1. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. MONEY, BANKING, AND THE FINANCIAL SECTOR MONEY, BANKING, AND THE FINANCIAL SECTOR Chapter 11

2. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-2 Today’s lecture will: Discuss why the financial sector is central to almost all macroeconomic debates. Explain what money is. Enumerate the three functions of money. State the alternative measures of money and their components.

3. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-3 Today’s lecture will: Explain how banks create money. Calculate both the simple and the approximate real world multiplier. Explain how a financial panic can occur and the potential problem with government guarantees to prevent such panics.

4. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-4 The Financial Sector Financial sector – the market for the creation and exchange of financial assets such as money, stocks, and bonds. For every transaction involving real goods and services, there is a financial transaction that mirrors it. The financial sector plays a central role in organizing and coordinating the economy.

5. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-5 Why is the Financial Sector Important to Macro? The financial sector channels savings back into the circular flow. For every financial asset, there is a corresponding financial liability.  Financial assets – assets such as stocks or bonds, whose benefit to the owner depend on the issuer of the asset meeting certain obligations.  Financial liabilities - obligations by the issuer of the financial asset.

6. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-6 The Financial Sector as a Conduit for Savings Financial Sector Loans Saving Gov’t House- holds Corpor- ations Pension funds CDs Savings deposits Checkable deposits Stocks Bonds Government Securities Life insurance Outflow from spending stream Large business loans Small business loans Venture capital loans Construction loans Investment loans Gov’t House- holds Corpor- ations Inflow from spending stream

7. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-7 The Role of Interest Rates in the Financial Sector The interest rate is the price paid for use of a financial asset. Just as price equates demand and supply in the real sector, interest rates balance demand and supply in the financial sector. When interest rates increase, people are less likely to borrow (sell financial assets) and more likely to save (buy financial assets).

8. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-8 The Role of Interest Rates in the Financial Sector Bonds are promises to pay a certain amount plus interest in the future. The price of a bond is determined by the market interest rate. The price of bonds varies inversely with the interest rate. Interest Rates Bond Prices Interest Rates Bond Prices

9. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-9 Interest Rates and Inflation Real interest rate = nominal interest rate – expected inflation Nominal interest rate – the interest rate you actually see and pay when borrowing or receive when lending. Real interest rate – the nominal interest rate adjusted for inflation. If inflation occurs, the value of money decreases, so lenders charge a higher interest rate to compensate for the loss of purchasing power.

10. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-10 The Definition and Functions of Money Money is a highly liquid financial asset.  Liquid – easily changeable into another good or asset. Money serves as:  A medium of exchange.  A unit of account.  A store of wealth.

11. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-11 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 holding money for, and lending money to, individuals and firms. Individuals’ deposits in savings and checking accounts serve the same function as does currency and are also considered to be money.

12. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-12 Money as a Medium of Exchange Money facilitates exchange by reducing the cost of trading. Without money, we would have to barter. Money has no inherent value to function as a medium of exchange. It acts as a medium of exchange because people are willing to accept as payment for goods and services.

13. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-13 Money as a Unit of Account Money is used as a common denominator to measure the relative values of goods and services. Without money, we would have to measure the value of goods and services in terms of other goods and services. Money is a useful unit of account only if its value relative to the average of all other prices doesn’t change too quickly.

14. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-14 Money as a Store of Value Money is a financial asset that can be used to store wealth (income that you have saved and not consumed). As a store of wealth, money pays no interest, but is perfectly liquid. Money’s usefulness as a store of wealth depends on how will it maintains its value.

15. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-15 Alternative Measures of Money M1 – currency in the hands of the public, checking account balances, and travelers’ checks. M2 – M1 plus other relatively liquid assets, such as savings deposits, small- denomination time deposits (CDs), and money market mutual fund shares. L – almost all short-term liquid financial assets.

16. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-16 Components of M1 and M2 Components of M2Components of M1 Savings deposits (54%) Checking accounts (48%) Small-denomination time deposits (15%) Currency (51%) M1 (28%) Money market mutual funds (12%) Traveler’s checks (1%) M1 (21%)

17. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-17 Distinguishing Between Money and Credit Credit cards are not money. Credit card balances are assets of a bank in the form of a prearranged loan and liabilities of the credit card user. Generally credit card holders carry less cash. A debit card is part of the monetary system because it serves the same function as a check.

18. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-18 Banks and the Creation of Money Banks are both borrowers and lenders.  Banks borrow money from people when they accept deposits and use the money they borrow to make loans to others.  Banks make a profit by charging a higher interest rate on the money they lend out than they pay for the money they borrow. A bank creates money when it places the proceeds of a loan it makes to you in your checking account.

19. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-19 The Creation of Money: Step 1 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.

20. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-20 The Creation of Money: Step 2 The bank lends a fraction of the deposit. The amount of money has expanded:  Initial deposit + new loan The amount of money is multiplied

21. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-21 The Money Multiplier Banks lend a portion of their deposits and keep the balance as reserves. Reserves are cash and deposits a bank keeps on hand or at the Fed. The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals.

22. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-22 The Money Multiplier Banks must keep a portion of deposits: required reserve ratio. Banks can keep more reserves: excess reserve ratio. Reserve ratio = required + excess.

23. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-23 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, the amount of money ultimately created is: New money created = $1000 - $100 = $900

24. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-24 Calculating the Money Multiplier The simple money multiplier (1/r)is the measure of the amount of money ultimately created per dollar deposited in the banking system when people hold no currency. The higher the reserve ratio, the smaller the money multiplier, and the less money will be created. The money multiplier decreases if banks keep excess reserves for safety reasons.

25. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-25 An Example of the Creation of Money

26. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-26 What if People Hold Cash The approximate real-world money multiplier in the economy is: r = the percentage of deposits banks hold in reserve c = the ratio of money people hold in cash to the money they hold as deposits

27. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-27 Calculating the Approximate Real-World Money Multiplier If banks keep 10 percent in reserve and the ratio of individuals’ cash holdings to their deposits is 25 percent, the real-world multiplier is: A $100 deposit could ultimately support $190.

28. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-28 Financial Panics Banks borrow short-term and lend long- term. If depositors lose faith in banks and call on the bank to redeem checking accounts, banks have only their reserves, a small percentage of deposits, to give depositors. The result is that the bank fails, even though it might be financially sound in the long run.

29. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-29 Government Policy to Prevent Panic To prevent panics, the U.S. government guarantees the obligations of various financial institutions through programs such as the Federal Deposit Insurance Corporation (FDIC). Financial institutions pay a small premium for each dollar of deposits to the FDIC. The FDIC uses the money to bail out banks experiencing a run on deposits.

30. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-30 The Benefits and Problems of Guarantees A lack of deposit guarantees acts as an effective restraint on bank lending practices. When deposits are guaranteed, some banks may make risky loans knowing that the government has guaranteed deposits. Guaranteeing deposits can be expensive for taxpayers.

31. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-31 The Savings and Loan Bailout During the late 1980s, the recently deregulated S&Ls made bad loans that led to their failure and the government’s repaying their depositors. The cost of funds increased during the 1980s and the S&Ls charged high interest rates and made many risky loans that failed.

32. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-32Summary The financial sector is the market where financial assets are created and exchanged. The financial sector channels flows out of the circular flow and back into the circular flow. Every financial asset has a corresponding financial liability. Money is a highly liquid financial asset that serves as a unit of account, a medium of exchange, and a store of wealth.

33. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-33Summary The measures of money are:  M1 – currency in the hands of the public, checking account balances, and traveler’s checks  M2 – M1 plus savings deposits, small- denomination time deposits, and money market mutual fund shares  L – almost all short-term assets Banks create money by loaning out deposits.

34. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-34Summary The simple money multiplier is 1/r. The money multiplier tells you the amount of money ultimately created per dollar in the banking system. The approximate real-world multiplier is 1/(r+c). Financial panics are based on fear and can be prevented by government guaranteeing deposits.

35. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 11-35 Suppose that the reserve ratio is 20% An initial deposit of $1000 is made. Review Question 11-1 What is the simple multiplier? The simple multiplier is 1/r = 1/.2 = 5 Review Question 11-2 How much money can ultimately be created (including the initial deposit)? Total money = $1000 x 5 = $5000 Review Question 11-3 How much is new money? New money = $5000 - $1000 = $4000 Review Question 11-4 If the public’s ratio of currency to demand deposits is 5%, how much money can be created (including the initial deposit)? Total money = $1000x[1/(.2+.05)] = $1000 x 4 = $4000