unit five the financial sector unit five the financial sector ap macroeconomics mr. graham

Unit FiveThe Financial Sector

Unit FiveThe Financial Sector

AP MacroeconomicsAP MacroeconomicsMR. GrahamMR. Graham

Do Now.

• Why do individuals save money?• Why do individuals invest? • What is the difference between saving and

investment?• What are some specific ways people can

invest? • http://www.criticalcommons.org/Members/

AdrianFohr/clips/trading-information

3

Module 22:Saving, Investment, and

the Financial System

Module 22:Saving, Investment, and

the Financial System

Savings and Investment

• Two instrumental sources of economic growth

– Human Capital• Increases in the skills and knowledge of the workforce

• Provided by the government through public education

– Physical Capital• Increases in “capital”--goods used to make other

goods.

• Mainly created through private investment spending

The Interest Rate and Investment Spending

• Private Investment Spending

– In today’s economy, individuals and firms who create physical capital often do it with other people’s money (i.e. borrow)

– Interest Rate—price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year.

Savings and Investment

• Savings-Investment Spending Identity– Total Income = Total Spending

– Total Income = Consumer Spending + Savings

– Total Spending = Consumer + Investment Spending

– Consumer Spending + Savings = Consumer Spending + Investment Spending

– So…Savings = Investment Spending

Saving and Investment (with G added)• Limitation #1: the identity doesn’t include government

– Budget Balance

– Difference bet. tax revenue and government spending.

– Can be a deficit or a surplus

– In recent years the US has experienced a consistent budget deficit ($1.089 trillion in 2012).

– National Savings

• the sum of private savings and the budget balance; is the total amount of savings generated within the economy.

U.S. deficit falls to $680 billion

• US budget deficit 2008-2013

Saving and Investment (with X added)• Limitation #2: savings need not be used to finance

investment spending in one’s own country

– Capital Inflow—the net inflow of investment funds into a country.

• Includes both inflows or outflows

• In recent years the US has experienced a consistent net inflow of capital from foreigners (≈$300 Billion in 2012).

Saving and Investment (with G and X added)• In an economy with a positive capital inflow some

investment spending is funded by the savings of foreigners.

• In an economy with a negative capital inflow some national savings is funding investment spending in other countries

• In the United States in 2012:– Investment spending totaled $2,072 billion;– Private savings were $2,916 billion…

• …offset by a budget deficit of $1,089 billion • and supplemented by capital inflows of ≈$300 billion.

– There is a “statistical discrepancy” of ≈$55 billion because data collection isn’t perfect, but the identity is still true.

Components of the Financial System• Wealth– A household’s accumulated savings– Can take the form of physical or financial assets

• Physical Assets

– Claim on a tangible object (pre-existing house or piece of equipment).

• Financial Assets• Paper claim that entitles the buyer to future income

from the seller. • Financial Markets

– Where households invest their current savings and their accumulated savings by purchasing financial assets.

Three Problems with Physical Assets

1. Transaction Costs: expenses of actually putting together and executing a deal.

2. Financial Risk: uncertainty about future outcomes that involve financial losses or gains

3. Desire for Liquidity: (in)ability for assets to be quickly converted into cash

Three Tasks of a Financial System

• By allowing people to buy/sell financial assets rather than physical assets, they…

1.Reduce Transaction Costs2.Reduce Risk3.Provide Liquidity

Four Types of Financial Assets• Loans: lending agreement between an

individual lender and an individual borrower.– Good—usually tailored to needs of the borrower– Bad—typically involves a lot of transaction costs

Four Types of Financial Assets

• Bonds: IOU issued by the borrower for a fixed sum of annual interest.– Good—easily acquired

information on the quality*, easy to resell (i.e. more liquid)

– Bad—risk for default

Four Types of Financial Assets• Stocks: share in the ownership of a company– Good—more diversification and more liquidity– Bad—difficult to assess the true quality because of

securitization (loans packaged together) the process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool

Four Types of Financial Assets• Bank Deposits:– Good—the most liquid and secure financial asset– Bad—forgone opportunity for appreciation

Financial Intermediary• Institutions that transform funds gathered

from many individuals into financial assets

– Banks

– Mutual Funds

– Pension Funds

– Life Insurance Companies

The Federal Reserve

• http://www.youtube.com/watch?v=I2m3t2Yr8Vg

• http://www.youtube.com/watch?v=3hYxH5_d5Xk

• http://www.youtube.com/watch?v=r8lHeLJ6ie0

Do Now.

• http://www.criticalcommons.org/Members/jtierney86/clips/shawshank-redemption-money-in-prison

• http://www.criticalcommons.org/Members/jtierney86/clips/the-league-medium-of-exchange

• http://www.criticalcommons.org/Members/Ghent/clips/the%20invitations.mp4

21

Module 23:The Definition and Measurement of Money

Module 23:The Definition and Measurement of Money

15-22

Is This Money?

15-23

The Meaning of Money

• Money includes not only coins and dollar bills, but also the balance in your checking account.

• Anything widely accepted in exchange for items of value is considered to be money.

15-24

What Is Money?

• Money

– Any asset that can easily be used to purchase goods and services

– It is the asset with the most liquidity

• The ease with which an asset can be converted into cash

15-25

The Roles of Money (3)

1. Medium of Exchange2. Store of Value3. Unit of Accounting

15-26

• Medium of Exchange– An asset that individuals acquire for the purpose

of trading goods and services rather than for their own consumption

– Money makes it possible to trade without exchanging goods and services directly • Eliminates the difficulty of “barter”—

finding a double coincidence of wants• Permits specialization• Facilitates efficiency in exchanges

The Roles of Money (3)

15-27

• Store of Value

– The ability to hold purchasing power over time

– Money allows you to transfer value (wealth) into the future.

– A necessary property of money

The Roles of Money (3)

15-28

• Unit of Accounting

– A measure by which prices are expressed

– The common denominator of the price system—allows people to compare and measure values

– A central property of money

The Roles of Money (3)

15-29

So…What Is Money?

Complete “Activity 34: Money Is What Money Does”

Evaluate each item as to how well it would perform the 3 functions of money.

Be sure to consider portability, uniformity, acceptability, durability and stability in value.

15-30

• Commodity Money– A good used as a medium of exchange that has

intrinsic value in other uses (i.e. gold)

• Commodity-Backed Money– A medium of exchange with no intrinsic value whose

ultimate value is guaranteed by a promise that it can be converted into valuable goods

• Fiat Money– a medium of exchange whose value derives entirely

from its official status as means of payment

The Types of Money (3)

15-31

• Fiat Money

– Advantages:

• It doesn’t tie up any real resources, except for the paper it’s printed on.

• The money supply can be managed by the needs of the economy, instead of being determined by the amount of gold and silver.

– Risks

• Counterfeiting

• Inflation

The Types of Money (3)

15-32

Measuring the Money Supply

• Money Supply– The amount of money in circulation

• Changes in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP.

15-33

• Economists use two basic approaches to define and measure money.

– The transactions approach

– The liquidity approach

Measuring the Money Supply

15-34

• Transactions Approach– A method of measuring the money

supply by looking at money as a medium of exchange (a.k.a. “narrow money”)

• Liquidity Approach– A method of measuring the money supply by

looking at money as a temporary store of value (a.k.a. “broad money”)

Measuring the Money Supply

15-35

• M1: Transactions approach to measuring money

– Coin and Currency

– Transactions deposits (i.e. checking accounts)

– Traveler’s checks not issued by banks

– Consists of the most liquid forms of money

Measuring the Money Supply

15-36

Measuring the Money Supply

15-37

• M2: Liquidity approach to measuring money

– Savings deposits

– Time deposits

– Money market mutual funds

– Includes “near moneys”– Assets that are almost money

– Still highly liquid

– Easily converted to cash

Measuring the Money Supply

15-38

Measuring the Money Supply

15-39

Defining the U.S. Money Supply• Question– Which definition of money correlates best with

economic activity?

• Answer– M2, although some businesspeople and

policymakers prefer even broader definitions with further assets added to the definition.

15-40

• Complete “Activity 35: What’s All This About the M’s?”

Measuring the Money Supply

Do Now.

• What is Money?• Identify M1 and M2 and explain the difference• List and explain the 3 tasks of the financial

system• Speculate on the time value of money. What

does that mean?

42

Module 24:The Time Value of Money

Module 24:The Time Value of Money

15-43

The Time Value of Money

• Making economic decisions can sometimes be difficult because the benefits and costs of a project may not arrive at the same time.

• How, specifically is time an issue in economic decision-making?

15-44

Borrowing, Lending and Interest• In general, having a dollar today is worth more

than having a dollar a year from now.– The value of money depends on when it is paid or

received• $1 that is paid to you today is worth more than $1

that is paid to you a year from now. • $1 that you must pay today is more burdensome

than $1 that you must pay next year.

– There is a simple way to adjust for these complications so we can correctly compare the value of $ received and paid out at different times

15-45

Present Value vs. Future Value

• Present Value– Price of what you are going to be paid or what

you are going to pay NOW instead of waiting to be paid or waiting to pay for it in the future

– Let’s say you win the lottery for $1 million dollars, and are given the choice of receiving the $1 million dollars in two years or receiving something less than $1 million right NOW.

–Which would you choose?

15-46

Present Value vs. Future Value

• Which would you choose? It depends on…– How much you are going to get paid NOW?

Lottery officials offer you $910,000 NOW

–What is the expected interest rate?

The expected interest rate for the next 2 years is 5%.

• Would you take their offer?

15-47

Present Value v. Future Value

• We need to know the formula for present value– PV = FV x 1/(1 + r)n • r is the interest rate

• n is the number of years

• So the present value of $1 million received 2 years from now is:– PV = 1,000,000 x 1/(1 + .05)2

– PV = $907,029.48

• We should take the 910,000 NOW!

15-48

• Future Value– Value at some point in the FUTURE of a

present amount of money

– Let’s say you put $200 in the bank and it earns 3.5%. If you left this money in the bank, how much would you have in the bank at the end of two years?

Present Value v. Future Value

15-49

Present Value v. Future Value

• We need to know the formula for future value– FV = PV x (1 + r)n • r is the interest rate

• n is the number of years

• So the future value of $200 in the bank that earns 3.5% left in the bank for 2 years is:– FV = 200 x (1 + .035)2

– FV = $214.25

15-50

• Complete “Present and Future Value”

• http://www.reffonomics.com/TRB/chapter18/presentvalue.html

• http://www.learner.org/series/econusa/unit20/

Present v. Future Value

Do Now

• What is the purpose of banks?• How do they make money?• What are bank runs? • Why is it important for the government to

keep banks in business?

52

Module 25:Banking and Money Creation

Module 25:Banking and Money Creation

15-53

The Monetary Role of Banks

• Roughly half of M1 consists of currency in circulation (i.e. $1 bills, $5 bills, and so on)

• The rest of M1 (and the bulk of M2) consists of bank deposits

– Checkable and debitable account balances in commercial banks and other types of financial institutions—high liquidity

15-54

• A bank is a financial intermediary

– Uses liquid assets (i.e. bank deposits) to finance the illiquid investments of borrowers.

• Process is known as Fractional Reserve Banking

– A system in which depository institutions hold liquid assets less than the amount of deposits.

– Can take the form of:

1. Currency in bank vaults

2. Bank Reserves—deposits held at the Federal Reserve

What Banks Do

15-55

What Banks Do

• To understand the role of banks in determining the money supply, we start by introducing a simple tool for analyzing the bank’s financial position: a T-Account.

• T-Account (Balance Sheet)– Statements of assets and liabilities

• Assets (Amounts owned)– Items to which a bank holds legal claim

– The uses of funds by financial intermediaries

• Liabilities (Amounts owed)– The legal claims against a bank

– The sources of funds for financial intermediaries

What Banks Do—Basic Accounting Review

What Banks Do—Basic Accounting Review

What Banks Do—Basic Accounting Review

Notice that in this example First Street’s assets are larger than its liabilities—that’s the way it’s supposed to be!

Banks are required by law to maintain assets larger by a specific percentage than their liabilities

What Banks Do—Basic Accounting Review

Reserve Ratio

The fraction of bank deposits that a bank holds as reserves (i.e. 10% for “First Street Bank”)

Required Reserve RatioThe smallest fraction of deposits that the Federal

Reserve allows banks to hold (currently 10%)

Helps protect against bank runs

Banking Regulation

• In addition to “Reserve Requirements,” we have three more regulatory features that protect against bank runs and failures:

1. Deposit Insurance: FDIC guarantees $250,000 of each account.

2. Capital Requirements: “Bank Capital” is the excess of a bank’s assets over its bank liabilities.

3. Discount Window: arrangement that allows the Federal Reserve to lend money to member banks.

Questions?

• Define fractional reserve banking.• List and explain 3 features that protect against

bank runs and failures• How can banks essentially create money?

Determining the Money Supply

And this may not be the end of the story…

Determining the Money SupplyMary uses her cash to buy a TV and a DVD player from

Acme Merchandise.

Anne Acme, the store’s owner, deposits the $900 into a checkable bank deposit at Second Street Bank.

Second Street Bank will keep only part of that deposit in reserves, lending out the rest.

Second Street Bank keeps 10% of any bank deposit in reserves and lends out the rest, further increasing the

money supply.

Determining the Money Supply

This process of money creation may sound familiar--recall the multiplier process that we described in Module 16.

We have here is another multiplier—the money multiplier

The Money Multiplier

The money multiplier represents the total number of dollars created in the money supply by each $1 addition to the monetary base.

Monetary Base: Bank reserves plus currency in circulation.

Money Supply: Checkable deposits plus currency in circulation.

The Money Multiplier

• In a simplified situation in which banks hold no excess reserves and all cash is deposited in banks, the money multiplier is:

1/rr• Excess Reserves: reserves over and above the amount

needed to satisfy the minimum reserve ratio.• In reality, the determination of the money supply is

more complicated than our simple model

The Money MultiplierIf the reserve requirement is 10% (the minimum

required ratio for most checkable deposits in the United States), the money multiplier is 1/0.1 = 10.

So…if the Federal Reserve adds $100B to the monetary base, the money supply will increase by 10 × 100 = $1,000B

In reality, the actual money multiplier in the United States, using M1 as our measure of money, is currently only .9. That’s a lot smaller than 10.

What is going on?

The Money Multiplier

The Money MultiplierThe required reserve ratio is 10%.1.If a bank has deposits of $100,000 and holds $15,000 as reserves, how much are its excess reserves?

$50002.If a bank holds no excess reserves and it receives a new deposit of $1,000, how much of that $1,000 can it lend out and how much is the bank required to add to its reserves?

Loans +$900Reserves +100

3.By how much can an increase in excess reserves of $2,000 change the money supply?

Money Multiplier = 10; 2000 x 10 = $20,000

Do Now.

• Define the following:– Central bank– Commercial bank– Investment bank – Panic of 1907

71

Module 26:The Federal Reserve System:

History and Structure

Module 26:The Federal Reserve System:

History and Structure

15-72

The Federal Reserve System

• Central Bank

– An institution that oversees and regulates the banking system and controls the monetary base

1.Perform banking functions for their nations’ governments

2.Provide financial services for private banks

3.Conduct their nations’ monetary policies

15-73

The Federal Reserve System

• The Federal Reserve

– The central bank of the United States

– The most important regulatory agency in the U.S. monetary system

– Established by the Federal Reserve Act (1913) in response to the lessons learned in the Panic of 1907.

15-74

The Structure of the Fed• Board of Governors (Washington, D.C.)

– 7 members, 14-year terms, appointed by the President

– Oversee the entire Federal Reserve System

– Janet L. Yellen

• Federal Reserve Banks

– 12 Districts

– Audit the books of private-sector banks, among other roles.

• Federal Open Market Committee (FOMC)

– B.O.G. and 5 bank presidents (always including NY)

– Conducts Monetary Policy

15-75

The Structure of the Fed

15-76

The Structure of the Fed

Do Now.

• Watch this video: – http://www.youtube.com/watch?

v=GsxmwjQWiZs

78

Module 27:The Federal Reserve System:

Monetary Policy

Module 27:The Federal Reserve System:

Monetary Policy

15-79

The Functions of the Federal Reserve System

1. Provides Financial Services:

– holds reserves, clears checks, provides cash, and transfers funds for commercial banks and the federal government.

2. Supervises and Regulates Banking Institutions

– examines and regulates commercial banks in their district

3. Maintains the Stability of the Financial System

– provide liquidity to financial institutions

4. Conducts Monetary Policy

What the Fed Does(a.k.a. the 3 ways they do monetary policy)

1. Reserve Requirement

2. Discount Rate

3. Open Market Operations

• The Reserve Requirement– “Least used tool of the Federal Reserve”– Sets a minimum required reserve ratio (10%)• Banks that fail to maintain minimum face penalties• Can borrow excess reserves from the other banks via

the federal funds market to meet minimum

– Fed can change reserve requirements to alter the money supply

What the Fed Does

• The Discount Rate– Banks in need of reserves can also borrow

from the Fed itself via the discount window– Discount rate is currently set at 25 basis points

(.25%) above the federal funds rate– Fed can change the discount rate to alter the

money supply

What the Fed Does

• Open-Market Operations– Treating the Federal Reserve as a bank, we realize

they have their own “assets” and “liabilities”.– Fed’s assets consist of its holdings of debt issued by

the U.S. government (i.e. U.S. Treasury bills). – Fed’s liabilities consist of currency in circulation

and bank reserves (i.e. the “monetary base”).

What the Fed Does

What the Fed Does

• In panel (a), the Federal Reserve increases the monetary base by purchasing U.S. Treasury bills from private commercial banks.

• The purchase is paid for by a $100 million increase in the monetary base.

• This will ultimately lead to an increase in the money supply as banks lend out some of these new reserves.

What the Fed Does• In panel (b), the Federal

Reserve reduces the monetary base by selling U.S. Treasury bills to private commercial banks.

• The sale leads to a $100 million reduction in commercial bank reserves, resulting in a $100 million decrease in the monetary base.

• This will ultimately lead to a decrease in the money supply as banks reduce their loans.

Do Now.

• What do you think of the following short video clips? – http://www.criticalcommons.org/Members/

fsustavros/clips/commanding-heights-3-chapter-11-global-contagion

– http://www.criticalcommons.org/Members/fsustavros/clips/commanding-heights-3-chapter-12-contagion-engulfs

87

Module 28:The Money Market

Module 28:The Money Market

The Demand for Money

Recall…M1: Currency in circulation, plus checkable

bank deposits, plus traveler’s checks. M2: consists of M1 plus deposits that can

easily be transferred into checkable deposits. People hold money to make it easier to

purchase goods and services. But what determines how much money

individuals and firms want to hold at any time?

The Demand for Money

The Opportunity Cost of Holding MoneyHolding money is “convenient”The opportunity cost for that

convenience: money held in your wallet earns no interest

Even holding money in a checking account involves a trade-off between convenience and earning interest.

The Demand for Money

The opportunity cost of holding money changes when the overall level of interest rates changes. Specifically, when the overall level of interest rates falls, the opportunity cost of holding money falls, too.

The Money Demand CurveBecause the overall level of interest rates affects the

opportunity cost of holding money, the quantity of money individuals and firms want to hold is, other things equal, negatively related to the interest rate

Shifts in the Money Demand Curve

Changes in Aggregate Price Levelother things equal, the demand for money is

proportional to the price level (i.e. if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate also rises by 20%).

Changes in Real GDPThe larger the quantity of goods and services

households buy, the larger the quantity of money they will want to hold at any given interest rate.

Shifts in the Money Demand Curve

Changes in TechnologyAdvances in information technology have tended

to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money.

Changes in InstitutionsWhen banking regulations change (i.e. allowing or

prohibiting interest), the demand for money will change as well.

Shifts in the Money Demand Curve

Money and Interest Rates

• “The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2¼ percent”—March 18, 2008

• As we’ve already seen, other short-term interest rates, such as the rates on CDs, move with the federal funds rate.• How does the Fed go about achieving a target

federal funds rate? • And more to the point, how is the Fed able to

affect interest rates at all?

The Money MarketThe Fed can increase or decrease money supply:

it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements

Do Now.

• Draw a correctly labeled graph showing the money market in equilibrium

• What happens if there is an interest rate below equilibrium?

• What will people do with their wealth if there is an interest rate above equilibrium?

• Illustrate these two situations graphically.

98

Module 29:The Market for Loanable Funds

Module 29:The Market for Loanable Funds

Two Models of the Interest Rate

Money MarketSupply of money is chosen by the Fed.Represents the market for short-term borrowing.

Loanable Funds MarketHypothetical market in which those who want to

save supply funds and those who want to borrow to invest demand funds.

Represents the market for long-term borrowing.

The Loanable Funds Market

• “Loanable funds” refers to all income that people have chosen to save (and lend out), rather than use for their own consumption.

• The loanable funds market coordinates the economy’s saving and investment

The Demand for Loanable Funds• The demand for loanable funds comes from firms and

households that wish to borrow to make investments.

The Supply of Loanable Funds• The supply of loanable funds comes from people who

have extra income they want to save and lend out.

Equilibrium in the Loanable Funds Market• The interest rate is the “price” of the loan.• It represents the amount that borrowers pay for loans

and the amount that lenders receive on their saving.• The equilibrium of the supply and demand for

loanable funds determines the real interest rate.

Shifts in Demand for Loanable Funds1. Changes in perceived business opportunities• A change in beliefs about the rate of return on

investment spending can increase or reduce the amount of desired spending at any interest rate.

2. Changes in the government’s borrowing• Governments that run budget deficits need to

borrow funds to finance the government.• “Crowding Out”:

the negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates

Shifts in Supply for Loanable Funds1. Changes in private savings behavior• Perceptions about wealth can cause the level of

private savings to change at any level of interest.2. Changes in capital inflows• As investors’ perception of a country change, then

international capital flows can change.

The Interest Rate in the Short-Run

The Interest Rate in the Long Run

Economics USA-Monetary Policy

• http://www.learner.org/series/econusa/unit25/