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Money, Banking, Credit and Financial Flows

Money, Banking, Credit and Financial Flows Income Credit Buy goods & services Service debt Pay taxes Save Flow of Funds: Sources Uses Financial Cash, deposits, NOW and money market accounts Government securities, stocks, bonds, mutual funds Mortgages Insurance and pension reserves

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Money, Banking, Credit and Financial Flows

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  1. Money, Banking, Creditand Financial Flows

  2. Income Credit Buy goods & services Service debt Pay taxes Save Flow of Funds:Sources Uses

  3. Financial Cash, deposits, NOW and money market accounts Government securities, stocks, bonds, mutual funds Mortgages Insurance and pension reserves Tangible Real estate, cars, appliances, electronics, art, jewelry, etc. Plant and equipment Payables, mortgages, installment debt, loans, etc. Payables, loans, commercial paper, bonds, etc. Equity and Net Worth Balance Sheet:Assets Liabilities

  4. Functions of Money • A standard of deferred payment or medium of exchange • A store of value (in competition with other assets) • Issues of liquidity and debasement through inflation • Unit of account (prices are quoted in $) • Commodity versus fiat monies

  5. Why hold money? • Transactions demand • Speculative demand • Portfolio choice and asset allocation • Considers transactions and opportunity costs • Considers risks and returns • It is sufficient to have money demand directly related to income (and expenditure) and indirectly related to interest rates • Think of income/expenditure in price and quantity terms

  6. The Stock of Money Defined • M1 (Narrow) - currency held by the public, non-bank travelers checks, demand deposits at banks and S&L’s, NOW accounts, credit union drafts • M2 - M1 plus small denomination savings accounts (aka, time deposits), money market accounts, overnight repurchase agreements • M3 - M2 plus large denomination time deposits, institutional money market accounts • L (Broad) - M3 plus short-term Treasury securities, savings bonds, bankers acceptances, commercial paper

  7. Money Stocks

  8. Federal Reserve Responsibilities • Functional • Mint currency • Clear checks • Serve as the bank for the US government • Regulatory • Economic stabilization • Control inflation • Limit the adverse consequences of recession • Ensure liquidity as lender of last resort

  9. Reserves (cash and due from banks) Vault cash Deposits at Fed Deposits at member banks Loans Investments Other Plant and equipment Transaction deposits Other deposits Equity and Net Worth Bank Balance Sheet:Assets Liabilities

  10. Gold Loans to banks US securities Other Plant and equipment Currency outstanding Deposits Reserves US Treasury Other Net Worth Federal Reserve Balance Sheet:Assets Liabilities

  11. Federal Reserve Policy Instruments • Reserve requirements ratio • Legal reserves (LR), required reserves (RR) • The Federal Reserve discount rate • Rate on overnight bank loans [borrowed reserves (BR)] from Fed • Excess reserves (ER) = LR - RR • Net free reserves (NFR) = ER - BR • Open market operations • The purchase and sale of US government securities previously issued by the US Treasury and sold by the Fed to the public

  12. Financial Market Fundamentals • Interest rates and bond prices vary inversely • Rising rates mean lower bond prices and visa versa • Fundamentally, bond prices and stock prices vary directly • Lower bond prices (higher interest rates) should coincide with lower stock prices • Think discounted present value (DPV) and expected future cash flows • What are the effects of higher rates on the components of firm value

  13. Bond Prices and Yields

  14. Stock and Bond Prices

  15. Monetary Policy • Monetary policy is transmitted through financial markets to effect change in the markets for real goods and services • Think bond market! • Bond market! • BOND MARKET!!!

  16. The Monetary Policy Sequence • Bond market - prices, yields, interest rates • Stock prices and exchange rates • Reserve and deposit growth • Loanable and investable funds • Credit sensitive spending • Income growth • Income sensitive spending

  17. The Monetary Policy Sequence • The characteristics of income growth • Labor compensation and profits • Government spending and revenue • Goods & services, transfers, debt service and tax receipts • The foreign sector - exports and imports • Personal and business saving • Recall the composition of business saving

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