Unit 7 ‑ The Financial Sector

Functions of Money

  • Medium of Exchange
    • Money is universally accepted in payment for goods and services.
    • Eliminates the double-coincidence of wants that plagues a barter system.
  • Unit of Account
    • Provides a common metric to quote prices and record debts, making comparison of values possible.
    • Example: Saying a laptop costs $1 500\$1\,500 immediately conveys its worth relative to other goods.
  • Store of Value
    • Allows wealth to be held and deferred for future use because it is highly liquid and convenient.
    • Inflation can erode this function; stable money keeps purchasing power intact.

Liquidity

  • Definition: The speed and ease with which an asset can be converted to a means of payment (cash) without loss of value.
  • Highly Liquid Assets
    • Cash
    • Government securities (e.g. Treasury bills)
    • Gold (due to organized markets)
  • Low-Liquidity (Illiquid) Assets
    • Real estate
    • Fine art or collectibles
  • Opportunity-cost logic
    • Holding cash sacrifices the interest that could have been earned on interest-bearing assets.
    • Thus, as market interest rates rise, the opportunity cost of liquidity rises and the quantity of money demanded falls.

Asset Classes

  • Financial ("Paper") Assets
    • Represent claims on future cash flow.
    • Examples: Shares, corporate or government bonds, bank deposits.
  • Real Assets
    • Tangible physical objects that provide service or utility.
    • Examples: Property, machinery, art, commodities.

Cost of Holding Money

  • Opportunity cost equals the foregone interest income from alternative financial assets.
  • Relationship between interest rate and money demand:
    • High interest rate → high opportunity cost → low money demand.
    • Low interest rate → low opportunity cost → higher desire to hold money balances.

Financial Intermediaries

  • Role: Bridge savers (surplus units) and borrowers (deficit units).
  • Typical Institutions: Banks, credit unions, finance companies.
  • Core Mechanics
    • Accept deposits from households/firms and pay deposit interest.
    • Issue loans at a higher rate and earn the margin (interest differential).
  • Heterogeneity Across Products
    • Time period: on-demand (current) deposits vs. term deposits.
    • Type: cheque, savings, certificates of deposit.
    • Minimum balance requirements.
    • Different risk profiles (secured vs. unsecured lending).

Debt vs. Equity Financing

  • Debt Financing
    • Borrowed funds create a legal obligation to repay principal + interest.
    • Priority over equity in bankruptcy; interest is tax-deductible for firms.
  • Equity Financing
    • Sale of ownership shares; investors receive residual claims on profit (dividends) and capital gains.
    • No mandatory repayment, but ownership is diluted.
    • Cost to firm is implicit (required return on equity > interest rate due to higher risk).

Simplified Bank Balance Sheet Example

  • Data: Deposits =$1 000= \$1\,000; Required Reserve Ratio =10%=10\%.
  • Balance Sheet
    • Assets:
    • Reserves =$100=\$100 (held in cash/securities).
    • Loans =$900=\$900.
    • Liabilities: Deposits =$1 000=\$1\,000.
  • Lending capacity: Bank can advance the excess $900\$900; once spent and redeposited, the money supply expands.

Reserves in Detail

  • Fraction of deposits held back and kept liquid.
  • Held in three primary forms:
    • Vault cash
    • Deposits with the central bank
    • Highly liquid government securities
  • Regulatory requirement stabilizes the system and limits over-extension of credit.

Bank Lending, Money Multiplication & Economic Growth

  • Sequence
    1. Bank issues loan → borrower purchases goods/services.
    2. Payment becomes someone else’s income →\rightarrow redeposited.
    3. Bank lends out a fraction again (subject to reserve ratio).
  • Result: Repetitive cycle increases the money stock (credit creation).
  • Macroeconomic Impact
    • Supports higher aggregate demand, production YY, and sustained long-run growth.

Interest Rates — Core Ideas

  • Definition: "Price of money"; compensation paid by borrowers, received by lenders.
  • Triple Interpretation
    1. Reward for parting with liquidity.
    2. Premium for bearing default risk.
    3. Compensation for expected inflation (Fisher effect).

Yield (Rate of Return)

  • General formula:
    Percentage Yield=ReturnAsset Price×100\text{Percentage Yield} = \frac{\text{Return}}{\text{Asset Price}} \times 100
  • Illustrative Cases
    1. Share: Buy at $20\$20, dividend $1.20\$1.20 (→ 6\%).
    2. Apartment: Buy at $500 000\$500\,000, rent $11 000\$11\,000 (→ 5.5\%).
    3. Government bond: Pay $100\$100, receive $107\$107 at maturity → Yield =$7=\$7 → 7%7\%.

Investment Rule

  • Rational investor borrows only if:
    Asset Yield>Borrowing Interest Rate\text{Asset Yield} > \text{Borrowing Interest Rate}
  • Example: Yield 7%7\% vs. interest 6%6\% → net profit 1%1\%.
  • Corporate finance link: Firms judge capital equipment against market borrowing costs (cost of capital).

Interest Rates and Investment

  • Higher interest rate shrinks the set of profitable projects.
  • Investment demand curve slopes downward with respect to the interest rate.
  • Numerical scenario
    • Expected return on machine =5%=5\%.
    • If loan rate rises from 4%4\% to 6%6\% → project becomes unviable.

Interest Rates and Consumption

  • Channels
    1. Credit-card usage: higher variable rates discourage spending.
    2. Mortgage/loan servicing: higher repayments squeeze disposable income.
    3. Saving incentive: higher deposit rates encourage postponing consumption.
  • Household Example
    • Gross income =$100 000=\$100\,000; tax 15%15\% → $15 000\$15\,000.
    • Mortgage =$400 000= \$400\,000.
    • Interest at 6%6\% ⇒ annual payment $24 000\$24\,000.
    • Disposable income =100,000−(15,000+24,000)=$61 000=100,000-(15,000+24,000)=\$61\,000.
    • If rate ↑ to 8%8\% ⇒ payment $32 000\$32\,000 → disposable $53 000\$53\,000 (consumption falls).

Risk Margin & Differential Lending Rates

  • Banks stratify borrowers by probability of default.
  • Typical spectrum
    • Inter-bank overnight loans: very low risk (close to policy rate).
    • Mortgage lending: medium risk.
    • Credit-card / unsecured consumer loans: high risk.
  • Higher default risk → higher interest rate to cover expected losses + capital charges.

Policy Interest Rate — The Cash Rate (RBA context)

  • Overnight inter-bank market rate for settling daily cash shortages.
  • Determined by Reserve Bank of Australia (RBA) via open-market operations.
  • Pass-through Mechanism
    • Changes in cash rate shift wholesale funding costs.
    • Retail lending/deposit rates adjust, affecting C and I, and hence aggregate demand.

Liquidity Management & Securities Yield

  • Banks hold reserves either as cash or short-term government securities.
  • If the central bank increases the yield on its securities:
    • Opportunity cost of holding cash rises.
    • Banks substitute cash for securities → cash scarcity.
    • Scarcity pushes the cash (overnight) rate upward, reinforcing policy.

Macro Transmission Summary

  • Rise in policy rate → higher market rates →
    1. Investment spending II down (projects cancel).
    2. Household consumption CC down (higher loan servicing + bigger incentive to save).
  • Central bank thus modulates aggregate expenditure and inflation via the interest-rate channel.

Broader Connections & Implications

  • Ties to Quantity Theory: money demand depends negatively on interest rate (Keynes’ liquidity preference).
  • Ethical/Practical Note
    • Access to credit enables growth but can create leverage-driven fragility (2008 GFC as cautionary tale).
    • Policy must balance stimulation with financial stability.
  • Real-World Relevance
    • Mortgage stress tests incorporate potential rate hikes.
    • Corporate hurdle rates include a premium above risk-free interest to reflect risk margin.