Unit 4

Financial Sector: the one-page sheet

4.1 Financial Assets

Financial assets are claims on money or future income: money, bonds and stocks. A bond is a loan to its issuer and a stock is a share of ownership. Assets trade off liquidity, risk and return, and money is the most liquid. The interest rate is the price of borrowing. Because a bond pays a fixed amount, its price moves opposite to market interest rates.

A financial asset is a claim on money or future income: money, bonds (loans to a government or firm) and stocks (shares of ownership).
Assets trade off three things: liquidity (how easily they become money at full value), risk and return. Money is the most liquid and pays little or no interest.
The interest rate is the price of borrowing: the yearly charge as a percent of the amount borrowed, and the reward a lender earns.
A bond pays a fixed amount, so its price moves opposite to market interest rates: rates up, bond prices down.

new bonds pay more than an existing bond with a fixed payment fewer buyers want the existing bond at its old price its price falls until its yield matches the new market rate

financial asset: A claim on money or future income, such as money, a bond or a share of stock. Bonds are loans to the issuer; stocks are shares of ownership. Liquidity is how easily an asset becomes money without losing value.
bond prices and interest rates: The prices of existing bonds move opposite to market interest rates. A bond pays a fixed amount, so when new bonds pay more, buyers pay less for an old one.
interest rate: The price of borrowing: what a borrower pays each year for the use of money, as a percent of the amount borrowed. To a lender it is the reward for lending.

4.2 Nominal v. Real Interest Rates

The nominal interest rate is the rate stated in dollars; the real interest rate is the gain in buying power, the nominal rate minus the expected inflation rate. Lenders add the expected inflation rate to the real return they want, so nominal rates rise when lenders expect more inflation. When inflation turns out higher than expected, fixed-rate borrowers gain and lenders lose, because the real rate actually paid falls.

The nominal interest rate is the rate stated on a loan, in dollars. The real interest rate is the gain in buying power.
Real interest rate = nominal interest rate - expected inflation rate. With a 7% nominal rate and a 3% expected inflation rate, the real rate is 4%.
Lenders build the expected inflation rate into nominal rates, so when lenders expect more inflation, nominal rates rise.
If inflation is higher than expected, fixed-rate borrowers gain and lenders lose; if lower than expected, the reverse.

they add the expected inflation rate to the real return they want, so nominal rates rise the real interest rate actually earned is lower than agreed the borrower gains and the lender loses buying power

nominal interest rate: The interest rate stated on a loan or bond, in dollars, before any adjustment for inflation.
real interest rate: The interest rate adjusted for inflation: the nominal interest rate minus the expected inflation rate. It measures the gain in buying power a lender earns and the true cost of borrowing.

4.3 Definition, Measurement, and Functions of Money

Money is whatever people accept as a medium of exchange, use as a unit of account and hold as a store of value. Modern money is fiat money, valued because the government declares it money and people accept it. M1 counts the most spendable money: currency held by the public and checkable deposits. M2 adds less liquid near-money, such as small time deposits and retail money market funds. Credit cards, stocks and bonds are not money.

Money has three functions: medium of exchange (accepted in payment), unit of account (prices are stated in it) and store of value (it holds buying power over time).
Fiat money has value because the government declares it money and people accept it; commodity money, such as gold, is valued as a good.
M1 is currency held by the public, checkable deposits and other deposits you can withdraw at once. M2 adds small time deposits and retail money market funds.
Credit cards, stocks and bonds are not money: a card is a loan, and stocks and bonds must be sold for money first.

people adopt one thing everyone accepts in trade: money as a medium of exchange prices are stated in it, so money becomes the unit of account people can save it, so it works as a store of value, until high inflation erodes it

money: Anything widely accepted in payment for goods and services. Its three functions are a medium of exchange, a unit of account and a store of value.
M1: M1 is the most spendable money: currency held by the public, checkable deposits and other deposits that can be withdrawn at once. M2 is M1 plus small time deposits and retail money market funds.

4.4 Banking and the Expansion of the Money Supply

Banks hold a fraction of deposits as reserves and lend the rest. Required reserves are deposits times the required reserve ratio, which the central bank sets, and excess reserves are the rest of a bank's reserves. A bank creates money when it lends its excess reserves, because the loan becomes a new deposit. As loans are spent and redeposited, the money supply can grow by up to excess reserves times the money multiplier, 1 / required reserve ratio, less when banks hold extra reserves or people hold cash.

In fractional reserve banking, banks keep part of deposits as reserves and lend the rest. A balance sheet lists assets (reserves, loans, bonds) and liabilities (deposits).
Required reserves = deposits x required reserve ratio. Excess reserves = total reserves - required reserves. One bank can lend its excess reserves.
The money multiplier is 1 / required reserve ratio. The most the money supply can grow is excess reserves x the money multiplier. This is the limited reserves picture: banks hold few reserves beyond the required amount, so the reserve requirement limits lending.
A cash deposit does not change the money supply at first; new money is created when banks lend.

it keeps the required reserves (deposits x ratio) and has excess reserves to lend a new checkable deposit is created, so the money supply rises they lend again, so the money supply can grow by up to excess reserves x 1 / required reserve ratio

fractional reserve banking: A banking system in which banks keep only part of their deposits as reserves (vault cash and deposits at the central bank) and lend out the rest.
balance sheet: A table of what a bank owns (assets: reserves, loans, bonds) and what it owes (liabilities: deposits), with owners' equity balancing the two sides. Also called a T-account.
required reserves: The reserves a bank must hold: its deposits times the required reserve ratio. Excess reserves are any reserves above that amount, which the bank can lend.
money multiplier: The most the money supply can grow for each dollar of new excess reserves: 1 divided by the required reserve ratio. With a ratio of 0.1 it is 10.
money creation: Banks create money when they lend excess reserves, because each loan becomes a new deposit; as loans are spent and redeposited, the money supply expands by a multiple.
money supply: The total amount of money in an economy, usually measured by M1. Banks expand it when they lend, and the central bank influences it.
central bank: The institution that oversees a country's banks and money. In the United States it is the Federal Reserve, which sets reserve requirements and interest rate policy.
limited reserves: A banking system in which banks hold few reserves beyond what the reserve requirement makes them hold, so the requirement limits how much they can lend and the money multiplier applies. The central bank changes interest rates there by changing the quantity of reserves and so the money supply.

4.5 The Money Market

The money market sets the nominal interest rate. Money demand slopes down because the nominal interest rate is the opportunity cost of holding money, and it shifts right when the price level or real GDP rises. The money supply is vertical, set by the central bank. A rise in money demand, or a fall in money supply, raises the nominal interest rate and lowers bond prices; a rise in money supply lowers the rate and raises bond prices.

The money market graph: nominal interest rate on the vertical axis, quantity of money on the horizontal; money demand (MD) slopes down and the money supply (MS) is vertical.
MD slopes down because the nominal interest rate is the opportunity cost of holding money (asset demand).
MD shifts right when the price level or real GDP rises (transaction demand); MS shifts when the central bank changes the money supply.
Rate above equilibrium: people buy bonds, bond prices rise, the rate falls. Below: they sell bonds and the rate rises.

people need more money for transactions, so money demand shifts right people sell bonds to get money, so bond prices fall the nominal interest rate rises until people want to hold the money that exists

money market: The market where the demand for money meets the money supply. Its graph has the nominal interest rate on the vertical axis and the quantity of money on the horizontal axis.
money demand: How much money people want to hold at each nominal interest rate. It slopes down because the interest rate is the cost of holding money (asset demand), and it rises with the price level and real GDP (transaction demand).

4.6 Monetary Policy

Monetary policy is the central bank changing interest rates to shift aggregate demand. With limited reserves, open market operations, the discount rate and the reserve requirement change the money supply, shown on the money market graph. With ample reserves, the Federal Reserve sets administered rates, mainly the interest on reserve balances; on the reserve market graph the flat part of reserve demand moves with them and the policy rate follows, while shifts in reserve supply leave the rate alone. Lower rates raise investment and interest-sensitive consumption, so AD rises; higher rates do the reverse.

Monetary policy is the central bank changing interest rates to shift AD: expansionary (lower rates) for a recessionary gap, contractionary (higher rates) for an inflationary gap.
Limited reserves (money market graph): open market operations (buy bonds to raise the money supply, sell to lower it), the discount rate and the reserve requirement shift MS.
Ample reserves (reserve market graph): the central bank sets administered rates, mainly interest on reserves; the flat part of reserve demand moves with them, and so does the policy rate.
With ample reserves, shifting reserve supply in the flat part leaves the policy rate alone. Always say which framework a question sets.

the flat part of reserve demand moves down, so the policy rate falls other interest rates fall, so investment and interest-sensitive consumption rise aggregate demand shifts right real output and the price level rise and unemployment falls in the short run

ample reserves: A framework in which banks hold so many reserves that reserve supply sits in the flat part of reserve demand, so changing the quantity of reserves does not move the policy rate. The central bank sets the rate with administered rates. Its graph is the reserve market.
policy rate: The interest rate a central bank targets; for the Federal Reserve it is the federal funds rate, what banks charge each other for overnight loans of reserves. With ample reserves it is set by administered rates such as the interest on reserve balances (IORB).
open market operations: The central bank's purchases and sales of government bonds. With limited reserves, buying bonds adds to banks' reserves and the money supply and lowers interest rates; selling bonds does the reverse.
discount rate: The interest rate the central bank charges banks that borrow reserves from it. With limited reserves, a lower discount rate encourages banks to borrow reserves and lend more.
monetary policy: Actions by the central bank to change interest rates and so shift aggregate demand. Expansionary policy lowers rates to fight a recessionary gap; contractionary policy raises them to fight an inflationary gap.

4.7 The Loanable Funds Market

The loanable funds market brings together saving (supply) and borrowing (demand), and its price is the real interest rate. National saving is private saving plus public saving, and public saving is negative when the government spends more than it collects. More government borrowing shifts the demand for loanable funds right, raising the real interest rate and lowering private investment. More private saving shifts supply right, lowering the real interest rate and raising investment.

The loanable funds market: real interest rate on the vertical axis, quantity of loanable funds on the horizontal; supply (SLF) slopes up and demand (DLF) slopes down.
Supply comes from saving: national saving = private saving + public saving, where public saving = tax revenue - government spending.
Demand comes from borrowers: firms that invest, households and a government that spends more than it collects.
More government borrowing shifts DLF right, so the real interest rate rises and private investment falls. More private saving shifts SLF right and lowers the real rate.

the demand for loanable funds shifts right the real interest rate rises borrowing costs more for firms, so the quantity of private investment falls

loanable funds market: The market where savers supply funds and borrowers demand them. Its graph has the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis.
national saving: Private saving (by households and firms) plus public saving (tax revenue minus government spending). It is the main source of the supply of loanable funds.