© 2007 Thomson South-Western 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

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western 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)

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western 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 $$$ comes to us  Imports = we buy other countries goods so our $$$

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western Savings and Investments  The Finance System  Financial Asset is a …  Paper claim  Entitles the buyer to future income from the seller

© 2007 Thomson South-Western Savings and Investments  The Finance System has Three Tasks  Reducing Transaction Costs  Banks loan $$$$ so easier to engage in financial transactions (central location)

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western Savings and Investments  Types of Financial Assets  Loans  Bonds  Stocks  Financial Intermediaries  Mutual Funds  Pension Funds  Banks

© 2007 Thomson South-Western THE MEANING OF MONEY Money - the set of assets in an economy regularly used to buy goods and services

© 2007 Thomson South-Western Money v. Wealth MONEYWEALTH CashStock in Microsoft

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western 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 $$ v. US $$.

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western Two Measures of the Money Stock for the U.S. Economy Billions of Dollars Currency ($699 billion) Demand deposits Traveler’s checks Other checkable deposits ($664 billion) Everything in M1 ($1,363 billion) Savings deposits Small time deposits < $100,000 Money market mutual funds A few minor categories ($5,035 billion) 0 M1 $1,363 M2 $6,398

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western Present Value Checking to see if we really need to cover this topic. (mod 24)

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western The Fed’s Tools of Monetary Control Open-Market Operations Changing the Reserve Requirement Changing the Discount Rate Increase Money Supply Fed buys gov. bonds from public Decrease Decrease Money Supply Fed sells gov. bonds to the public Increase

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western BANKS AND THE MONEY SUPPLY Money supply = –Currency + –Demand deposits.

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western 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

© 2007 Thomson South-Western 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. AssetsLiabilities What you ownWhat you owe

© 2007 Thomson South-Western 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. AssetsLiabilities Cash Reserves +$5000Checking Deposits +$5000 Loans +$0

© 2007 Thomson South-Western 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. AssetsLiabilities Cash Reserves +$500Checking Deposits +$5000 Loans +$4500

© 2007 Thomson South-Western 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. AssetsLiabilities Cash Reserves +$4500Checking Deposits +$4500 Loans +$0

© 2007 Thomson South-Western 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. AssetsLiabilities Cash Reserves +$450Checking Deposits +$4500 Loans +$4050

© 2007 Thomson South-Western Determining the Money Supply  How Banks Create Money  Summary: 1.Tina deposits $ Ray borrows $ Hazen Furniture deposits $4500 at First Bank of Hazen. 4.First Bank of Hazen has $4050 to spend. The initial deposit of $5000 created new M! of $ $4050 = $8550. This process would continue with other loans and deposits.

© 2007 Thomson South-Western The Money Multiplier How much money is eventually created by a new deposit in this economy?

© 2007 Thomson South-Western 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.

© 2007 Thomson South-Western The Money Multiplier Increase in the Money Supply = $190.00! AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

© 2007 Thomson South-Western The Money Multiplier Original deposit = $ st Natl. Lending = (=.9 x $100.00) 2nd Natl. Lending = (=.9 x $ 90.00) 3rd Natl. Lending = (=.9 x $ 81.00) … Total money created by this $ deposit is $ (= 1/.1 x $100.00)

© 2007 Thomson South-Western The Money Multiplier Reserve Ratio$ loaned out smaller Money Multiplier