The Financial Sector

Saving, Investment, and the

Financial System
 Savings-investment spending identity:
savings and investment spending are always
equal for the economy as a whole.
 Important Identities
• Remember that GDP can be divided up into 4
components: consumption, investment,
government purchases, and net exports
• Y = C + I + G + NX
• We will assume that we are dealing with a closed
economy (an economy that does not engage in
international trade or international borrowing and
lending). This implies that GDP can now be
divided into only 3 components.
•Y=C+I+G
 Important Identities (cont.)
 To isolate investment, we can subtract C
and G from both sides
 Y–C–G=I
 The left side of this equation (Y–C-G) is
the total income in the economy after
paying for consumption and government
purchases. This amount is called national
saving (saving) – the total income in the
economy that remains after paying for
consumption and government purchases.
 Important Identities (cont.)
 Substitute saving (S) into our
identity gives us: S=I
 This equation tells us that saving

equals investment
 Let’s go back to our definition of

national saving once again:

 S = Y – C - G
 Important Identities (cont.)
 We can add taxes (T) and subtract taxes (T)
 S = (Y-C-T) + (T-G)
 The first part of this equation (Y-T-C) is called
private saving; the second part (T-G) is called
public saving.
• Private saving – the income that households have left
after paying for taxes and consumption
• Public saving – the tax revenue that the government
has left after paying for its spending
• Budget surplus –an excess of tax revenue over
government spending
• Budget deficit – a shortfall of tax revenue from
government spending
 Important Identities (cont.)
 The fact that S=I means that for the
economy as a whole saving must be
equal to investment
• The bond market, stock market, banks,
mutual funds, and other financial
markets and institutions stand between
the two sides of the S=I equation
• These markets and institutions take in
the nation’s saving and direct it to the
nation’s investment
 Open Economy: Savings and
Investments
 Savings of people in one country can
be used to finance investment
spending that occurs in another
country.
 Capital inflow: the net inflow of funds

into a country.
 Can be positive or negative

 Negative if more foreign funds come

into country then leave the country.

 The Meaning of Saving and
Investment
 In macroeconomics, investment
refers to the purchase of new capital,
such as equipment or buildings
 If an individual spends less than he

earns and uses the rest to buys

stocks or mutual funds, economists
call this saving.
 The Meaning of Saving and
Investment
 Private saving is the income
remaining after households pay their
taxes and pay for consumption.
 Examples of what households do with

saving:
• buy corporate bonds or equities
• purchase a certificate of deposit at the bank
• buy shares of a mutual fund
• let accumulate in saving or checking
accounts
 Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
• General Motors spends $250 million to build
a new factory in Flint, Michigan.
• You buy $5000 worth of computer equipment
for your business.
• Your parents spend $300,000 to have a new
house built.

Remember:
Remember: In
In economics,
economics, investment
investment is
is NOT
NOT
the
the purchase
purchase of
of stocks
stocks and
and bonds!
bonds!
A C T I V E L E A R N I N G 1:
Exercise
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300
billion.
 Find public saving, taxes, private

saving, national saving, and

investment.

11
A C T I V E L E A R N I N G 1:
Answers
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

Public saving = T–G = – 0.3

Taxes: T = G – 0.3 = 1.7

Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

Investment = national saving = 1.5

12
A C T I V E L E A R N I N G 1B:
Exercise
 Now suppose the government cuts
taxes by 200 billion.
 In each of the following two scenarios,

determine what happens to public

saving, private saving, national saving,
and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and
spend the other 3/4.
13
A C T I V E L E A R N I N G 1B:
Answers
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged,
so investment is unchanged.
2. If consumers save $50 billion and spend
$150 billion, then national saving and
investment each fall by $150 billion.

14
A C T I V E L E A R N I N G 1C:
Discussion questions
The two scenarios are:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and
spend the other 3/4.
 Which of these two scenarios do you
think is the most realistic?
 Why is this question important?

15
 Financial System
 Financial System – the group of institutions in the
economy that help to match one person’s saving
with another person’s investment
 Where households invest their current savings and
their accumulated savings (wealth)
 Financial institutions in the US economy
• Financial markets – financial institutions through which
savers can directly provide funds to borrowers
 Stock Market
 Bond Market
• Financial intermediaries – financial institutions through
which savers can indirectly provide funds to borrowers
 Banks
 Mutual funds
 Three Tasks of a Financial System
 3 Problems facing borrowers and lenders:
transactions costs, risk, and the desire for
liquidity.
 1) Reducing Transaction Costs
• Transaction costs – the expenses of negotiating
and executing a deal
• Company wants a $1 billion loan, to get 1000
loans from 1000 different people of $1 million
dollars will have a high transaction cost.
• Result: Go to a bank and get a loan or sell bonds
Three Tasks of a Financial System
 2) Reducing Risk
 Financial risk – uncertainty about

future outcomes that involve

financial losses and gains.
 Diversification – investing in several

different assets so that the possible

losses are independent events.
 Most people are risk averse.
 Risk Aversion
 Most people are risk averse – they dislike
uncertainty.
 Example: You are offered the following
gamble.
Toss a fair coin.
• If heads, you win $1000.
• If tails, you lose $1000.
Should you take this gamble?
 If you are risk averse, the pain of losing
$1000 would exceed the pleasure of winning
$1000,
so you should not take this gamble.
 The Utility Function
Utility
Utility
Utility is
is aa
subjective
subjective measure
measure Current
of
of well-being
well-being utility
that
that depends
depends on on
wealth.
wealth.
As
As wealth
wealth rises,
rises, the
the
curve
curve becomes
becomes flatter
flatter
due
due toto diminishing
diminishing
marginal
marginal utility
utility:: the
the Wealth
more
more wealth
wealth aa person
person Current
has,
has, the
the less
less extra
extra wealth
utility
utility he
he would
would get
get
The Utility Function and Risk Aversion
Utility
Utility gain from
winning $1000
Utility loss
from losing
$1000
Because
Because ofof
diminishing
diminishing
marginal
marginal utility,
utility,
Wealth
aa $1000
$1000 loss
loss –1000 +1000
reduces
reduces utility
utility
more
more than
than aa $1000
$1000
gain
gain increases
increases it.it.
Three Tasks of a Financial System
 3) Providing Liquidity
 Liquid asset is an asset that can be

quickly converted into cash without

much loss of value
 Illiquid asset is an asset that cannot

be quickly converted into cash

without much loss of value.
Degrees of Liquidity
 Liquidity
 Liquidity – the ease with which
an asset can be converted into
the economy’s medium of
exchange
 Money is the money liquid asset
available
 Other assets (such as stocks,
bonds, and real estate) vary in
liquidity
 When people decide what forms
to hold their wealth; they have
to balance liquidity of each
possible asset against the asset’s
usefulness as a store of value
 Financial markets
 The Bond Market
 Bond – a certificate of indebtedness

 A bond identifies the date of maturity

and the rate of interest that will be

paid periodically until the loan
matures
 Characteristics of a Bond
 One characteristic that determines a bond’s value
is its term. The term is the length of time until the
bond matures. All else equal, long-term bonds pay
higher rates of interest than short-term bonds
 Another characteristic of a bond is its credit risk,
which is the probability that the borrower will fail to
pay some of the interest or principal. All else equal,
the more risky a bond is, the higher its interest
rate
 Tax treatment. For example, when state and local
governments issue bonds, the interest income
earned by the holders of these bonds is not taxed
by the federal government. This makes these
bonds more attractive; thus, lowering the interest
rate needed to entice people to buy them.
 Financial Markets
 Stock Market
• Stock – a claim to partial ownership in a firm
• The sale of stock is called equity finance, the
sale of bonds to raise money is called debt
finance
• Stocks are sold on organized stock exchanges
(such as the New York Stock Exchange or
NASDAQ) and the prices of stocks are
determined by supply and demand
• The price of a stock generally reflects the
perception of a company’s future profitability
• A stock index is computed as an average of a
group of stock prices
 Financial Assets
 Stock
 Bond
 Loan – a lending agreement between an
individual lender and an individual
borrower.
 Loan-backed securities – an asset created
by pooling individual loans and selling
shares in that pool.
• Example: Mortgage backed securities (MBS)
 Financial Intermediaries
 Banks
• The primary role of banks is to take in deposits
from people who want to save and then lend
them out to others who want to borrow
• Banks pay depositors interest on their deposits
and charge borrowers a higher rate of interest
to cover the costs of running the bank and
provide the bank owners with some amount of
profit
• Banks also pay another important role in the
economy by allowing individuals to use
checking deposits as a medium of exchange
 Financial Intermediaries
 Mutual funds – an institution that sells shares to
the public and uses the proceeds to buy a
portfolio of stocks and bonds
 The primary advantage of a mutual fund is that it
allows individuals with small amounts of money
to diversify
 Mutual funds called “index funds” buy all of the
stocks of a given stock index. These funds have
generally performed better than funds with active
fund managers. This may be true because they
trade stocks less frequently and they do not have
to pay the salaries of fund managers
 Financial Intermediaries
 Pension fund: a type of mutual fund
that holds assets in order to provide
retirement income to its members
• 2009 pension funds in United States
held more than $9 trillion in assets.
 Life insurance company: sells policies
that guarantee a payment to a
policyholder’s beneficiaries when the
policyholder dies.
 Definition and Measurement of
Money
 Money: the set of
assets in an
economy that
people regularly
use to buy goods
and services from
other people.
 Money serves three
functions in our
economy
Types of Money
 The Functions of Money
 Medium of exchange – an item
that buyers give to sellers
when they want to purchase
goods and services
 Unit of account – the yardstick
people use to post prices and
record debts
 Store of value – an item that
people can use to transfer
purchasing power from the
present to the future
 Kinds of Money
Commodity money:
takes the form of a commodity with
intrinsic value
Examples: gold coins, cigarettes in
POW camps

Fiat money:

money without intrinsic

value, used as money
because of government
decree
 Money is the U.S. Economy
 The quantity of money circulating
in the United States is sometimes
called the money stock
 Monetary aggregates - an
overall measure of the money
supply
 Included in the measure of the
money stock are currency,
demand deposits and other
monetary assets
• Currency – the paper bills and coins
in the hands of the public
• Demand deposits – balances in
bank accounts that depositors can
access on demand by writing a check
Credit Cards, Debit Cards, and
Money
 Credit cards are not a form
of money; when a person
uses a credit card, he or she
is simply deferring payment
for the item
 Because using a debit card is
like writing a check, the
account balances that lie
behind debit cards are
included in the measures of
money
 Measures of the U.S. Money Supply
 M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.
M2: everything in M1 plus near moneys
(financial assets that can’t be directly used as a
medium of exchange but can be readily converted
into cash or checkable bank deposits) savings
deposits, small time deposits, money market
mutual funds, and a few minor categories.

The distinction between M1 and M2

will usually not matter when we talk about
“the money supply” in this course.
Composition of the U.S. M1 and M2
Money Supply, 2011
Financial markets coordinate saving and
investment
 Financial decisions involve two elements –
time and risk.
 For example, people and firms must make
decisions today about saving and investment
based on expectations of future earnings,
but future returns are uncertain
 The field of finance studies how people make
decisions regarding the allocation of
resources over time and the handling of risk.
Present Value: Measuring the Time Value
of Money
 The present value of any future
value is the amount today that would
be needed, at current interest rates,
to produce that future sum.
 The future value is the amount of

money in the future that an amount

of money today will yield, given
prevailing interest rates.
Present Value: Measuring the Time Value
of Money
 r = the interest rate expressed in
decimal form
 n = years to maturity

 PV = present value

 FV = future value

 PV(1+r)^n = FV and

 FV/(1+r)^n = PV
 EXAMPLE 1: A simple deposit

 Deposit $100 in the bank at 5% interest.

What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In this example, $100 is the present value (PV).

 In general, FV = PV(1 + r )N
where r denotes the interest rate (in decimal
form).
 Solve for PV to get: PV
PV =
= FV/(1
FV/(1 +
+ rr ))NN
 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In three years, FV = $100(1 + 0.05)3 =
$115.76
 In two years, FV = $100(1 + 0.05)2 = $110.25
 In one year, FV = $100(1 + 0.05) = $105.00
EXAMPLE 2: Investment Decision
Present
Present value
value formula:
formula: PV
PV =
= FV/(1
FV/(1 +
+ rr ))NN
Suppose r = 0.06.
Should General Motors spend $100 million to
build a factory that will yield $200 million in
ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.06)10 = $112 million
Since PV > cost of factory, GM should build it.
 EXAMPLE 2: Investment Decision
Instead, suppose r = 0.09.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.09)10 = $84 million
Since PV < cost of factory, GM should not build it.
 A C T I V E L E A R N I N G 1:
Present value
You are thinking of buying a six-acre
lot for $70,000. The lot will be worth
$100,000 in 5 years.
A. Should you buy the lot if r = 0.05?
B. Should you buy it if r = 0.10?

47
 A C T I V E L E A R N I N G 1:
Answers
You are thinking of buying a six-acre lot for
$70,000. The lot will be worth $100,000 in 5
years.
A. Should you buy the lot if r = 0.05?
PV = $100,000/(1.05)5 = $78,350.
PV of lot > price of lot.
Yes, buy it.

B. Should you buy it if r = 0.10?

PV = $100,000/(1.1)5 = $62,090.
PV of lot < price of lot.
No, do not buy it.
48
 Compounding

 Compounding: the accumulation of a sum

of money where the interest earned on the
sum earns additional interest
 Because of compounding, small differences in
interest rates lead to big differences over
time.
 Example: Buy $1000 worth of Microsoft
stock, hold for 30 years.
If rate of return = 0.08, FV = $10,063
If rate of return = 0.10, FV = $17,450
 The Rule of 70
 The Rule of 70:
If a variable grows at a rate of x
percent per year, that variable will
double in about 70/x years.
 Example:

• If interest rate is 5%, a deposit will double

in about 14 years.
• If interest rate is 7%, a deposit will double
in about 10 years.
 Banks and the Money Supply
 The simple case of 100 percent
reserve banking
 A bank is created as a safe place First National Bank
to store currency; all deposits are
kept in the vault until the
depositor withdraws them. Assets Liabilities
 Bank Reserves – deposits that
banks have received but have not Reserves $100.00 Deposits $100.00
loaned out
 T-account – a tool for analyzing
a business’s financial position by
showing, in a single table, the
business’s assets and liabilities.
 Ex: Suppose that currency is the
only form of money and the total
amount of currency is $100.
 Banks and the Money Supply
 The money supply in this
economy is unchanged by the
creation of a bank
• Before the bank was created, the
money supply consisted of $100
worth of currency
• Now, with the bank, the money
supply consists of $100 worth of
deposits
 This means that, if banks hold all
deposits in reserve, banks do not
influence the supply of money.
 Money Creation with Fractional-
Reserve Banking
 Fractional-reserve banking – a
banking system in which banks
hold only a fraction of deposits
First National Bank
as reserves.
 Reserve ratio – the fraction of
deposits that banks hold as Assets Liabilities
reserves
Reserves $10.00 Deposits $100
 Reserve ratio can be the
required reserves plus the Loans $90.00
excess reserves – a bank’s
reserves over and above its
required reserves.
 Example: Same as before, but Required reserve ratio: the
First National decides to set is smallest fraction of deposits
reserve ratio equal to 10 percent that the Federal Reserve
and lend the remainder of the allows banks of hold.
deposits.
Money Creation with Fractional-
Reserve Banking
 When the bank makes these loans, the money
supply changes.
• Before the bank made any loans, the money supply was
equal to the $100 worth of deposits
• Now, after the loans, deposits are still equal to $100,
but borrowers now also hold $90 worth of currency from
the loans
• Therefore, when banks hold only a fraction of deposits
in reserve, banks create money
 Note that, while new money has been created, so
has debt. There is now new wealth created by
this process.
 The Money Multiplier
 The creation of money does
not stop at this point.
 Borrowers usually borrow
money to purchase something Second National Bank
and then the money likely
becomes redeposited at a
bank. Assets Liabilities
 Suppose a person borrowed Reserves $9.00 Deposits $90.00
the $90 to purchase
something and the funds then Loans $81.00
get redeposited in Second
National Bank. Here is this
bank’s T-account (reserve
ratio is 10%)
 If the $81 in loans becomes
redeposited in another bank,
this process will go on and
on.
 The Money Multiplier
 Each time the money is deposited and a bank
loan is created, more money is created.
 Money multiplier – the amount of money the
banking system generates with each dollar of
reserves
 Money multiplier = 1/reserve ratio
 If we started with a deposit of $100 and a
reserve ratio of 10%, our money multiplier would
be 10. We then multiply the money multiplier 10
by the initial deposit of $100 and our money
supply increased from $100 to $1000 after the
establishment of fractional reserve banking.
 Monetary base – the sum of currency in
circulation and bank reserves.
 A C T I V E L E A R N I N G 1:
Exercise
While cleaning your apartment, you look under
the sofa cushion find a $50 bill (and a half-eaten
taco). You deposit the bill in your checking
account. The Fed’s reserve requirement is 20%
of deposits.

A. What is the maximum amount that the

money supply could increase?
B. What is the minimum amount that the
money supply could increase? 57
 A C T I V E L E A R N I N G 1:
Answers

You deposit $50 in your checking account.

A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200. 58
 A C T I V E L E A R N I N G 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the
money supply could increase?
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply remains unchanged.
59
 Bank Runs and the Money
Supply
 Bank run – a phenomenon in
which many of a bank’s
depositors try to withdraw their
funds due to fears of a bank
failure.
 Bank runs create a large problem
under fractional-reserve banking.
 Since the bank only holds a
fraction of its deposits in reserve,
it will not have the funds to
satisfy all of the withdrawal
requests from its depositors.
 Bank Regulation
 Today depositors are guaranteed through
the Federal Depository Insurance
Corporation (FDIC).
 Deposit Insurance – a guarantee that a

bank’s depositors will be paid even if the

bank can’t come up with the funds, up to a
maximum amount per account
 Currently, the FDIC insures accounts up to

the first $250,000 and can be changed in

2014.
 Bank Regulation
 Capital Requirement: regulators require that the
owners of banks hold substantially more assets
than the value of bank deposits.
 Reserve requirements: rules set by the

Federal Reserve that determine the required

reserve ratio for banks
 Fed can also lend money to banks through the

discount window – an arrangement in which

the Federal Reserve stands ready to lend money
to the banks.
The Federal Reserve System
 Federal Reserve (Fed) –
the central bank of the
United States
 Central bank – an
institution designed to
oversee the banking
system and regulate the
quantity of money in
the economy
 Created in response to
the Panic of 1907
 The Fed’s Organization
 Not part of the U.S. government,
but not a private institution either.
Strange
 The Fed has a Board of Governors
with seven members who serve 14-
year terms
• The Board of Governors has a chairman
who is appointed for a four-year term
• The current chairman is Ben Bernanke
 The Federal Reserve System is
made up of 12 regional Federal
Reserve Banks located in major
cities around the country
The Federal Reserve System
 The Federal Open Market
Committee
 The Federal Open Market
Committee (FOMC) consists of
the 7 members of the Board of
Governors and 5 of the 12
regional Federal Reserve
District Bank presidents
 President of the Federal
Reserve Bank of NY is always
on the FOMC
 The FOMC meets about every
six weeks in order to discuss
the condition of the economy
and consider changes in
monetary policy
 The Federal Open Market
Committee
 The primary way in which the
The primary way in which the
Fed increases or decreases the
supply of money is through
open market operations
(which involve the purchase or
sale of U.S. government bonds)
• If the Fed wants to increase the
supply of money, it creates dollars
and uses them to purchase
government bonds from the public
through the nation’s bond markets
• If the Fed wants to lower the
supply of money, it sells
government bonds from its
portfolio to the public. Money is
then taken out of the hands of the
public and the supply of money
falls.
Open-Market Operations
 Glass-Steagall Act of 1933
 Glass-Steagall Act of 1933 – separated
banks into two catergories commercial
banks and investment banks.
 Commercial banks –accepts deposits

and is covered by deposit insurance.

 Investment bank – trades in financial

assets(stocks and bonds) and is not

covered by deposit insurance.
 Glass-Steagall Act has been repealed
 Savings and Loan Crisis of the
1980s
 Savings and loan (thrift) – type of deposit-taking
bank, usually specialized in issuing home loans.
 Covered by deposit insurance and tightly regulated.
 High inflation in 1970s caused the S&Ls to take losses
due to people taking their money out of their low interest
rate accounts plus the value of assets decreasing
 Congress deregulates so they can get higher returns, but
they take greater risks without regulation.
 S&Ls fail and from 1986 to 1995 federal government
closes over 1000 and costing taxpayers over $124 billion.
 Financial Crisis of 2008
 Declining asset prices from 2000 to 2002 and
the economy going into a recession.
 Fed lowers interest rates to historic lows and

China buying a lot of U.S. drives down the

interest rates.
 Sparking a housing boom.

 Banks start to use subprime lending – lending

to home buyers who don’t meet the usual

criteria for being able to afford their payments.
 Financial Crisis of 2008
 Subprime lending explodes by loan
originators, which then sell these loans as
a security.
 Securitization – pool of loans is assembled

and shares of that pool are sold to

investors.
 Considered safe because no one believed

the whole housing market would collapse

across the entire country at the same
time.
 Financial Crisis of 2008
 Housing prices start to fall in 2006
 The people with subprime mortgages have

trouble paying the mortgage and foreclose

causing the prices to drop further
 Causing the MBS to fall in value and the

banks to lose money

 Banks start to deleverage.

 Leverage – it finances its investments with

borrowed funds.
 Financial Crisis of 2008
 Vicious cycle of deleveraging – takes place
when asset sales to cover losses produce
negative balance sheet effects on other firms
and force creditors to call in their loans, forcing
sales of more assets and causing further
declines in asset prices.
 Firms and households find it hard to borrow
money.
 Fed provides funds for banks and saves some
firms from failures AIG and Bear Stearns.

Functions
One function performed
of the Fed
by the Fed is the
regulation of banks to
ensure the health of
the nation’s banking
system
• The Fed monitors each
bank’s financial condition
and facilitates bank
transactions by clearing
checks
• The Fed also makes
loans to banks when they
want (or need) to borrow
 Functions of the Fed
 The second function of the Fed is to
control the quantity of money
available in the economy
• Money supply – the quantity of money
available in the economy
• Monetary policy – the setting of the
money supply by policymakers in the
central bank
 The Federal Reserve System: The U.S. Central
Bank (cont’d)
 Functions of the Fed
1. Supplies the economy with fiduciary currency
2. Provides a payment-clearing system among banks
 Using the Fedwire

3. Holds depository institutions’ reserves

4. Acts as the government’s fiscal agent
 Fed acts as the government’s banker

5. Supervises depository institutions

6. Regulates the money supply
 Most important task

7. Intervenes in foreign currency markets (tries to keep the value of the

dollar constant – buys/sells dollars)
8. Acts as the “lender of last resort”
 The Way Fed Policy is Currently
Implemented
 At present the Fed announces an interest
rate target
 If the Fed wants to raise “the” interest rate,
it engages in contractionary open market
operations
• Fed sells more Treasury securities than it
buys, thereby reducing the money supply
 This tends to boost “the” rate of interest
 The Way Fed Policy is Currently
Implemented
 Conversely, if the Fed wants to
decrease “the” rate of interest, it
engages in expansionary open
market operations
• Fed buys more Treasury securities,
increasing the money supply
 This tends to lower “the” rate of interest
 The Way Fed Policy is Currently
Implemented
 In reality, “the” interest rates that
are relevant to Fed policymaking:
• Federal funds rate
• Discount rate
• Interest rate on reserves
 The Way Fed Policy is Currently Implemented
 Federal Funds Rate
• The interest rate that depository institutions
pay to borrow reserves in the interbank
federal funds market
 Federal Funds Market
• A private market (made up mostly of banks)
in which banks can borrow reserves from
other banks that want to lend them
• Federal funds are usually lent for overnight
use
 The Way Fed Policy is Currently
Implemented
 Discount Rate
• The interest rate that the Federal Reserve
charges for reserves that it lends to depository
institutions (through the “discount window”)
• Altering the discount rate is a signal to banking
system on the change of policy of the Fed
 Performed first
• It is sometimes referred to as the rediscount
rate or, in Canada and England, as the bank
rate
 The Way Fed Policy is Currently
Implemented
 The interest rate on reserves
• In October 2008, Congress granted the Fed authority to
pay interest on both required reserves and excess
reserves of depository institutions
• If the Fed raises the interest rate on reserves and
thereby reduces the differential between the federal
funds rate and the interest rate on reserves, banks have
less incentive to lend reserves in the federal funds
market
• Raise (Higher) interest rates on reserves, Less lending,
decrease in the money supply
• Lower interest rates on reserves, more lending, increase
in money supply
The Market for Bank Reserves and the Federal Funds
Rate, Panel (a)
The Market for Bank Reserves and the Federal Funds
Rate, Panel (b)

An open market
purchase increases
the supply of
reserves, and thus
lowers the
equilibrium federal
funds rate
 Theory of Liquidity Preference
 Theory of liquidity preference – Keynes’s theory that
the interest rate adjusts to bring money supply and
money demand into balance.
 This theory is an explanation of the supply and demand
for money and how they relate to the interest rate.
 Opportunity cost of holding money is the interest rate.
 Short-term interest rates – interest rates on financial
assets that mature within less than a year.
 Long-term interest rates – interest rates on financial
assets that mature a number of years in the future.
 Money Demand
 Money demand curve – shows the
relationship between the quantity of money
demanded and the interest rate.
 Any asset’s liquidity refers to the ease with that
asset can be converted into a medium of
exchange. Thus, money is the most liquid asset
in the economy.
 The liquidity of money explains why people
choose to hold it instead of other assets that
could earn them a higher return
 However, the return on other assets (the
interest rate) is the opportunity cost of holding
money. All else equal, as the interest rate
rises, the quantity of money demanded will fall.
Therefore, the demand for money will be
downward sloping.
Three Main Motives behind the
Demand for Money
 Transactions Motive
 Speculative Motive

 Precautionary Motive
 Transactions Motive
 Money demand can be transactions demand
for money, money needed for transactions
 Depend on interest rate and level of RDGP

 Interest rate goes up, less money on hand

because more to gain by converting to a

different interest-bearing asset.
 Transactions motive: the desire to hold onto

money for cash-based transactions.

 Speculative Motive
 People choose to hold cash because they want to be
prepared for cash-based investment opportunities
 Rests on the theory that market value of most
interest-bearing bonds is inversely related to interest
rates
 When market interest rates fall, bond values rise;
when market interest rates rise, bond values fall
 Speculative and Transaction motives make the
quantity of money demanded a function of interest
rates.
 Precautionary Motive
 Describes people’s inclination to hold
onto money for unexpected cash
expenses, such as medical bills and
car repairs.
 Kinds of expenses often need to paid

immediately, and less liquid assets

are not much help
 Money Demand
 Suppose real income (Y) rises. Other things equal,
what happens to money demand?
 If Y rises:

• Households want to buy more g&s,

so they need more money.
• To get this money, they attempt to sell some of their
bonds.
 I.e., an increase in Y causes
an increase in money demand, other things equal.
The Downward Slope of the Aggregate-
Demand Curve
 When the price level increases, the quantity of money
that people need to hold becomes larger. Thus, an
increase in the price level leads to an increase in the
demand for money, shifting the money demand curve
to the right.
 For a fixed money supply, the interest rate must rise to
balance the supply and demand for money.
 At a higher interest rate, the cost of borrowing
increases and the return on saving increases. Thus,
consumers will choose to spend less likely to borrow
funds for new equipment or structures. In short, the
quantity of goods and services purchased in the
economy will fall.
 This implies that as the price level increases, the
quantity of goods and services demanded falls. This is
Keynes’ interest-rate effect.
 Shifts of the Money Demand
Curve
 Changes in the Aggregate Price Level
• Price level rises, MD increases shifts right
 Changes in Real GDP
• Rise in RGDP, increases MD, shifts right
 Changes in Technology
• Introduction of ATM caused MD to decrease, shifting
left
 Changes in Institutions
• Banks pay interest on checking accounts, MD
increased and shifted right
 A C T I V E L E A R N I N G 1:
The determinants of money demand

A. Suppose r rises, but Y and P are

unchanged. What happens to
money demand?
B. Suppose P rises, but Y and r are
unchanged. What happens to
money demand?

95
 A C T I V E L E A R N I N G 1:
Answers
A. Suppose r rises, but Y and P are
unchanged. What happens to money
demand?
r is the opportunity cost of holding money.
An increase in r reduces money demand:
Households attempt to buy bonds to take
advantage of the higher interest rate.
Hence, an increase in r causes a decrease
in money demand, other things equal.

96
 A C T I V E L E A R N I N G 1:
Answers
B. Suppose P rises, but Y and r are
unchanged. What happens to
money demand?
If Y is unchanged, people will want
to buy the same amount of g&s.
Since P is higher, they will need
more money to do so.
Hence, an increase in P causes an
increase in money demand, other
things equal.
97
 Money Supply
 The money supply in the economy is controlled
by the Federal Reserve.
 The Fed can alter the supply of money using open
market operations, changes in the discount rate,
and changes in reserve requirements.
 Because the Fed can control the size of the
money supply directly, the quantity of money
supplied does not depend on any other variables,
including the interest rate. Thus, the supply of
money is represented by a vertical supply curve.
 How r Is Determined
MS curve is vertical:
Interes Changes in r do not
t rate MS
affect MS, which is
fixed by the Fed.
r1 MD curve is
downward sloping:
Eq’m a fall in r increases
interest money demand.
rate MD1

M
Quantity fixed
by the Fed
Equilibrium in the Money Market
 The interest rate adjusts to bring money demand and money
supply into balance.
 If the interest rate is higher than the equilibrium interest
rate, the quantity of money that people want to hold is less
than the quantity that the Fed has supplied. Thus, people will
try to buy bonds or deposit funds in an interest bearing
account. This increases the funds available for lending,
pushing interest rates down.
 If interest rate is lower than the equilibrium interest rate, the
quantity of money that people want to hold is greater than
the quantity that the Fed has supplied. Thus, people will try
to sell bonds or withdraw funds from an interest bearing
account. This decreases the funds available for lending,
pulling interest rates up.
 Taking into account the nominal interest rate.
 How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s

demanded.
 Monetary Policy and
Aggregate Demand
 To achieve macroeconomic goals, the Fed can use
monetary policy to shift the AD curve.
 The Fed’s policy instrument is the money supply.
 The news often reports that the Fed targets the
interest rate.
• more precisely, the federal funds rate – which
banks charge each other on short-term loans
 To change the interest rate and shift the AD curve,
the Fed conducts open market operations to
change the money supply.
 Changes in the Money Supply
 Example: The Fed buys government bonds in open-market
operations.
 This will increase the supply of money, shifting the money
supply curve to the right. The equilibrium interest rate will
fall.
 The lower interest rate reduces the cost of borrowing and
the return to saving. This encourages households to
increase their consumption and desire to invest in new
housing. Firms will also increase investment, building new
factories and purchasing new equipment.
 The quantity of goods and services demanded will rise at
every price level, shifting the aggregate-demand curve to
the right.
 Thus, a monetary injection by the Fed increases the money
supply, leading to a lower interest rate, and a larger
quantity of goods and services demanded.
 The Role of Interest-Rate Targets in
Fed Policy
 In recent years, the Fed has conducted policy by
setting a target for the federal funds rate (the
interest rate that banks charge on another for
short-term loans)
• The target is reevaluated every six weeks when the
Federal Open Market Committee meets
• The Fed has chosen to use this interest rate as a target
in part because the money supply is difficult to measure
with sufficient precision.
 Because changes in the money supply lead to
changes in interest rates, monetary policy can be
described either in terms of the money supply or
in terms of the interest rate.
 The Effects of Reducing the Money
Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

 A C T I V E L E A R N I N G 2:
Exercise
For each of the events below,
- determine the short-run effects on output
- determine how the Fed should adjust the
money
supply and interest rates to stabilize output
A. Congress tries to balance the budget by
cutting govt spending.
B. A stock market boom increases household
wealth.
C. War breaks out in the Middle East,
causing oil prices to soar.
106
 A C T I V E L E A R N I N G 2:
Answers
A. Congress tries to balance the
budget by
cutting govt spending.
This event would reduce agg
demand and output.
To offset this event, the Fed should
increase MS and reduce r to
increase agg demand.

107
 A C T I V E L E A R N I N G 2:
Answers
B. A stock market boom increases
household wealth.
This event would increase agg
demand,
raising output above its natural
rate.
To offset this event, the Fed should
reduce MS and increase r to reduce
agg demand.
108
 A C T I V E L E A R N I N G 2:
Answers
C. War breaks out in the Middle East,
causing oil prices to soar.
This event would reduce agg
supply,
causing output to fall.
To offset this event, the Fed should
increase MS and reduce r to
increase agg demand.

109
 Interest Rates and Bond Prices
 Inverse Relationship
 Bond prices increase the interest rate decreases

 If the bond is $1000 and the price is $950 the

interest rate is 5-6%

 If the bond is $1000 and the price is $900 the

interest rate is 11%

 So as the interest rate goes up the price goes

down, as the price goes up the interest rate

goes down.
The Market for Loanable Funds
 Market for loanable funds – the market in
which those who want to save supply funds and
those who want to borrow to invest demand
funds
 Helps us understand
• how the financial system coordinates
saving & investment
• how govt policies and other factors affect saving,
investment, the interest rate
Assume: only one financial market.
• All savers deposit their saving in this market.
• All borrowers take out loans from this market.
• There is one interest rate, which is both the return to
saving and the cost of borrowing.
 Supply and Demand for Loanable
Funds
 The supply of loanable funds comes from
those who spend less than they earn. The
supply can occur directly through the
purchase of some stock or bonds or
indirectly through a financial intermediary
 The demand for loans comes from
households and firms who wish to borrow
funds to make investments. Families
generally invest in new homes while firms
may borrow to purchase new equipment
or to build factories.
 The Slope of the Supply Curve
An increase in
Interest
Rate Supply the interest rate
makes saving
more attractive,
6%
which increases
the quantity of
loanable funds
3% supplied.

60 80 Loanable Funds
($billions)
 The Slope of the Demand Curve
A fall in the interest
Interest
rate reduces the cost
Rate
of borrowing, which
7% increases the quantity
of loanable funds
demanded.
4%

Demand

50 80 Loanable Funds
($billions)
 Supply and Demand for Loanable
Funds
 The price of a loan is the interest rate
• All else equal, as the interest rate rises, the
quantity of loanable funds supplied will
increase
• All else equal, as the interest rate rises, the
quantity of loanable funds demanded will fall
• The supply and demand for loanable funds
depends on the real (rather than nominal)
interest rate because the real rate reflects the
true return to saving and the true cost of
borrowing.
 Supply and Demand for Loanable
Funds
 At the equilibrium, the quantity of funds
demanded is equal to the quantity of
funds supplied
• If the interest rate in the market is greater
than the equilibrium rate, the quantity of funds
demanded would be smaller than the quantity
of funds supplied. Lenders would compete for
borrowers, driving the interest rate down
• If the interest rate in the market is less than
the equilibrium rate, the quantity of funds
demanded would be greater than the quantity
of funds supplied. The shortage of loanable
funds would encourage lenders to raise the
interest rate they charge.
 Equilibrium
The interest rate
Interest adjusts to equate
Rate Supply supply and demand.

The eq’m quantity

5% of L.F. equals
eq’m investment
and eq’m saving.
Demand

60 Loanable Funds
($billions)
 Shifts of the Demand for
Loanable Funds
 Changes in Perceived Business
Opportunities
• If business believes they can make a lot of
money in the future with an investment,
investment will increase shifting the demand
curve to the right
 Changes in the government’s borrowing
• Government deficits increase the government
borrows more money which causes the demand
curve to shift right.
 The Crowding-Out Effect
 The crowding out effect works in the opposite direction.
 Crowding out effect – the offset in aggregate demand that
results when expansionary fiscal policy raises the interest rate
and thereby reduces investment spending
 As we discussed earlier, when the government buys a product
from a company, the immediate impact of the purchase is to
raise profits and employment at that firm. As a result, owners
and workers at this firm will see an increase in income, and
will therefore likely increase their own consumption.
 If consumers want to purchase more goods and services, they
will need to increase their holdings of money. This shifts the
demand for money to the right, pushing up the interest rate.
 The Crowding-Out Effect
 The higher interest rate raises the cost of borrowing and the
return to saving. This discourages households from spending
their incomes for new consumption or investing in new
housing. Firms will also decrease investment, choosing not to
build new factories or purchase new equipment.
 Thus, even though the increase in government purchases
shifts the aggregate demand curve to the right, this fall in
consumption and investment will pull aggregate demand back
toward the left. Thus, aggregate demand increases by less
than the increase in government purchases.
 Therefore, when the government increases its purchases by
$X, the aggregate demand for goods and services could rise
by more or less than $X, depending on whether the multiplier
effect or the crowding out effect is larger.
• If the multiplier effect is greater than the crowding-out
effect, aggregate demand will rise by more than $X.
• If the multiplier effect is less than the crowding-out effect,
aggregate demand will rise by less than $X.
Shifts of the Supply of Loanable
Funds
 Changes in private savings behavior
• Save less supply shifts left
• Save more supply shifts right
 Changes in capital inflows
• More funds flow into the country savings
increase, supply shifts right
• Funds leave a country, savings
decrease, supply shifts left
 Policy 1: Saving Incentives
 Savings rates in the United States are
relatively low when compared with other
countries such as Japan and Germany
 Suppose that the government changes the
tax code to encourage greater saving
• This will cause an increase in saving, shifting
the supply of loanable funds to the right
• The equilibrium interest rate will fall and the
equilibrium quantity of funds will rise
 Thus, the result of the new tax laws would
be a decrease in the equilibrium interest
rate and greater saving and investment
 Policy 1: Saving Incentives
Tax incentives for
Interest saving increase
Rate S1 S2 the supply of L.F.

…which reduces the

5%
eq’m interest rate
4%
and increases the
eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)
 Policy 2: Investment Incentive
 Suppose instead that the government passed a
new law lowering taxes for any firm building a
new factory or buying a new piece of equipment
(through the use of an investment tax credit)
• This will cause an increase in investment, causing the
demand for loanable funds to shift to the right
• The equilibrium interest rate will rise, and the
equilibrium quantity of funds will increase as well
 Thus, the result of the new tax laws would be an
increase in the equilibrium interest rate and
greater saving and investment
 Policy 2: Investment Incentives
An investment tax
Interest credit increases the
Rate S1 demand for L.F.
6%
…which raises the
5% eq’m interest rate
and increases the
D2 eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)
A C T I V E L E A R N I N G 2:
Exercise
Use the loanable funds model to analyze
the effects of a government budget
deficit:
• Draw the diagram showing the initial
equilibrium.
• Determine which curve shifts when the
government runs a budget deficit.
• Draw the new curve on your diagram.
• What happens to the equilibrium values of
the interest rate and investment?
126
A C T I V E L E A R N I N G 2:
Answers A
A budget
budget deficit
deficit reduces
reduces
national
national saving
saving and
and the
the
Interest S2 supply
S1 supply of
of L.F.
L.F.
Rate

…which
…which increases
increases
6% the
the eq’m
eq’m interest
interest rate
rate
5% and decreases the
eq’m quantity of L.F.
and investment.
D1

50 60 Loanable Funds
($billions)
127
 Policy 3: Government Budget
Deficits and Surpluses
 A budget deficit occurs if the
government spends more than it
receives in tax revenue
 This implies that public saving (T-G)

falls which will lower national saving.

• The supply of loanable funds will shift to
the left
• The equilibrium interest rate will rise,
and the equilibrium quantity of funds
will decrease.
 Policy 3: Government Budget
Deficits and Surpluses
 When the interest rate rises, the quantity of
funds demanded for investment purposes falls
 Crowding out – a decrease in investment that
results from government borrowing
 When the government reduces national saving by
running a budget deficit, the interest rate rises
and investment falls.
 Recall from the preceding chapter: Investment is
important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
 Government budget surpluses work in the
opposite way. The supply of loanable funds
increases, the equilibrium interest rate falls, and
investment rises.
 The U.S. Government Debt
 The government finances deficits by
borrowing (selling government bonds).
 Persistent deficits lead to a rising govt
debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s
indebtedness relative to its ability to raise
tax revenue.
 Historically, the debt-GDP ratio usually
rises during wartime and falls during
peacetime – until the early 1980s.
 The Fisher Effect
 Real interest rate is equal to the nominal
interest rate minus inflation rate.
 This, of course, means that:
 NIR = RIR + inflation rate
• The supply and demand for loanable funds
determines the real interest rate
• Growth in the money supply determines the
inflation rate
 When the Fed increases the rate of growth
of the money supply, the inflation rate
increases. This in turn will lead to an
increase in the nominal interest rate.
 The Fisher Effect
 Fisher Effect – the one-for-one
adjustment of the nominal interest
rate to the inflation rate.
• The Fisher effect does not hold in the
short run to the extent that inflation is
unanticipated.
• If inflation catches borrowers and
lenders by surprise, the nominal interest
rate they set will fail to reflect the rise in
prices.
Interest Rates in the Long Run and the
Short Run
 It may appear we have two theories of how
interest rates are determined.
 We said that the interest rate adjusts to balance
the supply and demand for loanable funds.
 Then we proposed that the interest rate adjusts
to balance the supply and demand for money.
 To understand how these two statements can
both be true, we must discuss the difference
between the short run and the long run.
Interest Rates in the Long Run and the
Short Run
 In the long run, the economy’s level of
output, the interest rate, and the price
level are determined by in the following
manner:
• Output is determined by the levels of resources
and technology available.
• For any given level of output, the interest rate
adjusts to balance the supply and demand for
loanable funds
• The price level adjusts to balance the supply
and demand for money. Changes in the supply
of money lead to proportionate changes in the
price level.
Reconciling the Two Interest Rate
Models:
The Interest Rate in the Short Run
Reconciling the Two Interest Rate
Models: The Interest Rate in the Long
Run