Principles & Policies I: Macroeconomics

1. Principles & Policies I: Macroeconomics Chapter 11: Money, Banking, and the Financial Sector Macroeconomics, Maclachlan Nov. 10, 2004

2. Chapter 11 Learning Objectives. You should be able to: • Explain why the financial sector is central to almost all macroeconomic debates. • Explain what money is. • Enumerate three functions of money. • State the alternative measures of money and their primary components. • Calculate both the simple and the approximate real world money multiplier. • Explain how a financial panic can occur and the potential problem with government guarantees to prevent such panics. Macroeconomics, Maclachlan Nov. 10, 2004

3. 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 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

4. Debt -business loans -bonds -mortgages -return in the form interest Equity -shares of publicly held stock -return in form of dividends Types of Financial Assets Macroeconomics, Maclachlan Nov. 10, 2004

5. What’s Money A highly liquid financial asset that’s generally accepted in exchange for other goods, is used as a reference in valuing other goods, and can be stored as wealth. Macroeconomics, Maclachlan Nov. 10, 2004

6. Functions of Money • Medium of exchange. • Unit of account. • Store of wealth. Macroeconomics, Maclachlan Nov. 10, 2004

7. Money market mutual funds (16%) Currency (50%) Savings deposits (48%) M1 (21%) M1 (28%) Checking accounts (49%) Small-denomination time deposits (15%) Traveler’s checks (1%) Components of M2 and M1 Components of M2 Components of M1 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

8. Banking and Goldsmiths • In the past, gold was used as payment for goods and services. • But gold is heavy and the likelihood of being robbed was great. • Goldsmiths kept gold and issued receipts that could be transferred—first form of paper money. Macroeconomics, Maclachlan Nov. 10, 2004

9. Fractional Reserve Banking • Little gold was redeemed, so the goldsmith began making loans by issuing more receipts than he had in gold. Macroeconomics, Maclachlan Nov. 10, 2004

10. The Money Multiplier • Banks lend a portion of their deposits keeping the balance as reserves. • Reserves are vault cash and the bank’s deposits at the Fed. Macroeconomics, Maclachlan Nov. 10, 2004

11. The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals. Macroeconomics, Maclachlan Nov. 10, 2004

12. The requiredreserveratio is the percentage of their deposits banks are required to hold by the Fed. • If banks choose to hold an additional amount, this is called the excessreserveratio. Macroeconomics, Maclachlan Nov. 10, 2004

13. An Example of the Creation of Money • The first 7 rounds of the money creation process is illustrated on the following table. • Assume a deposit of $10,000 and a reserve ratio of 20 percent. • Assume that all new money remains in the banking system, none is held as currency. Macroeconomics, Maclachlan Nov. 10, 2004

14. An Example of the Creation of Money Macroeconomics, Maclachlan Nov. 10, 2004

15. Determining How Many Demand Deposits Will Be Created • To find the total amount of deposits that will eventually be created, multiply the original deposited amount by 1/r, where r is the reserve ratio. Macroeconomics, Maclachlan Nov. 10, 2004

16. Determining How Many Demand Deposits Will Be Created • If the original deposit is $100 and the reserve ratio is 10 percent, then: 10 X $100 = $1,000 Macroeconomics, Maclachlan Nov. 10, 2004

17. The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system. • It equals 1/r when people hold no currency. Macroeconomics, Maclachlan Nov. 10, 2004

18. Calculating the Approximate Real-World Money Multiplier • The approximate real-world money multiplier in the economy is: r = the percentage of deposits banks hold in reserve c = the ratio of money people hold in cash to the money they hold as deposits Macroeconomics, Maclachlan Nov. 10, 2004

19. Calculating the Approximate Real-World Money Multiplier • If banks keep 10 percent in reserve and the ratio of individuals’ cash holdings to their deposits is 25 percent, the real-world money multiplier is: Macroeconomics, Maclachlan Nov. 10, 2004

20. Financial Panics • The financial history of the world is filled with stories of financial upheavals and monetary problems. • In the 1800s, local banks in the U.S. were allowed to issue their own notes, which often became worthless. Macroeconomics, Maclachlan Nov. 10, 2004

21. Anatomy of a Financial Panic • Financial systems are based on trust that expectations will be fulfilled. • Banks borrow short and lend long. • If people lose faith in banks, the banks cannot keep their promises. Macroeconomics, Maclachlan Nov. 10, 2004

22. Anatomy of a Financial Panic • Banks fail when their depositors lose faith. • If all the people decided to ask for their money all at once, there would not be nearly enough to satisfy everyone. Macroeconomics, Maclachlan Nov. 10, 2004

23. Government Policy to Prevent Panic • To prevent panics, the U.S. government has guaranteed the obligations of various financial institutions. • The most important guaranteeing program is the Federal Deposit Insurance Corporation (FDIC). Macroeconomics, Maclachlan Nov. 10, 2004

24. Government Policy to Prevent Panic • Financial institutions pay a small premium for each dollar of deposit to the FDIC. • The FDIC puts the money into a fund used to bail out banks experiencing a run on deposits. Macroeconomics, Maclachlan Nov. 10, 2004

25. Government Policy to Prevent Panic • FDIC guarantees prevent the unwarranted fear that causes financial crises. • FDIC guarantees prevent the fear that banks will make unreasonable loans. Macroeconomics, Maclachlan Nov. 10, 2004

26. The Benefits and Problems of Guarantees • A lack of deposit guarantees act as an effective restraint or discipline on bank lending policies. • When deposits are guaranteed, some banks may make risky loans knowing that the depositors will not leave. • Moral hazard problem. Macroeconomics, Maclachlan Nov. 10, 2004

27. Problem 11-1 Reserve requirements {5%, 10%, 20%, 25%, 50%, 75%, 100%} Simple money multipliers {20, 10, 5 ,4 , 2, 1.33, 1} If currency holding is 20%, then multipliers are: {4., 3.33 ,2.5, 2.22, 1.43, 1.05, 0.83} Macroeconomics, Maclachlan Nov. 10, 2004

28. Problem 11-2 Jon finds $100 and deposits in his bank. The reserve requirement is 5%. • How much money can the bank lend? $95. b) How much more money is in the economy after first loan? $195 c) What is the money multipler? 20 d) How much money will eventually be created? $2000 Macroeconomics, Maclachlan Nov. 10, 2004