AP Macroeconomics
MR. Graham
Unit Five
The Financial Sector
Do Now.
• Why do individuals save money?
• Why do individuals invest?
• What is the difference between saving and
investment?
• What are some specific ways people can
invest?
• http://www.criticalcommons.org/Members/A
drianFohr/clips/trading-information
Module 22:
Saving, Investment, and
the Financial System
3
Savings and Investment
• Two instrumental sources of economic growth
– Human Capital
• Increases in the skills and knowledge of the workforce
• Provided by the government through public education
– Physical Capital
• Increases in “capital”--goods used to make other goods.
• Mainly created through private investment spending
The Interest Rate and
Investment Spending
• Private Investment Spending
– In today’s economy, individuals and firms who create
physical capital often do it with other people’s
money (i.e. borrow)
– Interest Rate—price,
calculated as a percentage
of the amount borrowed,
charged by lenders to
borrowers for the use of
their savings for one year.
Savings and Investment
• Savings-Investment Spending Identity
– Total Income = Total Spending
– Total Income = Consumer Spending + Savings
– Total Spending = Consumer + Investment Spending
– Consumer Spending + Savings =
Consumer Spending + Investment Spending
– So…Savings = Investment Spending
Saving and Investment (with G added)
• Limitation #1: the identity doesn’t include government
– Budget Balance
– Difference bet. tax revenue and government spending.
– Can be a deficit or a surplus
– In recent years the US has experienced a consistent
budget deficit ($1.089 trillion in 2012).
– National Savings
• the sum of private savings and the budget balance; is the
total amount of savings generated within the economy.
U.S. deficit falls to $680 billion
• US budget deficit 2008-2013
Saving and Investment (with X added)
• Limitation #2: savings need not be used to finance
investment spending in one’s own country
– Capital Inflow—the net inflow of investment funds
into a country.
• Includes both inflows or outflows
• In recent years the US has experienced a consistent net
inflow of capital from foreigners (≈$300 Billion in 2012).
Saving and Investment (with G and X added)
• In an economy with a positive capital inflow some
investment spending is funded by the savings of
foreigners.
• In an economy with a negative capital inflow some
national savings is funding investment spending in
other countries
• In the United States in 2012:
– Investment spending totaled $2,072 billion;
– Private savings were $2,916 billion…
• …offset by a budget deficit of $1,089 billion
• and supplemented by capital inflows of ≈$300 billion.
– There is a “statistical discrepancy” of ≈$55 billion
because data collection isn’t perfect, but the identity is
still true.
Components of the Financial System
• Wealth
– A household’s accumulated savings
– Can take the form of physical or financial assets
• Physical Assets
– Claim on a tangible object (pre-existing house or piece
of equipment).
• Financial Assets
• Paper claim that entitles the buyer to future income
from the seller.
• Financial Markets
– Where households invest their current savings and their
accumulated savings by purchasing financial assets.
Three Problems with Physical Assets
1. Transaction Costs: expenses of actually
putting together and executing a deal.
2. Financial Risk: uncertainty about future
outcomes that involve financial losses or gains
3. Desire for Liquidity: (in)ability for assets to be
quickly converted into cash
Three Tasks of a Financial System
• By allowing people to buy/sell financial assets
rather than physical assets, they…
1. Reduce Transaction Costs
2. Reduce Risk
3. Provide Liquidity
Four Types of Financial Assets
• Loans: lending agreement between an
individual lender and an individual borrower.
– Good—usually tailored to needs of the borrower
– Bad—typically involves a lot of transaction costs
Four Types of Financial Assets
• Bonds: IOU issued by
the borrower for a fixed
sum of annual interest.
– Good—easily acquired
information on the
quality*, easy to resell
(i.e. more liquid)
– Bad—risk for default
Four Types of Financial Assets
• Stocks: share in the ownership of a company
– Good—more diversification and more liquidity
– Bad—difficult to assess the true quality because of
securitization (loans packaged together) the
process creates liquidity by enabling smaller
investors to purchase shares in a larger asset pool
Four Types of Financial Assets
• Bank Deposits:
– Good—the most liquid and secure financial asset
– Bad—forgone opportunity for appreciation
Financial Intermediary
• Institutions that transform funds gathered
from many individuals into financial assets
– Banks
– Mutual Funds
– Pension Funds
– Life Insurance Companies
The Federal Reserve
• http://www.youtube.com/watch?v=I2m3t2Yr8
Vg
• http://www.youtube.com/watch?v=3hYxH5_d
5Xk
• http://www.youtube.com/watch?v=r8lHeLJ6ie
0
Do Now.
• http://www.criticalcommons.org/Members/jti
erney86/clips/shawshank-redemption-moneyin-prison
• http://www.criticalcommons.org/Members/jti
erney86/clips/the-league-medium-ofexchange
• http://www.criticalcommons.org/Members/G
hent/clips/the%20invitations.mp4
Module 23:
The Definition and Measurement of Money
21
Is This Money?
15-22
The Meaning of Money
• Money includes not only coins and dollar bills,
but also the balance in your checking account.
• Anything widely accepted in exchange for
items of value is considered to be money.
15-23
What Is Money?
• Money
– Any asset that can easily be used to purchase
goods and services
– It is the asset with the most liquidity
• The ease with which an asset can be converted into cash
15-24
The Roles of Money (3)
1. Medium of Exchange
2. Store of Value
3. Unit of Accounting
15-25
The Roles of Money (3)
• Medium of Exchange
– An asset that individuals acquire for the purpose
of trading goods and services rather than for their
own consumption
– Money makes it possible to trade without
exchanging goods and services directly
• Eliminates the difficulty of “barter”—
finding a double coincidence of wants
• Permits specialization
• Facilitates efficiency in exchanges
15-26
The Roles of Money (3)
• Store of Value
– The ability to hold purchasing power over time
– Money allows you to transfer value (wealth)
into the future.
– A necessary property of money
15-27
The Roles of Money (3)
• Unit of Accounting
– A measure by which prices are expressed
– The common denominator of the price system—
allows people to compare and measure values
– A central property of money
15-28
So…What Is Money?
 Complete “Activity 34: Money Is What Money Does”
 Evaluate each item as to how well it would perform
the 3 functions of money.
 Be sure to consider portability, uniformity, acceptability,
durability and stability in value.
15-29
The Types of Money (3)
• Commodity Money
– A good used as a medium of exchange that has
intrinsic value in other uses (i.e. gold)
• Commodity-Backed Money
– A medium of exchange with no intrinsic value whose
ultimate value is guaranteed by a promise that it can
be converted into valuable goods
• Fiat Money
– a medium of exchange whose value derives entirely
from its official status as means of payment
15-30
The Types of Money (3)
• Fiat Money
– Advantages:
• It doesn’t tie up any real resources, except for the
paper it’s printed on.
• The money supply can be managed by the needs of the
economy, instead of being determined by the amount
of gold and silver.
– Risks
• Counterfeiting
• Inflation
15-31
Measuring the Money Supply
• Money Supply
– The amount of money in circulation
• Changes in the rate at which the money
supply increases or decreases affect important
economic variables (at least in the short run)
such as inflation, interest rates, employment,
and the level of real GDP.
15-32
Measuring the Money Supply
• Economists use two basic approaches to
define and measure money.
– The transactions approach
– The liquidity approach
15-33
Measuring the Money Supply
• Transactions Approach
– A method of measuring the money
supply by looking at money as a medium of
exchange (a.k.a. “narrow money”)
• Liquidity Approach
– A method of measuring the money supply by
looking at money as a temporary store of value
(a.k.a. “broad money”)
15-34
Measuring the Money Supply
• M1: Transactions approach to measuring money
– Coin and Currency
– Transactions deposits (i.e. checking accounts)
– Traveler’s checks not issued by banks
– Consists of the most liquid forms of money
15-35
Measuring the Money Supply
15-36
Measuring the Money Supply
• M2: Liquidity approach to measuring money
– Savings deposits
– Time deposits
– Money market mutual funds
– Includes “near moneys”
–
Assets that are almost money
–
Still highly liquid
–
Easily converted to cash
15-37
Measuring the Money Supply
15-38
Defining the U.S. Money Supply
• Question
– Which definition of money correlates best with
economic activity?
• Answer
– M2, although some businesspeople and
policymakers prefer even broader definitions with
further assets added to the definition.
15-39
Measuring the Money Supply
• Complete “Activity 35: What’s All This About
the M’s?”
15-40
Do Now.
• What is Money?
• Identify M1 and M2 and explain the difference
• List and explain the 3 tasks of the financial
system
• Speculate on the time value of money. What
does that mean?
Module 24:
The Time Value of Money
42
The Time Value of Money
• Making economic decisions can sometimes be
difficult because the benefits and costs of a
project may not arrive at the same time.
• How, specifically is time an issue in economic
decision-making?
15-43
Borrowing, Lending and Interest
• In general, having a dollar today is worth more
than having a dollar a year from now.
– The value of money depends on when it is paid or
received
• $1 that is paid to you today is worth more than $1
that is paid to you a year from now.
• $1 that you must pay today is more burdensome
than $1 that you must pay next year.
– There is a simple way to adjust for these
complications so we can correctly compare the
value of $ received and paid out at different times
15-44
Present Value vs. Future Value
• Present Value
– Price of what you are going to be paid or what
you are going to pay NOW instead of waiting
to be paid or waiting to pay for it in the future
– Let’s say you win the lottery for $1 million
dollars, and are given the choice of receiving
the $1 million dollars in two years or receiving
something less than $1 million right NOW.
– Which would you choose?
15-45
Present Value vs. Future Value
• Which would you choose? It depends on…
– How much you are going to get paid NOW?
Lottery officials offer you $910,000 NOW
– What is the expected interest rate?
The expected interest rate for the next 2 years is 5%.
• Would you take their offer?
15-46
Present Value v. Future Value
• We need to know the formula for present value
– PV = FV x 1/(1 + r)n
• r is the interest rate
• n is the number of years
• So the present value of $1 million received 2
years from now is:
– PV = 1,000,000 x 1/(1 + .05)2
– PV = $907,029.48
• We should take the 910,000 NOW!
15-47
Present Value v. Future Value
• Future Value
– Value at some point in the FUTURE of a
present amount of money
– Let’s say you put $200 in the bank and it earns
3.5%. If you left this money in the bank, how
much would you have in the bank at the end of
two years?
15-48
Present Value v. Future Value
• We need to know the formula for future value
– FV = PV x (1 + r)n
• r is the interest rate
• n is the number of years
• So the future value of $200 in the bank that
earns 3.5% left in the bank for 2 years is:
– FV = 200 x (1 + .035)2
– FV = $214.25
15-49
Present v. Future Value
• Complete “Present and Future Value”
• http://www.reffonomics.com/TRB/chapter18/
presentvalue.html
• http://www.learner.org/series/econusa/unit20
/
15-50
Do Now
•
•
•
•
What is the purpose of banks?
How do they make money?
What are bank runs?
Why is it important for the government to
keep banks in business?
Module 25:
Banking and Money Creation
52
The Monetary Role of Banks
• Roughly half of M1 consists of currency in
circulation (i.e. $1 bills, $5 bills, and so on)
• The rest of M1 (and the bulk of M2) consists
of bank deposits
– Checkable and debitable account balances in
commercial banks and other types of financial
institutions—high liquidity
15-53
What Banks Do
• A bank is a financial intermediary
– Uses liquid assets (i.e. bank deposits) to finance
the illiquid investments of borrowers.
• Process is known as Fractional Reserve Banking
– A system in which depository institutions hold liquid
assets less than the amount of deposits.
– Can take the form of:
1.
Currency in bank vaults
2.
Bank Reserves—deposits held at the Federal Reserve
15-54
What Banks Do
• To understand the role of banks in determining the
money supply, we start by introducing a simple tool for
analyzing the bank’s financial position: a T-Account.
15-55
What Banks Do—
Basic Accounting Review
• T-Account (Balance Sheet)
– Statements of assets and liabilities
• Assets (Amounts owned)
– Items to which a bank holds legal claim
– The uses of funds by financial intermediaries
• Liabilities (Amounts owed)
– The legal claims against a bank
– The sources of funds for financial intermediaries
What Banks Do—
Basic Accounting Review
What Banks Do—
Basic Accounting Review
 Notice that in this example First Street’s assets are larger
than its liabilities—that’s the way it’s supposed to be!
 Banks are required by law to maintain assets larger by a
specific percentage than their liabilities
What Banks Do—
Basic Accounting Review
 Reserve Ratio
 The fraction of bank deposits that a bank holds as
reserves (i.e. 10% for “First Street Bank”)
 Required Reserve Ratio
 The smallest fraction of deposits that the Federal
Reserve allows banks to hold (currently 10%)
 Helps protect against bank runs
Banking Regulation
• In addition to “Reserve Requirements,” we
have three more regulatory features that
protect against bank runs and failures:
1. Deposit Insurance: FDIC guarantees $250,000
of each account.
2. Capital Requirements: “Bank Capital” is the excess
of a bank’s assets over its bank liabilities.
3. Discount Window: arrangement that allows the
Federal Reserve to lend money to member banks.
Questions?
• Define fractional reserve banking.
• List and explain 3 features that protect against
bank runs and failures
• How can banks essentially create money?
Determining the Money Supply
 And this may not be the end of the story…
Determining the Money Supply
Mary uses her cash to buy a TV and a DVD player from
Acme Merchandise.
Anne Acme, the store’s owner, deposits the $900 into a
checkable bank deposit at Second Street Bank.
Second Street Bank will keep only part of that deposit
in reserves, lending out the rest.
Second Street Bank keeps 10% of any bank deposit in
reserves and lends out the rest, further increasing the
money supply.
Determining the Money Supply
 This process of money creation may sound familiar--recall the
multiplier process that we described in Module 16.
 We have here is another multiplier—the money multiplier
The Money Multiplier
 Monetary Base: Bank reserves
plus currency in circulation.
 Money Supply: Checkable
deposits plus currency in
circulation.
 The money multiplier represents the total number of
dollars created in the money supply by each $1
addition to the monetary base.
The Money Multiplier
•
In a simplified situation in which banks hold no
excess reserves and all cash is deposited in banks,
the money multiplier is:
1/rr
• Excess Reserves: reserves over and above the amount
needed to satisfy the minimum reserve ratio.
•
In reality, the determination of the money supply is
more complicated than our simple model
The Money Multiplier
 If the reserve requirement is 10% (the minimum
required ratio for most checkable deposits in the
United States), the money multiplier is 1/0.1 = 10.
 So…if the Federal Reserve adds $100B to the
monetary base, the money supply will increase by
10 × 100 = $1,000B
 In reality, the actual money multiplier in the United
States, using M1 as our measure of money, is
currently only .9. That’s a lot smaller than 10.
 What is going on?
The Money Multiplier
The Money Multiplier
The required reserve ratio is 10%.
1.
If a bank has deposits of $100,000 and holds $15,000 as
reserves, how much are its excess reserves?
$5000
2. If a bank holds no excess reserves and it receives a new
deposit of $1,000, how much of that $1,000 can it lend out
and how much is the bank required to add to its reserves?
Loans
Reserves
+$900
+100
3. By how much can an increase in excess reserves of $2,000
change the money supply?
Money Multiplier = 10; 2000 x 10 = $20,000
Do Now.
• Define the following:
– Central bank
– Commercial bank
– Investment bank
– Panic of 1907
Module 26:
The Federal Reserve System:
History and Structure
71
The Federal Reserve System
• Central Bank
– An institution that oversees and regulates the
banking system and controls the monetary base
1. Perform banking functions for their nations’
governments
2. Provide financial services for private banks
3. Conduct their nations’ monetary policies
15-72
The Federal Reserve System
• The Federal Reserve
– The central bank of the United States
– The most important regulatory agency in the U.S.
monetary system
– Established by the Federal Reserve Act (1913) in
response to the lessons learned in the Panic of
1907.
15-73
The Structure of the Fed
• Board of Governors (Washington, D.C.)
– 7 members, 14-year terms, appointed by the President
– Oversee the entire Federal Reserve System
– Janet L. Yellen
• Federal Reserve Banks
– 12 Districts
– Audit the books of private-sector banks, among other
roles.
• Federal Open Market Committee (FOMC)
– B.O.G. and 5 bank presidents (always including NY)
– Conducts Monetary Policy
15-74
The Structure of the Fed
15-75
The Structure of the Fed
15-76
Do Now.
• Watch this video:
– http://www.youtube.com/watch?v=GsxmwjQWiZs
Module 27:
The Federal Reserve System:
Monetary Policy
78
The Functions of the Federal Reserve System
1. Provides Financial Services:
– holds reserves, clears checks, provides cash, and
transfers funds for commercial banks and the
federal government.
2. Supervises and Regulates Banking Institutions
– examines and regulates commercial banks in
their district
3. Maintains the Stability of the Financial System
– provide liquidity to financial institutions
4. Conducts Monetary Policy
15-79
What the Fed Does
(a.k.a. the 3 ways they do monetary policy)
1. Reserve Requirement
2. Discount Rate
3. Open Market Operations
What the Fed Does
• The Reserve Requirement
– “Least used tool of the Federal Reserve”
– Sets a minimum required reserve ratio (10%)
• Banks that fail to maintain minimum face penalties
• Can borrow excess reserves from the other banks via
the federal funds market to meet minimum
– Fed can change reserve requirements to alter the
money supply
What the Fed Does
• The Discount Rate
– Banks in need of reserves can also borrow
from the Fed itself via the discount window
– Discount rate is currently set at 25 basis points
(.25%) above the federal funds rate
– Fed can change the discount rate to alter the
money supply
What the Fed Does
• Open-Market Operations
– Treating the Federal Reserve as a bank, we realize
they have their own “assets” and “liabilities”.
– Fed’s assets consist of its holdings of debt issued by
the U.S. government (i.e. U.S. Treasury bills).
– Fed’s liabilities consist of currency in circulation
and bank reserves (i.e. the “monetary base”).
What the Fed Does
• In panel (a), the Federal
Reserve increases the
monetary base by purchasing
U.S. Treasury bills from
private commercial banks.
• The purchase is paid for by a
$100 million increase in the
monetary base.
• This will ultimately lead to an
increase in the money supply
as banks lend out some of
these new reserves.
What the Fed Does
• In panel (b), the Federal
Reserve reduces the monetary
base by selling U.S. Treasury
bills to private commercial
banks.
• The sale leads to a $100 million
reduction in commercial bank
reserves, resulting in a $100
million decrease in the
monetary base.
• This will ultimately lead to a
decrease in the money supply
as banks reduce their loans.
Do Now.
• What do you think of the following short
video clips?
– http://www.criticalcommons.org/Members/fsusta
vros/clips/commanding-heights-3-chapter-11global-contagion
– http://www.criticalcommons.org/Members/fsusta
vros/clips/commanding-heights-3-chapter-12contagion-engulfs
Module 28:
The Money Market
87
The Demand for Money
 Recall…
 M1: Currency in circulation, plus checkable
bank deposits, plus traveler’s checks.
 M2: consists of M1 plus deposits that can
easily be transferred into checkable deposits.
 People hold money to make it easier to
purchase goods and services.
 But what determines how much money
individuals and firms want to hold at any time?
The Demand for Money
 The Opportunity Cost of Holding Money
 Holding money is “convenient”
 The opportunity cost for that
convenience: money held in
your wallet earns no interest
 Even holding money in a
checking account involves a
trade-off between convenience
and earning interest.
The Demand for Money
 The opportunity cost of holding money changes when
the overall level of interest rates changes. Specifically,
when the overall level of interest rates falls, the
opportunity cost of holding money falls, too.
The Money Demand Curve
 Because the overall level of interest rates affects the
opportunity cost of holding money, the quantity of
money individuals and firms want to hold is, other
things equal, negatively related to the interest rate
Shifts in the Money Demand Curve
 Changes in Aggregate Price Level
 other things equal, the demand for money is
proportional to the price level (i.e. if the aggregate
price level rises by 20%, the quantity of money
demanded at any given interest rate also rises by 20%).
 Changes in Real GDP
 The larger the quantity of goods and services
households buy, the larger the quantity of money they
will want to hold at any given interest rate.
Shifts in the Money Demand Curve
 Changes in Technology
 Advances in information technology have tended
to reduce the demand for money by making it
easier for the public to make purchases without
holding significant sums of money.
 Changes in Institutions
 When banking regulations change (i.e. allowing or
prohibiting interest), the demand for money will
change as well.
Shifts in the Money Demand Curve
Money and Interest Rates
• “The Federal Open Market Committee decided
today to lower its target for the federal funds rate
75 basis points to 2¼ percent”—March 18, 2008
• As we’ve already seen, other short-term
interest rates, such as the rates on CDs, move
with the federal funds rate.
• How does the Fed go about achieving a target
federal funds rate?
• And more to the point, how is the Fed able to
affect interest rates at all?
The Money Market
 The Fed can increase or decrease money supply:
it usually does this through open-market operations,
buying or selling Treasury bills, but it can also lend via the
discount window or change reserve requirements
Do Now.
• Draw a correctly labeled graph showing the
money market in equilibrium
• What happens if there is an interest rate
below equilibrium?
• What will people do with their wealth if there
is an interest rate above equilibrium?
• Illustrate these two situations graphically.
Module 29:
The Market for Loanable Funds
98
Two Models of the Interest Rate
 Money Market
 Supply of money is chosen by the Fed.
 Represents the market for short-term borrowing.
 Loanable Funds Market
 Hypothetical market in which those who want to
save supply funds and those who want to borrow
to invest demand funds.
 Represents the market for long-term borrowing.
The Loanable Funds Market
• “Loanable funds” refers to all income that
people have chosen to save (and lend out),
rather than use for their own consumption.
• The loanable funds market coordinates the
economy’s saving and investment
The Demand for Loanable Funds
• The demand for loanable funds comes from firms and
households that wish to borrow to make investments.
The Supply of Loanable Funds
• The supply of loanable funds comes from people who
have extra income they want to save and lend out.
Equilibrium in the Loanable Funds Market
• The interest rate is the “price” of the loan.
•
•
It represents the amount that borrowers pay for loans
and the amount that lenders receive on their saving.
The equilibrium of the supply and demand for
loanable funds determines the real interest rate.
Shifts in Demand for Loanable Funds
1. Changes in perceived business opportunities
• A change in beliefs about the rate of return on
investment spending can increase or reduce the
amount of desired spending at any interest rate.
2. Changes in the government’s borrowing
• Governments that run budget deficits need to
borrow funds to finance the government.
• “Crowding Out”:
the negative effect of
budget deficits on private
investment, which occurs
because government
borrowing drives up
interest rates
Shifts in Supply for Loanable Funds
1. Changes in private savings behavior
• Perceptions about wealth can cause the level of
private savings to change at any level of interest.
2. Changes in capital inflows
• As investors’ perception of a country change, then
international capital flows can change.
The Interest Rate in the Short-Run
The Interest Rate in the Long Run
Economics USA-Monetary Policy
• http://www.learner.org/series/econusa/unit2
5/