Study Notes on The Financial Sector

Section 5: The Financial Sector

Savings and Investment

• Savings = Investment

  • Corporations and households invest in physical capital seeking positive returns.

  • Methods for financing include:

    • Borrowing money.

    • Using savings directly.

  • Interest Rate: Percentage of the amount borrowed, charged by lenders to borrowers for using their savings for one year.

• Savings - Investment Spending Identity: The formula reiterates that savings equal investment across the economy.

Budget Components

• Budget Surplus: Savings of the federal government when tax revenue exceeds expenditures.

• Budget Deficit: Occurs when spending exceeds tax revenue, resulting in negative savings.

• Budget Balance: The difference between tax revenue and government spending, determining whether there is a surplus or deficit.

• National Savings: The total savings in an economy, calculated as:
  { ext{National Savings}} = ext{Private Household Savings} + ext{Budget Balance (of Government)}

Capital Inflows and Outflows

• Capital Inflows: Foreign savings that finance investment spending in a country.

  • Result in positive inflows of capital, providing additional funds for investments.

• Capital Outflows: Domestic savings that are used to finance investments in other countries.

• Formula:

  • { ext{Capital Inflow}} = ext{Inflows} + ext{Outflows} (can be negative).

  • Inflows carry a higher cost due to interest paid to foreign investors.

• Overall Saving Relation:

  • { ext{Savings}} = ext{National Savings} + ext{Capital Inflows}

Financial Markets

• Definition: Venues where households invest savings by purchasing financial assets.

  • Critical for long-term economic growth as they facilitate savings and investment spending while ensuring efficient allocation of investments.

• Types of Assets:

  • Financial Asset: A claim entitling the holder to future income (e.g., stocks, bonds, loans).

  • Physical Asset: A tangible claim (e.g., buildings, gold).

• Liabilities: Financial obligations or debts that require payment in the future.

  • Example: Loans are financial assets for lenders and liabilities for borrowers.

Financial System Tasks

• Primary functions include:

  • Reducing transaction costs.

  • Mitigating financial risk.

  • Providing liquidity, defined as the ease with which assets can be converted to cash.

  • Liquidity: Assets like savings accounts that can be converted quickly to cash.

  • Illiquid Assets: Items such as buildings or cars, which cannot be easily converted to cash.

Types of Financial Assets

• Investors seek higher rates of return:

  • Loans: Agreements between lenders and borrowers.

  • Bonds: IOUs issued by borrowers with a fixed interest payout.

  • Default Risk: Potential failure of the bond issuer to make payments.

  • Loan-Backed Securities: Created by pooling individual loans and selling shares from that pool (known as securitization).

  • Stocks: Represent ownership in a company and are assets for buyers while liabilities for companies.

• Financial Intermediaries: Institutions that transform funds from individuals into financial assets, including:

  • Mutual funds.

  • Pension funds.

  • Insurance companies.

  • Banks: Provide liquid assets through deposits and use those funds to finance borrowing.

  • Bank Deposit: A claim the bank gives back in cash on demand.

Financial Institutions Overview

Bonds

• Interest-Bearing Assets: Bonds have a term; stocks do not.

• Typically issued by governments for funding projects:

  • Treasury Bills (T-bills).

• Price and Interest Rate Relationship:

  • When interest rates fall, the price of previously issued bonds rises due to demand for higher returns.

  • When interest rates rise, bond prices fall, reflecting an inverse relationship.

• As interest rates rise, the opportunity cost for holding cash increases: potential investments earning returns are foregone.

Interest Rates: Nominal vs. Real

• Nominal Interest Rates: Rates visible at financial institutions, not adjusted for inflation.

• Real Interest Rates: Returns on financial assets adjusted for inflation.

• Fisher Effect: The relationship given by:

  • { ext{Nominal Interest Rate}} = ext{Real Interest Rate} + ext{Inflation}

• Important distinctions exist between fixed and variable rates when analyzing options.

Expected vs. Actual Inflation

• Expected Inflation: Used by banks to set loan terms.

• Actual Inflation: Calculated over the life of the loan.

• Unexpected inflation can reduce the real rate of return on financial assets, impacting their value.

Money Definition and Measurement

• Money: Any asset that can facilitate purchasing goods/services.

  • Must be widely accepted, durable, portable, uniform, limited in supply, and divisible.

• Types of Money:

  • Commodity Money: Intrinsically valuable money, like gold.

  • Fiat Money: Money with value derived primarily from official status by the government.

• Money Aggregates:

  • M1: Most liquid form, including currency and checkable deposits.

  • M2: Broader measure including M1 plus short-term CDs and money market accounts.

Time Value of Money

• Concept: Having a dollar today is more valuable than a dollar in the future, allowing lenders to charge interest.

• Present Value (PV): Value today of a future amount received:

  • PV = rac{X}{(1 + r)^n}, where:

  • $X$: dollar amount in future.

  • $r$: interest rate.

  • $n$: number of years.

• The process of finding present values is known as discounting, with the interest rate termed the discount rate.

• The Net Present Value (NPV) of a project is the present value of benefits minus costs.

• Example:

  • $100 received in one year valued at:
    PV = rac{100}{(1 + 0.10)^1}
    ightarrow 90.91

  • $100 received in two years valued at:
    PV = rac{100}{(1 + 0.10)^2}
    ightarrow 82.64

Future Value

• Definition: Accumulation of interest transforms current amounts into larger future sums:

  • FV = X imes (1 + r)^n.

Banking and Money Creation

• Banks utilize liquid assets (deposits) to make loans and financing illiquid investments.

• Bank Reserves: Currency in vaults and deposits at the Fed, not included in currency in circulation.

  • Banks cannot lend out all deposits due to reserve requirements.

  • Required Reserves: Amount of deposits that must be kept at reserve ratio:
    ext{Required Reserves} = ext{Checkable Deposits} imes ext{Reserve Ratio}.

• T-account: Tool for evaluating financial position:

  • Summarizes assets (on the left) and liabilities (on the right).

  • Example of T-account:

  • Assets: $900,000 in outstanding loans, $100,000 in reserves.

  • Liabilities: $1,000,000 in deposits.

Bank Runs and Regulation

• Bank Run: Occurs when depositors withdraw funds en masse due to fear of bank insolvency.

• Regulation: Involves measures to protect the banking system, including:

  • FDIC: Insures deposits up to $250,000.

  • Capital Requirements: Ensure banks maintain a minimum asset level relative to deposits to mitigate risk.

  • Reserve Requirement: Set by the Fed, dictates minimum reserves.

  • Discount Window: Fed lending to banks to prevent runs.

Money Creation by Banks

• Banks alter the money supply through processes such as lending excess reserves.

• Money Multiplier: = rac{1}{ ext{rr}} where rr = required reserve ratio.

• Monetary Base: Total currency in circulation and bank reserves.

• Money creation entails accounting entries rather than physical printing.

• Example: A sequence shows how deposits and loans multiply the money supply. For instance:

  • Initial cash: $1,000.

  • Subsequent deposits and lending will show a gradual increase in the total money supply.

Federal Reserve System

• Role: Central banking system that regulates the economy and oversees monetary policy and financial systems.

  • Composed of a Board of Governors and 12 regional Federal Reserve Banks.

  • Monetary Policy: Enacted by the Federal Open Market Committee (FOMC).

  • Distinction between commercial banks and investment banks with respect to their operations and regulations.

Tools of the Federal Reserve

1. Reserve Requirement: Minimum percentage of checkable deposits that banks must hold.

2. Federal Funds Market: Overnight lending market among banks.

   • Federal Funds Rate: Interest rate for overnight loans between banks.

3. Open Market Operations: Buying/selling bonds to influence the money supply.

   • Buying bonds increases reserves and lending, while selling reduces reserves.

Monetary Policy Techniques

• Expansionary Policy: Enacted during recessions to lower interest rates, expanding the money supply and fostering economic growth.

• Restrictive Policy: Utilized during inflationary periods to increase interest rates and limit money supply.

Loanable Funds Market Model

• Loanable Funds Market: Examines the interaction of borrowers and lenders, determining interest rates based on supply and demand.

  • Demand: Downward-sloping; as interest rates decline, more loans are taken due to increased profitability.

  • Supply: Upward-sloping; higher rates lead to higher savings and greater funds available for loans.

• Initial equilibrium is set at the intersection of supply and demand curves.

• Shifts in Demand/Supply: Changes in investment perception, government borrowing, private savings behavior, and capital inflows directly affect the balance of the loanable funds market, influencing interest rates accordingly.