Financial Sector

A . Money, banking and financial markets

1 . Definition of financial assets: money, stocks, bonds

Money-Anything can considered money but it should have these qualities:

i. Medium of exchange-used to make a purchase

ii. Unit of account-a way to value goods and services

iii. Store of value-maintains the value stated on the currency

Stocks-are sold by firms to create financial capital and in return shareholders become part owners.

Bonds-are loans given to firms in exchange for interest income

2 . Time value of money (present and future value)

Money today is more valuable than the same amount of money in the future

Present value-The present value of $1 received t years from now is $1/(1+r)t

Future value-The future value, after t years of time, of $1 invested today is $1*(1+r)t

3 . Measures of money supply

M1=Currency & checkable deposits

M2=M1 + savings

4 . Banks and creation of money

A bank accepts deposits from customers. Deposits create reserves.

A reserve requirement demands banks to keep 10% of their deposits as cash in their own vault or at the Fed vaults.

Excess reserves (reserves that exceed the requirement) can be loaned out or used to purchase government bonds.

The process of deposits to create loans is called the expansion of deposits.

Examples of the reserve ratio(rr) and the money multiplier (1/rr):

If a new $1,000 is deposited it can multiply through the banking process

5 . Money demand

The demand for money varies inversely with the NOMINAL interest rate

Four main determinants of demand (shifters):

1. Changes in the Aggregate Price Level-inflation

2. Changes in Real GDP-economic growth

3. Changes in Technology-ex. online banking

4. Changes in Institutions

6 . Money market

Interaction of the banks and the Fed.

Money supply is controlled by the Fed and does not have a relationship to the NOMINAL interest rate.

The Fed can decrease the NOMINAL interest rate by buying bonds-increases the money supply

The Fed can increase the NOMINAL interest rate by selling bonds-decreases the money supply

7 . Loanable funds market

Interaction of customers (households and businesses) demanding loans and the reserves of banks (supply).

The loanable funds REAL interest rate is based on the nominal interest rate + the expected rate of inflation.

Higher interest rates slow borrowing and spending and lower interest rates increase borrowing and spending.

B . Central bank and control of the money supply

1 . Tools of central bank policy

Central banks like the Federal Reserve has three main tools:

i. Open market operations-banks borrowing from each other

ii. Discount rate-banks borrowing from the Fed

iii. Reserve ratio

2 . Quantity theory of money

Money Supply (M) X Velocity (V) = Price X Quantity (nominal GDP)

The equation states, for example, if the velocity of money decreases the Fed should increase the money supply to increase nominal GDP.

3 . Real versus nominal interest rates

Fisher Equation:

Real interest rates=nominal interest rates - inflation.

Nominal interest rates do not account for inflation.