the financial sector and the economy the peculiar essence of our banking system is an unprecedented...

The Financial Sector and the Economy

The peculiar essence of our banking system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.

— Walter Bagehot

CHAPTER

13

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

The Financial Sector andthe Economy

13

The Financial Sector and the Economy

• The financial sector is central to almost all macroeconomic debates

• The real sector is the market for the production and exchange of goods and services

• The financial sector is the market for the creation and exchange of financial assets

• Financial assets include money, stocks, and bonds• Plays a central role in organizing and coordinating

our economy

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Why is the Financial Sector Important to Macro?

• For every real transaction, there is a financial transaction that mirrors it

• The financial sector channels savings back into spending

• For every financial asset, there is a corresponding financial liability

• Financial assets are assets such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations

• Financial liabilities are obligations by the issuer of the financial asset

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The Financial Sector as a Conduit for Savings

FINANCIAL SECTOR

Outflow Savings Loans Inflow

GOVERNMENT

HOUSEHOLDS

BUSINESS

GOVERNMENT

HOUSEHOLDS

BUSINESS

Financial institutions channel saving (outflows from the spending stream) back into the spending stream as loans

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The Role of Interest Rates in the Financial Sector

• The interest rate is the price paid for use of a financial asset

• The long-term interest rate is the price paid for financial assets with long maturities,

• The market for long-term financial assets is called the loanable funds market

• The short-term interest rate is the price paid for financial assets with short maturities,

• Short-term financial assets are called money

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Market for Loanable Funds

• The long-term interest rate is determined in the market for loanable funds

• At equilibrium, the quantity of loanable funds supplied (savings) is equal to the quantity of loanable funds demanded (investment)

Interest Rate

Q of Loanable FundsQ

S

4%

= Savings

D = Investment

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The Definition and Functions of Money

• Money is a highly liquid financial asset that serves as a:• Medium of exchange• Unit of account• Store of wealth

• Liquid means to be easily changeable into another asset or good

• Money is a financial asset that makes the real economy function smoothly

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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

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Alternative Measures of Money

• Economists have developed different measures of money

• Two are M1 and M2

• M1 is a measure of the money supply; it consists of currency in the hands of the public plus checking accounts and traveler’s checks

• M2 is a measure of the money supply; it consists of M1 plus other relatively liquid assets

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The Money Multiplier

• Reserves are currency and deposits a bank keeps on hand or at the Fed or central bank, to manage the normal cash inflows and outflows

• The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals

• Banks can keep more reserves: excess reserve ratio

• Reserve ratio = required reserve ratio + excess reserve ratio

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Calculating the Money Multiplier

• We will call the ratio 1/r the simple money multiplier

• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency

• It tells us how much money will ultimately be created by the banking system from an initial inflow of money

• The higher the reserve ratio, the smaller the money multiplier, and the less money will be created

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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 (0.1), the amount of money ultimately created is:

New money created = $1000 – $100 = $900

$100 x 1/0.1 = $1000

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Calculating the Money Multiplier when People Hold Currency

• The simple money multiplier reflects the assumption that only banks hold currency

• When firms and individuals hold currency, the money multiplier in the economy is:

• Where r is the percentage of deposits banks hold in reserve and c is the ratio of money people hold in currency to the money they hold as deposits

(1 + c)(r + c)

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Why People Hold Money

The only reason people would be willing to hold money is if they get some benefit from doing so

• The transactions motive is the need to hold money for spending

• The precautionary motive is holding money for unexpected expenses and impulse buying

• The speculative motive is holding cash to avoid holding financial assets whose prices are falling

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Equilibrium in the Money Market

• The demand for money is downward-sloping: as the interest rate falls the cost of holding money falls

• When interest rates rise, bonds and other financial assets become more attractive, so you hold more financial assets and less money

Interest Rate

Q of Money

S

i0

D

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the financial sector and the economy the peculiar essence of our banking system is an unprecedented...

Documents

financial sector important

financial transaction

longterm financial assets

shortterm financial

functions of money money

liquid financial asset

money supply

real sector