1. THE FINANCIAL SECTOR AND THE DEMAND FOR MONEY
Chapter 27
THE FINANCIAL SECTOR AND THE DEMAND FOR MONEY

2. Today’s lecture will:
Explain why the financial sector is central to almost all macroeconomic debates.
Explain what money is.
Enumerate the three functions of money.
State the alternative measures of money and their primary components.

3. Today’s lecture will:
Explain how banks create money.
Calculate both the simple money multiplier and the money multiplier.
Demonstrate graphically how the long-term interest rate is determined.
Explain why people hold money and how the short-term interest rate is determined in the money market.

4. Why is the Financial Sector Important to Macro?
The financial sector channels savings back into the circular flow.
For every financial asset, there is a corresponding financial liability.
Financial assets – assets such as stocks or bonds, whose benefit to the owner depend on the issuer of the asset meeting certain obligations.
Financial liabilities - obligations by the issuer of the financial asset.

5. The Financial Sector as a Conduit for Savings
Outflow
from
spending
stream
Inflow
from
spending
stream
Large business loans
Small business loans
Venture capital loans
Construction loans
Investment loans
Pension funds
CDs
Savings deposits
Checkable deposits
Stocks
Bonds
Government Securities
Life insurance
Financial Sector
Gov’t
Gov’t
House-
holds
Saving
Loans
House-
holds
Corpor-
ations
Corpor-
ations

6. The Role of Interest Rates in the Financial Sector
The interest rate is the price paid for use of a financial asset.
The long-term interest rate is the price paid for financial assets with long maturities, called loanable funds
The short-term interest rate is the price paid for financial assets with short maturities, called money.

7. Market for Loanable Funds
Interest
rate S 5% 4% D
Quantity of
loanable funds I1 S1

8. The Definition and Functions of Money
Money is a highly liquid financial asset.
Money serves as:
A medium of exchange.
A unit of account.
A store of wealth.

9. The U.S. Central Bank : The Fed
The Federal Reserve Bank (the Fed) is the U.S. central bank.
Federal Reserve notes are liabilities of the Fed that serve as cash in the U.S.
A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms.
Individuals’ deposits in savings and checking accounts serve the same function as does currency and are also considered to be money.

10. Measures of Money Components of M2 Components of M1
Money market mutual funds (15%)
Currency (54%)
Savings deposits (51%)
M1 (28%)
M1 (19%)
Checking accounts (45%)
Small-denomination
time deposits (15%)
Traveler’s checks (1%)

11. Distinguishing Between Money and Credit
Credit cards are not money.
Credit card balances are assets of a bank in the form of a prearranged loan and liabilities of the credit card user.
Generally credit card holders carry less cash.
A debit card is part of the monetary system because it serves the same function as a checkbook.

12. Banks and the Creation of Money
Banks are both borrowers and lenders.
Banks borrow money from people when they accept deposits and use the money they borrow to make loans to others.
Banks make a profit by charging a higher interest rate on the money they lend out than they pay for the money they borrow.
A bank creates money when it places the proceeds of a loan it makes to you in your checking account.

13. The Creation of Money: Step 1
The Fed creates money by simply printing currency.
Currency is a financial asset to the bearer and a liability to the Fed.
The bearer deposits the currency in a checking account at the bank.
The form of money has changed from currency to a bank deposit.

14. The Creation of Money: Step 2
The bank lends a fraction of the deposit.
The amount of money has expanded:
Initial deposit + new loan
The amount of money is multiplied

15. The Money Multiplier
Reserves are cash and deposits a bank keeps on hand or at the Fed.
The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals.
Banks must keep a portion of deposits: required reserve ratio.
Banks can keep more reserves: excess reserve ratio.
Reserve ratio = required + excess.

16. Determining How Many Demand Deposits Will Be Created
To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio.
If the original deposit is $100 and the reserve ratio is 10 percent, the amount of money ultimately created is:
New money created = $ $100 = $900

17. An Example of the Creation of Money

18. What if People Hold Cash
If people hold cash, the money multiplier in the economy is:
r = the percentage of deposits banks hold in reserve
c = the ratio of money people hold in cash to the money they hold as deposits

19. The Demand for Money Transaction motive Precautionary motive
Speculative motive

20. Money Market EquilibriumS
Interest
rate i0 D
Quantity of
money

21. The Housing Bust of 2007
In the early 2000s prices of houses increased by more than 30% per year.
Many people bought houses with sub-prime mortgages.
The housing financial bubble burst in 2007.

22. Summary
The financial sector is the market where financial assets are created and exchanged.
The financial sector channels flows out of the circular flow and back into the circular flow.
Every financial asset has a corresponding financial liability.
The economy has many interest rates. The long-term rate is determined in the market for loanable funds, while the short-term rate is determined in the money market.

23. Summary
Money is a highly liquid financial asset that serves as a unit of account, a medium of exchange, and a store of wealth.
The measures of money are:
M1 – currency in the hands of the public, checking account balances, and traveler’s checks
M2 – M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares
Banks create money by loaning out deposits.

24. Summary The simple money multiplier is 1/r.
The money multiplier tells you the amount of money ultimately created per dollar in the banking system.
The money multiplier when people hold cash is (1+c)/(r+c).
People hold money for the transactions motive, the precautionary motive, and the speculative motive. The demand for money is inversely related to the interest rate.

25. Suppose that the reserve ratio is 20% An initial deposit of $1000 is made.
Review Question What is the simple multiplier?
The simple multiplier is 1/r = 1/.2 = 5
Review Question How much money can ultimately be created (including the initial deposit)?
Total money = $1000 x 5 = $5000
Review Question How much is new money?
New money = $ $1000 = $4000
Review Question If the public’s ratio of currency to demand deposits is 5%, how much money can be created (including the initial deposit)?
Total money = $1000x[(1+.05)/(.2+.05)] = $1000 x 4.2 = $4200