Unit 4 Financial Sector Megaset

Loans

When $ is given to another party in exchange for repayment of the loan principal amount + interest

Bank Deposits

$ placed into a deposit account at a bank

• savings accounts

• checkings accounts

• other money market accounts

Stocks

• A share in ownership of a company

• includes claim of company’s earnings & assets

Mutual Fund - financial program that creates a portfolio (of financial assets) made up of different stocks& resells shares to individual investors

Mutual Fund

financial program that creates a portfolio (of financial assets) made up of different stocks& resells shares to individual investors

Bonds

• loan from a company or government used to fund operations

• Market value can change

• Investor does NOT have claim on borrower’s company (profits)

• Bond interest rate is called a yield or coupon rate

Financial Asset

a paper claim that entitles its buyer to future income from the seller

4 types: bonds, stocks, loans, bank deposits

Two Parts of a Financial System

Borrowers (households) & Lenders (banks)

Purpose of Financial Markets

1. Reduce transaction costs

2. reduce risks for lenders & borrowers

3. provide way to liquidity

Lender & Borrower in Bonds

Lenders are households

Borrowers are companies & governments

Bonds vs Stocks

in a bond, investors do NOT have a claim on the borrower’s company

Price of previously issues bonds VS current interest rates

the price (value) of previously issued bonds has an inverse relationship with current interest rates

• If interest rates increase on new bonds, previously issued bonds (w/ lower rate of return) become less valuable

Nominal Interest Rates

• rates presented by banks when you buy a new car, house, or any loan

• NOT adjusted for inflation!

Nominal Rate = Real Rate + Inflation Rate

Real Interest Rates

• Real rate of return earned on financial assets (ex. bonds) or paid back on loans

• inflation is REMOVED

Real Rate = Nom. Rate - Inflation Rate

Anticipated vs Unanticipated Inflation

• Lenders, borrowers, and savers make decisions based on expected inflation

• unexpected inflation - lenders lose $

Charge extra % on top of expected inflation to earn $
ex. exp. inf. 2% + real int. goal of 6% = charge 8%

Bond Formula

Yield (return rate) = (Annual Interest Payment)/(Bond Price)

OR

Bond Price = Interest Payment)/(Yield Rate Decimal)

effective money characteristics

1. durable and portable

2. recognizable

3. accepted

4. backed by a stable supply

5. difficult to counterfeit

commodity money

something that performs the function of money, but also has an alternate, non-monetary use

ex.) silver

fiat money

something that serves as a currency with no other purposes

ex.) paper money, coins

money

anything used to purchase goods and services

wealth

the accumulation of savings thru purchase of assets over time

opportunity cost of someone holding cash and not depositing it into a bank or purchasing an asset

the interest they could have earned if the money was invested

3 Functions of Money

1. medium of exchange

2. unit of account

3. store of value

medium of exchange

• money must be accepted by people when they buy/sell goods & services

• be portable

• divisible

• uniform

unit of account

• money must be useful for denominating values (prices)

• familiar

• divisible

• accepted

store of value

• money must be durable

• have a stable value

Liquidity

the efficiency with which an asset or security can be converted into ready cash without affecting its market price

• most liquid is cash

• availability of cash is important for market efficiency

High Liquidity

cash, bank accounts

Medium liquidity

stocks, bonds

low liquidity

houses/real estate, fine art

Money Supply

Currency + Liquid Assets

M0

Currency in circulation + Currency in bank reserves

Monetary Base - physical paper and coin currency used in the economy and bank deposits

• NOT included in MS

Monetary Base

physical paper and coin currency used in the economy and bank deposits

M1

includes

• paper currency and coins in circulation

• demand deposits

• savings accounts

• traveler’s checks

HIGH liquidity & function

Medium of Exchange

M2

include M1 & additional less liquid assets like

• small time deposits

• certificate of deposits (CDs)

• money market shares

MED liquidity/function

store of value

M3

= M1 + M2 + Large time deposits (>$100k) + Large liquid assets

Financial Asset Examples

1. Currency in Circulation

2. Demand Deposits

3. Traveler’s Checks

4. Small time Deposits

5. Certificate of Deposits

6. Large time Deposits

Currency in Circulation

currency in people’s hands

demand deposits

accessible account funds

Traveler’s checks

secure alternative to cash

Small time deposits

<$100k, pre-set maturity date

Certificate of Deposits

locked savings account

Large time deposits

>$100k, specified maturity

Credit Cards

• NOT considered money

• more like loans

• good medium of exchange and store of value

Banking System

• made up of commercial and investment banks

• regulated in US by FED, nation’s central bank

FRACTIONAL reserve banking

• FED sets reserve requirement (required reserve ratio) - the % of customer demand deposit that a bank MUST hold in reserves

• banks can loan rest of deposits

• is how banks make money

Commercial Banks

• you deposit money in checkings/savings accounts and banks pay interest (bank liabilities)

• banks then loan money at higher interest rate (bank assets)

87% of money is literally made up thru banking sys

Bank Balance Sheets (T-accounts)

show amounts of bank assets and bank liabilities each bank has, and both sides are EQUAL to each other

Assets (OWNS), Liabilities (OWES)

• changes in demand deposits affect the size of the bank’s REQUIRED and EXCESS reserves

• if a bank buys/sells securities, funds come from EXCESS reserves!! Required Reserves do NOT change!!

Money Multiplier (definition)

• determines maximum changes to money supply when deposits or withdrawals of cash occur

Money Multiplier (equation)

Δ Excess Reserves * Money Multiplier = Δ MS

AND

Money Multiplier = 1/(Reserve Req. decimal)

Withdrawals of cash

taking money from demand deposits DECREASES MS

when customers withdraw money, it is taken from bank’s reserves (bank assets) and it is SUBTRACTED from bank’s demand deposits (bank liabilities)

• taken from EXCESS reserves first!

Demand for Money

1. Transaction Demand

2. Precautionary Demand

3. Asset Demand for Money

Transaction demand

people hold money for everyday transactions

precautionary demand

people hold onto money “just in case”

asset demand for money

people hold money since it is less risky than other assets (bonds, stocks, etc.)

opportunity cost of holding money in your pocket/checking account

interest you could have made from other financial assets (stocks, bonds, real estate)

Interest Rates vs Quantity of money demanded Relationship

inverse relationship between interest rate and quantity of money demanded

(explains why MD curve is sloping downwards)

Money Demand Shifters

1. changes in price level

2. changes in national income (personal income)

3. changes in technology (if easier to convert less liquid assets, less money is demanded)

Supply of Money

the Federal Reserve System (FED) is a nonpartisan gov office that sets and adjusts the money supply to adjust the economy

Why is MS vertical?

supply of money is NOT impacted by the interest rate

FED sets it wherever they want

Federal Reserve

created in 1913, the FED’s job is to regulate banks and ensure people have faith in financial systems

use MONETARY POLICY to change money supply and help inflationary or recessionary gaps

Market Equilibrium

occurs when the Nominal Interest rate (ir_e) is set where the current money supply (MS) intersects the current demand for money (MD)

draw money market in SURPLUS

ir is above ir_e, arrow pointing downwards along MD towards equilibrium

QM₁ < QM_e

draw money market in SHORTAGE

ir is below ir_e, arrow pointing upwards along MD towards equilibrium

QM₁ > QM_e

3 Economic Goals of a Country

1. Limit inflation (stable prices)

2. limit unemployment (or full employment)

3. promote economic growth (increase RGDP)

Scarce Reserves System

= Fractional Banking System

• uses money market graph to explain how FED changes interest rates

• central bank targets commercial banks’ policy rate through changes in Money Supply

Money Market Graph

• explains how the FED changes interest rates

• Central Bank targets commercial banks’ policy rate (Federal Funds Rate) through changes in Money Supply

2 Options if Commercial Banks aren’t at Reserve Requirement Rate

1. Federal Funds Rate

2. Discount Rate

Federal Funds Rate (Policy Rate)

_____ is what commercial banks charge when they lend out excess reserves to other banks overnight to make Reserve Requirement

Discount Rate

____ is what the FED charges when they lend money to commercial banks for overnight loans to make Reserve Requirement

• one of 3 monetary policy tools in scarce reserves system

  • Increase Disc. Rate = MS← = AD←

  • Decrease Disc. Rate = MS→ = AD→

3 Monetary Policy Tools in Scarce Reserves System

1. Discount Rates

2. Reserve Requirement

3. Open Market Operations ***

Reserve Requirement

% of demand deposits that banks cannot loan out

one of 3 monetary policy tools in scarce reserves system

• Increase RR = MS← = AD←

• Decrease RR = MS→ = AD→

Open Market Operations

FED buys/sells gov bonds (securities) to commercial banks

MOST EFFECTIVE monetary policy by fed in scarce reserves system

• Sell Securities = MS← = AD←

• Buy Securities = MS→ = AD→

“Sell Small, Buy Big”

Scarce Reserves Contractionary Policy

• fight inflation

• Raise discount rate

• Raise reserve requirement

• Open Market SALE of gov bonds

MS← = ir→ = AD←

Scarce Reserves Expansionary Policy

• fight unemployment

• Lower discount rate

• Lower reserve requirement

• Open Market PURCHASE of gov bonds

MS→ = ir← = AD→

Reserves

funds that banks have (in Federal Reserves + Commercial Banks’ Required Reserves)

NOT considered money

2008 Recession

Since ____, bank reserves (Monetary Base) dramatically increased

US went from SCARCE reserve system to AMPLE reserve system

Upper Bound of Reserves Market Graph

highest part of Reserve Demand curve (set at discount rate)

Discount rate shfits this

Lower Bound of Reserves Market Graph

lowest part of Reserve Demand curve (set at Interest on Reserves Rate)

IOR shifts this

Interest on Reserves

• interest that FED gives banks for their excess reserves

• more reserves = more interest!

• shifts Reserve Demand curve’s LOWER BOUND and POLICY RATE (equilibrium)

_____ increase = PR increase

Policy Rate

interest rate that banks charge each other

synonymous with Federal Funds Rate in US

Reserve Supply (Curve)

= reserves at the Federal Bank + reserves at Commercial Banks

Open Market Operations

• the purchase and sale of securities in the open market by the FED

• shifts Reserve Supply curve

• maintains Ample Reserves supply

• with Ample reserves, ___ does NOT change policy rate

Monetary policies that work in a Scarce/Limited Reserve System

1. Required Reserves

2. Discount Rate

3. Open Market Operations

Monetary policies that work in an Ample Reserves system

1. Interest on Reserves

Discount Rate

• does NOT change policy rate

• only moves upper bound

• won’t change equilibrium

Expansionary Monetary Policy

• fight unemployment

• LOWER IOR to increase investment and other interest rate sensitive spending (car, college, housing, etc)

• INCREASES employment and real output (AD→)

  • more INCOME

Contractionary Monetary Policy

• fight INFLATION

• RAISE IOR to DECREASE investment and other interest rate sensitive spending (car, college, housing, etc.)

• DECREASES PRICE LEVEL and LOWERS inflation (AD←)

Loanable Funds Market Graph

• shows long run changes

• private sector supply & demand of LOANS

• shows effect on REAL interest rate

• banks’ perspective

Demand_borrowers - INVERSE relationship b/w RIR and quantity loans demanded

Supply_lenders - DIRECT relationship b/w RIR and quantity loans supplied

• supply is not vertical bc banks decide how much to loan out

Equilibrium real interest rate

amount borrowers want to borrow = amount lenders want to lend

Demand of Loans

consumers, businesses, govt

Supply of Loans

loanable money banks have ability and desire to lend

money comes from SAVERS

Demand Shifters

1. change in perceives business/consumer opportunities (more invest = more D)

2. change in govt borrowing

   1. Budget deficit

   2. Budget surplus

Supply Shifters

1. Changes in SAVING behavior

2. change in MS (MS incr = S_L incr)

3. change in foreign investment (more foreign = less supply)

4. change in expected profitability of loans (for banks)