Money, Banking and the Financial Sector

1. Money, Banking and the Financial Sector Chapter 13

2. Laugher Curve A central banker walks into a pizzeria to order a pizza. When the pizza is done, he goes up to the counter get it.

3. Laugher Curve The clerk asks him: �Should I cut it into six pieces or eight pieces?�

4. Introduction Real goods and services are exchanged in the real sector of the economy. For every real transaction, there is a financial transaction that mirrors it.

5. Introduction The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it.

6. Introduction All trade�s in the goods market involves both the real sector and the financial sector.

7. Why Is the Financial Sector So Important to Macro? The financial sector is important to macroeconomics because of its role in channeling savings back into the circular flow.

8. Why Is the Financial Sector So Important to Macro? Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government.

9. Why Is the Financial Sector So Important to Macro? Savings are channeled into the financial sector when individuals buy financial assets such as stocks or bonds and back into the spending stream as investment.

10. Why Is the Financial Sector So Important to Macro? For every financial asset there is a corresponding financial liability.

11. The Financial Sector as a Conduit for Savings

12. The Role of Interest Rates in the Financial Sector While price is the mechanism that balances supply and demand in the real sector, interest rates do the same in the financial sector.

13. The Role of Interest Rates in the Financial Sector The interest rate is the price paid for use of a financial asset.

14. The Role of Interest Rates in the Financial Sector When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate.

15. The Role of Interest Rates in the Financial Sector When interest rates rise, the value of the flow of payments from fixed-interest-rate bonds goes down because more can be earned on new bonds that pay the new, higher interest.

16. The Role of Interest Rates in the Financial Sector As the market interest rates go up, price of the bond goes down.

17. Savings That Escape the Circular Flow Some economists believe that the interest rate does not balance the demand and supply of savings causing macroeconomic problems.

18. Savings That Escape the Circular Flow In order to make sense of the problem, macroeconomics divides the flows into two types of financial assets.

19. Savings That Escape the Circular Flow In order to make sense of the problem, macroeconomics divides the flows into two types of financial assets.

20. Savings That Escape the Circular Flow The first type include bonds and loans which work their way into the system.

21. The Definition and Functions of Money Money is a highly liquid financial asset. To be liquid means to be easily changeable into another asset or good. Social customs and standard practices are central to the liquidity of money.

22. The Definition and Functions of Money Money is generally accepted in exchange for other goods.

23. The U.S. Central Bank: The Fed American currency is printed with the caption "Federal Reserve Note," meaning that it is a liability of the Federal Reserve Bank (the Fed). The Federal Reserve Bank (the Fed) is the central bank of the U. S.

24. The U.S. Central Bank: The Fed Federal Reserve Notes serve as cash in the U.S. They are liabilities of the Fed.

25. The U.S. Central Bank: The Fed The Fed, being the nation�s central bank has the right to issue these notes and by convention the notes are acceptable for payment to all the people of the country.

26. The U.S. Central Bank: The Fed A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms.

27. The U.S. Central Bank: The Fed Individuals� deposits in savings and checking accounts serve the same function as does currency and are also considered money.

28. Functions of Money Money is a medium of exchange. Money is a unit of account. Money is a store of wealth.

29. Money As a Medium of Exchange Without money, we would have to barter�a direct exchange of goods and services. Money facilitates exchange by reducing the cost of trading.

30. Money As a Medium of Exchange Money does not have to have any inherent value to function as a medium of exchange.

31. Money As a Medium of Exchange The Fed�s job is to not issue too much or too little money.

32. Money As a Medium of Exchange If there is too much money, compared to the goods and services at existing prices, the goods and services will sell out, or the prices will rise.

33. Money As a Medium of Exchange If there is too little money, compared to the goods and services at existing prices, there will be a shortage of money and people will have to resort to barter, or prices will fall.

34. Money As a Unit of Account Money prices are actually relative prices. A single unit of account saves our limited memories and helps us make reasonable decisions based on relative costs.

35. Money As a Unit of Account Money is a useful unit of account only as long as its value relative to other prices does not change too quickly.

36. Money as a Store of Value Money is a financial asset. It is simply a government bond that pays no interest.

37. Money as a Store of Value As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.

38. Money as a Store of Value Money�s usefulness as a store of wealth also depends upon how well it maintains its value.

39. Money as a Store of Value Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest.

40. Alternative Measures of Money Since it is difficult to define money unambiguously, economists have defined different concepts of money. They are called M1, M2, and L.

41. Alternative Measures of Money: M1 M1 consists of currency in the hands of the public, checking account balances, and travelers� checks. Checking account deposits are included in all definitions of money.

42. Alternative Measures of Money: M2 M2 is made up of M1 plus savings deposits, small-denomination time deposits (certificates of deposit or CDs), and money market mutual fund shares, along with some other esoteric financial instruments.

43. Alternative Measures of Money: M2 The money in savings accounts is counted as money because it is readily available.

44. Alternative Measures of Money: M2 All M2 components are highly liquid and play an important role in providing reserves and lending capacity for commercial banks.

45. Alternative Measures of Money: M2 The M2 definition is important because economic research has shown that the M2 definition most closely correlates with the price level and economic activity.

46. Beyond M2: L The broadest definition of the money supply is L (which stands for liquidity. It consists of almost all short-term financial assets.

47. Beyond M2: L Because of the difficulty of defining money in an ever-changing world, measures of money have lost some their appeal, and broader concepts of asset liquidity have taken their place.

48. Distinguishing Between Money and Credit Credit card balances cannot be money since they are assets of a bank. In a sense, they are the opposite of money.

49. Distinguishing Between Money and Credit Credit cards are prearranged loans.

50. Components of M2 and M1

51. Banks and the Creation of Money Banks are both borrowers and lenders. Banks take in deposits and use the money they borrow to make loans to others. Banks make a profit by charging a higher interest on the money they lend out than they pay for the money they borrow.

52. Banks and the Creation of Money Banks can be analyzed from the perspective of asset management and liability management.

53. Banks and the Creation of Money Asset management is how a bank handles its loans and other assets.

54. Banks and the Creation of Money Banks operate in a regulated environment, the primary regulator being the Fed.

55. How Banks Create Money Banks create money because a bank�s liabilities are defined as money. When a bank incurs liabilities it creates money.

56. How Banks Create Money When a bank places the proceeds of a loan it makes to you in your checking account, it is creating money.

57. The First Step in the Creation of Money The Fed creates money by simply printing currency and exchanging it for bonds. Currency is a financial asset to the bearer and a liability to the Fed.

58. The Second Step in the Creation of Money The bearer deposits the currency in a checking account at the bank. The bank holds your money and keeps track of it until you write a check.

59. Banking and Goldsmiths In the past, gold was used as payment for goods and services. But gold is heavy and the likelihood of being robbed was great.

60. From Gold to Gold Receipts It was safer to leave gold with a goldsmith who gave you a receipt. The receipt could be exchanged for gold whenever you needed gold.

61. From Gold to Gold Receipts People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold.

62. The Third Step in the Creation of Money Little gold was redeemed, so the goldsmith began making loans by issuing more receipts than he had in gold. He charged interest on the newly created gold receipts.

63. The Third Step in the Creation of Money When the goldsmith began making loans by issuing more receipts than he had in gold, he created money.

64. The Third Step in the Creation of Money The gold receipts were backed partly by gold and partly by people�s trust that the goldsmith would pay off in gold on demand.

65. The Third Step in the Creation of Money The goldsmith soon realized that he could make more money in interest than he could earn in goldsmithing.

66. Banking Is Profitable As the goldsmiths became wealthy, others jumped in offering to hold gold for free, or even offering to pay for the privilege of holding the public�s gold.

67. Banking Is Profitable That is why most banks today are willing to hold the public�s money at no charge � they can lend it out and in the process, make profits.

68. The Money Multiplier Banks lend a portion of their deposits keeping the balance as reserves. Reserves are cash and deposits a bank keeps on hand or at the Fed or central bank, enough to manage the normal cash inflows and outflows.

69. The Money Multiplier The reserve ratio is the ratio of cash (or deposits at the central bank) to deposits a bank keeps as a reserve against cash withdrawals.

70. The Money Multiplier The required reserve ratio is the percentage of their deposits banks are required to hold by the Fed.

71. The Money Multiplier Banks �hold� currency for people and in return allow them to write checks for the amount they have on deposit at the bank.

72. Determining How Many Demand Deposits Will Be Created To determine the total amount of deposits that will eventually be created, the original amount that is deposited is multiplied by 1/r, where r is the reserve ratio.

73. Determining How Many Demand Deposits Will Be Created For an original deposit of $100 and a reserve ratio of 10 percent, the formula would be: 1/r = 1/0.10 = 10 10 X $100 = $1,000

74. Determining How Many Demand Deposits Will Be Created This means that $900 of new money was created ($1,000 -$100).

75. Calculating the Money Multiplier The ratio 1/r is called 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. It equals 1/r when people hold no cash.

76. Calculating the Money Multiplier The higher the reserve ratio, the smaller the money multiplier, and the less money will be created.

77. An Example of the Creation of Money The first 10 rounds of the money creation process is illustrated on the following table. Assume a deposit of $10,000 and a reserve ratio of 20 percent.

78. An Example of the Creation of Money

79. An Example of the Creation of Money If banks keep excess reserves for safety reasons, the money multiplier decreases.

80. Calculating the Approximate Real-World Money Multiplier The approximate real-world money multiplier in the economy is: 1/(r +c) r = the percentage of deposits banks hold in reserve c = the ratio of money people hold in cash to the money they hold as deposits

81. Calculating the Approximate Real-World Money Multiplier Assume banks keep 8 percent in reserve and the ratio of individuals� cash holdings to their deposits is 20 percent.

82. Calculating the Approximate Real-World Money Multiplier The approximate real-world money multiplier is:

83. Faith as the Backing of Our Money Supply Promises to pay underlie any financial system. All that backs the modern money supply are promises by borrowers to repay their loans and government guarantees that banks� liabilities to depositors will be met.

84. Regulation of Banks and the Financial Sector The banking system�s ability to create money present potential problems.

85. Financial Panics The financial history of the world is filled with stories of financial upheavals and monetary problems. In the U.S. in the 1800s, local banks were allowed to issue their own notes, which often became worthless.

86. Anatomy of a Financial Panic Financial systems are based on trust that expectations will be fulfilled. Banks borrow short and lend long, which means that if people lose faith in banks, the banks cannot keep their promises.

87. Anatomy of a Financial Panic If all the people, all at once, decided to ask for their money (�a run on a bank�), there would not be nearly enough to satisfy everyone.

88. Government Policy to Prevent Panic To prevent panics, the U.S. government has guaranteed the obligations of various financial institutions. The most important guaranteeing program is the Federal Deposit Insurance Corporation (FDIC).

89. Government Policy to Prevent Panic Financial institutions pay a small premium for each dollar of deposit to the FDIC.

90. Government Policy to Prevent Panic FDIC guarantees prevent the unwarranted fear that causes financial crises.

91. The Benefits and Problems of Guarantees The fact that deposits are guaranteed does not serve to inspire banks to make certain deposits are covered by loans in the long run.

92. The Benefits and Problems of Guarantees Since deposits are covered up to $100,000 by the FDIC, some financial institutions make risky loans knowing that the guarantee is good.

93. The Savings and Loan Bailout During the late 1980s and early 1990s, the deregulated S&Ls made so many bad loans that many failed. The S&Ls could not repay depositors their money, so the government had to step in and do it for them.

94. Banks and Bad Loans How could the savings and loan fiasco of happen? Part of the answer lay in out-and-out fraud. Part of it lies in the spread.

95. Banks and Bad Loans The spread is the difference between a bank's costs of funds and the interest it receives on lending out those funds.

96. Banks and Bad Loans The cost of funds grew because of competition from other S&Ls.

97. Should Government Guarantee Deposits? It is an open question whether the government should have guaranteed S&L deposits.

98. Should Government Guarantee Deposits? The guarantee program prevented unwarranted runs on S&Ls.

99. Money, Banking and the Financial Sector End of Chapter 13