Transcript Powerpoints Macro Ch12 R2

Introduction:
Thinking Like an Economist
CHAPTER 12
The Financial Sector and the Economy
The peculiar essence of our banking system is an unprecedented
trust between man and man; and when that trust is much weakened
by hidden causes, a small accident may greatly hurt it, and a great
accident for a moment may almost destroy it.
— Walter Bagehot
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
The Financial Sector and
the Economy
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The Financial Sector and the Economy
 The financial sector is central to almost all macroeconomic
debates
 The real sector (aka “Main St.”) is the market for the
production and exchange of goods and services
 The financial sector (aka “Wall St.”)is the market for the
creation and exchange of financial assets
• Financial assets include money, stocks, and bonds
• Plays a central role in organizing and coordinating
our economy
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The Financial Sector and
the Economy
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1
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The Financial Sector and
the Economy
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Why is the Financial Sector Important to Macro?
 For every real transaction, there is a financial transaction
that mirrors it
 The financial sector channels savings back into spending
 For every financial asset, there is a corresponding
financial liability
 Financial assets are assets such as stocks or
bonds, whose benefit to the owner depends on the
issuer of the asset meeting certain obligations
 Financial liabilities are obligations by the issuer of
the financial asset
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the Economy
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The Financial Sector as a Conduit for Savings
Financial institutions channel savings back into the
spending stream as loans
 Saving is outflows from the spending stream from
government, households, and corporations
• Savings deposits, bonds, stocks, life insurance
 Loans are made to government, households, and
corporations
• Business loans, venture capital loans, construction
loans, investment loans
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the Economy
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1
The Financial Sector as a Conduit for Savings
Financial institutions channel saving (outflows from the
spending stream) back into the spending stream as loans
GOVERNMENT
Outflow
GOVERNMENT
Savings
HOUSEHOLDS
BUSINESS
Loans
FINANCIAL SECTOR
Inflow
HOUSEHOLDS
BUSINESS
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the Economy
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The U.S. Central Bank: The Fed
 The Federal Reserve Bank (the Fed) is the U.S. central
bank
• Federal Reserve notes are liabilities of the Fed that
serve as cash in the U.S.
 A bank is a financial institution whose primary function is
accepting deposits for, and lending money to, individuals
and firms
 Individuals’ deposits in savings and checking accounts
serve the same purpose as does currency and are also
considered money
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the Economy
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The Definition and Functions of Money
 Money is a highly liquid financial asset that serves as a:
• Medium of exchange
• Unit of account
• Store of wealth
 Liquid means to be easily changeable into another asset
or good
 Money is a financial asset that makes the real economy
function smoothly
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the Economy
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Alternative Measures of Money
 Economists have developed different measures of money
 Two are M1 and M2
• M1 is a measure of the money supply; it consists of
currency in the hands of the public plus checking
accounts and traveler’s checks
• M2 is a measure of the money supply; it consists
of M1 plus other relatively liquid assets (savings
accounts, money market accounts, short term
Certificates of Deposits, or CDs)
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the Economy
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1
The Process of Money Creation
 Reserves are currency and deposits a bank keeps on
hand or at the Fed or central bank, to manage the
normal cash inflows and outflows
 The reserve ratio is the ratio of reserves to deposits a
bank keeps as a reserve against cash withdrawals
 Banks can keep more reserves: excess reserve ratio
 Reserve ratio = required reserve ratio + excess reserve
ratio
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the Economy
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Banks and the Creation of Money
The first step in the creation of money
 The Fed creates money by simply printing currency
• Currency is a financial asset to the bearer
and a liability to the Fed
 The bearer deposits the currency in a checking
account at the bank
• The form of money has changed from
currency to a bank deposit
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the Economy
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Banks and the Creation of Money
The second step in the creation of money
 The bank lends a fraction of the deposit
 The amount of money has expanded:
• Initial deposit + new loan
 The amount of money is multiplied
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The Financial Sector and
the Economy
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Calculating the Money Multiplier
• We will call the ratio 1/r 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, when people
hold no currency
• It tells us how much money will ultimately be created by
the banking system from an initial inflow of money
• The higher the reserve ratio, the smaller the money
multiplier, and the less money will be created
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the Economy
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Determining How Many
Demand Deposits Will Be Created
• To find the total amount of deposits that will be created,
multiply the original deposit by 1/r, where r is the
reserve ratio
• If the original deposit is $100 and the reserve ratio is
10 percent (0.1), the amount of money ultimately
created is:
$100 x 1/0.1 = $1000
New money created = $1000 – $100 = $900
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the Economy
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Calculating the Money Multiplier
when People Hold Currency
• The simple money multiplier reflects the assumption
that only banks hold currency
• When firms and individuals hold currency, the
money multiplier in the economy is:
(1 + c)
(r + c)
• Where r is the percentage of deposits banks hold in
reserve and c is the ratio of money people hold in
currency to the money they hold as deposits
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3 Motives for Holding Money
(as formulated by Keynes)
• The transactions motive is the need to hold
money for spending
• The precautionary motive is holding money
for unexpected expenses and impulse
buying
• The speculative motive is holding cash to
avoid holding financial assets whose prices
are falling
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the Economy
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The Role of Interest Rates in the Financial Sector
 The interest rate is the price paid for use of a financial
asset
 The long-term interest rate is the price paid for financial
assets with long maturities
• The market for long-term financial assets is called
the loanable funds market
 The short-term interest rate is the price paid for financial
assets with short maturities
• Short-term financial assets are called money
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Equilibrium in the Money Market
Interest Rate
• The demand for money is
downward-sloping: as the interest
rate falls the cost of holding money
falls
S
i0
D
• When interest rates rise, bonds
and other financial assets become
more attractive, so you hold more
financial assets and less money
Q of Money
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the Economy
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Market for Loanable Funds
Interest Rate
The long-term interest rate is
determined in the market for
loanable funds
S = Savings
4%
At equilibrium, the quantity of
loanable funds supplied
(savings) is equal to the
quantity of loanable funds
demanded (investment)
D = Investment
Q
Q of Loanable Funds
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the Economy
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The Many Interest Rates in the Economy
 The economy doesn’t have just a single interest rate;
it has many
 Each financial asset will have an implicit interest rate
associated with it
 In a multiple-asset market, the potential for the interest
rate in the loanable funds market to differ from the
interest rate in the market for a particular asset is large
• The result can be a financial asset market
bubble
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the Economy
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US Mortgage Delinquencies & Foreclosures
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