U4: The Financial Sector

Unit 4: The Financial Sector

Economic Growth

● Comes from increases in human capital and physical capital.

● Savings = Investment Spending

● National Savings + Capital Inflow = Investment Spending

Financial Asset Types

● Loans

● Bonds (bonds & interest rates for bonds are inversely related)

● Loan-backed securities

● Stocks

● Bank Deposits

Financial Intermediaries Types

● Mutual Funds

● Life insurance companies

● Pension funds

● Banks (meant to reduce transaction costs, reduce risk, and provide liquidity)

Inflation & Interest rate:

○ Inflation rate: [(PL in Year 2 - PL in Year 1)/PL in Year 1 ] * 100

■ Inflation does not make everyone poorer (because increase in wages & increase in price of goods → no real change)

■ Nominal interest rate is unadjusted for inflation.

■ Real interest rate = Nominal interest rate - actual interest rate

■ Higher inflation than expected:

● Winners: Borrowers since they have to return funds with a lower value.

● Losers: Lenders

■ Lower inflation than expected:

● Winners: Lenders since they get funds with higher values

● Losers: Lenders

● Interest rate: Additional rate charged by lenders to borrowers for money lent.

● National Savings = Private savings + budget balance

Capital Inflow

● Net inflow of funds into a country.

● Liquid: If an asset can be converted into cash without much loss of value (most liquid form is cash).

● Illiquid: If an asset loses a lot of value when converted to cash.

Diversification

● When an investor invests in several different assets to avoid total loss.

Money

● Any asset accepted as a means of payment:

○ Roles in economy

■ Medium of exchange (used to trade for G&S)

■ Unit of account (can be stored and saved without losing value)

■ Store of value (A commonly accepted measure to set prices and make economic calculations.)

● Types

■ Commodity money (Medium of exchange that also has intrinsic value.)

■ Commodity-backed money (Medium of exchange with no intrinsic value but can be converted to valuable goods.)

■ Fiat Money (Medium of exchange that gets its value from the government deciding it does.)

● Is measured using monetary aggregates M1 & M2

M1 = Currency in circulation + traveler’s checks + checkable bank deposits

M2 = Currency in circulation + traveler’s checks + checkable bank deposits +  near-moneys (savings account, time deposits, small denotation CDs)

● Present and future worth of a dollar

A dollar’s worth today > a dollar’s worth in the future (because of inflation)

Present Value = (Future Value)/(1 + Interest Rate)(Time(Years)) 

Future Value = Present Value * (1 + Interest Rate)(Time(Years)) 

Net Present Value = PV of current & future benefits - PV of current & future costs

Banks

○ Accept and keep funds as deposits; keep part of deposits and lend the rest out.

(T-accounts are used to show one’s liabilities and assets.)

Bank Runs

● When a lot of depositors go to the bank and demand their money at the same time are caused by rumors that a bank failure has occurred. Therefore, bank regulations have been created to prevent bank-runs and ensure depositors' money

■ Deposit insurance (guarantees security of the first $250,000 of every bank account)

■ Reserve requirements (banks are required to maintain the required reserve ratio)

■ Discount Window (banks can get loans and money from the FED)

■ Capital requirements (assets have to be > deposits)

● Can decrease the money supply by removing currency in circulation and putting them in bank vaults

● Can increase the money supply by making loans and creating money

Money Multiplier Process

■ Money multiplier = 1 / reserve ratio

■ Money multiplier: Total amount created from every $ increase in monetary base.

■ Total Increase in checkable bank deposits = (excess reserves)/(reserve ratio)

Banks have required reserves and excess reserves (basis for the creation of money)

● Required reserve ratio: Portion of deposits banks are required to keep as reserves.

Money Market

● Short-term interest rates tend to move together.

○ Affects the money supply, unlike long-term interest rates.

● Demand for money is driven by the opportunity cost of holding money and short-term interest rate (money that could be earned from holding other assets).

● Money demand (relationship of quantity of money demanded and interest rate) shifters.

Aggregate Price Level

Increase in aggregate price level increases money demand

● Changes in Real GDP (Increase in GDP increases money demand)

● Changes in technology (Inventions that decrease difficulty of changing assets to currency in circulation increase money demand.)

● Changes in institutions

Money Supply

● Shows relationship of quantity of money supplied and interest rate) shifters are monetary policy tools.

● Reserve requirement (lower required reserve ratio increases money supply)

● Discount rate (lower discount rate increases money supply)

● Open-Market operations (Fed buying more T-bills increases money supply.)

Money Supply is chosen by the FED and does not change from changes in the interest rate.

Liquidity Preference Model (name for money market model)

● Equilibrium is achieved when the nominal interest rate is such that money demand & money supply are equal.

● Surplus and shortages are created in the money market when economy is not at the equilibrium interest rate.

Market for Loanable Funds

● Suppliers - savers/lenders

● Demanders - borrowers

Demand Curve Shifters

○ Changes in perceived business opportunities (optimistic beliefs increase demand)

○ Changes in government borrowing (more borrowing increases demand)

Supply Curve Shifters

● Changes in private savings behavior (them saving more increase supply)

● Changes in capital inflows (optimistic views of country from other countries increases supply)

National Savings = public savings + private savings

■ In open economy, investment = national savings + net capital inflow.

Fisher Effect

A rise in expected future inflation → a rise in the interest rate

A fall in expected future inflation → a fall in the interest rate

● Government spending can cause lower investment spending from the crowding out effect. The equilibrium interest rate for the liquidity preference model & the loanable funds model are the same in the short-run & long-run.

Federal Reserve

Functions

○ Provides financial services (ex. Holds reserves, clears checks)

○ Supervises banking institutions (ex. Makes sure they follow required reserve ratio.)

○ Maintains stability of financial system (provides liquidity to all commercial banks)

○ Conducts monetary policy

Expansionary

◆ Decrease in required reserve ratio

◆ Lower discount rate

◆ Fed buying more T-bills (has greatest effect on money supply)

Contractionary

◆ Increase in required reserve ratio

◆ Increase in discount rate

◆ FED sells T-bills (has greatest effect on money supply)

Most banks strive to stay on the federal funds rate!