Financial System Dynamics and Policy Implications

1. Thursday, September 1, 2011 Key Slides from Class

2. Financial System -- Components, Players, & Roles -- • Government Policy Makers • Laws & Policies • Federal Reserve • & Banks • Create & Transfer Money Monetary System Financial Institutions Financial Markets • Banks, Insurance Cos, • Stock Brokers, Mutual • Funds, etc. • Stock, Bond, • Currency, etc., • Markets • Accumulate & Lend / Invest Savings • Market & Xfer Financial Assets

3. Financial System -- Components, Players, & Roles -- Policy Makers • Pass laws • Make fiscal, monetary, & debt mgmt policy • President • Congress • Federal Reserve System • Treasury • Federal Reserve • Commercial Banks • Create money • Transfer money Monetary System Financial Institutions Financial Markets • Depository Inst. • Contractual Savings Inst. • Securities Firms • Finance Firms • Securities Markets • Mortgage Markets • Derivatives Markets • Currency Exchange Mkts • Accumulate savings • Lend / invest savings • Market finl assets • Facilitate xfer of finl assets

4. CHAPTER 2 Money and the Monetary System

5. Financial System -- Components, Players, & Roles -- Policy Makers • Pass laws • Make fiscal, monetary, & debt mgmt policy • President • Congress • Federal Reserve System • Treasury • Federal Reserve • Commercial Banks • Create money • Transfer money Monetary System Financial Institutions Financial Markets • Depository Inst. • Contractual Savings Inst. • Securities Firms • Finance Firms • Securities Markets • Mortgage Markets • Derivatives Markets • Currency Exchange Mkts • Accumulate savings • Lend / invest savings • Market finl assets • Facilitate xfer of finl assets

6. Money Functions of Money (1) (2) (3) Medium of Exchange Store of Value Standard of Value * Used to purchase stuff * Used for future purchases * Must be fairly liquid * Prices are expressed in terms of it

7. Money Supply Measures M1 = “liquid”: (1) Currency (2) Traveler’s Checks (3) Demand Deposits M1 M2 • M2 = “liquid + store of value”: M1 plus… • Savings accts • Small “time deposits” • (3) Money market funds M3 • M3: “liquid + more store”: M2 plus… • (1) Large “time deposits” • Inst’l money mkt funds • Eurodollars Cash (i.e., “currency”) = about 50% of M1, 10% of M2, and 7% of M3 M1 = $ 2.0 Trillion M2 = $ 9.3 Trillion M3 = No longer reported As of July, 2011

8. Money Supply & Economic Activity “Gross Domestic Product (GDP)” = “a measure of the output of goods and services in an economy” o MONETARISTS: “The amount of money in circulation determines the level of GDP” GDP = Money Supply (MS) X Velocity of Money (VM) … versus … o KEYNESIANS: “Economic activity results from changes in interest rates, which are affected by the money supply” GDP = Real Output (RO) X Price Level (PL)

9. CHAPTER 3 Banks and Other Financial Intermediaries

10. Financial System -- Components, Players, & Roles -- Policy Makers • Pass laws • Make fiscal, monetary, & debt mgmt policy • President • Congress • Federal Reserve System • Treasury • Federal Reserve • Commercial Banks • Create money • Transfer money Monetary System Financial Institutions Financial Markets • Depository Inst. • Contractual Savings Inst. • Securities Firms • Finance Firms • Securities Markets • Mortgage Markets • Derivatives Markets • Currency Exchange Mkts • Market finl assets • Facilitate xfer of finl assets • Accumulate savings • Lend / invest savings

11. Financial Intermediaries / Institutions DEPOSITORY INST. OR “BANKS” CONTRACTUAL SAVINGS * Banks * Credit Unions * Savings & Loans * Savings Banks * Insurance Companies * Pension Plans Savings $$ Premiums & contributions $$ Cash / Loans $$ * Loans * Stocks * Bonds * etc. Insur. benefits & Pensions $$ SECURITIES FIRMS FINANCE FIRMS * Inv’t Co’s (mutual funds) * Inv’t Banking Firms * Brokerage Firms * Finance Co. * Mortgage Banking Investment $$ Institutional Inv’t $$ Securities Loans $$

12. $$ $$ Functions of Banks & the Banking System Depository Institutions (1) Accepts Deposits $$ (2) Creates Checking Accounts (3) Clears Checks Bank A Bank B $$ (4) Makes Loans (5) Creates “Deposit Money”

13. CHAPTER 4 Federal Reserve System

14. Financial System -- Components, Players, & Roles -- Policy Makers • Pass laws • Make fiscal, monetary, & debt mgmt policy • President • Congress • Federal Reserve System • Treasury • Federal Reserve • Commercial Banks • Create money • Transfer money Monetary System Financial Institutions Financial Markets • Depository Inst. • Contractual Savings Inst. • Securities Firms • Finance Firms • Securities Markets • Mortgage Markets • Derivatives Markets • Currency Exchange Mkts • Market finl assets • Facilitate xfer of finl assets • Accumulate savings • Lend / invest savings

15. The Federal Reserve System (aka “The Fed”) The Fed is the US’s “Central Bank” = “a government agency that facilitates the operation of the financial system and regulates money supply growth” Responsibilities Of the Fed Formulate Monetary Policy Supervise & Regulate Provide Services

16. The Federal Reserve System -- Components & Functions -- * Sets Reserve Reqt * Sets Federal Discount Rate * Protective regulation * Oversees / supervises District Banks * Hold reserve balances * Lend to member bank * Provide currency * Clear checks * Handle US debt Fedl. Res. District Banks (12) Board of Governors Fedl Open Mkt Committee Advisory Committees Member Banks * 3500 members * 1/3 of all coml banks * Own the District Banks * Directs buying & selling of US govt securities

17. The Federal Reserve System -- Affecting the Money Supply -- 3 Tools to Affect Money Supply (1) (2) (3) Open Market Operations Reserve Requirement Discount Rate * The % of deposits banks must keep on hand * 10% since 1992 * The rate at which member banks can borrow from the Fed * Currently .75% * Buy and sell govt securities * Most commonly used tool