AB0901 Principles of Economics Lecture 9 Capital Formation, Financial Markets and Money Supply

Prepared by Dr. Sng Hui Ying Lecturer: Ng Beoy Kui abkng@ntu.edu.sg Tel: 63168958

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, All Rights Reserved

Topics to Be Discussed
Saving, Wealth and National Saving Investment and Capital Formation Demand and Supply of Saving Money and Its Uses Commercial Banks and Money Creation Central Bank and Money Supply Money Demand and Money Supply Ref: Frank and Bernanke, Chapters 20,21 & 24
McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, All Rights Reserved

Savings and Wealth

Saving is current income minus spending on current needs Saving rate is saving divided by income Wealth is the value of assets minus liabilities Assets are the value that one owns Liabilities are the debts one owes Balance sheet is a list of assets and liabilities

LO 20 - 1

20-3

Flow Variables and Stock Variables

A flow variables is defined per unit of time Income Spending Saving Wage A stock variable is defined at a point in time Wealth Debt The flow of saving causes the stock of wealth to change Every dollar a person saves adds to his wealth A high rate of saving today leads to an improved standard of living in the future
LO 20 - 1 20-4

National Saving
National savings determines a country's ability to invest in new capital goods Consists of household saving, business saving and government saving Start with the definition of production and income for the economy : Y = C + I + G + NX
Y = aggregate income C = consumption expenditure G = government purchases of goods and services

I = investment spending
LO 20 - 2

NX = net exports
20-5

Calculate National Savings

Assume NX = 0 for simplicity National savings (S) is current income less spending on current needs Current income is GDP or Y Spending on current needs Exclude all investment spending (I) Most consumption and government spending is for current needs For simplicity, we assume all of C and all of G are for current needs S=YCG
LO 20 - 2 20-6

Private Saving
Private saving is household plus businesses saving Household's total income is Y Households pay taxes from this income Government transfer payments increase household incomes Transfer payments are made by the government to households without receiving any goods in return Interest is paid to government bond holders T = Taxes Transfers Government interest payments
LO 20 - 2 20-7

Private Saving
Private saving is after-tax income less consumption SPRIVATE = Y T C Private saving is done by households and businesses Household saving or personal saving is done by families and individuals Business saving makes up the majority of private saving in the US Business saving is revenues less operating costs less dividends to shareholders Business saving can purchase new capital equipment
LO 20 - 2 20-8

Public Saving and National Saving

Public saving is the amount of the public sector's income that is not spent on current needs Public sector income is net taxes Public sector spending on current needs is G SPUBLIC = T G National saving (S) is private savings plus public savings
SPRIVATE + SPUBLIC = (Y T C) + (T G) S=YCG
LO 20 - 2 20-9

The Government Budget

Balanced budget occurs when government spending equals net tax receipts Government budget surplus is the excess of government net tax collections over spending (T G) Budget surplus is public savings Government budget deficit is the excess of government spending over net tax collections Budget deficit is public dissaving

LO 20 - 2

20-10

Three Reasons for Household Saving

1. Life-cycle saving is to meet long-term objectives Purchase a home Retirement Children's college attendance 2. Precautionary saving is for protection against setbacks Medical emergency Loss of job 3. Bequest saving is to leave an inheritance Mainly higher income groups

LO 20- All

20-11

Saving and the Real Interest Rate

Savings often take the form of financial assets that pay a return Bonds Interest-bearing checking CDs Savings Stocks Mutual funds The real interest rate (r) is the nominal interest rate (i) minus the rate of inflation () The increase in purchasing power from a financial asset Marginal benefit of the extra saving

LO 20 - 3

20-12

Explaining US Household Savings Rate

Savings rate may be depressed by Social Security, Medicare, and other government programs for the elderly Mortgages with small or no down payment Confidence in a prosperous future Increasing value of stocks and growing home values Readily available home equity loans Demonstration effects and status goods

LO 20 - 3

20-13

Investment and Capital Formation

Investment is the creation of new capital goods and housing Firms buy new capital to increase profits Cost Benefit Principle Cost is the cost of using the machine or other capital Benefit is the value of the marginal product of the capital

LO 20 - 4

20-14

The Investment Decision

Two important costs Price of the capital goods Real interest rates Opportunity cost of the investment Value of the marginal product of the capital is its benefit Net of operating and maintenance expenses and of taxes on revenues generated Technical innovation increases benefits Lower taxes increase benefits Higher price of the output increases benefits
LO 20 - 4 20-15

Saving, Investment, and Financial Markets

Supply of savings (S) is the amount of savings that would occur at each possible real interest rate (r) The quantity supplied increases as r increases Demand for investment (I) is the amount of savings borrowed at each possible real interest rate The quantity demanded is inversely related to r

LO 20 - 5

20-16

Financial Market
Equilibrium interest rate equates the amount of saving with the investment funds demanded If r is above equilibrium, there is a surplus of savings If r is below equilibrium, there is a shortage of savings
LO 20 - 5

Saving S Real interest rate (%)

r Investment I

S, I Saving and investment

20-17

Technological Improvement
S Real interest rate (%)

F r' r I' E

A A' Saving and Investment

New technology raises marginal productivity of capital Increases the demand for investment funds Movement up the savings supply curve Higher interest rate Higher level of savings and investment

LO 20 - 5

20-18

Government Budget Deficit Increases

S' Real interest rate (%) S

F r' r I

A' A Saving and investment

Government budget deficit increases Reduces national saving Movement up the investment curve Higher interest rate Lower level of savings and investment Private investment is crowded out
20-19

LO 20 - 5

Increase National Saving

Policymakers know the benefits of increased national saving rates Reducing government budget deficit would increase national saving Political problems Increase incentives for households Federal consumption tax Reduce taxes on dividends and investment income Higher national saving rate leads to greater investment in new capital goods and a higher standard of living

LO 20 - 5

20-20

Singapore: Output, Saving and Investment

LO 20 - 5

20-21

Financial System and Allocation of Saving

A successful economy uses its savings for investments that are likely to be the most productive The interest on deposits is one important reason people put savings in banks The financial system improves the allocation of saving Provides information to savers about the possible uses of their funds Help savers share the risks of individual investment projects Risk sharing makes funding possible for projects that are risky but potentially very productive
LO 20 - All 20-22

Financial Intermediaries and Banking System

Financial intermediaries are firms that extend credit to borrowers using funds raised from savers Commercial banks accept deposits from individuals and businesses and make loans Banks gather information, evaluate potential investments, and direct savings to higher-return, more productive investments Banks provide access to credit for small businesses and homeowners When banks make loans, they earn interest which, in turn, is paid to the bank's depositors
LO 20 - All 20-23

Bonds
A bond is a legal promise to repay a debt Each bond specifies Principal amount, the amount originally lent Maturation date, the date when the principal amount will be repaid The term of a bond is the length of time from issue to maturation Coupon payments, the periodic interest payments to the bondholder Coupon rate, the interest rate that is applied to the principal to determine the coupon payments
LO 20 - All 20-24

Bonds
Corporations and governments issue bonds The coupon rate depends on The bond's term 30 days to 30 years; longer term, higher coupon rate The issuer's credit risk Probability the issuer will default on repayment Higher risk, higher coupon rate Tax treatment for the coupon payments Municipal bonds are free from federal taxes Lower taxes, lower coupon rates
LO 20 - All 20-25

Bond Market
Bonds can be sold before their maturation date Market value at any time is the price of the bond Price depends on the relationship between the coupon rate and the interest rate in financial markets A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 Coupon rate is 5% $50 will be paid 1/1/10 $1,050 will be paid 1/1/11 Bond's price on 1/1/10 depends on the prevailing interest rate
LO 20 - All 20-26

Selling a Bond
Offer for sale: a government bond with payment of $1,050 due in one year The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% Pays $1,060 in one year Year-old bond with 5% coupon rate is less valuable than the new bond Price of the used bond will be less than $1,000 (Bond price) (1.06) = $1,050 Bond price = $991 Bond prices and interest rates are inversely related
LO 20 - All 20-27

Stocks
A share of stock is a claim to partial ownership of a firm Receive dividends, a periodic payment determined by management Receive capital gains if the price of the stock increases Prices are determined in the stock market Reflect supply and demand

LO 20 - All

20-28

FortuneCookie.com
New company with estimated dividend of $1 in 1 year Selling price of stock will be $80 in 1 year Interest rate is 6% Value of the new stock is $81 in 1 year (Stock price) (1.06) = $81 Stock price = $76.42 Value would be higher if Dividend were higher Price of stock in one year were higher Interest rate were lower
LO 20 - All 20-29

Risk Premium
Risk premium is the difference between the required rate of return to hold risky assets and the rate of return on safe assets Suppose interest on a safe investment is 6% FortuneCookie.com is risky, so 10% return is required Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64 Risk aversion increases the return required of a risky stock and lowers the selling price
LO 20 - All 20-30

Bond Markets and Stock Markets

Channel funds from savers to borrowers with productive investment opportunities Sale of new bonds or new stock can finance capital investment Like banks, bond and stock markets allocate savings Provision of information on investment projects and their risks Provide risk sharing and diversification across projects Diversification is spreading one's wealth over a variety of investments to reduce risk
LO 20 - All 20-31

Benefits of Diversification
Vikram has $200 to invest in stocks, each $100
Increase in Stock Price per Share Actual Weather Rainy (50%) Sunny (50%) Smith Umbrella +$10 $0 Jones Suntan Lotion $0 +$10

Buy 2 shares of either stock 50% chance of $20 gain and 50% chance of $0 Diversify and buy 1 share of each One stock will be worth $100 and the other will be worth $110 Return is $10 with no risk
LO 20 - All 20-32

Stock and Bond Markets

Savers can put savings into a variety of financial assets Diversification makes risky but potentially valuable projects possible No individual saver bears the whole risk Society is better off A mutual fund is a variety of financial assets sold to the public as shares in a single financial intermediary Diversified asset for the saver Less costly than buying many stocks and bonds directly

LO 20 - All

20-33

Money
Money is any asset that can be used in making purchases Examples include coins and currency, checking account balances, and traveler's checks Shares of stock are not money Money has three principal uses 1. Medium of exchange 2. Unit of account 3. Store of value Money makes barter unnecessary Barter is trading goods directly
LO 20 - All 20-34

Measuring Money
Definitions of money range from narrow to broad
M1 ($B) Currency Demand deposits Other checkable deposits Traveler's checks M2 ($B) M1 Savings deposits Small-denomination time notes Money market mutual funds
LO 20 - All

$1,364.7 $758.1 292.5 307.9 6.2 $7,498.7 $1,364.7 3,903.4 1,224.4 1,006.1
20-35

Commercial Banks Create Money

Republic of Gorgonzola begins with no banking system Government issues 1 million guilders Banks are created to store cash Payments are made by withdrawing cash or writing checks Checks tell bankers of change in ownership of the specified number of guilders Without interest, banks earn profits by charging depositors fees

LO 20 - All

20-36

Consolidated Bank Balance Sheet Part 1

All guilders (g) are deposited
Assets
Currency 1,000,000 g Deposits

Liabilities
1,000,000 g

Bank reserves are cash or similar assets held by banks Used to meet depositors' withdrawals and payments Gorgonzola's banks have 100% reserves 100% reserve banking is when banks' reserves equal 100% of their deposits

LO 20 - All

20-37

Bank Reserves
Cash in a bank's vault is not part of the money supply Unavailable for payments Bank deposits available for use in transactions are part of the money supply Depositing a $100 bill in your checking account does not change the money supply Bankers realize that inflows and outflows from vaults leave some guilders unused Only 10% of deposits are needed for transactions 90% can be lent to borrowers for a fee -- interest

LO 20 - All

20-38

Consolidated Bank Balance Sheet Part 2

Currency held in the vault is the bank reserves
Assets Currency 100,000 g Deposits Liabilities 1,000,000 g

Loans

900,000 g

The reserve deposit ratio is bank reserves divided by total deposits Fractional reserve banking system holds less bank reserves than deposits The reserve deposit ratio is less than 100%

LO 20 - All

20-39

Consolidated Bank Balance Sheet Part 3

Farmers borrow 900,000 guilders to buy supplies Farmers spend the 900,000 guilders which are then deposited in the banks
Assets Currency Loans 1,000,000 g 900,000 g Deposits Liabilities 1,900,000 g

Bank deposits are the entire money supply Loan of 900,000 guilders increased the money supply by 900,000 guilders Banks are again holding excess reserves on deposits of 1,900,000 guilders
LO 20 - All 20-40

Consolidated Bank Balance Sheet Part 4

With deposits of 1,900,000 guilders and a reserve deposit ratio of 10%, banks want only 190,000 guilders in reserves Currently holding 1,000,000 guilders Loan 810,000 guilders
Assets Liabilities

Currency
Loans

1,000,000 g
1,710,000 g

Deposits

2,710,000 g

Loan are spent and re-deposited Excess reserves are created and re-loaned
LO 20 - All 20-41

Consolidated Bank Balance Sheet The End

Expansion of loans and deposits stops when reserves are 10% of deposits 1,000,000 guilders available as reserves Deposits stabilize at 10,000,000 guilders
Assets Liabilities

Currency
Loans

1,000,000 g
9,000,000 g

Deposits

10,000,000 g

Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders

LO 20 - All

20-42

Money Creation
With 10% reserves, each guilder supports 10 guilders in deposits The general case of money creation with fractional reserve banking is Bank reserves = Desired reserve deposit ratio Bank deposits
Solving for bank deposits we get Bank reserves Bank deposits = Desired reserve deposit ratio

LO 20 - All

20-43

Money Supply with Currency and Deposits

Gorgonzola residents hold 500,000 guilders as currency Deposit 500,000 guilders in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000 / 0.10 = 5,000,000 guilders Money supply = 500,000 cash + 5,000,000 deposits = 5,500,000 guilders
Money supply = Currency held by public +

Bank reserves Desired reserve deposit ratio

LO 20 - All 20-44

Money Supply at Christmas

Suppose banks hold $500 billion in reserves and the public hold $500 billion in cash Reserve-deposit ratio = 0.20 Money supply = $500 + (500 / 0.20) = $3,000 As Christmas approaches, consumers reduce bank deposits by $100 billion Banks have $400 billion in reserves; public holds $600 billion cash Money supply = $600 + ($400 / 0.20) = $2,600 Reducing bank deposits reduces the money supply

LO 20 - All

20-45

Singapore: Money Supply

LO 20 - All

20-46

Increasing the Money Supply

An economy has 1,000 shekels in currency and bank reserves of 200 shekels Reserve-deposit ratio = 0.2 Money supply = 1,000 + (200 / 0.2) = 2,000 shekels Central bank pays 100 shekels for a bond held by the public Assume that all 100 shekels are deposited Money supply = 1,000 + (300/ 0.2) = 2,500 shekels 100 shekel increase in reserves leads to a 500 shekel increase in the money supply

LO 20 - All

20-47

Money and Prices

In the long run, the amount of money circulating and the level of prices are closely linked Sustained high inflation rates occur with a comparably high growth rate of the money supply

LO 20 - All

20-48

Money and Inflation in the Long Run

Quantity equation states (M) (V) = (P) (Y) Restatement of the velocity definition The quantity equation relates the money supply to price levels Suppose velocity and real GDP are constant V and Y, respectively The quantity equation becomes
MV=PY An increase in the money supply by a given percentage would increase prices by the same percentage
LO 20 - All 20-49

Demand for Money

The demand for money is the amount of wealth held in the form of money Demand for money is sometimes called an individual's liquidity preference The Cost Benefit Principle indicates people will balance the marginal cost of holding money versus the marginal benefit Money's benefit is the ability to make transactions Quantity of money demanded increases with income Technologies such as online banking and ATMs have reduced the demand for money
LO 20 - All 20-50

Demand for Money

The marginal cost of holding money is the interest foregone Most forms of money pay little or no interest Assume the nominal interest rate on money is 0 Alternative assets such as stocks or bonds have a positive nominal interest rate The higher the nominal interest rate, the smaller the quantity of money demanded Business demand for money is similar to individuals' Businesses hold more than half of the money stock

LO 20 - All

20-51

Demand for Money

Demand for money depends on Nominal interest rate (i) The higher the interest rate, the lower the quantity of money demanded Real income or output (Y) The higher the level of income, the greater the quantity of money demanded The price level (P) The higher the price level, the greater the quantity of money demanded

LO 20 - All

20-52

The Money Demand Curve

Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rate An increase in the nominal interest rate increases the opportunity cost of MD holding money Money (M) Negative slope
LO 20 - All

Nominal interest rate (i)

20-53

The Money Demand Curve

Changes in factors other than the nominal interest rate cause a shift in the money demand curve An increase in demand for money can result from An increase in output Higher price levels Technological advances Financial advances Foreign demand for MD' dollars MD
Nominal interest rate (i) Money (M)
20-54

LO 20 - All

Supply of Money
The central bank controls the supply of money with open-market operations An open-market purchase of bonds by the central bank increases the money supply An open-market sale of bonds by the central bank MS decreases the money supply E i Supply of money is vertical MD Equilibrium is at E
Nominal interest rate (i)
M Money (M)
20-55

LO 20 - All

Equilibrium in the Money Market

Bond prices are inversely related to the interest rate Suppose the interest rate is at i1, below equilibrium Quantity of money demanded is M1, more than the money available To get more money, people MS sell bonds Bond prices go down, E i interest rates rise i1 MD Quantity of money demanded decreases from M1 to M M M Money (M)
Nominal interest rate (i)
1
LO 20 - All 20-56

Central Bank Controls the Money Supply

Initial equilibrium at E Central bank increases the money supply to MS' New equilibrium at F Interest rated decrease to i' to convince the market to hold the new, larger i i' amount of money
Nominal interest rate (i)

MS

MS'

E F MD M M'
Money (M)

LO 20 - All

20-57

Additional Controls over the Money Supply

Open market operations are the main tool of money supply Fed offers lending facility to banks, called discount window lending If a bank needs reserves, it can borrow from the Fed at the discount rate The discount rate is the rate the Fed charges banks to borrow reserves Lending increases reserves and ultimately increases the money supply Changes in the discount rate signal tightening or loosening of the money supply
LO 20 - All 20-58

Additional Controls over the Money Supply

The central bank can also change the reserve requirement for banks The reserve requirement is the minimum percentage of bank deposits that must be held in reserves The reserve requirement is rarely changed The central bank could increase the money supply by decreasing the reserve requirement Banks would have excess reserves to loan The central bank could decrease the money supply by increasing the reserve requirement
LO 20 - All 20-59

Singapore: Interest Rates

LO 20 - All

20-60

References
Frank, R. H., B. S. Bernanke, L. Gan, Chen Kang, Asian Edition, Chapter 20, 21 & 24.

LO 20- All

20-61