Money, Banking and the Financial Sector

1. Money, Banking and the Financial Sector Chapter 11

2. Laugher Curve A central banker walks into a pizzeria to order a pizza. When the pizza is done, he goes up to the counter get it.

3. Laugher Curve The clerk asks him: “Should I cut it into six pieces or eight pieces?” The central banker replies: “I’m feeling rather hungry right now. You’d better cut it into eight pieces.”

4. Introduction • Real goods and services are exchanged in the real sector of the economy. • For every real transaction, there is a financial transaction that mirrors it.

5. Introduction • The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it.

6. Introduction • All trade’s in the goods market involves both the real sector and the financial sector.

7. Why Is the Financial Sector So Important to Macro? • The financial sector is important to macroeconomics because of its role in channeling savings back into the circular flow.

8. Why Is the Financial Sector So Important to Macro? • Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government.

9. Why Is the Financial Sector So Important to Macro? • Savings are channeled into the financial sector when individuals buy financial assets such as stocks or bonds and back into the spending stream as investment.

10. Why Is the Financial Sector So Important to Macro? • For every financial asset there is a corresponding financial liability. • Financial assets such as loans, stocks, and bonds are obligations or financial liabilities of the issuer.

11. Outflow from spending stream Inflow from spending stream Pension funds CDs Savings deposits Checkable deposits Stocks Bonds Government Securities Life insurance Large business loans Small business loans Venture capital loans Construction loans Investment loans Gov’t Gov’t Saving Loans House- holds House- holds Corpor- ations Corpor- ations Financial Sector The Financial Sector as a Conduit for Savings

12. The Role of Interest Rates in the Financial Sector • While price is the mechanism that balances supply and demand in the real sector, interest rates do the same in the financial sector.

13. The Role of Interest Rates in the Financial Sector • The interest rate is the price paid for use of a financial asset. • Bonds are promises to pay a certain amount plus interest in the future.

14. The Role of Interest Rates in the Financial Sector • When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate.

15. The Role of Interest Rates in the Financial Sector • When interest rates rise, the value of the flow of payments from fixed-interest-rate bonds goes down because more can be earned on new bonds that pay the new, higher interest.

16. The Role of Interest Rates in the Financial Sector • As the market interest rates go up, price of the bond goes down. • As the market interest rates go down, the price of the bond goes up.

17. Savings That Escape the Circular Flow • Some economists believe that the interest rate does not balance the demand and supply of savings causing macroeconomic problems.

18. Savings That Escape the Circular Flow • In order to make sense of the problem, macroeconomics divides the flows into two types of financial assets.

19. Savings That Escape the Circular Flow • In order to make sense of the problem, macroeconomics divides the flows into two types of financial assets.

20. Savings That Escape the Circular Flow • The first type include bonds and loans which work their way into the system. • The second type, money held by individuals, is not necessarily assumed to work its way back into the flow.

21. The Definition and Functions of Money • Money is a highly liquid financial asset. • To be liquid means to be easily changeable into another asset or good. • Social customs and standard practices are central to the liquidity of money.

22. The Definition and Functions of Money • Money is generally accepted in exchange for other goods. • Money is used as a reference in valuing other goods. • Money can be stored as wealth.

23. The U.S. Central Bank: The Fed • American currency is printed with the caption "Federal Reserve Note," meaning that it is a liability of the Federal Reserve Bank (the Fed). • The Federal Reserve Bank (the Fed) is the central bank of the U. S.

24. The U.S. Central Bank: The Fed • Federal Reserve Notes serve as cash in the U.S. • They are liabilities of the Fed.

25. The U.S. Central Bank: The Fed • The Fed, being the nation’s central bank has the right to issue these notes and by convention the notes are acceptable for payment to all the people of the country.

26. The U.S. Central Bank: The Fed • A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms.

27. The U.S. Central Bank: The Fed • Individuals’ deposits in savings and checking accounts serve the same function as does currency and are also considered money.

28. Functions of Money • Money is a medium of exchange. • Money is a unit of account. • Money is a store of wealth.

29. Money As a Medium of Exchange • Without money, we would have to barter—a direct exchange of goods and services. • Money facilitates exchange by reducing the cost of trading.

30. Money As a Medium of Exchange • Money does not have to have any inherent value to function as a medium of exchange. • All that is necessary for money to work is that everyone believes that other people will exchange it for their goods.

31. Money As a Medium of Exchange • The Fed’s job is to not issue too much or too little money.

32. Money As a Medium of Exchange • If there is too much money, compared to the goods and services at existing prices, the goods and services will sell out, or the prices will rise.

33. Money As a Medium of Exchange • If there is too little money, compared to the goods and services at existing prices, there will be a shortage of money and people will have to resort to barter, or prices will fall.

34. Money As a Unit of Account • Money prices are actually relative prices. • A single unit of account saves our limited memories and helps us make reasonable decisions based on relative costs.

35. Money As a Unit of Account • Money is a useful unit of account only as long as its value relative to other prices does not change too quickly. • In a hyperinflation, all prices rise so much that our frame of reference is lost and money loses its usefulness as a unit of account.

36. Money as a Store of Value • Money is a financial asset. • It is simply a government bond that pays no interest.

37. Money as a Store of Value • As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.

38. Money as a Store of Value • Money’s usefulness as a store of wealth also depends upon how well it maintains its value. • Hyperinflations destroy money’s usefulness as a store of value.

39. Money as a Store of Value • Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest.

40. Alternative Measures of Money • Since it is difficult to define money unambiguously, economists have defined different concepts of money. • They are called M1, M2, and L.

41. Alternative Measures of Money: M1 • M1 consists of currency in the hands of the public, checking account balances, and travelers’ checks. • Checking account deposits are included in all definitions of money.

42. Alternative Measures of Money: M2 • M2 is made up of M1 plus savings deposits, small-denomination time deposits (certificates of deposit or CDs), and money market mutual fund shares, along with some other esoteric financial instruments.

43. Alternative Measures of Money: M2 • The money in savings accounts is counted as money because it is readily available.

44. Alternative Measures of Money: M2 • All M2 components are highly liquid and play an important role in providing reserves and lending capacity for commercial banks.

45. Alternative Measures of Money: M2 • The M2 definition is important because economic research has shown that the M2 definition most closely correlates with the price level and economic activity.

46. Beyond M2: L • The broadest definition of the money supply is L (which stands for liquidity. • It consists of almost all short-term financial assets.

47. Beyond M2: L • Because of the difficulty of defining money in an ever-changing world, measures of money have lost some their appeal, and broader concepts of asset liquidity have taken their place.

48. Distinguishing Between Money and Credit • Credit card balances cannot be money since they are assets of a bank. • In a sense, they are the opposite of money.

49. Distinguishing Between Money and Credit • Credit cards are prearranged loans. • Credit cards affect the amount of money people hold. • Generally, credit card holders carry less cash.

50. Money market mutual funds (11%) Currency (37%) Savings deposits (33%) Other (3%) M1 (28%) Small-denomination time deposits (25%) Traveler’s checks (1%) Components of M2 and M1 Components of M1 Components of M2 Checking accounts (62%)