Section 5 Lecture December 2016 Mr. Gammie AP Macroeconomics Section 5 Lecture December 2016 Mr. Gammie

MONEY

Module 22: Saving, Investment, and the Financial System

When a firm invests money in machinery, equipment, factories, they usually do so by borrowing money. Where does that money come from?

Simple Economy No gov’t No trade --- all money spent by consumers and firms ends up in another persons pocket as profit

Total Income = Total Spending Total Spending = GDP = C+I+G+Xn

You have $500 of disposable income for the month of December You have $500 of disposable income for the month of December. What can you do with it? MPC + MPS = 1 Spend or Save

Some Math… Total Income = Total Spending Total Income = C + S Total Spending = C + I C + S = C + I Therefore….. S = I

Savings = Investment

+ Government Budget Balance = tax revenue – gov’t spending – transfer payments Budget surplus (+) Budget deficit (-) National Saving = S + BB S = I S = National Saving = Private Saving + BB Surplus – investment increases Deficit – investment decreases

+ Other Countries Capital Inflow = the total inflow of foreign funds minus the total outflow of domestic funds to other countries I = S S = National Saving + Capital Inflow Capital inflow = investment increases Capital outflow = investment decreases

Financial market – where households invest their current savings, accumulated savings, wealth

Three Tasks of a Financial System Reduce Transaction Costs vs. Pork, apples, and bread Supermarket = bank

Three Tasks of a Financial System Reducing Risk Owners can spread risk by selling shares in their company.

Diversification: investing in several assets with unrelated, or independent risks. It allows a business owner to lower his/her total risk of loss. Key Takeaway: The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and the stock market.

Three Tasks of a Financial System Providing Liquidity

Financial Assets Financial Asset: A paper claim that entitles the buyer to future income from the seller. Four Types: Loans Bonds Loan Backed Securities Stocks

Financial Intermediaries Financial Intermediary: an institution that transforms funds gathered from many individuals in financial assets. Three Key Types: Mutual Funds Pension Funds and Life Insurance Companies Banks

Review Question Economists view investment spending as which of the following: Stocks Bonds Spending on physical capital Mutual investment spending Spending on human capital c

Review Question Given: Closed Economy S=I In a closed economy suppose that GDP is $12 trillion. Consumption is $8 trillion, government spending is $2 trillion, and taxes are $0.5 billion. How much is national saving? $2 trillion $3 trillion $3.5 trillion $4 trillion None of the above a

Review Questions Financial markets: Increase transaction costs Reduce diversification Provide liquidity Determine tax rates Are the same as resource markets c

Module 22 Summary The saving investment identity tells us that, in a simple economy without gov’t or foreign trade, that private dollars saved must equal private dollars invested. When the gov’t is included we discover that they can also contribute to the national savings if there is a budget surplus, and can detract from national savings if there is a budget deficit. Money can also flow into Canada from foreign citizens and money can flow out of Canada into foreign economies. This inflow or outflow affects domestic saving and investment. If more money flows into Canada than leaves Canada to other nations, there is a capital inflow. This increases domestic investment. (Vice versa applies). The financial system facilitates transactions between savers and investors and provides three key roles in this process: reducing transaction costs, reducing risk, and increasing liquidity.

Module 23: The Definition and Measurement of Money

Define: money

Average price of a home?

How much is this car?

Money and wealth are often confused, we need to separate money from assets that have value What makes this $20 different from you’re your laptop, cell phone, car, or even tooth brush for that matter? Which one could you bring to the subway across the street to exchange for a sub? --- only the $20 --- that is the key difference.

Defined: money is any asset that can easily be used to purchase goods and services. Of course you could take your laptop, or cell phone and sell it for money then bring that money to subway. Or you could give your cell phone to subway in exchange for a sub. But how many subs will you get? This is barter. Barter is one of the things money reduces the need for.

Roles of Money Medium of Exchange Imagine you have just worked al week in your summer job. Your employer has decided to pay you in apples. They give you 1 bushel of apples, obviously more than you can eat on your own. What would you do with those apples? You could try to sell them, or bring them to another place and try to trade them.

Roles of Money Store of Value As long as there is not rapid inflation, money is a good way to store value. You can put money in your bank account and it will still be useful – essentially be of the same value- -- a week or month later. Cheese maker, store all your value in cheese, cheese will go bad

Roles of Money Unit of Account How much is this house, car, toothbrush? in money? In terms of the other … Value is measured on a consistent scale.

Types of Money Commodity Money ex. Commodity-backed Money ex. Fiat Money ex. https://www.youtube.com/watch?v=ADaY6THQp3Y

Measuring the Money Supply M1: currency and coin in circulation + checking deposits + travelers checks M2: M1 + savings accounts + short term CDs + money market accounts *Review this section in your textbook. CD = certificate of deposit

Review Question Suppose you transfer $500 from your checking account to your savings account. With this transaction M1 _____ and M2 _____. Increased; stayed the same Stayed the same; increased Decreased; stayed the same Decreased; increased Increased; decreased c

Review Question The narrowest definition of money excludes: Currency in the vault at a bank Traveler’s checks Currency in circulation Checkable bank deposits Coins in circulation a

Review Question The medium of exchange function means that money is used: As the common denominator of prices As the common denominator of future payments. To save and earn interest income. To accumulate purchasing power. To pay for goods and services. e

Module 23 Summary Money is not the same as wealth. Money is essentially anything that is easily exchangeable for goods and services. Many things have been used as money by different human civilizations. All successful forms of money must serve as a medium of exchange, a store of value, and unit of account. Two aggregate measures of the money supply are M1 and M2. M1 is the narrowest definition. You will most often work with this definition. M2 adds several other assets, known as near-moneys, that can easily be converted into cash. HW: M22 CYU 1, 2 MC 1-5, FR 2 HW: M23 CYU 1, 3 MC 1-5, FR 2

Module 24: The Time Value of Money

What if you could invest $10,000 now and receive a guaranteed $20,000 later. Is this a good deal?

$1000 If you could have $1000 today or $1000 next year, which would you choose? Today! Why? --- allows me to buy or save today, rather than wait a year to do so If you put $1000 in a bank today, you could have more than $1000 in a year from now

$1 today > $1 tomorrow

Lending Why should you receive interest if you lend money? What would be repayment of $100 after 1 year? What about after 2 years? Loan $100 at 10% interest

In Context Your friend, a borrower, must pay you $21 to compensate you for the fact he has your $100 for 2 years. You, as a saver, could put $100 in the bank today, and two years from now, you would have $121 to spend on goods and services. Therefore, we can say you would be completely indifferent to having $100 today, or $121 2 years from now.

Key Takeaway These are equivalent measures of purchasing power, just measured at two different points in time.

$1.5 billion parsed out in slowly increasing annual intervals, beginning at $22 million and ending at $92 million paid 30 years down the line. The other, more popular possibility, is a fat, one-time lump sum of $930 million.

Defining Present Value To see the difference between dollars today (present value or PV) and dollars 1 year from now (future value or FV) we apply an equation. FV = PV*(1+r) r = interest rate FV = 100*1.10 = 110 Our example … (100*1.1)= 110

Defining Present Value Rearranging the formula we can solve for present value when we know the FV. PV = FV/(1+r) PV = 110/(1+0.1) = 100

1 Year 2 Years 3 Years 20 Years How long are most loans? 1 = 110 2 = 121 3 = 133 20 = 259

PV = FV/(1+r)t FV = PV (1+r)t PV and FV Formulas PV = FV/(1+r)t FV = PV (1+r)t

Applications of PV What if you could invest $10,000 now and receive a guaranteed $20,000 later. Is this a good deal? Maybe! Depends on time and interest rate

Applications of PV $10,000 today or $20,000 10 years from now Interest rate of 8% could be earned if you invest the money. Should you take the 10,000 today, or the $20,000 in 10 years? FV of $10,000 is $21,589.25 PV of $20,000 is $9263.87 Take 19,000 today

Applications of PV Interest rate of 3%

Applications of PV

Applications of PV

M24 Summary Money today is more valuable than the same amount of money in the future. The present value of $1 one year from now is $1/(1+r) The future value of $1 invested today is $1*(1+r) Interest paid on savings and interest charged on borrowing are designed to equate the values of dollars today with the value of future dollars.

Module 25: Banking and Money Creation

The Monetary Role of Banks M1 = currency + coin + traveler’s checks + checking deposits

What Banks Do Banks are financial intermediaries in business to earn a profit. In the process, banks actually do make more money. Banks are a safe place for deposits. Banks offer lending services. Interest is paid or earned.

Banks take liquid assets (cash) and turn them into illiquid assets (homes and capital equipment).

Banks hold a fraction of deposits in reserve, the rest is lent out

T accounts

T Accounts Assets Liabilities Assets and Liabilities

Jim’s Jerseys Assets Liabilities Equipment $50,000 Cloth $10,000 Loan $25,000 Assets and Liabilities

Main Street Bank Assets Liabilities Loans $2,000,000 Cash Reserves $200,000 Deposits $2,000,000 In this example Main street is holding 10% of its deposits in reserve

Bank Regulation Deposit Insurance Capital Requirements Reserve Requirements Discount Window

Determining the Money Supply

How Banks Make Money Eli has $5000 in cash and decides that he needs to open a checking account at Main Street Bank. The t-account shows assets and liabilities of the bank. Has money been created? No, Eli has just moved money from his home to the bank.

How Banks Make Money Main Street keeps 10% of Eli’s deposit in reserve, and makes a $4500 loan to Max so he can buy some furniture at Melanie’s Mega Mart. The loan has the following effect:

How Banks Make Money Melanie Banks at the First Bank of Sherman, so when Melanie receives $4500 from Max for the furniture, she deposits the money at the FBS. The effect on the t-account for FBS is:

How Banks Make Money The FBS must also keep 10% of Melanie’s deposit in reserve, and then can make a $4050 loan to Fekru. How much did the initial deposit of $5000 result in? 5000 increase in M1 vs. 5000+4500+4050 = 13550 increase in M1 Difference = $8550, so the intial deposit of $5000 resulted in an increase in the money supply (M1) of $8550.

Summary Eli deposits $5000. Max borrows $4500 to buy furniture. Melanie receives the payment for her furniture, and then deposits $4500. Fekru borrows $4050.

Money Multiplier Excess reserves = total reserves – required reserves Money Multiplier (MM) = 1/rr rr = reserve ratio What was the money multiplier from our last example? Excess reserves can be lent out 1/0.1 = 10 Therefore the total increase would be $4500 *10 = $45,000

Money Market in Reality In theory 10 In reality 1.9

M25 Summary Banks create money by taking a deposit from one customer (a saver) and lending a fraction of that deposit to another customer (a borrower). Through the process of lending, when money is deposited into a bank, that initial deposit multiplies into an amount much greater than the initial deposit. This is known as the money multiplier.