Introduction: Thinking Like an Economist CHAPTER 12 The peculiar essence of our banking system is an...

Introduction: Thinking Like an EconomistCHAPTER

12

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

The Financial Sector and the Economy

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

112

The Financial Sector andthe 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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12-4

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 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 Financial Sector as a Conduit for Savings

FINANCIAL SECTOR

Outflow Savings Loans Inflow

GOVERNMENT

HOUSEHOLDS

BUSINESS

GOVERNMENT

HOUSEHOLDS

BUSINESS

Financial institutions channel saving (outflows from the spending stream) back into the spending stream as loans

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12-7

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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12-8

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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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 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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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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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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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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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:

New money created = $1000 – $100 = $900

$100 x 1/0.1 = $1000

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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:

• 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

(1 + c)(r + c)

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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 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

• The demand for money is downward-sloping: as the interest rate falls the cost of holding money falls

• When interest rates rise, bonds and other financial assets become more attractive, so you hold more financial assets and less money

Interest Rate

Q of Money

S

i0

D

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Market for Loanable Funds

The long-term interest rate is determined in the market for loanable funds

At equilibrium, the quantity of loanable funds supplied (savings) is equal to the quantity of loanable funds demanded (investment)

Interest Rate

Q of Loanable FundsQ

S

4%

= Savings

D = Investment

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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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US Mortgage Delinquencies & Foreclosures

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