1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 13 Money and Financial Markets

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-2 Introduction to Financial Markets Financial Markets are organized exchanges where securities and financial instruments are bought and sold. – Financial markets provide direct finance when borrows issues securities directly to savers. – More commonly, Financial Intermediaries make loans to borrowers and obtain funds from savers, often by accepting deposits. Financial intermediaries spread risk and collect information efficiently.

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-3 Figure 13-1 The Role of Financial Intermediaries and Financial Markets

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-4 Money vs. Capital Market Instruments Money Market Instruments are assets that have short maturities, usually less than one year, small fluctuations in price and minimal risk of default. – Examples: CDs, commercial paper, U.S. T-bills Capital Market Instruments are assets that have relatively long maturities, can experience large fluctuations in price, and often expose investor to more risk of default. – Examples: Corporate stocks and bonds, U.S. T-notes and bonds, mortgages

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-5 Table 13-1 The Main Financial Intermediaries and Instruments in 2007 (1 of 2)

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-6 Table 13-1 The Main Financial Intermediaries and Instruments in 2007 (2 of 2)

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-7 Table 13-1 The Main Financial Intermediaries and Instruments in 2007

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-8 Definitions of Money M1 is the U.S. definition of the money supply that includes only currency (CU), transactions accounts or deposits (D), and traveler’s checks. – Algebraically: M1 = CU + D M2 is the U.S. definition of the money supply that includes M1; savings deposits, including money market deposit accounts; small time deposits; and money market mutual funds. High-powered Money (H) is the sum of currency hold outside depository institutions and the reserves (RES) held inside them. – Algebraically: H = CU + RES – H is also sometimes referred to as the Monetary Base.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-9 Table 13-2 Components of the M1 and M2 Measures of the Money Supply, Sept. 2007 ($ billions)

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-10 Process of Money Creation Suppose there is a $100 deposit of gold coins. – Assume the Reserve Ratio (e) is 10%, so the bank keeps 10% of all deposits as reserves. Therefore, the bank can loan out the remaining $90 of gold coins. – Assuming the public holds no currency, the new $90 loan will be spent and then redeposited by the new holder of the $90 – The bank keeps $9 to meet the 10% reserve requirement and then can make another loan of $81. – This process repeats and repeats… and ultimately the original deposit of $100 leads to the creation of $1000 units of money, all in the form of bank deposits!

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-11 Money Multiplier Equations The money creation process can be represented algebraically to show how the amount of high-powered money affects the total value of deposits when there are no currency holdings: When the public holds a fraction of its deposits as currency (where c = CU/D), the money multiplier equation becomes: – Note: The coefficient of H is called the Money Multiplier

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-12 Three Fed Tools for Changing M S Open Market Operations are purchases and sales of government securities made by the Federal Reserve in order to change H. – An open market purchase (sale) of bonds would increase (decrease) the money supply. The Discount Rate is the interest rate the Federal Reserve charges depository institutions when they borrow reserves. – An increase (decrease) in the discount rate would tend to decrease (increase) the money supply. Required Reserves are the reserves that Federal Reserve regulations require depository institutions to hold. – An increase (decrease) in the required reserve ratio would tend to decrease (increase) the money supply.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-13 Difficulties in Controlling M S The Federal Reserve cannot control the money supply precisely for several reasons: – Multiple definitions of money. – The public chooses the amount of currency it holds. – Funds shifting between accounts subject to reserve requirements (like deposits) and those that are not (like money market mutual funds) will change the average reserve ratio. A Money-Multiplier Shock is any event that causes the money multiplier to change.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-14 Table 13-3 A Simplified Version of the Fed’s Balance Sheet (all values in $ billions)

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-15 Theories on the Demand for Money In the early 1950s, William J. Baumol and James Tobin demonstrated that the transactions demand for money depends on the interest rate. James Tobin also showed that people demand money as a store of value as part of an effort to diversify their portfolios of financial assets. Milton Friedman had a similar approach to Tobin’s portfolio theory suggesting that money demand depends on both income and wealth.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-16 Figure 13-2 Alternative Allocations of an Individual’s Monthly Paycheck Between Cash and Savings Deposits

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-17 International Perspective: Cash Fades Out as Plastic Takes Over

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-18 Financial Regulation and the IS Curve Until 1986, federal regulations put ceilings on the interest rate that could be on many types of deposits. – If nonregulated i , then funds from regulated accounts would be shifted out of commercial banks and thrift institutions (this process was called Disintermediation)  The supply of funds available for mortgages   Spending in the housing market became depressed – Financial deregulation removed this interest rate gap, and thus, spending does not fall as much when i  The effect of financial regulation on the IS curve is to make the IS curve steeper since now an increase in interest rates does not lead to as large a fall in spending.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-19 Financial Regulation and the LM Curve Before deregulation, we can assume that the interest rate paid on M1 was r m = 0. If r   people will switch out of M1 into interest-bearing financial assets. But after financial deregulation, if r   r m  since banks and thrift institutions are now allowed to pay interest on their deposits.  There is a smaller switch out of M1 into other higher interest-bearing financial assets. Result: The LM curve is steeper after financial deregulation.

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-20 Figure 13-3 The Effect of Financial Deregulation in the Commodity and Money Markets

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-21 Figure 13-4 The Effect of a Lower Money Supply on Interest Rates and Output

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-22 Fed Target Policies The Federal Reserve has a choice of policy targets in its conduct of monetary policy: – Target the money supply – Target the interest rate – Target inflation The unpredictability of M D and the resulting volatility of interest rates has caused the Fed to target interest rates at this time.

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-23 Figure 13-5 Effects on Real Output of Policies that Either Stabilize the Interest Rate or Stabilize the Real Money Supply when Either Commodity Demand or Money Demand Is Unstable

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-24 Chapter Equations

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-25 Chapter Equations

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-26 Chapter Equations

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-27 Chapter Equations

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-28 Chapter Equations