Unit 4: Financial Sector

The Financial Sector

Individuals, businesses, and governments borrow and save so they need institutions to help.

The part of the economy made up of institutions (like banks) that bring together lenders and borrowers.

Financial Sector

Network of institutions that link borrowers and lenders. Includes banks, mutual funds, pension funds, and other financial intermediaries.

Assets

Anything tangible or intangible that has value.

Something owned.

Interest Rate

The amount a lender charges borrowers for borrowing money. It's the "price" of a loan.

Interest-bearing Assets

Assets that earn interest over time. e.g. bonds.

Personal Finance

The way individuals and families budget, save, and spend

Investment

Business spending on tools and machinery

Liquidity

The ability to purchase goods and services with your assets

The ease with which an asset can be converted to a medium of exchange. In general, the higher the liquidity the lower the rate of return.

Bonds (securities)

A loan to a corporation or government

Paid back original investment plus interest

An interest-baring asset often issued by businesses or the government.

Loans, or IOUs, that represent debt that the government, business, or individual must repay to the lender.

The bond holder has NO OWNERSHIP of the company and is paid interest.

To get more money, you could sell half of your company and issue shares of stock.

Stocks (equities)

Equity ownership of a corporation.

Ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends.

Nominal Interest Rates

The interest banks charge for loans

It has not been adjusted for inflation.

The percentage increase in money that the borrower pays (not adjusted for inflation).

Nominal = real interest rate + expected inflation

Real Interest Rates

Inflation adjusted interest banks charge

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

Real = nominal interest rate - expected inflation

The Barter System

Goods and services are traded directly. There is no money exchanged.

Double Coincidence of Wants

Before trade could occur, each trader had to have something the other wanted.

Money

Anything that is generally accepted as payment for goods and services.

Checking and savings along with currency

Most liquid of all assets

Wealth

The total collection of assets.

Income

A flow of earnings per unit of time.

Commodity Money

Something that performs the function of money and has intrinsic value.

Examples: Gold, silver, cigarettes, etc.

Fiat Money

Something that serves as money but has no other value or uses.

Examples: Paper Money, Coins, Digital Currency

3 Functions of Money

1. A Medium of Exchange

2. A Unit of Account (Measure of Value)

3. A Store of Value

A Medium of Exchange

Money can easily be used to buy goods and services with no complications of barter system.

A Unit of Account (Measure of Value)

Money measures the value of all goods and services. Money acts as a measurement of value.

1 goat = $50 = 5 chickens OR 1 chicken = $10

A Store of Value

Money allows you to store purchasing power for the future.

M1 (Highest Liquidity)

1. Currency in circulation.

2. Checkable bank deposits (checking accounts).

3. Traveler's checks.

M2 (Near-Moneys)

M1 plus the following:

1. Savings deposits (money market accounts).

2. Time deposits (CDs = certificates of deposit).

3. Money market funds.

Fractional Reserve Banking

When banks hold a portion of deposits to cover potential withdrawals and then loans the rest of the money out.

Process where banks hold a portion of deposits in reserve and loan the rest of the money out.

The Money Multiplier

1 / Reserve Requirement (ratio)

Bank Balance Sheets

Demand Deposits

Required Reserves

Excess Reserves

Balance Sheet

Demand Deposits

Money deposited in a commercial bank in a checking account.

Deposits by customers that can be withdrawn at any time.

Required Reserves

The percent that banks must hold by law.

The amount of deposits that banks must legally hold. The amount they cannot loan out.

Excess Reserves

The amount that banks can loan out.

Excess Reserves = Total Reserves - Required Reserves

Balance Sheet

A record of bank's assets, liabilities, and net worth.

Transaction Demand for Money

People hold money for everyday transactions.

People demand money to make everyday purchases. This is not affected by the interest rate.

Asset Demand for Money

People hold money since it is less risky than other assets.

When people demand money as a liquid asset because they prefer it to other non-liquid assets like bonds.

The Demand for Money

There is an inverse relationship between interest rates and the quantity of money demanded.

When interest rates are high people prefer less money since they can earn a higher rate of return by owning bonds instead.

Money Demand Shifters

1. Changes in price level - Inflation requires consumer to hold more cash for financial transactions.

2. Changes in income - Growth in the economy leads to an increase in the demand for money.

3. Changes in technology

4. Changes in taxation - Government policies such as changing the capital gains tax.

The Supply for Money

The U.S. Money Supply is set by the central bank and is independent from the interest rate.

The money supply is set by the central bank and is unrelated to the nominal interest rate.

The Fed

A nonpartisan government office that adjusts the money supply to influence the economy.

The Fed has direct control of the DR but not the FFR.

The Federal Reserve

Created in 1913, the Fed's job is to regulate banks and make sure people have faith in our financial system.

3 Shifters of Money Supply

1. The Reserve Requirement - the percent of deposits that banks must hold in reserve.

2. The Discount Rate (DR) - the interest rate that the FED charges commercial banks.

3. Open Market Operations (OMO) - when the FED buys or sells government bonds (securities).

The Reserve Requirement (Reserve Ratio)

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

The Discount Rate

The interest rate that the Fed charges commercial banks.

Open Market Operations

When the Fed buys or sells government bonds (securities). This is the most important and widely used monetary policy.

Federal Funds Rate

The interest rate that banks charge one another for one-day loans of reserves.

The Loanable Funds Market

The supply and demand of loans and shows the equilibrium real interest rate.

Demand

Inverse relationship between real interest rate and quantity loans demanded.

Supply

Direct relationship between real interest rate and quantity loans supplied.

Demand Shifters

1. Changes in borrowing by consumers

2. Changes in borrowing by businesses (investment spending)

3. Changes in borrowing by the government (ex: deficit spending)

Supply Shifters

1. Changes in private savings behavior

2. Changes in public savings

3. Changes in foreign investment (ex: more inflow of foreign financial capital)

Private Sending

The amount that households save instead of consume.

Public Saving

The amount that the government saves instead of spends.

National Savings

Public + Private Saving

Capital Inflow

The amount of money entering the country.

Capital Outflow

The amount of money leaving the country

Net Capital Inflow

Inflow - Outflow

Private Investment

Borrowing by businesses and consumers.

Government Borrowing

Deficit spending when government spending is greater than tax revenue.

Mutual Funds

Pension Funds

Index Funds

Inflation Rate (π)

As measured by the CPI or GDP Deflator.

The Fisher Formula

i ≈ r + π

r ≈ i - π

π ≈ i - r

Liabilities

Something owned that must be paid back.

Monetary Policy

When a central bank manipulates the money supply to adjust interest rates and influence the overall economy.

Monetary Base

Includes money in circulation and bank reserves.

Demand for Loanable Funds Shifters

Anything that changes the amount of borrowing and investment (e.g. changes in perceived business

opportunities and government borrowing).

Supply for Loanable Funds Shifters

Anything that changes lending or savings (eg. changes in private or public savings, changes in the profitability of loans, changes in lending by foreigners).