Savings, Investment and the
Financial System
Macro
© 2007 Thomson South-Western
Savings and Investments
‘People save, firms invest.’
Y = C + I + G + NX
Savings-Investment Spending Identity
Savings = Investment
S=I
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Savings and Investments
Let’s being with a Simple Economy
 No government, no trade (zero imports and exports)
Total income = Total spending = C + I
People do what with income?
CONSUME or SAVE
Total Income = C + S = Total Spending = C + I
C + S = C + I
S = I
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Savings and Investments
Let’s add the government (public sector) to the
private sector.
 Tax revenue = government spending + transfer payments
Rearranging this for a balanced budget …
Budget Balance = Tax Revenue – G – Transfers
BB > 0 indicates the government has a budget surplus
(saving $$$)
BB < 0 indicates the government has a budget deficit
(borrowing $$$$ - dissaving)
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Savings and Investments
Let’s include the private sector
 Total National Savings = S + BB
Rearranging this for a balanced budget …
S + BB = I
BB > 0 on the left side (surplus), the right side must
increase
BB < 0 on the left side (deficit), the right side must
decrease
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Savings and Investments
Let’s add foreign sector
 Capital inflow (CI) into the US =
 Total inflow of foreign funds (from exports) – total outflow of
domestic funds to other countries (from imports)
 Exports = other countries buying our goods so their $$$ comes to
us
 Imports = we buy other countries goods so our $$$
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Savings and Investments
Rearranging this to include public and private
sectors…
S + BB + CI = I
CI > 0 on the left side (more $$$ coming in than $$$
going out), the right side must increase
CI < 0 on the left side (more $$$ going out than $$$
coming in), the right side must decrease
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Savings and Investments
The Finance System
Financial Asset is a …
Paper claim
Entitles the buyer to future income from the seller
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Savings and Investments
The Finance System has Three Tasks
Reducing Transaction Costs
Banks loan $$$$ so easier to engage in financial
transactions (central location)
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Savings and Investments
The Finance System has Three Tasks
Reducing Risk
Buying shares of stock reduces the risk of one or two
people risking all their funds
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Savings and Investments
The Finance System has Three Tasks
Providing Liquidity
Liquidity is the ease by which an asset is converted into
cash.
 A Royals Royce is an asset but not very liquid.
 A Savings Account is an asset and very liquid.
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Savings and Investments
Types of Financial Assets
Loans
Bonds
Stocks
 Financial Intermediaries
 Mutual Funds
 Pension Funds
 Banks
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THE MEANING OF MONEY
Money - the set of assets in an economy
regularly used to buy goods and services
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Money v. Wealth
MONEY
WEALTH
Cash
Stock in
Microsoft
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The Functions of Money
• Medium of Exchange
– an item that buyers give to sellers when they want
to purchase goods and services.
– anything that is readily acceptable as payment.
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The Functions of Money
• Unit of Account
– the yardstick people use to post prices and record
debts.
• Store of Value
– an item used to transfer purchasing power from the
present to the future.
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The Kinds of Money
• Commodity money - an item with intrinsic
(value of its own).
– Examples: Gold, silver, cigarettes.
• Fiat money is government decreed money.
– No intrinsic value.
– Examples: Coins, currency, check deposits
• Monopoly $$ v. US $$.
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Money in the U.S. Economy
• Currency - the paper bills and coins in the
hands of the public.
• Demand deposits -balances in bank accounts
that depositors can access on demand.
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Two Measures of the Money Stock for
the
U.S.
Economy
Billions
of Dollars
M2
$6,398
• Savings deposits
• Small time deposits < $100,000
• Money market
mutual funds
• A few minor categories
($5,035 billion)
M1
$1,363
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
• Everything in M1
($1,363 billion)
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Additional Measures of the Money
Stock for the U.S. Economy
M3 = M2 + large time deposits (> $100,000)
Debit cards are in M1
Credit cards are not in M1
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Present Value
• Checking to see if we really need to cover this
topic. (mod 24)
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THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (Fed) serves as the
nation’s central bank.
– oversees the banking system – safe and sound
banking practices.
– Acts as a banker’s bank – makes loans to banks
– Conducts monetary policy by controlling the
quantity of money in the economy.
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The Federal Open Market Committee
(FOMC)
• Monetary policy is conducted by the Federal
Open Market Committee.
– Money supply - the quantity of money available in
the economy.
– Monetary policy - the setting of the money supply
by policymakers in the central bank.
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The Fed’sOpen-Market
Tools of Monetary
Control
Changing the Changing the
Operations
Reserve
Requirement
Discount Rate
Increase
Money Supply
Fed buys gov.
bonds from
public
Decrease
Decrease
Decrease
Money Supply
Fed sells gov.
bonds to the
public
Increase
Increase
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Problems in Controlling the Money
Supply
• The Fed does not control
• the amount of money that households choose to hold as
deposits in banks.
• the amount of money that bankers choose to lend.
• Bank runs – depositors withdraw all their
money
• FDIC – guarantees deposit safety
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BANKS AND THE MONEY SUPPLY
• Money supply =
– Currency +
– Demand deposits.
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BANKS AND THE MONEY SUPPLY
• Reserves - deposits received by banks but not
loaned out.
• Fractional-reserve banking system - banks
hold a fraction of the money deposited as
reserves and lend out the rest.
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BANKS AND THE MONEY SUPPLY
Reserve ratio - the fraction of deposits
that banks hold as reserves.
= cash reserves/total deposits
Excess reserves =
checking deposits - reserves
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Determining the Money Supply
How Banks Create Money
Tina has $5000 in cash and decides to open a checking account at Hazen Bank.
The T-Account shows how the assets and liabilities change at the bank.
Assets
What you own
Liabilities
What you owe
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Determining the Money Supply
How Banks Create Money
Money has not been created. Tina has just moved her money from cash to
checking. M1 is unaffected.
Assets
Cash Reserves +$5000
Loans
+$0
Liabilities
Checking Deposits +$5000
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Determining the Money Supply
How Banks Create Money
Hazen Bank must keep 10% ($500) of Tina’s deposit in reverse. Ray wants to
borrow $4500 to buy some furniture at Hazen Furniture. Ray’s load changes
the T-account at Hazen Bank.
Assets
Cash Reserves +$500
Loans
+$4500
Liabilities
Checking Deposits +$5000
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Determining the Money Supply
How Banks Create Money
Hazen Furniture banks at the First Bank of Hazen. Hazen Furniture deposits
the $4500 from Ray. The affect on the T-Account at First Bank of Hazen is
shown below.
Assets
Cash Reserves +$4500
Loans
+$0
Liabilities
Checking Deposits +$4500
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Determining the Money Supply
How Banks Create Money
First Bank of Hazen must keep 10% ($450) of Hazen Furniture’s deposit in
reserves. First Bank of Hazen now has $4050 loan.
Assets
Cash Reserves +$450
Loans
+$4050
Liabilities
Checking Deposits +$4500
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Determining the Money Supply
How Banks Create Money
 Summary:
1.
2.
3.
4.
Tina deposits $5000.
Ray borrows $4500.
Hazen Furniture deposits $4500 at First Bank of Hazen.
First Bank of Hazen has $4050 to spend.
The initial deposit of $5000 created new M! of $4500 + $4050 = $8550.
This process would continue with other loans and deposits.
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The Money Multiplier
• How much money is eventually created by a
new deposit in this economy?
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The Money Multiplier
• The money multiplier - the amount of money
the banking system generates with each dollar
of reserves.
• The money multiplier is the reciprocal of the
reserve ratio: M = 1/R
• Example:
– With a reserve requirement, R = 20% or .2:
– The money multiplier is 1/.2 = 5.
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The Money Multiplier
Increase
in theBank
MoneySecond
Supply =National
$190.00!
First National
Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
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The Money Multiplier
Original deposit = $100.00
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• …
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)
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The Money Multiplier
Reserve Ratio
$ loaned out
smaller Money Multiplier
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