Banks and Financial Sector

What is a bank? On the whiteboard at the front of the room, write down a phrase or word that describes a bank

Definition A bank is a financial institution that uses bank deposits to finance investments

Huh? Banks receive deposits from savers (households) and loans them out to investors (firms). Banks earn profits by making loans They loan out most (NOT ALL) deposits they receive They have to keep some money in stock in order for customers to withdraw their funds whenever needed

I Know What You’re Thinking… Mary Poppins People don’t usually ask for all of their money out of a bank all at once Which is why banks are able to loan out money for investments

Useful Terms Demand Deposits = a deposit of money that can be withdrawn without prior notice Reserves = the fraction of deposits that banks keep on hand (in their vault or in the Federal Reserve) Required Reserves = banks are required by law to keep a certain minimum fraction of their deposits on reserve Excess Reserves = any reserves in excess of the required ones Fractional Reserves = when banks keep only a fraction of their deposits and loan out the rest

More Useful Terms Assets = a resource with economic value that an individual, company or country owns/controls with the expectation it will provide future benefit Includes loans, deposits within the Federal Reserve, stocks and bonds Liabilities = a company’s legal debts or obligations that arise during the course of business Settled through a transfer of economic benefits (money, goods, or services)

Deposit Expansion Multiplier The Deposit Expansion Multiplier determines how much money can be created in the economy from an initial deposit DEM = 1 rr Rr = the reserve requirement

Expansion of the Money Supply Expansion of the money supply = excess reserves x the multiplier (DEM) Remember = Excess reserves is the money that is loaned out of the bank

Let’s try it! Let’s say there’s a $5,000 deposit into a bank with a 10% required reserve The DEM is 1/0.1= 10 ASSETS__________________________LIABILITIES Loans $4,500 Deposits $5,000 Reserves $500 EMS = $4,500 x 10 = $45,000 Is this M1, M2, or M3? M1

Mr. Clifford Mr. Clifford Mr. Clifford 2

Time Value of Money Money changes! Why? Interest rates and value of the dollar! PV = FV / (1 + r)ⁿ PV = present value FV = future value R = rate of interest per period n = number of compounding periods per year

Useful Term Compounded = “to add to” In reference to compounded interest, it means that interest is added on top of interest It accumulates over time

Example Part 1 What happens in a year if you put $3,000 into a savings account now and it has a compounded interest of 3%? $3,000 (1 + 0.03) $3,090

Example Part 2 Calculate what $3,000 deposit into a savings account will be worth after 1 year if the current interest rate is 3%. PV = $3,000 / (1 + 0.03)¹ PV = $3,000 / (1.03) Answer = $2912.62 The value dropped because the dollar value isn’t worth the same in the future

Example Part 3 What will the same $3,000 be worth after two years if compounded interest rates are 3%? $3,000 (1.03)² $3,182.70

Stock Market Definition = the market where publicly held companies’ shares are traded or exchanged One of the most vital components of a free- market economy Investors get a “slice” of ownership in the company Stock Market

Functions of a Financial System 1) Reduce transaction costs The costs of negotiating and executing a legal deal 2) Reduce financial risk People are more willing to invest if the risk is minimized 3) Provide liquidity Liquid investments can be turned into cash easily

Stocks Stocks have value because of their ability to generate future income Companies pay interest, or dividends, to shareholders Shareholders can sell their stock for profit as well A stock’s price is determined by expectations of the future If a stock’s future looks good = demand increases, supply decreases If a stock’s future looks bad = demand decreases, supply increases

So, what’s the Dow Jones? The Dow Jones is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ (National Association of Securities Dealers Automated Quotations) Dow Jones Nasdaq

The DOW The Dow includes: 3M, American Express, Apple, Boeing, Caterpillar, Chevron, Cisco Systems, Coca- Cola, DuPont, Exxon Mobile, General Electric, Goldman Sachs, The Home Depot, Intel, IBM, Johnson & Johnson, JP Morgan Chase, McDonald’s, Merck, Microsoft, Nike, Pfizer, Procter & Gamble, Travelers, UnitedHealth Group, United Technologies, Verizon, Visa, Wal-Mart, Walt Disney