Unit Five The Financial Sector

1. AP Macroeconomics MR. Graham Unit Five The Financial Sector

2. Do Now. • Why do individuals save money? • Why do individuals invest? • What is the difference between saving and investment? • What are some specific ways people can invest? • http://www.criticalcommons.org/Members/AdrianFohr/clips/trading-information

3. Module 22: Saving, Investment, and the Financial System 3

4. Savings and Investment Two instrumental sources of economic growth Human Capital Increases in the skills and knowledge of the workforce Provided by the government through public education Physical Capital Increases in “capital”--goods used to make other goods. Mainly created through private investment spending

5. The Interest Rate and Investment Spending Private Investment Spending In today’s economy, individuals and firms who create physical capital often do it with other people’s money (i.e. borrow) • Interest Rate—price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year.

6. Savings and Investment Savings-Investment Spending Identity Total Income = Total Spending Total Income = Consumer Spending + Savings Total Spending = Consumer + Investment Spending Consumer Spending + Savings = Consumer Spending + Investment Spending So…Savings = Investment Spending

7. Saving and Investment (with G added) Limitation #1: the identity doesn’t include government Budget Balance Difference bet. tax revenue and government spending. Can be a deficit or a surplus In recent years the US has experienced a consistent budget deficit ($1.089 trillion in 2012). National Savings the sum of private savings and the budget balance; is the total amount of savings generated within the economy.

8. U.S. deficit falls to $680 billion • US budget deficit 2008-2013

9. Saving and Investment (with X added) Limitation #2: savings need not be used to finance investment spending in one’s own country Capital Inflow—the net inflow of investment funds into a country. Includes both inflows or outflows In recent years the US has experienced a consistent net inflow of capital from foreigners (≈$300 Billion in 2012).

10. Saving and Investment (with G and X added) In an economy with a positive capital inflow some investment spending is funded by the savings of foreigners. In an economy with a negative capital inflow some national savings is funding investment spending in other countries In the United States in 2012: Investment spending totaled $2,072 billion; Private savings were $2,916 billion… …offset by a budget deficit of $1,089 billion and supplemented by capital inflows of ≈$300 billion. There is a “statistical discrepancy” of ≈$55 billion because data collection isn’t perfect, but the identity is still true.

11. Components of the Financial System Wealth A household’s accumulated savings Can take the form of physical or financial assets Physical Assets Claim on a tangible object (pre-existing house or piece of equipment). Financial Assets Paper claim that entitles the buyer to future income from the seller. Financial Markets Where households invest their current savings and their accumulated savings by purchasing financial assets.

12. Three Problems with Physical Assets Transaction Costs: expenses of actually putting together and executing a deal. Financial Risk: uncertainty about future outcomes that involve financial losses or gains Desire for Liquidity: (in)ability for assets to be quickly converted into cash

13. Three Tasks of a Financial System By allowing people to buy/sell financial assets rather than physical assets, they… Reduce Transaction Costs Reduce Risk Provide Liquidity

14. Four Types of Financial Assets Loans: lending agreement between an individual lender and an individual borrower. Good—usually tailored to needs of the borrower Bad—typically involves a lot of transaction costs

15. Four Types of Financial Assets Bonds: IOU issued by the borrower for a fixed sum of annual interest. Good—easily acquired information on the quality*, easy to resell (i.e. more liquid) Bad—risk for default

16. Four Types of Financial Assets Stocks: share in the ownership of a company Good—more diversification and more liquidity Bad—difficult to assess the true quality because of securitization (loans packaged together) the process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool

17. Four Types of Financial Assets Bank Deposits: Good—the most liquid and secure financial asset Bad—forgone opportunity for appreciation

18. Financial Intermediary Institutions that transform funds gathered from many individuals into financial assets Banks Mutual Funds Pension Funds Life Insurance Companies

19. The Federal Reserve • http://www.youtube.com/watch?v=I2m3t2Yr8Vg • http://www.youtube.com/watch?v=3hYxH5_d5Xk • http://www.youtube.com/watch?v=r8lHeLJ6ie0

20. Do Now. • http://www.criticalcommons.org/Members/jtierney86/clips/shawshank-redemption-money-in-prison • http://www.criticalcommons.org/Members/jtierney86/clips/the-league-medium-of-exchange • http://www.criticalcommons.org/Members/Ghent/clips/the%20invitations.mp4

21. Module 23: The Definition and Measurement of Money 21

22. Is This Money? 15-22

23. The Meaning of Money Money includes not only coins and dollar bills, but also the balance in your checking account. Anything widely accepted in exchange for items of value is considered to be money. 15-23

24. What Is Money? Money Any asset that can easily be used to purchase goods and services It is the asset with the most liquidity The ease with which an asset can be converted into cash 15-24

25. The Roles of Money (3) Medium of Exchange Store of Value Unit of Accounting 15-25

26. Medium of Exchange An asset that individuals acquire for the purpose of trading goods and services rather than for their own consumption Money makes it possible to trade without exchanging goods and services directly Eliminates the difficulty of “barter”— finding a double coincidence of wants Permits specialization Facilitates efficiency in exchanges The Roles of Money (3) 15-26

27. Store of Value The ability to hold purchasing power over time Money allows you to transfer value (wealth) into the future. A necessary property of money The Roles of Money (3) 15-27

28. Unit of Accounting A measure by which prices are expressed The common denominator of the price system—allows people to compare and measure values A central property of money The Roles of Money (3) 15-28

29. So…What Is Money? • Complete “Activity 34: Money Is What Money Does” • Evaluate each item as to how well it would perform the 3 functions of money. • Be sure to consider portability, uniformity, acceptability, durability and stability in value. 15-29

30. Commodity Money A good used as a medium of exchange that has intrinsic value in other uses (i.e. gold) Commodity-Backed Money A medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods Fiat Money a medium of exchange whose value derives entirely from its official status as means of payment The Types of Money (3) 15-30

31. Fiat Money Advantages: It doesn’t tie up any real resources, except for the paper it’s printed on. The money supply can be managed by the needs of the economy, instead of being determined by the amount of gold and silver. Risks Counterfeiting Inflation The Types of Money (3) 15-31

32. Measuring the Money Supply Money Supply The amount of money in circulation Changes in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP. 15-32

33. Economists use two basic approaches to define and measure money. The transactions approach The liquidity approach Measuring the Money Supply 15-33

34. Transactions Approach A method of measuring the money supply by looking at money as a medium of exchange (a.k.a. “narrow money”) Liquidity Approach A method of measuring the money supply by looking at money as a temporary store of value (a.k.a. “broad money”) Measuring the Money Supply 15-34

35. M1: Transactions approach to measuring money Coin and Currency Transactions deposits (i.e. checking accounts) Traveler’s checks not issued by banks Consists of the most liquid forms of money Measuring the Money Supply 15-35

36. Measuring the Money Supply 15-36

37. M2: Liquidity approach to measuring money Savings deposits Time deposits Money market mutual funds Includes “near moneys” Assets that are almost money Still highly liquid Easily converted to cash Measuring the Money Supply 15-37

38. Measuring the Money Supply 15-38

39. Defining the U.S. Money Supply Question Which definition of money correlates best with economic activity? Answer M2, although some businesspeople and policymakers prefer even broader definitions with further assets added to the definition. 15-39

40. Complete “Activity 35: What’s All This About the M’s?” Measuring the Money Supply 15-40

41. Do Now. • What is Money? • Identify M1 and M2 and explain the difference • List and explain the 3 tasks of the financial system • Speculate on the time value of money. What does that mean?

42. Module 24: The Time Value of Money 42

43. The Time Value of Money Making economic decisions can sometimes be difficult because the benefits and costs of a project may not arrive at the same time. How, specifically is time an issue in economic decision-making? 15-43

44. Borrowing, Lending and Interest In general, having a dollar today is worth more than having a dollar a year from now. The value of money depends on when it is paid or received $1 that is paid to you today is worth more than $1 that is paid to you a year from now. $1 that you must pay today is more burdensome than $1 that you must pay next year. There is a simple way to adjust for these complications so we can correctly compare the value of $ received and paid out at different times 15-44

45. Present Value vs. Future Value Present Value Price of what you are going to be paid or what you are going to pay NOW instead of waiting to be paid or waiting to pay for it in the future Let’s say you win the lottery for $1 million dollars, and are given the choice of receiving the $1 million dollars in two years or receiving something less than $1 million right NOW. Which would you choose? 15-45

46. Present Value vs. Future Value Which would you choose? It depends on… How much you are going to get paid NOW? Lottery officials offer you $910,000 NOW What is the expected interest rate? The expected interest rate for the next 2 years is 5%. Would you take their offer? 15-46

47. Present Value v. Future Value We need to know the formula for present value PV = FV x 1/(1 + r)n r is the interest rate n is the number of years So the present value of $1 million received 2 years from now is: PV = 1,000,000 x 1/(1 + .05)2 PV = $907,029.48 We should take the 910,000 NOW! 15-47

48. Present Value v. Future Value • Future Value • Value at some point in the FUTURE of a present amount of money • Let’s say you put $200 in the bank and it earns 3.5%. If you left this money in the bank, how much would you have in the bank at the end of two years? 15-48

49. Present Value v. Future Value We need to know the formula for future value FV = PV x (1 + r)n r is the interest rate n is the number of years So the future value of $200 in the bank that earns 3.5% left in the bank for 2 years is: FV = 200 x (1 + .035)2 FV = $214.25 15-49

50. Complete “Present and Future Value” http://www.reffonomics.com/TRB/chapter18/presentvalue.html http://www.learner.org/series/econusa/unit20/ Present v. Future Value 15-50