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds



Money and Credit

• Credit cards are not money

• They are a short-term loan (usually with a higher than normal interest rate)

• A debit card is part of the monetary system because it serves the same function as a check since it allows you to spend money from your bank account

30-9


Why People Hold Money

• The transactions motive is the need to hold money for spending

• The precautionary motive is holding money for unexpected expenses and impulse buying

• The speculative motive is holding cash to avoid holding financial assets whose prices are falling

30-10


Time Value of Money

• The future value of money is:

• P (1 + r)n

• P = principal or amount of money

• R = interest rate

• n = number of years



Time Value of Money

• Calculate the future value of $100 with 5% interest, 10 years from now

• P (1 + r)n

• 100 (1 + 0.05)10

• = $162.89



Present Value of Money

• The present value of money is:

Amount of money

(1 + r)n

• Present value of $100 a year from now

100

(1+0.10)1

See Mr. Clifford Video


= $90.91


INTEREST RATES



Interest Rates

• Interest rate: the price paid for use of a financial asset

• The long-term interest rate is the price paid for financial assets with long maturities, such as mortgages

• The market for long-term financial assets is called the loanable funds market

30-15


Interest Rates

• The short-term interest rate is the price paid for financial assets with short maturities

• Short-term financial assets are called money



Interest Rates and Inflation

• Real Interest Rate

• The percentage increase in purchasing power that a borrower pays (adjusted for inflation)

• Real interest rate = nominal interest rate -expected inflation




• Nominal Interest Rate

• The percentage increase in money that the borrower pays not adjusting for inflation

• Nominal interest rate = Real interest rate + expected inflation




Example #1: You lend out $100 with 20% interest. Inflation is 15%.

• A year later you get paid back $120.

• What is the nominal and what is the real interest rate?

• The nominal interest rate is 20%. The real interest rate was 5%.

• In reality, you get paid back an amount with less purchasing power.




Example #2: You lend out $100 with 10% interest. Prices are expected to increase 20%. In a year you get paid back $110.

• What is the nominal and what is the real interest rate?

• The nominal interest rate is 10%. The real rate was –10%

• In reality, you get paid back an amount with less purchasing power



Loanable Funds



Loanable Funds Market

• The loanable funds market is the private sector supply and demand of loans

• It represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption)

• This market shows the effect on the real interest rate (r)




• Demand for loanable funds: there is an inverse relationship between the real interest rate and the quantity of loans demanded

• At higher interest rates, households prefer to delay their spending and put their money in savings




• Supply of loanable funds: there is a directrelationship between the real interest rate and the quantity of loans supplied

• An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)




Demand Shifters

1. Changes in perceived business opportunities

2. Changes in government borrowing

3. Budget deficit

4. Budget surplus

Supply Shifters

1. Changes in private savings behavior

2. Changes in public savings

3. Changes in foreign investment

4. Changes in expected profitability



Draw the Graph: Increase in the Supply of Loanable Funds

Real Interest Rate

Q of Loanable FundsQ1

S1 or SLF1

r1

D1 or DLF1

30-26

S2 or SLF2

r2

Q2


Draw the Graph: Decrease in the Supply of Loanable Funds

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

30-27

S2 or SLF2

r1

Q1


Draw the Graph: Increase in the Demand for Loanable Funds

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

30-28

r1

Q2

D2 or DLF2


Draw the Graph: Decrease in the Demand for Loanable Funds

Real Interest Rate


S1 or SLF1

r1

D1 or DLF1

30-29

r2

Q1

D2 or DLF2


Loanable Funds Example

• The government increases deficit spending

• Draw the graph that illustrates this concept

30-30


Loanable Funds Example Government borrows from the private sector, increasing the

demand for loansReal Interest Rate


S1 or SLF1

r2

D1 or DLF1

30-31

r1

Q2

D2 or DLF2

Real interest rates increase

causingcrowding out

(of investment)


The Fed and Monetary Policy



The Fed

• The Federal Reserve Bank (the Fed) is the U.S. central bank

• Federal Reserve notes are liabilities of the Fed that serve as cash

• A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms

30-33


Structure of the Fed

Board of Governors

7 members appointed by the president and confirmed by the

senate

FINANCIAL SECTOR GOVERNMENT

Regional Reserve Banks and Branches

12 regional Federal Reserve banks and 25 branches

Oversees

Federal Open Market Committee (FOMC)

Board of Governors plus 5 Federal Reserve bank presidents

Provides ServicesOpen Market Operations

31-34


Six Duties of the Fed

1. Conducts monetary policy (influencing the supply of money and credit in the economy)

2. Supervises and regulates financial institutions

3. Lender of last resort to financial institutions

31-35


Six Duties of the Fed

4. Provides banking services to the U.S. government

5. Issues coin and currency

6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions



Monetary Policy

• Monetary policy: influencing the economy through changes in the banking system’s reserves, which in turn, influences the money supply and credit availability in the economy

31-37


Monetary Policy

• If commercial banks need to borrow money, they can do so from the Fed

• If there’s a financial panic and a run on banks, the central bank is there to make loans

• Can we go to the Fed to get a loan?

• No

31-38


Expansionary Monetary Policy

• Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment

• It increases the money supply

• It decreases interest rates and it tends to increase both investment and output

• Also called the easy money policy

M i I Y

31-39M=money supply i=interest rate I=investment Y=output


Draw the AS/AD Graph: Expansionary Monetary Policy

31-40

Price level

Real GDP

AD1

P1 AD2

P2

Y1 Y2

SRAS

LRAS


Contractionary Monetary Policy

• Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment

• It decreases the money supply

• It increases the interest rate, and it tends to decrease both investment and output

• Also called the tight money policy

M i I Y

31-41

M=money supply i=interest rate I=investment Y=output


Draw the AS/AD Graph: Contractionary Monetary Policy

31-42

Price level

Real GDP

AD1

P1

Y1

SRAS

AD2

Y2

P2

LRAS


Tools of Monetary Policy

• 1. Reserve requirement

• 2. Discount rate

• 3. Open market operations

• These are the 3 shifters of the money supply

• These tools are used by the Fed to regulate the amount of money in circulation



The Reserve Requirement

• The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)

• Banks keep some of the money in reserve and loan out their excess reserves

• Reserves and interest rates are inversely related

31-44


Reserve Requirement

• By changing the reserve requirement the Fed can increase or decrease the money supply

– If the Fed increases the reserve requirement it contracts the money supply—banks have to keep more reservesand lend out less money (decreases the money multiplier)



Reserve Requirement

• If the Fed decreases the reserve requirement it expands the money supply—banks have more money to lend out (increases the money multiplier)



Reserve Requirement

• If there is a recession, what should the Fed do to the reserve requirement?

• It should decrease the reserve ratio

• This means banks hold less money and have more excess reserves

• Banks create more money by loaning out excess reserves

• The money supply increases, interest rates fall, and AD increases



Reserve Requirement

• If there is inflation, what should the Fed do to the reserve requirement?

• Increase the reserve ratio

• This means banks hold more money and have less excess reserves

• Banks create less money

• The money supply decreases, interest rates go up, and AD decreases



The Discount Rate

• Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks

• To increase the money supply, the Fed should decrease the discount rate

• To decrease the money supply, the Fed should increase the discount rate



Open Market Operations

• The primary way in which the Fed changes the amount of reserves in the system

• Open market operations occur when the Fed buys or sells government securities (bonds)

• To expand the money supply, the Fed buys bonds

• To decrease the money supply, the Fed sells bonds

31-50



• How are you going to remember this?

• Buy-BIG: Buying bonds increases the money supply

• Sell-SMALL: Selling bonds decreases the money supply




• There is an inverse relationship between bond prices and interest rates

• When the Fed buys bonds, the price of bonds rises and interest rates fall

• When the Fed sells bonds, the price of bonds falls and interest rates rise



Open Market Purchases

• An open market purchase is an expansionary monetary policy that tends to reduce interest rates and increase income

• When the Fed buys bonds, it deposits money in banks’ account with the Fed

• Bank reserves are then increased

• When banks loan out the excess reserves, the money supply increases

31-53


Open Market Sales

• An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income

• When the Fed sells bonds, it receives checks drawn against banks

• The bank’s reserves are reduced and the money supply decreases

31-54


The Federal Funds Market

• The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves

• Fed funds are loans of excess reserves banks make to one another

• (Often asked about on the AP exam)

31-55


The Federal Funds Market

• The Fed can increase or reduce reserves by buying or selling bonds

• By selling bonds, the Fed decreasesreserves

• This causes the fed funds rate to increase

• By buying bonds, the Fed increases reserves

• This causes the fed funds rate to decrease



The Fed Funds Rate as an Operating Target

• If the Fed funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate

• If the Fed funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate



Quantitative Easing

• Quantitative easing is a monetary policy used by the Fed to buy government bonds to stimulate the economy

• The Fed might decide to purchase assetsfrom commercial banks in order to increasethe price of those assets, which increasesthe money supply and lowers interest rates

• May be used when inflation is low and open market operations are not working



The Money Market



The Money Market

• The market where the Fed and the users of money interact thus determining the nominal interest rate (i%)



The Money Market

• Money Demand (MD) comes from households, firms, government and the foreign sector

• The demand for money shows an inverserelationship between nominal interest rates and the quantity of money demanded



The Money Market

• The Money Supply (MS) is determined only by the Federal Reserve

• The money supply curve is verticalbecause it is determined by the Fed’s (or central bank’s) particular monetary policy



Draw the Graph: The Money Market


NOTE:•i=nominal interest rate•I= InvestmentBe careful!

QM1

MD or DM

MS

i1

Quantity of Money or QM

Nominal Interest Rate

(ir)


The Demand for Money

• What happens to the quantity demanded of money when interest rates increase?

• Quantity demanded falls because individuals would prefer to have interest earning assets instead

• What happens to the quantity demanded when interest rates decrease?

• Quantity demanded increases

• There is no incentive to convert cash into interest earning assets



1. Changes in price level

2. Changes in income

3. Changes in taxation that affects personal investment

McGraw-Hill/Irwin Colander, Economics 65 65

Shifters of Money Demand



Draw the Graph: Increase in Money Demand

QM1

MD1

MS

i1

QM(billions of dollars)


(ir)

MD2

i2

Scenario: The price level increases.



Draw the Graph: Decrease in Money Demand

QM1

MD2

MS

i2



(ir)

MD1

i1

Scenario: The price level decreases.


Shifters of the Money Supply

• 1. Reserve requirement

• 2. Discount rate

• 3. Open market operations




Draw the Graph: Increase in Money Supply

QM1

MD1

MS1

i1



(ir)

i2

MS2

QM2

Scenario: The Fed buys bonds on the open market.



Draw the Graph: Decrease in Money Supply

QM2

MD1

MS2

i2



(ir)

i1

MS1

QM1

Scenario: The Fed sells bonds on the open market.


The Money Supply and AD

• How does this affect AD?

• An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD


IM I ADi


The Money Supply and AD

• How does this affect AD?

• Decreasing the money supply leads to an increase in interest rates, which decreasesinvestment and AD


M i I AD


Draw the Graphs: The Money Supply and AD

• The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.




• The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.




• The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.



How are AS/AD, Loanable Funds, and the Money Market Connected?

• If there is an expansionary monetary policy, what are the results?

• AD increases

• MS increases

• The supply of loanable funds increases



How are AS/AD, Loanable Funds, and the Money Market Connected?

• If there is a contractionary monetary policy, what are the results?

• AD decreases

• MS decreases

• The supply of loanable funds decreases



Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market


Money Market

Interest Rate

Q of Money

MS2

i1

DM

i2

MS1

Expansionary monetary policy leads to…

QM1 QM2

Interest Rate

Q of Loanable Funds

SLF2

DLF


SLF1

r1

r2

… an increase in loanable funds

Q1 Q2

Expansionary Monetary Policy: Increases AD


Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market


Money Market

Interest Rate

Q of Money

MS1

i2

DM

i1

MS2

Contractionary monetary policy leads to…

QM2 QM1

Interest Rate

Q of Loanable Funds

SLF1

DLF


SLF2

r2

r1

… an decrease in loanable funds

Q2 Q1

Contractionary Monetary Policy: Decreases AD


The Fed and the Creation of Money



Banks and the Creation of Money• The first step in the creation of money:

• The Fed creates money by simply printing currency

• Currency is a financial asset to the bearer and a liability to the Fed

• The bearer deposits the currency in a checking account at the bank

• The form of money has changed from currency to a bank deposit

30-82


Banks and the Creation of Money

• The second step in the creation of money:

• The bank lends a fraction of the deposit

• The amount of money has expanded:

• Initial deposit + new loan

• The amount of money is multiplied

30-83


Reserves

• Reserves: currency and deposits a bank keeps on hand or at the Fed or central bank, to manage the normal cash inflows and outflows

• The required reserve ratio (RRR) is the percentage that banks are required to hold (set by the Fed)

30-84


Reserves

• The reserve ratio is the ratio of reserves to deposits a bank keeps and does not loan out (can include excess reserves)

• Reserve ratio = required reserve ratio + excess reserve ratio



Calculating the Money Multiplier

• 1/r is the simple money multiplier

• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency

30-86


Calculating the Money Multiplier

• It tells us how much money will ultimately be created by the banking system from an initial inflow of money

• The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created



Calculating the Money Multiplier When People Hold Currency

• The simple money multiplier reflects the assumption that only banks hold currency

• When firms and individuals hold currency, the money multiplier in the economy is:

(1 + c)(r + c)

30-88


Calculating the Money Multiplier when People Hold Currency

• Where r is the percentage of deposits banks hold in reserve and c is the ratio of money people hold in currency to the money they hold as deposits



Determining How Many Demand Deposits Will Be Created

• Demand deposits: bank deposits that can be withdrawn at any time

• To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio

30-90


Determining How Many Demand DepositsWill Be Created

• A customer deposits $100 into a bank. What is the immediate impact on the money supply?

• No impact—the money was already in the money supply so there is no change




• A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately created is:

• $100 x 1/0.1 = $1,000

• New money created = $1,000 – $100 = $900




• New money created = $1,000 – $100 = $900

• Why is the new money created only $900 and not $1,000?

• Because the $100 deposit was already in the money supply

• This is due to our fractional reserve banking system: banks hold a portion of deposits and loan out the rest of the money

• If the Fed had created money this number would have been different ($1,000)



Change in Money Supply vs. Change in Loans

• The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system?

• 1/r =1/0.2=5

• 5 *(10 million)=50 million

• Fed has to hold 20% though

• 50 million*(0.2)=10 million

• Total available for loans: 50 million -10 million =40 million



Change in Money Supply vs. Change in Loans

• The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system?

• 1/r =1/0.2=5

• 5 *(10 million)=50 million



Sample Question: Bank Balance Sheet

Assets Liabilities

Loans $15,000

Total reserves $ 5,000

Treasury bonds $10,000

Demand deposits $20,000

Owner’s equity $10,000

Total: $30,000 Total: $30,000


Owner’s equity: money put into a business or bank; not held in reserves

(This concept often shows up in the FRQs)



Assets Liabilities

Loans $15,000





Total: $30,000 Total: $30,000


The reserve requirement is 10%. How much is the bank’s required reserves?To answer, we will look at the demand deposits.$20,000 x .1 = $2,000

Is the bank holding excess reserves? If so, how much?Yes: $3,000 (Total reserves – required reserves)



Assets Liabilities

Loans $15,000





Total: $30,000 Total: $30,000


How much could the bank increase the money supply if it loaned out its excess reserves?$3,000 x 1/.1 = $30,000

Assume John deposits $1,000 into the bank. What is the initial change in the money supply?None—the $1,000 was already in the money supply


Chapter Summary • The financial sector is the market where financial

assets are created and exchanged

• The financial sector channels flows out of the circular flow and back into the circular flow

• Every financial asset has a corresponding financial liability

• The economy has many interest rates

• The long-term rate is determined in the market for loanable funds, while the short-term rate is determined in the money market

30-99


Chapter Summary • Money is a highly liquid financial asset that serves as

a unit of account, a medium of exchange, and a store of wealth

• The measures of money are:

• M1 is currency in the hands of the public, checking account balances, and traveler’s checks

• M2 is M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares

• Banks create money by loaning out deposits30-100


Chapter Summary • The simple money multiplier is 1/r

• The money multiplier tells you the amount of money ultimately created per dollar deposited in the banking system

• The money multiplier when people hold cash is (1+c)/(r+c)

• People hold money for the transactions motive, the precautionary motive, and the speculative motive

30-101

Monetary Policy 31

Chapter Summary

• Monetary policy influences the economy through changes in the banking system’s reserves that affect the money supply and credit availability

• Expansionary monetary policy works as follows:

↑M → i↓ → ↑I → ↑Y

• Contractionary monetary policy works as follows:

↓ M → ↑i → ↓I → ↓Y

• The Federal Open Market Committee (FOMC) makes the actual decisions about monetary policy

31-102

Monetary Policy 31

Chapter Summary

• When the Fed buys bonds, the price of bonds rises and interest rates fall. When the Fed sells bonds, the price of bonds falls and interest rates rise.

• A change in reserves changes the money supply by the change in reserves times the money multiplier

• The Federal funds rate is the rate at which one bank lends reserves to another bank

• It is the Fed’s primary operating target

31-103

the financial sector and the...

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