Unit 5 Macro The Financial Sector

For example on interest

-if you have $100 and save it in a banks savings account, and the banks pays 5% interest, then in one year you will have an extra $5 in interest, or $105 in total. Therefore, the bank paid you $5 for saving your money with them

Interest rate in the long run

-in the short run, an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate -in the long run, however, changes in the money supply don't affect the interest rate -in the long run, the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output

Stocks rise and fall

-in the stock market, prices rise and fall everyday -when you invest in the stock market, you are hoping that over the years, the stock will become much more valuable than the price you paid for it -investors who hold stock for 15 years or more usually succeed in the market

Interest

-interest will be earned on teh money you have on deposit at the bank -each bank may pay a different amount of interest, so you should look at several banks to decide which one to use

Diversification

-investing in several assets with unrelated, or independent, risks-allows a business owner to lower his/her total risk of loss -the desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market

The opportunity cost of holding money

-it is convenient to hold money in your pocket because it allows you to conveniently make purchases -the price of that convenience is taht money in your pockey earns no interest -the Rule: the lighter the short-term interest rate, the higher the opportunity cost of holding money --the lower the short term interest rate, the lower the opportunity cost of holding money

3. Providing Liquidty

-liquidty refers to the ease by which an asset can be converted to cash -a vintage Rolls Royce is a valuable asset, but isn't very liquid -a savings account is very liquid

Rule of 72

-mathematcians say that you can see how long doubling your money will take simply by dividing 72 by the interest rate -72/interest rate=years needed to double investment

To summarize

-money today is more valuable than the same amount of money in the future -the present value of $1 received one year from now is $1/(1+r) -the future value of $1 invested today is $1* (1+r) -interest paid on savings and interest charged on borrowing is designed to equate the value of dollars today with the value of future dollars

Fisher effect

-named after the American economist Irving Fisher, who proposed the idea in 1930 -the expected real interest rate is unaffected by the change in expected future inflation

The Monetary Role of Banks

-recall the definition of M1=currency+coin+traveler's checks+checking deposits -this last component of M1 is where the role of banks comes into focus. If a large part (about half) of the money supply is accounted for by checking deposits into banks, the banks must play a crucial role in the supply of money in the economy

Banks Run

-when the public begins to fear that the bank itself might fold, or if they fear for the stability of the entire financial system, they may want to withdraw their money -if everyone goes to teh bank to withdraw their deposits, it creates a bank run

How do stocks work?

-when you buy a stock, you become a shareholder, which means you now own a "part" of the company. IF the company's profits go up, you "share" in those profits. If the company's profits fall, so does the price of your stock. If you sold your stock on a day when the price of that stock falls below the price you paid for it, you would lose money

Long term Interest Rates

-why don't we consider the long term interest rates like 10 year CDs as the opportunity cost of holding money? --Because we hold money to make transactions in the short term. Therefore, we must consider the oportunity cost in the short term, not the long term

Lending Example

-you are going to lend your friend $100 and he is going to pay you back in a year -assume no inflation, you agree to 10% interest rate, the going rate you could receive if you had simply saved the money

What this tells us

-your friend, as a borrower, must pay you $21 to compensate you for the fact that he has your $100 for a period of 2 years -You, as a saver, could put the $100 in the bank today, 2 years form now you would have $121 to spend on goods and services -This implies that you would be completely indifferent between having $100 in your pocket today or $121 2 years from today -They are equivalent measures of purchasing power, just measured at 2 different points in time, and it is the interest rate that equates the 2

Shifts of the demand for loanable funds

1. Changes in perceived business opportunities 2. Change in the government's borrowing

The 3 Tasks of a Financial System

1. Reducing Transaction Costs 2. Reducing Risks 3. Providing Liquidty

Shifts in the supply of loanable funds

1. changes in private savings behavior: if households decide to consume more and save less, the supply of loanable funds will shift to the left 1. changes in capital inflows: If a nation is perceived to have a stable gvt, a strong economy and is a good place to save money, foreign money will flow into that nation's financial markets, increasing the supply of loanable funds

Shifts of the Money Demand Curve

1. changes in the aggregate price level 2. changes in real GDP 3. changes in banking technology 4. changes in banking institutions

The Functions of Money

1.Medium of Exchange 2. Store of Value 3.Unit of Account

Notes on MM

MM=1/rr where rr is the reserve ration -MM tells us how much money will be created if a bank has $1 of excess reserves

Notes on I

S+BB+CI=I -If Ci is greater than 0 on the left side (more forieng funds coming into the US, than US funds going out), I must increase on the right side -If CI is less than 0 on the left side (fewer foreign funds coming into the US, than US funds going out), I must decrease on the right side

The Savings-Investment Spending Identity

Savings=Identity

1. Changes in percieved business opportunities

-if firms believe that the economy is ripe with profitable investment opportunities, the demand for loanable funds will increase

Start with a Simple Economy

(no gvt and no trade) -remember the very simple circular flow diagram. All money spent by consumers and firms ends up in another person's pocket as income (including profit) -Households give consumer expenditure and factors for production -firms give goods and services and wages, rent and dividends

Movements on the Money Demand Curve

-An increase in the nominal interest rate will cause a movement upward along the money demand curve

Budget Balance

-Budget Balance=tax revenue=+G+ transfers -If BB is greater than 0, the government has a budget surplus and is actually saving money -If BB is less than 0, the government has a budget deficit and is borrowing money (dissaving)

2. Changes in the government's borrowing

-governments that run budget deficits are major sources of the demand for loanable funds -when the government runs a budget deficit, the Treasury must borrow funds and acquire more debt -this increases the demand for loanable funds in the market -an increase in demand increases interest rates and quantity

Future Payment

-Future payment or FV=PV*(1+r) -using our examples, FV=$100*(1.10)=$110 -in other words, one year into the future, $100 in the present will be worth $110. This is true whether you saved it or lent it to your friend -using the example again, PV=$110/(1.10)=$10 -this tells us that $110 received a year from now is worth $100 in today's dollars -now let's look again at the decision to lend the money for a period of t=2 years: -repayment in 2 years=$100(1.10)*(1.10)=$121 -generalization:FV=PV (1+r) (1+r)=PV (1+r) raised to the t

How do we measure the money supply?

-M1=currency and coin in circulation+checking deposits+traveler's checks (things that are most liquid)

Indicators of the stock market

-Nasdaq and Dowjones

Formuals

-S+BB=i -if BB is greater than 0 on the left side (a surplus), i must increase on the right side -if BB is less than 0 on the left side (a deficit), i must decrease on the right side

Notes on the government

-The government spends on goods and services (G) and pays transfers to some -the government collects tax revenue to pay for these things

Savings accounts

-a bank savings account allows you to deposit money (add money to your account) or withdraw money (remove money form your account) at any time -in return for keeping your money at the bank, the bank pays you money, also known as interest

Financial intermediaries

-a financial intermediary is an institution that transforms funds gathered from many individuals into financial assets -the most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks

The Market for Loanable Funds

-a simplified model that brings together those who want to lend money (savers) and those who want to borrow money (firms with investment spending projects) -the price that's determined in the loanable funds market is the interest rate, denoted by r -the interest rate on the vertical axis represents the real interest rate, not the nominal

What if the economy wasn't so simple?

-add the government (public sector) to the private sector

Add the foreign sector

-an American can saver her money in the US or in another nation -A foreign citizen can save his money in his home country, or in the US -So the US recieves inflows of funds-foreign savings that finance investment spending in the US -The US also generates outflows of funds-domestic savings that finance investment spending in another country -Capital inflow (CI) can be positive or negative so it can increase or decrease the total funds available for investment in the US economy

Crowding Out

-an increase in the government's deficit shifts the demand curve for loanable funds to the right, which leads to a higher interest rate -if the interest rate rises, businesses spend less -so a rise in government budget deficit reduces overall investment spending

Interest Rates and Inflation

-anything that shifts either the suply of loanable funds curve or the demand for loanable funds curve changes the interest rate -unexpected inflation creates winners and losers, particularly among borrowers and lenders

2. Changes in real GDP

-as the economy gets stronger, real incomes and real GDP rise -the larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate -so an increase in real GDP-the total quantity of goods and services produced and sold in the economy-shifts the money demand curve rightward

Money Market Funds

-available form mutual fund companies -you usually get a better return with money market funds -they are invested in very short-term bonds, which tend to be less risky than longer-term bonds and invest in safe government investments, corporate commercial paper, and other related investments

Step 2

-borrowers and lenders all expect inflation to be 5% into the future -nominal=10% and real=5%

3. Changes in Technology

-changes in technology can affect the demand for money -in general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money -if there was an ATM on every corner and in every retail store and restaurant, there would be little need to hold money in your pocket

Using Present Value

-decisions often involve dollars spent, or recieve, at different points in time -we can use the concept of FV to evaluate whether we should commit to a project (or choose between projects) today when benefits may not be enjoyed for several years -Example:many environmental programs are costly now, but pay off later -options-an energy efficient furnace, insulation, or a hybrid car -example-what if you could invest $10000 now and received a guaranteed (after inflation) $20000 later? Good deal? maybe. What if you had to wait 10 years to receive your $20000?

The demand for loanable funds

-demand comes from borrowers -demand is downward sloping because firms borrow to pay for capital investment projects -as the real rate falls, more projects become profitable, so the quantity of funds demanded will increase

Notes

-economists capture the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the differnce is as follows: real interest rate= nominal interest rate-inflation rate --for borrowers, the true cost of borrowing is the real interest rate, not the nominal interest rate --for lenders, the true payoff to lending is the real interest rate, not the nominal interest rate

Step 1

-expected inflation is 0% so real=nominal=5% in equilibrium at Point A. Loanable funds are equal to F1 dollars

1. Changes in the aggregate price level

-higher prices increase the demand for money (a rightward shift of the MD curve) -the demand for money is proportional to the price level --if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, also rises by 20%

Diversification

-reducing investment risk by putting money in several different types of investments -by spreading your money around, you're reducing the impact that a drop in any one investment's value can have on your overall investment portfolio -a mutual fund is an example of an investment that uses diversification -for instance, say you get $100 and decide to put $50 into both a money market account and a stick. 5 years later, the stock company has collapsed form a scandal, and the stock you invested in is worthless. Yes, you've now lost $50. But you would have lost the entire $100 if you hadn't split your investment between the money market account and the stock

Changes in banking institutions

-regulations that make it more attractive to keep money in banks will reduce the demand for money -if a nation's political and banking systems became dangerously unstable, it might increase the demand for money because people would rather hoard their money than store it in institutions that might be falling apart

Repayment received on lending $100 for one year

-repayment received on lending $100 for one year=$100+$100*.10=$100*(1+.10) -repayment in 2 years=$100(1.10)*(1.10)=$121

Factors to consider before investing

-safety-how risky is it? -liquidity- can you easily get your money out of the investment? -return on the investment-what's your earning potential?

Characteristics of a Currency

-scarce, uniform, portable, durable, divisible, acceptable

The money demand curve

-since we demand money to make purchases in the short term, the opportunity cost of holding money is the short term interest rate -we assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate -when the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall

Money and Interest Rates

-the Fed uses the three tools of monetary policy to achieve a target level for the federal funds rate -sine most interest rate will move closely with the FFR, we can use the money market to show how these policies work

The Fisher Effect

-the Fisher effect says that an increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by !% point -the central point is that both lenders and borrowers vase their decisions on the expected real interest rate -as long as the level of inflation is expected, it does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate

Certificates of Deposit (CD)

-the bank holds your money for a set of period of time (1 month to 5 years) -unlike a normal savings account, you may not withdraw your money at any time. If you do , you will be subject to withdrawal fees

1. Reducing Transaction Costs

-the bank, and other financial service companies, are able to make it easier, and less costly, for firms to engage in financial transaction like borrowing to make investments

Result of steps above

-the demand curve for funds shifts up to D2: borrowers are now willing to borrow as much at a nominal interest rate of 10% as they were previously willing to borrow at 5% -the supply curve of funds shifts up to S2: lender require a nominal interest rate of 10% to persuade them to lend as much as they would previously have lent at 5% -the new equilibrium is at point B -the result of an expected future inflation rate of 5% is that the equilibrium nominal interest rate rises from 5% to 10%

Equilibrium

-the equilibrium interest rate is r*% at which Q* dollars are lent and borrowed -investment spending projects with a rate of return of r*% or more are funded; projects with a rate of return of less than r*& are not -only lenders who are willing to accept an interest rate of r*% or less will have their offers to lend funds accepted

2. Reducing Risk

-the future is uncertain so investments, like building a factory, have a risk that they will not be profitable -financial institutions allow for diversification

Looking at Interest Rates

-the higher the interest rate, the less value is place upon future dollars (they're more heavily discounted) and more emphasis is placed upon current dollars - a higher interest rate makes an alternative (like a simple savings account) more attractive

Excess Reserves

-the key to this multiplication of money is that the bank holds 10% of case in reserve and lend the remaining 90%. This 90% refers to excess reserves

Opportunity Cost

-the opportunity cost of lending your friend $100 is the interest you could have earned, $10, after a year had passed -so the interest rate measures the cost to you of forgoing the use of that $100

Banks Savings Account

-the safest place to save your money is in a bank -the federal government backs these accounts with what is known as Federal Deposit Insurance Corporation (FDIC) Insurance

Bonds

-the seller of a bond promises ot pay a fixed sum of interest each year and to repay the principal-the value stated on the face of the bond-to the owner of the bond on a particular date

The Supply of Loanable funds

-the supply of loanable funds comes from savers -supply is upward sloping -savers can lend their money to borrowers, but in doing so must forgo consumption -in order to compensate for the forgone consumption, savers must receive interest income and as the real interest rate rises, the opportunity to earn more income rises, so more dollars will be saved -as the real rate rises, the quantity of funds supplied will increase

Near Monies

-then the Fed expands the definition to include "near monies" or forms of money that can fairly easily be converted to cash (slightly less liquid than M1) -near monies pay interest while few items in M1 pay interest -M2=M1+savings accounts+short term CDs+money market accounts

What are stocks

-units of ownership in a company

The Equilibrium Interest Rate

-we assume that the money supply MS is determined by the Fed and is fixed at any given point in time -it is also independent of the interest rate so it's depicted as a vertical line