Money, Banking and the Financial Sector

1
Money, Banking and the Financial Sector

• Chapter 13

2
Laugher Curve

• A central banker walks into a pizzeria to order a
  pizza.
  
• When the pizza is done, he goes up to the counter
  get it.

3
Laugher Curve

• The clerk asks him Should I cut it into six
  pieces or eight pieces?

4
Introduction

• Real goods and services are exchanged in the real
  sector of the economy.
  
• For every real transaction, there is a financial
  transaction that mirrors it.

5
Introduction

• The financial sector is central to almost all
  macroeconomic debates because behind every real
  transaction, there is a financial transaction
  that mirrors it.

6
Introduction

• All trades in the goods market involves both the
  real sector and the financial sector.

7
Why Is the Financial Sector So Important to Macro?

• The financial sector is important to
  macroeconomics because of its role in channeling
  savings back into the circular flow.

8
Why Is the Financial Sector So Important to Macro?

• Savings are returned to the circular flow in the
  form of consumer loans, business loans, and loans
  to government.

9
Why Is the Financial Sector So Important to Macro?

• Savings are channeled into the financial sector
  when individuals buy financial assets such as
  stocks or bonds and back into the spending stream
  as investment.

10
Why Is the Financial Sector So Important to Macro?

• For every financial asset there is a
  corresponding financial liability.

11
The Financial Sector as a Conduit for Savings
12
The Role of Interest Rates in the Financial Sector

• While price is the mechanism that balances supply
  and demand in the real sector, interest rates do
  the same in the financial sector.

13
The Role of Interest Rates in the Financial Sector

• The interest rate is the price paid for use of a
  financial asset.

14
The Role of Interest Rates in the Financial Sector

• When financial assets such as bond make fixed
  interest payments, the price of the financial
  asset is determined by the market interest rate.

15
The Role of Interest Rates in the Financial Sector

• When interest rates rise, the value of the flow
  of payments from fixed-interest-rate bonds goes
  down because more can be earned on new bonds that
  pay the new, higher interest.

16
The Role of Interest Rates in the Financial Sector

• As the market interest rates go up, price of the
  bond goes down.

17
Savings That Escape the Circular Flow

• Some economists believe that the interest rate
  does not balance the demand and supply of savings
  causing macroeconomic problems.

18
Savings That Escape the Circular Flow

• In order to make sense of the problem,
  macroeconomics divides the flows into two types
  of financial assets.

19
Savings That Escape the Circular Flow

• In order to make sense of the problem,
  macroeconomics divides the flows into two types
  of financial assets.

20
Savings That Escape the Circular Flow

• The first type include bonds and loans which work
  their way into the system.

21
The Definition and Functions of Money

• Money is a highly liquid financial asset.
• To be liquid means to be easily changeable into
  another asset or good.
  
• Social customs and standard practices are central
  to the liquidity of money.

22
The Definition and Functions of Money

• Money is generally accepted in exchange for other
  goods.

23
The U.S. Central Bank The Fed

• American currency is printed with the caption
  "Federal Reserve Note," meaning that it is a
  liability of the Federal Reserve Bank (the Fed).
  
• The Federal Reserve Bank (the Fed) is the central
  bank of the U. S.

24
The U.S. Central Bank The Fed

• Federal Reserve Notes serve as cash in the U.S.
• They are liabilities of the Fed.

25
The U.S. Central Bank The Fed

• The Fed, being the nations central bank has the
  right to issue these notes and by convention the
  notes are acceptable for payment to all the
  people of the country.

26
The U.S. Central Bank The Fed

• A bank is a financial institution whose primary
  function is holding money for, and lending money
  to, individuals and firms.

27
The U.S. Central Bank The Fed

• Individuals deposits in savings and checking
  accounts serve the same function as does currency
  and are also considered money.

28
Functions of Money

• Money is a medium of exchange.
• Money is a unit of account.
• Money is a store of wealth.

29
Money As a Medium of Exchange

• Without money, we would have to bartera direct
  exchange of goods and services.
  
• Money facilitates exchange by reducing the cost
  of trading.

30
Money As a Medium of Exchange

• Money does not have to have any inherent value to
  function as a medium of exchange.

31
Money As a Medium of Exchange

• The Feds job is to not issue too much or too
  little money.

32
Money As a Medium of Exchange

• If there is too much money, compared to the goods
  and services at existing prices, the goods and
  services will sell out, or the prices will rise.

33
Money As a Medium of Exchange

• If there is too little money, compared to the
  goods and services at existing prices, there will
  be a shortage of money and people will have to
  resort to barter, or prices will fall.

34
Money As a Unit of Account

• Money prices are actually relative prices.
• A single unit of account saves our limited
  memories and helps us make reasonable decisions
  based on relative costs.

35
Money As a Unit of Account

• Money is a useful unit of account only as long as
  its value relative to other prices does not
  change too quickly.

36
Money as a Store of Value

• Money is a financial asset.
• It is simply a government bond that pays no
  interest.

37
Money as a Store of Value

• As long as money is serving as a medium of
  exchange, it automatically also serves as a store
  of wealth.

38
Money as a Store of Value

• Moneys usefulness as a store of wealth also
  depends upon how well it maintains its value.

39
Money as a Store of Value

• Our ability to spend money for goods makes it
  worthwhile to hold money even though it does not
  pay interest.

40
Alternative Measures of Money

• Since it is difficult to define money
  unambiguously, economists have defined different
  concepts of money.
  
• They are called M1, M2, and L.

41
Alternative Measures of Money M1

• M1 consists of currency in the hands of the
  public, checking account balances, and travelers
  checks.
  
• Checking account deposits are included in all
  definitions of money.

42
Alternative Measures of Money M2

• M2 is made up of M1 plus savings deposits,
  small-denomination time deposits (certificates of
  deposit or CDs), and money market mutual fund
  shares, along with some other esoteric financial
  instruments.

43
Alternative Measures of Money M2

• The money in savings accounts is counted as money
  because it is readily available.

44
Alternative Measures of Money M2

• All M2 components are highly liquid and play an
  important role in providing reserves and lending
  capacity for commercial banks.

45
Alternative Measures of Money M2

• The M2 definition is important because economic
  research has shown that the M2 definition most
  closely correlates with the price level and
  economic activity.

46
Beyond M2 L

• The broadest definition of the money supply is L
  (which stands for liquidity.
  
• It consists of almost all short-term financial
  assets.

47
Beyond M2 L

• Because of the difficulty of defining money in an
  ever-changing world, measures of money have lost
  some their appeal, and broader concepts of asset
  liquidity have taken their place.

48
Distinguishing Between Money and Credit

• Credit card balances cannot be money since they
  are assets of a bank.
  
• In a sense, they are the opposite of money.

49
Distinguishing Between Money and Credit

• Credit cards are prearranged loans.

50
Components of M2 and M1
51
Banks and the Creation of Money

• Banks are both borrowers and lenders.
• Banks take in deposits and use the money they
  borrow to make loans to others.
  
• Banks make a profit by charging a higher interest
  on the money they lend out than they pay for the
  money they borrow.

52
Banks and the Creation of Money

• Banks can be analyzed from the perspective of
  asset management and liability management.

53
Banks and the Creation of Money

• Asset management is how a bank handles its loans
  and other assets.

54
Banks and the Creation of Money

• Banks operate in a regulated environment, the
  primary regulator being the Fed.

55
How Banks Create Money

• Banks create money because a banks liabilities
  are defined as money.
  
• When a bank incurs liabilities it creates money.

56
How Banks Create Money

• When a bank places the proceeds of a loan it
  makes to you in your checking account, it is
  creating money.

57
The First Step in the Creation of Money

• The Fed creates money by simply printing currency
  and exchanging it for bonds.
  
• Currency is a financial asset to the bearer and a
  liability to the Fed.

58
The Second Step in the Creation of Money

• The bearer deposits the currency in a checking
  account at the bank.
  
• The bank holds your money and keeps track of it
  until you write a check.

59
Banking and Goldsmiths

• In the past, gold was used as payment for goods
  and services.
  
• But gold is heavy and the likelihood of being
  robbed was great.

60
From Gold to Gold Receipts

• It was safer to leave gold with a goldsmith who
  gave you a receipt.
  
• The receipt could be exchanged for gold whenever
  you needed gold.

61
From Gold to Gold Receipts

• People soon began using the receipts as money
  since they knew the receipts were backed 100
  percent by gold.

62
The Third Step in the Creation of Money

• Little gold was redeemed, so the goldsmith began
  making loans by issuing more receipts than he had
  in gold.
  
• He charged interest on the newly created gold
  receipts.

63
The Third Step in the Creation of Money

• When the goldsmith began making loans by issuing
  more receipts than he had in gold, he created
  money.

64
The Third Step in the Creation of Money

• The gold receipts were backed partly by gold and
  partly by peoples trust that the goldsmith would
  pay off in gold on demand.

65
The Third Step in the Creation of Money

• The goldsmith soon realized that he could make
  more money in interest than he could earn in
  goldsmithing.

66
Banking Is Profitable

• As the goldsmiths became wealthy, others jumped
  in offering to hold gold for free, or even
  offering to pay for the privilege of holding the
  publics gold.

67
Banking Is Profitable

• That is why most banks today are willing to hold
  the publics money at no charge they can lend
  it out and in the process, make profits.

68
The Money Multiplier

• Banks lend a portion of their deposits keeping
  the balance as reserves.
  
• Reserves are cash and deposits a bank keeps on
  hand or at the Fed or central bank, enough to
  manage the normal cash inflows and outflows.

69
The Money Multiplier

• The reserve ratio is the ratio of cash (or
  deposits at the central bank) to deposits a bank
  keeps as a reserve against cash withdrawals.

70
The Money Multiplier

• The required reserve ratio is the percentage of
  their deposits banks are required to hold by the
  Fed.

71
The Money Multiplier

• Banks hold currency for people and in return
  allow them to write checks for the amount they
  have on deposit at the bank.

72
Determining How Many Demand Deposits Will Be
Created

• To determine the total amount of deposits that
  will eventually be created, the original amount
  that is deposited is multiplied by 1/r, where r
  is the reserve ratio.

73
Determining How Many Demand Deposits Will Be
Created

• For an original deposit of 100 and a reserve
  ratio of 10 percent, the formula would be
  
• 1/r 1/0.10 10
• 10 X 100 1,000

74
Determining How Many Demand Deposits Will Be
Created

• This means that 900 of new money was created
  (1,000 -100).

75
Calculating the Money Multiplier

• The ratio 1/r is called the simple money
  multiplier.
  
• The simple money multiplier is the measure of the
  amount of money ultimately created per dollar
  deposited in the banking system.
  
• It equals 1/r when people hold no cash.

76
Calculating the Money Multiplier

• The higher the reserve ratio, the smaller the
  money multiplier, and the less money will be
  created.

77
An Example of the Creation of Money

• The first 10 rounds of the money creation process
  is illustrated on the following table.
  
• Assume a deposit of 10,000 and a reserve ratio
  of 20 percent.

78
An Example of the Creation of Money
79
An Example of the Creation of Money

• If banks keep excess reserves for safety reasons,
  the money multiplier decreases.

80
Calculating the Approximate Real-World Money
Multiplier

• The approximate real-world money multiplier in
  the economy is
  
• 1/(r c)
• r the percentage of deposits banks hold in
  reserve
  
• c the ratio of money people hold in cash to the
  money they hold as deposits

81
Calculating the Approximate Real-World Money
Multiplier

• Assume banks keep 8 percent in reserve and the
  ratio of individuals cash holdings to their
  deposits is 20 percent.

82
Calculating the Approximate Real-World Money
Multiplier

• The approximate real-world money multiplier is

83
Faith as the Backing of Our Money Supply

• Promises to pay underlie any financial system.
• All that backs the modern money supply are
  promises by borrowers to repay their loans and
  government guarantees that banks liabilities to
  depositors will be met.

84
Regulation of Banks and the Financial Sector

• The banking systems ability to create money
  present potential problems.

85
Financial Panics

• The financial history of the world is filled with
  stories of financial upheavals and monetary
  problems.
  
• In the U.S. in the 1800s, local banks were
  allowed to issue their own notes, which often
  became worthless.

86
Anatomy of a Financial Panic

• Financial systems are based on trust that
  expectations will be fulfilled.
  
• Banks borrow short and lend long, which means
  that if people lose faith in banks, the banks
  cannot keep their promises.

87
Anatomy of a Financial Panic

• If all the people, all at once, decided to ask
  for their money (a run on a bank), there would
  not be nearly enough to satisfy everyone.

88
Government Policy to Prevent Panic

• To prevent panics, the U.S. government has
  guaranteed the obligations of various financial
  institutions.
  
• The most important guaranteeing program is the
  Federal Deposit Insurance Corporation (FDIC).

89
Government Policy to Prevent Panic

• Financial institutions pay a small premium for
  each dollar of deposit to the FDIC.

90
Government Policy to Prevent Panic

• FDIC guarantees prevent the unwarranted fear that
  causes financial crises.

91
The Benefits and Problems of Guarantees

• The fact that deposits are guaranteed does not
  serve to inspire banks to make certain deposits
  are covered by loans in the long run.

92
The Benefits and Problems of Guarantees

• Since deposits are covered up to 100,000 by the
  FDIC, some financial institutions make risky
  loans knowing that the guarantee is good.

93
The Savings and Loan Bailout

• During the late 1980s and early 1990s, the
  deregulated SLs made so many bad loans that many
  failed.
  
• The SLs could not repay depositors their money,
  so the government had to step in and do it for
  them.

94
Banks and Bad Loans

• How could the savings and loan fiasco of happen?
• Part of the answer lay in out-and-out fraud.
• Part of it lies in the spread.

95
Banks and Bad Loans

• The spread is the difference between a bank's
  costs of funds and the interest it receives on
  lending out those funds.

96
Banks and Bad Loans

• The cost of funds grew because of competition
  from other SLs.

97
Should Government Guarantee Deposits?

• It is an open question whether the government
  should have guaranteed SL deposits.

98
Should Government Guarantee Deposits?

• The guarantee program prevented unwarranted runs
  on SLs.

99
Money, Banking and the Financial Sector

• End of Chapter 13

100
(No Transcript)