Unit 4-The Financial Sector

Financial markets channel private savings into. . .

investment spending; government borrowing

Banks are financial _____________ for savers and borrowers

intermediaries

Money saved in banks is the source of money for _______________

loans

The word investment in economics will always refer to. . .

business spending and capital stock (physical capital)

Money

•cash and demand deposits

•most liquid

•no risk but the opportunity cost is the lost potential return from holding other financial assets

Bond

•a loan (IOU) to the government or business must be repaid to the lender

•somewhat liquid

•risk varies based on the issue/borrower

Stock

•certificate representing equity (ownership) in a company

•liquidity varies but less than money

•risk varies based on the company

Asset=

have

Liability=

owe

There is an inverse relationship between _____________ of previously issued bonds and ______________

price; interest rates

Nominal Interest rate

% increase in money that the borrower pays not adjusting for inflation

Nominal interest rate equation

nominal = real interest rate + expected inflation

Real Interest rate

% increase in purchasing power that a borrower pays adjusted for inflation

Real interest rate equation

real = nominal interest rate - expected inflation

You lend out $100 with 20% interest. Inflation is 15%. A year later you get paid back $120. Calculate the nominal interest rate (i) and the real interest rate (r).

•nominal interest rate = 20%

•real interest rate = 5%

You lend out $100 with 10% interest. Prices are expected to increased 20%. In a year you get paid back $110. Calculate the nominal interest rate (i) and the real interest rate (r).

•nominal interest rate = 10%

•real interest rate = -10%

If the nominal interest rate is 5.41% and the inflation rate is 3.12%. What is the real interest rate?

2.29%

If the nominal interest rate is 3.46% and the inflation rate is 2.30%. What is the real interest rate?

1.16%

Wealth

collection of assets

Income

flow of earning per unit of time

Medium of exchange

•accepted as a means of transaction payment

•eliminates the complication of barter

Unit of account

•a measurement of value

•allows comparison of prices

Store of value

•store purchasing power for future use

M0 or MB

•the monetary base

•currency in circulation

•bank reserves and bank deposits

M1

•currency in circulation

•checkable bank deposits (demand deposits)

•saving deposits other liquid deposits

M2

M1 plus the following. .

•money market accounts

•time deposits (CDs = certificates of deposits)

•mutual funds

A) a student pays tuition at a local college

B) a woman compares the cost of tennis shoes at several stores

C) a student puts $20 in his wallet for emergency use

A = medium of exchange

B = unit of account

C = store of value

Banks must hold a percentage of demand deposits as required reserves to cover potential. . .

withdrawals

Deposits are a ___________ for the bank and an ___________ for the depositor

liability; asset

Loans are ____________ for the bank and _____________ for the borrower

assets; liabilities

Asset

are items of ownership

Liabilities

are claims of non-owners, you have to give it back to someone if asked

Net worth

is the claims of the owners against the firm's assets

Assets =

liabilities + net worth

Balance sheet requirements

•MUST always balance

•left side of the equation MUST equal the right side of the equation

•every asset is either claimed by someone outside the company (liability) or by the owner (net worth)

Reserve requirement

the percentage of deposits that banking institutions must hold in reserve

If the reserve ratio is 10% and you have $100,000 in demand deposits, you must keep _________ as reserves

$10,000

Excess reserves

when a banks actual reserves exceed its required reserves

Multiple-deposit expansion of the money supply

•each individual can ONLY loan money equal its excess reserves (it can only create money equal to its excess reserves)

•when all banks are combined, they can create an amount greater their combined reserves

Simple money multiplier

•ratio of money supply (M1) to the monetary base (M0)

•tells us the change in M1 from the new excess reserves created by new deposits

•may overstate the predicted amount because it doesn't consider banks' DESIRE to hold excess reserves or the public holding more currency

Money multiplier equation

1/required reserve ratio

Grace deposits $10, 000 in cash into her checking account at a bank that holds no excess reserves and has a required reserve ratio is 25%

A) What is the value of the money multiplier

B) What is the amount of the required reserve

C) What is the maximum amount M1 will expand

A) 1/.25 = 4

B) 10,000 * .25 = 2,500

C) 4 * 7,500 = 30,000

Assume that the required reserve ratio is 10% and banks hold no excess reserves, in other words they lend out the other 90% and all money lent out by one bank is redeposited in another bank. Under these assumptions, if a new checkable deposit of $1,000 is made in Bank 1, how much money will. . .

i. bank 1 keep as required reserves?

ii. bank 1 lend out?

iii. redeposited in bank 2?

iv. bank 2 keep as required reserves?

v. bank 2 lend out?

vi. be redeposited in bank 3?

i. $100

ii. $900

iii. $900

iv. $90

v. $810

vi. $810

People demand a certain amount of liquid assets (money) for two different reasons:

•transaction demand for money

•asset demand for money

The opportunity cost of holding money in your pocket or checking account is the. . .

interest rate you could be earning from other financial assets (stocks, bonds, and real estate)

What kind of relationship is there between interest rate and the quantity of money demanded?

inverse relationship

3 shifters of money demanded

1. changes in price level

2. changes in RGDP

3. changes in technology

Why is the money supply curve vertical?

because it's a fixed amount determined by the central bank

Adjusting MS to affect the economy is . . .

monetary policy

At the equilibrium in money market

•QM = MS

•the nominal interest rate (i) is determined by MS = MD

Monetary policy is the actions a nation's central bank to stabilize its economy by managing the __________ supply to promote ________ employment, control ___________, and promote moderate long-term _____________

money; full; inflation; interest rate

The Federal Reserve (Fed) is the central bank of the U.S. it regulates the ________________________ and implements _________________

banking industry; monetary policy

The Fed uses monetary policy. . .

•to counter short-run output gaps

•by influencing the nominal interest rate (i) in the short run

•which in turn affects AD through investment and interest sensitive consumption

•and returns aggregate output (RGDP) to full employment

Monetary Policy Tool: Recessionary Output Gap

•counter cyclical policy required = expansionary monetary policy

•MS ↑

•Nominal interest rate ↓

•I and C ↑

•AD ↑

•Y ↑

Monetary Policy Tool: Inflationary Output Gap

•counter cyclical policy required = contractionary monetary policy

•MS ↓

•Nominal interest rate ↑

•I and C ↓

•AD ↓

•Y ↓

If there is a recession, the Fed should ___________ the reserve ratio

1. Banks have _________ excess reserves to make loans

2. The money multiplier ________ so loans create ________ money

3. Money supply _________, interest rates ______, AD ______

•decrease

1. more

2. increases; more

3. increase; decrease; increase

If there is inflation, the Fed should ___________ the reserve ratio

1. Banks have _________ excess reserves to make loans

2. The money multiplier ________ so loans create ________ money

3. Money supply _________, interest rates ______, AD ______

•increase

1. fewer

2. decrease; less

3. decrease; increase; decrease

If the reserve requirement is 0.5 and the Fed SELLS $10 million of bonds, what will happen to the money supply?

2 * -10M = -20M

If the reserve requirement is 0.1 and the Fed BUYS $10 million bonds, what will happen to the money supply?

$10M * $10M = 100M

What kind of a relationship is there between the reserve ratio and money supply?

inverse

Discount rate

the interest rate the Fed charges commercial banks to borrow money

Discount rate: increasing money supply

the Fed should decrease the discount rate

Discount rate: decreasing money supply

the Fed should increase the discount rate

There is ___________ relationship between the discount rate and MS

inverse

Conduction open-market operations

the buying and selling of securities

When the Fed buys securities from banks

it directly increases the reserves of the commercial banks

When the Fed buys securities from individuals

they end up putting the money in their banks which increases the banks reserves

When the Fed buys securities from the government

it is just like making a loan to the government, in doing so they are creating money because as the government spend the money it end up back in the bank

Federal funds

balances that banks maintain in their accounts at the Fed

Federal Funds Rate (FFR)

the target interest rate set by the Fed at which banks borrow and lend excess reserves overnight

There is an __________ relationship between the FFR and the money supply

inverse

What is the effect of changing the money supply under an ample reserves system?

changing the money supply has little or no effect on interest rates

How does the Fed conduct monetary policy under the ample reserves system?

the Fed adjusts its administered rates instead of relying on money supply changes

Administered rates

interest rates set by the Fed rather than determined by the market

Interest reserve balance

is the interest rate paid by the Fed on funds held in the banks' reserve balance account

Why don't banks loan money at an interest rate lower than the IORB?

reserves at the Fed have no risk, banks have no incentive to loan money at a lower interest rate

Monetary policy in an Ample Reserves System (Recessionary)

•counter cyclical policy required =

•the FED will _______ the IORB

•which _______ the FFR

•which ____________ interest sensitive spending

•expansionary monetary policy

•↓

•↓

•encourages

Monetary policy in an Ample Reserves System (Inflationary)

•counter cyclical policy required =

•the FED will _______ the IORB

•which _______ the FFR

•which ____________ interest sensitive spending

•contractionary monetary policy

•↑

•↑

discourages

There is an ________ relationship between the federal funds rate (FFR) and the quantity of reserves

inverse

What happens when FFR is high. . .

banks want to hold less reserves

What happens when FFR is low. . .

banks want to hold more reserves

The _______________ rate is usually the maximum rate that banks are willing to pay to borrow money

discount

What happens if FFR is higher than the discount rate?

banks will just borrow from the Fed

What happens if the Fed buys bonds from banks when there are limited reserves

•banks will have more reserves

•the supply of reserves will shift to the right and the interest rate will decrease

What happens if the Fed buys bonds from banks when there are ample reserves

•the interest rate does not change

•open-market-operations (OMO) does not work

What can the central bank do to change interest rates when there are ample reserves?

•decrease the interest rate on reserves and the discount rate

•increase interest on reserves and the discount rate

The FED increases the money supply to stimulate the economy. . .

•interest rates decreases

•investment increases

•AD, GDP, and PL increases

The FED decreases the money supply to slow down the economy. . .

•interest rates increase

•investment decreases

•AD, GDP, and PL decrease

Lower interest =

more borrowing

High interest

less borrowing

Private sector loanable funds

the supply of and demand for loanable funds in the economy

Real interest rate and the quantity of loans demanded have an _________ relationship

inverse

Real interest rate and the quantity of loans supplied have a __________ relationship

direct

At the equilibrium ______________________ the amount borrowers want to borrows equals the _________________________

real interest rate; amount lenders want to lend

Demand for loanable funds shifters

•changes in perceived business opportunities

•changes in government borrowing

Supply of loanable funds shifters

•changes in public and private saving behavior

•changes in foreign investment

•changes in expected profitability

Closed economy

national savings = public savings + private savings

Open economy

investment = national savings + net capital inflow

The flow of foreign financial capital into American financial markets begins to decrease

increase (shift to right) of supply curve

The marginal propensity to save decreases

increase (shift to right) of demand curve