© 2007 thomson south-western savings, investment and the financial system macro

© 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 IdentitySavings = Investment

S = I

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Savings and Investments

Let’s being with a Simple EconomyNo 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 + IC + S = C + I S = I

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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 – TransfersBB > 0 indicates the government has a budget surplus

(saving $$$)BB < 0 indicates the government has a budget deficit

(borrowing $$$$ - dissaving)

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Savings and Investments

Let’s include the private sectorTotal 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

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Savings and Investments

Let’s add foreign sectorCapital 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 $$$

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Savings and Investments

Rearranging this to include public and private sectors…

S + BB + CI = ICI > 0 on the left side (more $$$ coming in than $$$

going out), the right side must increaseCI < 0 on the left side (more $$$ going out than $$$

coming in), the right side must decrease

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Savings and Investments

The Finance SystemFinancial Asset is a …

Paper claimEntitles the buyer to future income from the seller

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Savings and Investments

The Finance System has Three TasksReducing Transaction Costs

Banks loan $$$$ so easier to engage in financial transactions (central location)

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Savings and Investments

The Finance System has Three TasksReducing Risk

Buying shares of stock reduces the risk of one or two people risking all their funds

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Savings and Investments

The Finance System has Three TasksProviding 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.

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Savings and Investments

Types of Financial AssetsLoansBondsStocks

Financial Intermediaries Mutual Funds Pension Funds Banks

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THE MEANING OF MONEY

Money - the set of assets in an economy regularly used to buy goods and services

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Money v. Wealth

MONEY WEALTH

Cash Stock in Microsoft

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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.

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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.

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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 $$ v. US $$.

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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.

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Two Measures of the Money Stock for the U.S. Economy

Billionsof 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

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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

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Present Value

• Checking to see if we really need to cover this topic. (mod 24)

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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.

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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.

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The Fed’s Tools of Monetary ControlOpen-Market

OperationsChanging the

Reserve Requirement

Changing the Discount Rate

Increase Money Supply

Fed buys gov. bonds from public

Decrease Decrease

Decrease Money Supply

Fed sells gov. bonds to the public

Increase Increase

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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

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BANKS AND THE MONEY SUPPLY• Money supply =

– Currency +– Demand deposits.

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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.

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BANKS AND THE MONEY SUPPLYReserve ratio - the fraction of deposits

that banks hold as reserves.

= cash reserves/total deposits

Excess reserves =

checking deposits - reserves

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Determining the Money Supply

How Banks Create MoneyTina 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.

Assets Liabilities What you own What you owe

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Determining the Money Supply

How Banks Create MoneyMoney has not been created. Tina has just moved her money from cash to checking. M1 is unaffected.

Assets Liabilities Cash Reserves +$5000 Checking Deposits +$5000 Loans +$0

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Determining the Money Supply

How Banks Create MoneyHazen 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.

Assets Liabilities Cash Reserves +$500 Checking Deposits +$5000 Loans +$4500

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Determining the Money Supply

How Banks Create MoneyHazen 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.

Assets Liabilities Cash Reserves +$4500 Checking Deposits +$4500 Loans +$0

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Determining the Money Supply

How Banks Create MoneyFirst Bank of Hazen must keep 10% ($450) of Hazen Furniture’s deposit in reserves. First Bank of Hazen now has $4050 loan.

Assets Liabilities

Cash Reserves +$450 Checking Deposits +$4500 Loans +$4050

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Determining the Money Supply

How Banks Create Money Summary:

1. Tina deposits $5000.2. Ray borrows $4500.3. 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 $4500 + $4050 = $8550.

This process would continue with other loans and deposits.

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The Money Multiplier

• How much money is eventually created by a new deposit in this economy?

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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.

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The Money Multiplier

Increase in the Money Supply = $190.00!

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

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The Money Multiplier

Original deposit = $100.00• 1st Natl. Lending = 90.00 (=.9 x $100.00)• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)• …• Total money created by this $100.00 deposit is

$1000.00. (= 1/.1 x $100.00)

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The Money Multiplier

Reserve Ratio $ loaned out

smaller Money Multiplier