04 04 2011 CHAPTER 13 Financial Institutions The financial system the group of institutions that helps match the saving of one person with the investment of another Financial markets institutions through which savers can directly provide funds to borrowers o The bond market o The stock market Bond a certificate of indebtedness Stock a claim to partial ownership in a firm Financial intermediaries institutions through which savers can indirectly provide funds to borrowers o Banks o Mutual funds institutions that sell shares to the public and use the proceeds to buy portfolios of stock and bonds Different kinds of saving Private saving the portion of households income that is not used for consumption or paying taxes Y T C T G Public saving tax revenue less government spending government purchases private saving public saving National saving the portion of national income that is not used for consumption or Y T C T G Y C G CHAPTER 16 The 3 Functions of Money present to the future The 2 Kinds of Money o Ex the U S dollar The Money Supply Medium of exchange item buyers give to sellers when they want to purchase g s Unit of account the yardstick people use to post prices and record debts Store of value an item people can use to transfer purchasing power from the Commodity money takes the form of a commodity with intrinsic value o Ex Gold coins cigarettes in POW camps Flat money money without intrinsic value used as money because of govt decree Money supply or money stock the quantity of money available in the economy What assets should be considered part of the money supply Two candidates o Currency the paper bills and coins in the hands of the non bank public o Demand deposits balances in bank accounts that depositors can access on demand by writing a check Measures of the U S Money Supply M1 currency demand deposits traveler s checks and other checkable deposits M2 everything in M1 plus saving deposits small time deposits money market o M1 1 4 trillion October 2005 mutual funds and a few minor categories o M2 6 6 trillion October 2005 money supply in this course The distinction between M1 and M2 will usually not matter when we talk about the Central banks Monetary policy Central bank an institution that oversees the banking system and regulates the Monetary policy the setting of the money supply by policymakers in the central money supply bank Federal Reserve Fed the central bank of the U S Bank Reserves In a fractional reserve banking system banks keep a fraction of deposits as reserves and use the rest to make loans The Fed establishes reserve requirements regulations on the minimum amount of reserves that banks must hold against deposits Banks may hold more than this minimum amount if they choose The reserve ratio R fraction of deposits that banks hold as reserves total reserves as a percentage of total deposits Bank T account T account a simplified accounting statement that shows a bank s assets liabilities Banks liabilities include deposits assets include loans reserves The Money Multiplier Money multiplier the amount of money the banking system generates with each dollar of reserves 1 R bonds by the Fed The Fed s 3 tools of Monetary Control 1 Open Market Operations OMOs the purchase and sale of U S government o To increase money supply Fed buys govt bonds paying with new dollars Which are deposited in banks increasing reserves Which banks use to make loans causing the money supply to expand o To reduce money supply Fed sells govt bonds taking dollars out of circulation and the process works in reverse o OMOs are easy to conduct and are the Fed s monetary policy tool of choice 2 Reserve Requirements RR affect how much money banks can create by making loans o to increase money supply Fed reduces RR Banks make more loans from each dollar of reserves which increases money multiplier and money supply o to reduce money supply Fed raises RR and the process works in reverse o Fed rarely uses reserve requirements to control money supply frequent changes would disrupt banking 3 The Discount Rate the interest rate on loans the Fed makes to banks o When banks are running low on reserves they may borrow reserves from the Fed o To increase money supply Fed can lower discount rate which encourages banks to borrow more reserves from Fed o Banks can then make more loans which increases the money supply o To reduce money supply o the Fed often uses discount lending to provide extra liquidity when financial institutions are in trouble such as after the stock market crash of Oct 1987 Fed can raise discount rate The Federal Funds Rate excess reserves On any given day banks with insufficient reserves can borrow from banks with The interest rate on these loans is the federal funds rate Many interest rates are highly correlated so changes in the fed funds rate cause changes in other rates and have a big impact in the economy The FOMC uses OMOs to target the fed funds rate So fed funds rate policy monetary policy are connected To raise fed funds rate Fed sells govt bonds OMO o This removes reserves from the banking system reduces the supply of fed funds causes rff to rise Problems controlling the Money Supply If households hold more of their money as currency banks have fewer reserves make fewer loans money supply falls If banks hold more reserves than required they make fewer loans money supply falls Yet Fed can compensate for household bank behavior to retain fairly precise control over the money supply CHAPTER 17 The Value of Money P the price level o P is the price of a basket of goods measured in money o 1 P is the value of 1 measured in goods inflation drive up prices and drives down the value of money In real world determined by Federal Reserve the banking system consumers In this model we assume the Fed precisely controls MS and sets it at some fixed Money Supply MS amount Money Demand MD Refers to how much wealth people want to hold in liquid form Depends on P o An increase in P reduces the value of money so more money is required to buy g s Thus quantity of money demanded is negatively related to the value of money and positively related to P other things equal other things real income interest rates The Money Supply Demand Diagram Diagram on slide 3 As the value of money rises the price level falls The Fed sets MS at some fixed value regardless of P A fall in value of money or increase in P increases the quantity of money demanded P adjusts to equate quantity of money demanded with money
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