Principles of Economics
Financial markets and Money supply
Tomislav Herceg, PhD
Faculty of Economics and Business
Zagreb
Modern financial system
• Finance is a process of intermediation
between borrowers and lenders.
• Financial system consists of:
1. Money market
2. Markets for fixed interest assets (bonds,
mortgages)
3. Stock markets
4. Foreign exchange markets
Functions of financial system
• Borrowing and lending takes place on FINANCIAL
MARKETS (stock, bond, foreign exchange)through
FINANCIAL INTERMEDIARIES (commercial banks,
insurance companies, pension funds and investment
funds)
• Functions of financial system:
1. Transfer of resources across time, sectors and regions
2. Risk management (insurance)
3. Portfolio diversification (investment funds)
4. Clearinghouse function (rapid everyday payment)
Flow of funds
Households purchase stocks,
bonds or mutual funds shares
Financial
markets
Firms issue bonds or stocks
investors
savers
Households deposit salaries and
savings
Financial
intermediaries
Investors borrow from lenders
Financial assets
•
•
•
•
•
Money
Savings accounts (guaranteed by government)
Government securities (bonds and bills)
Equities (ownership right to companies)
Financial derivatives (assets derived from the
value of another asset)
• Pension funds
Money
• Money is a mean of exchange
• Evolution of money:
o Barter
o Commodity money (cattle, olive oil, wine,
metals, gems, tobacco)
o Modern money has no value by itself but in
the goods for which it can be exchanged
(paper money and e-money)
Interest rates and returns
• Interest rate is the price paid for borrowing
money, usually calculated as annual %.
• Present value of an investment:
𝑁1
𝑁2
𝑁𝑡
𝑉 =
+
+ ⋯+
2
1+𝑖
1+𝑖
1+𝑖 𝑡
• Interest rates vary depending on TERM OF
MATURITY, RISK and LIQUIDITY (ability to be
converted into cash)
• Nominal interest rate ≈≈ real interest rate inflation
Components of money supply M
• Narrow money (M1):
1. Cash (coins & paper) outside banks (all cash
today is fiat money – one believes it carries
the value written on it)
2. Checking accounts
• Broad money (M2), or Near-money:
1. M1
2. Savings accounts and small time deposits
3. Retail money market mutual funds
Money demand L
Demand for money is deducted from demand for
trade and exchange
Functions of money:
• Medium of exchange
• Unit of account
• Store of value
Opportunity costs of holding money: the interest
forgone for not investing it
When i rises M1 falls. M1 should not be in a part
of a well balanced portfolio
Banking
• Banks seek to earn profits for their owners by
lending at a higher interest rate than the
borrowing (saving) interest rate.
• Balance sheet of a bank (at certain point of
time) has assets (what bank owns) and
liabilities (what bank owes) and net worth
(difference between them)
• Reserves are a part of a balance sheet of a
bank (it used to be 100% when gold was held)
Money creation
• Central bank determines the reserve ratio. The rest of
the money is lent. That money then forms deposits in
other banks.
• Assume 50% obligatory reserve:
• Jane puts 1000 HRK on her savings account. 500 HRK is
stored as a reserve and 500 is lent. The borrower takes
it to another bank where 250 HRK is a reserve and 250
is lent. Then 250 is lent and 125 is kept by a third bank
as a reserve etc. Finally, 1000 HRK is kept among
several banks and additional 1000 HRK is on the
current accounts. The lower reserve ratio, the greater
M1
Creation of money when r = 50%
Bank 2
Bank 1
Starting deposit
Ban
k5
Bank 3
Bank 4
Money-supply multiplier
• For a starting deposit d bank lends (1 – r) proportion of
the money they received and each further bank lends
(1 – r) proportion of what they got:
• 𝑀1 = 𝑑 1 − 𝑟 + 𝑑 1 − 𝑟
2
+⋯+𝑑 1 −𝑟
infinite number of transactions
• Hence money-supply multiplier is:
∆𝑀 =
1
𝑑
𝑟
⇒𝒎=
𝟏
𝒓
𝑛
=
𝑑
1−𝑟
for
• m shows total amount of loans and deposits for a 1
HRK deposit
• Loan multiplier: l = m - 1
• l shows how much money was lent for a 1 HRK deposit
Leakage from money creation spiral
• Money supply calculated using money-supply
multiplicator assumes no leakage which occur
in real life: leakage in cash (somebody takes
money from the bank in cash) or banks decide
to have excess reserves
Stock market
• Stock market is a market for shares of publicly
owned companies
• Rate of return is % gain from security:
1. For bonds, bills and savings accounts it interest
rate
2. For other assets it is a dividend +/- change in the
asset value (capital loss or gain)
• Risk is variability of return
• Risk-averse investors are those that evade risks.
Stock market (II)
• Bubbles are situations in which speculations
increase value of certain asset up to the
unrealistic level (bubble).
• Crashes are bursts of bubbles (when prices go
down to the level where they should be)
• 1929 Wall Street bubble crash
• Prices of assets have a random walk
(completely stochastic/unpredictable
movement)
Exercise 1
• Ann deposits 100 000 kn on her savings account.
Obligatory reserves are 20% and there is no leakage
in the system. Analyze multiplication process:
– a) for the first 5 banks
– b) for the rest of the banks
– c) for total banking system
• Calculate money-supply multiplicator, new loans,
new reserves, loan multiplicator, new reserves,
excess reserves and money supply increase
Commercia Initial
l banks
deposits
New
deposits
r
A
100 000
B
C
D
E
Σ first five
All the other banks 100 000
Sum
100 000
80 000
64 000
51 200
41 000
336 200
163 800
500 000
0,2
0,2
0,2
0,2
0,2
0,2
-
New
Excess
reserves reserves
20 000
16 000
12 800
10 200
8 200
67 200
32 800
100 000
80 000
64 000
51 200
41 000
32 800
269 000
131 000
400 000
New
loans
80 000
64 000
51 200
41 000
32 800
269 000
131 000
400 000
Money
supply
increase
0
80 000
64 000
51 200
41 000
236 200
163 800
400 000
• Each new deposit is 20% smaller (r = 0,2)
• Money supply multiplier: m=1/r = 1/0,2 = 5
Sum of new deposits = 1 /r × d = m ×d= 5 * 100 000
M1 = 500 000
• b) New reserves = new deposits × r
• c) Excess reserves = new deposits – new reserves
• d) k = 1/r – 1 = m – 1 = 5 – 1 = 4
Sum of new loans = l * d = 4 × 100 000 = 400 000
• e) Money supply increase = Sum of new deposits – initial
deposit (d) = 500 000 – 100 000 = 400 000
Exercise 2
• Mandatory reserves in a country are 30 Bill.€,
cash is 70 Bill. €, and it is known that reserve
ratio is 20%. Find the value of M1.
solution
• M1 = cash + current account deposits
• 30 = current account deposits×0.2
=>deposits are 150 Bill.
• M1 = 70 + 150 = 220 Bill.
Exercise 3
• Commercial banks’ reserves are 56 Bill. HRK,
cash 120 Bill. HRK, and reserve requirement
20%.
– Calculate M1.
– What is the change in M1 caused by a reserve
increase by 4 Bill. HRK and cash increase by 10 Bill.
HRK
solution
• a)
• M1 = cash + current account deposits
• M1 = 120 + 56/0,2 = 120 + 280 = 400
• b)
• M1 = 130 + 60/0,2 = 130 + 300 = 430