CUNY Macroeconomic Reflect Key Components of Each Chapter

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Chapter 17 Financial Economics Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Financial Investment • Economic investment • New additions or replacements to the capital stock • Financial investment • Broader than economic investment • Buying or building an asset for financial gain • New or old asset • Financial or real asset LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-2 Compound Interest • Compound interest • Earn interest on the interest • X dollars today = (1 + i)tX dollars in t years • $100 today at 8% is worth: • $108 in one year • $116.64 in two years • $125.97 in three years LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-3 Present Value Model • Present Value of a future amount of money • Calculate what you should pay for an asset today • Asset yields future payments • Asset’s price should equal total present value of future payments • The formula: X (1+ i)t dollars today = X dollars in t years LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-4 Applications • Take the money and run • Lottery jackpot paid over a number of years • Calculating the lump sum value • Salary caps and deferred compensation • Calculating the value of deferred salary payments LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-5 Popular Investments • Wide variety available to investors • Three features • Must pay to acquire • Chance to receive future payment • Some risk in future payments LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-6 Stocks • Represents ownership in a company • Bankruptcy possible • Limited liability rule • Capital gains • Dividends LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-7 Bonds • Debt contracts issued by government and corporations • Possibility of default • Investor receives interest LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-8 Mutual Funds • Company that maintains a portfolio of either stocks or bonds • Currently more than 8,000 mutual funds • Index funds • Actively managed funds • Passively managed funds LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-9 Mutual Funds Continued The 10 Largest Mutual Funds, April 2016 * The letter A indicates funds that have sales commissions and are generally purchased by individuals through their financial advisors. Source: Lipper Performance Report, March 31, 2016 LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-10 Calculating Investment Returns • Gain or loss stated as percentage rate of return • Difference between selling price and purchase price divided by purchase price • Future series of payments also considered into return • Rate of return inversely related to price LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-11 Arbitrage • Buying and selling process to equalize average expected returns • Sell asset with low return and buy asset with higher return at same time • Both assets will eventually have same rate of return LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-12 Risk • Future payments are uncertain • Diversification • Diversifiable risk • Specific to a given investment • Nondiversifiable risk • Business cycle effects • Comparing risky investments • Average expected rate of return • Beta LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-13 Risk Continued • Risk and average expected rates of return • Positively related • The risk-free rate of return • Short-term U.S. government bonds • Greater than zero • Time preference • Risk-free interest rate LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-14 Investment Risks LO7 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-15 The Security Market Line Compensate investors for: • Time preference • Nondiversifiable risk Average expected rate of return = Average expected rate of return = Rate that compensates for time preference if + + Rate that compensates for risk risk premium LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-16 Average expected rate of return The Security Market Line Graph Market Portfolio Security Market Line A Risk-free Asset (i.e., a short-term U.S. Government bond) Risk Premium for The Market Portfolio’s Risk Level of beta = 1.0 if Compensation For Time Preference Equals if 0 1.0 Risk Level (beta) LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-17 The Security Market Line Cont’d Average expected rate of return Risk levels determine average expected rates of return Security Market Line Y Risk Premium for This Asset’s Risk Level of beta = X if Compensation For Time-Preference Equals if 0 LO8 X Risk Level (beta) Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-18 Average expected rate of return Arbitrage and The Security Market Line A Y B f C 0 LO8 Security Market Line X Risk Level (beta) Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-19 The Security Market Line Concluded Average expected rate of return An increase in the risk-free rate SML 2 SML 1 Y2 A After Increase Y2 f2 Y1 A Before Increase Y1 f1 0 X Risk Level (beta) LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-20 SML: Applications • Fed’s expansionary monetary policy led to lower interest rates • SML shifted downward • Slope of SML increased due to increased investor risk-aversion • Stocks fell LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37-21 Index Funds versus Actively Managed Funds • Choice of actively or passively managed mutual funds • After costs, index funds outperform actively managed by 1% per year • Role of arbitrage • Management costs are significant • Index funds are boring — no chance to exceed average rates of return 37-22 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 16 Interest Rates and Monetary Policy Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Interest Rates • The price paid for the use of money • Many different interest rates • Speak as if only one interest rate • Determined by the money supply and money demand LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-2 Demand for Money • Why hold money? • Transactions demand, Dt • Determined by nominal GDP • Independent of the interest rate • Asset demand, Da • Money as a store of value • Varies inversely with the interest rate • Total money demand, Dm LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-3 Rate of interest, i percent Demand for Money Continued (a) Transactions demand for money, Dt (c) Total demand for money, Dm and supply (b) Asset demand for money, Da 10 Sm 7.5 =5 + 5 2.5 Dt 0 50 100 Da 150 200 Amount of money demanded (billions of dollars) 50 100 150 200 Amount of money demanded (billions of dollars) Dm 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-4 Interest Rates Continued • Equilibrium interest rate • Changes with shifts in money supply and money demand • Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-5 Federal Reserve Balance Sheet • Assets • Securities • Loans to commercial banks • Liabilities • Reserves of commercial banks • Treasury deposits • Federal Reserve Notes outstanding LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-6 Federal Reserve Balance Sheet Example April 6, 2016 (in Millions) Assets Liabilities and Net Worth Securities Loans to Commercial Banks All Other Assets $4,243,689 Total $4,484,069 37 240,343 Reserves of Commercial $2,467,091 Banks 263,537 Treasury Deposits 1,400,041 Federal Reserve Notes (Outstanding) 353,400 All Other Liabilities and Net Worth $4,484,069 Total Source: Federal Reserve Statistical Release, H.4.1, April 6,2016, www.federalreserve.gov LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-7 Central Banks LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-8 Four Tools of Monetary Policy 1. 2. 3. 4. Open Market Operations The Reserve Ratio The Discount Rate Interest on Reserves LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-9 Tool #1: Open-Market Operations • Open-market operations • Buying and selling of government securities (or bonds) • Commercial banks and the general public • Used to influence the money supply • When the Fed sells securities, commercial bank reserves are reduced LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-10 Open-Market Operations: Fed Buys Bonds from Commercial Banks Federal Reserve Banks Assets Liabilities and Net Worth + Securities + Reserves of Commercial Banks (a) Securities Assets (b) Reserves Commercial Banks Liabilities and Net Worth -Securities (a) +Reserves (b) LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-11 Open Market Operations: Fed Buys Bonds from Commercial Banks Continued •Fed buys $1,000 bond from a commercial bank New Reserves $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-12 Open Market Operations: Fed Buys Bonds from the Public • Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-13 Open Market Operations: Fed Sells Bonds to Commercial Banks • Fed sells bonds to commercial banks Federal Reserve Banks Assets Liabilities and Net Worth - Securities - Reserves of Commercial Banks (a) Securities Assets (b) Reserves Commercial Banks Liabilities and Net Worth + Securities (a) - Reserves (b) LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-14 Open Market Operations: Fed Sells Bonds to the Public • Same effect as selling bonds to commercial banks LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-15 Repos and Reverse Repos • Collateralized loans • Repo transaction — loan of money in exchange for government bonds used as collateral • Reverse repo — repo in reverse LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-16 Tool #2: The Reserve Ratio • Changes the money multiplier • The discount rate • The Fed as lender of last resort • Short term loans • Term auction facility • Introduced December 2007 • Banks bid for the right to borrow reserves LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-17 The Reserve Ratio Continued Effects of Changes in the Reserve Ratio (6) Money-Creating Potential of Single Bank, = (5) (7) Money-Creating Potential of Banking System (1) Reserve Ratio, % (2) Checkable Deposits (3) Actual Reserves (4) Required Reserves (5) Excess Reserves, (3) - (4) (1) 10 $20,000 $5000 $2000 $3000 $3000 $30,000 (2) 20 20,000 5000 4000 1000 1000 5000 (3) 25 20,000 5000 5000 0 0 0 (4) 30 20,000 5000 6000 -1000 -1000 -3333 LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-18 Tool #3: The Discount Rate • The discount rate • The Fed as lender of last resort • Short term loans LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-19 Tool #4: Interest on Reserves • Law changed in 2008 • Allows banks to pay interest on excess reserves • Can encourage or discourage banks to keep reserves LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-20 Tools of Monetary Policy Summary • Open market operations are the most important • Reserve ratio last changed in 1992 • Discount rate was a passive tool • Interest on reserves LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-21 The Federal Funds Rate • Rate charged by banks on overnight loans • Targeted by the Federal Reserve • FOMC conducts open market operations to achieve the target • Demand curve for Federal funds • Supply curve for Federal funds LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-22 Expansionary Monetary Policy • Economy faces a recession • Lower target for Federal funds rate • Fed buys securities • Expanded money supply • Downward pressure on other interest rates LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-23 Restrictive Monetary Policy • Periods of rising inflation • Increases Federal funds rate • Decreases money supply • Increases other interest rates LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-24 Prime Interest RatePolicy and Monetary Federal Funds Rate LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-25 Taylor Rule • Rule of thumb for tracking actual monetary policy • Fed has 2% target inflation rate • If real GDP = potential GDP and inflation is 2%, then targeted Federal funds rate is 4% • Target varies as inflation and real GDP vary LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-26 Monetary Policy, Real GDP, Price Level • Affect on real GDP and price level • Cause-effect chain • Market for money • Investment and the interest rate • Investment and aggregate demand • Real GDP and prices • Expansionary monetary policy • Restrictive monetary policy LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-27 (a) The market for money Sm1 Sm2 (c) Equilibrium real GDP and the Price level (b) Investment demand Sm3 AS 10 P3 Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP 8 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Dm 6 ID 0 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3 Real GDP (billions of dollars) LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-28 Monetary Policy and Equilibrium GDP Continued (d) Equilibrium real GDP and the Price level (c) Equilibrium real GDP and the Price level AS AS c P3 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Q1 Qf Q3 Real GDP (billions of dollars) a AD3 I=$25 AD4 I=$22.5 AD2 I=$20 AD1 I=$15 Price Level Price Level P3 b P2 Q1 Qf Q3 Real GDP (billions of dollars) LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-29 Expansionary Monetary Policy Effects CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or lowers interest on reserves Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases LO5 Real GDP rises Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-30 Restrictive Monetary Policy Effects CAUSE-EFFECT CHAIN Problem: Inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or raises interest on reserves Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases LO5 Inflation declines Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-31 Evaluation and Issues • Advantages over fiscal policy • Speed and flexibility • Isolation from political pressure • Monetary policy is more subtle than fiscal policy LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-32 Recent U.S. Monetary Policy • Highly active in recent decades • Responded with quick and innovative actions during the recent financial crisis and the severe recession • Critics contend the Fed contributed to the crisis by keeping the Federal funds rate too low for too long LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-33 After the Great Recession • Slow recovery especially in terms of employment • Zero interest rate policy • Zero lower bound problem • Quantitative easing • Forward commitment • Operation Twist LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-34 Problems and Complications • Lags • Recognition and operational • Cyclical asymmetry • Liquidity trap LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-35 The Big Picture Input Resources With Prices Productivity Sources LegalInstitutional Environment Consumption (Ca) Aggregate Supply Levels of Output, Employment, Income, and Prices Aggregate Demand Investment (Ig) Net Export Spending (Xn) Government Spending (G) LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36-36 Less than Zero • European Central Bank set negative interest rates • Idea is to make banks lend more • Existence of a negative lower bound 36-37 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 15 Money Creation Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fractional Reserve System • The Goldsmiths • Stored gold and gave a receipt • Receipts used as money by public • Made loans by issuing receipts • Characteristics: • Banks create money through lending • Banks are subject to “panics” LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-2 Balance Sheet for a Bank • Balance sheet • Assets = Liabilities + Net Worth • Both sides balance • Necessary transactions • Create a bank • Accept deposits • Lend excess reserves LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-3 A Single Commercial Bank: Transaction 1 Vault cash: cash held by the bank Creating a Bank Balance Sheet 1: Wahoo Bank Assets Cash Liabilities and Net Worth $250,000 Stock Shares $250,000 LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-4 A Single Commercial Bank: Transaction 2 Acquiring property and equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Assets Cash Property Liabilities and Net Worth $10,000 Stock Shares 240,000 $250,000 LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-5 A Single Commercial Bank: Transaction 3 Commercial bank functions • Accepting deposits • Making loans Accepting Deposits Balance Sheet 3: Wahoo Bank Assets Cash Property Liabilities and Net Worth Checkable $110,000 Deposits $100,000 240,000 Stock Shares 250,000 LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-6 Required Reserves Depositing reserves in a Federal Reserve bank • Required reserves • Reserve ratio Reserve ratio = Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-7 Reserve Requirements Type of Deposit Current Requirement Statutory Limits Checkable deposits: $0-$15.2 Million $15.2 - $110.2 Million Over $110.2 Million Noncheckable nonpersonal savings and time deposits 0% 3 10 3% 3 8-14 0 0-9 • The Fed can establish and vary the reserve ratio within limits set by Congress • Required reserves help the Fed control lending abilities of commercial banks LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-8 A Single Commercial Bank: Transaction 4 Assume the bank deposits all cash on reserve at the Fed Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Assets Liabilities and Net Worth Cash Reserves $0 Checkable 110,000 Deposits Property 240,000 Stock Shares $100,000 250,000 35-9 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Excess Reserves • Excess reserves • Actual reserves - required reserves • Required reserves • Checkable deposits × reserve ratio • Example: • Checkable deposits $100,000 • Reserve ratio 20% LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-10 A Single Commercial Bank: Transaction 5 Clearing a check • $50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Assets Reserves Property LO2 Liabilities and Net Worth Checkable $60,000 Deposits 240,000 Stock Shares $50,000 250,000 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-11 Money Creating Transactions: Transaction 6a Granting a loan • $50,000 loan made to a customer is deposited to the customer’s checking account When a Loan is Negotiated Balance Sheet 6a: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $60,000 Checkable Deposits 50,000 240,000 Stock Shares $100,000 250,000 LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-12 Money Creating Transactions: Transaction 6b Using the loan • $50,000 loan cashed After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $10,000 Checkable Deposits 50,000 $50,000 240,000 Stock Shares 250,000 A single bank can only lend an amount equal to its preloan excess reserves LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-13 Money Creating Transactions: Transaction 7 Bank buys government securities from a dealer • Deposits payment into checking Buying Government Securities Balance Sheet 7: Wahoo Bank Assets Reserves Securities Property Liabilities and Net Worth $60,000 Checkable Deposits 50,000 240,000 Stock Shares $100,000 250,000 • New money is created LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-14 Profits, Liquidity, and the Federal Funds Market • Conflicting goals • Earn profit • Make loans to earn interest • Buy securities to earn interest • Maintain liquidity • Alternative? • Overnight bank loans • Federal funds rate LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-15 The Banking System • Multiple-deposit expansion • Assumptions: • 20% required reserves • All banks “loaned up” • Banks lend all of their excess reserves • A $100 bill is found and deposited • Multiple deposits can be created LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-16 The Banking System Multiple Bank Expansion (3) Excess Reserves (1) - (2) (1) Acquired Reserves and Deposits (2) Required Reserves Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 Bank (4) Amount Bank Can Lend; New Money Created = (3) The process will continue… LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-17 Multiple Bank Expansion Illustration Bank (1) Acquired Reserves and Deposits Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks LO4 $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1) - (2) $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-18 The Monetary Multiplier Monetary multiplier = 1 required reserve ratio = 1 R LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35-19 The Monetary Multiplier Continued • Maximum amount of new money created by a single dollar of excess reserves • Higher R, lower m • Reversibility • Making loans creates money • Loan repayment destroys money 35-20 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Banking, Leverage, and Financial Instability • Leverage is the use of borrowed money to magnify profits and losses • Modern banks use lots of leverage • Thus small losses can drive banks into insolvency 35-21 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 14 Money, Banking, and Financial Institutions Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Functions of Money • Medium of exchange • Used to buy and sell goods • Unit of account • Goods valued in dollars • Store of value • Hold some wealth in money form • Money is liquid LO1 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-2 Money Definition M1 • M1 • Currency • Checkable deposits • Institutions offering checkable deposits • Commercial banks • Savings and loan associations • Mutual savings banks • Credit unions LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-3 Money Definition M2 • M2 • M1 plus near-monies • Savings deposits including money market deposit accounts (MMDA) • Small-denominated time deposits • Money market mutual funds (MMMF) LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-4 Money Definitions LO2 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-5 What “Backs” the Money Supply? • Guaranteed by government’s ability to keep value stable • Money as debt • Why is money valuable? • Acceptability • Legal tender • Relative scarcity LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-6 What “Backs” the Money Supply? Continued • Prices affect purchasing power of money • Hyperinflation renders money unacceptable • Stabilizing money’s purchasing power • Intelligent management of the money supply — monetary policy • Appropriate fiscal policy LO3 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-7 Federal Reserve — Banking System • Historical background • Board of Governors • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Banker’s bank LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-8 Federal Reserve — Banking System Continued Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-9 Federal Reserve Banks The 12 Federal Reserve Banks LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-10 Federal Reserve — Banking System Concluded • Federal Open Market Committee • Aids Board of Governors in setting monetary policy • Conducts open market operations • Commercial banks and thrifts • 6,000 commercial banks • 8,500 thrifts LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-11 Financial Institutions LO4 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-12 Federal Reserve Functions • Issue currency • Set reserve requirements • Lend money to banks • Collect checks • Act as a fiscal agent for U.S. government • Supervise banks • Control the money supply LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-13 Federal Reserve Independence • Established by Congress as an independent agency • Protects the Fed from political pressures • Enables the Fed to take actions to increase interest rates in order to stem inflation as needed LO5 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-14 The Financial Crisis of 2007 and 2008 • Mortgage Default Crisis • Many causes • Government programs that encouraged home ownership • Declining real estate values • Bad incentives provided by mortgagebacked bonds LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-15 The Financial Crisis of 2007 and 2008 Continued • Securitization — the process of slicing up and bundling groups of loans into new securities • As loans defaulted, the system collapsed • “Underwater” homeowners abandoned homes and mortgages LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-16 The Financial Crisis of 2007 and 2008 — Failures • Failures and near-failures of financial firms • Countrywide: second largest lender • Washington Mutual: largest lender • Wachovia • Other firms came close LO6 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-17 The Financial Crisis of 2007 and 2008 — Fiscal Response • Troubled Asset Relief Program (TARP) • Allocated $700 billion to make emergency loans • Saved several institutions from failure LO7 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-18 Post-Crisis U.S. Financial Services • Major categories of financial institutions • Commercial banks • Thrifts • Insurance companies • Mutual fund companies • Pension funds • Securities firms • Investment banks LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-19 Major Categories of Financial Institutions LO8 Institution Description Examples Commercial Banks State and national banks that provide checking and savings accounts and make loans JP Morgan Chase, Bank of America, Citibank, Wells Fargo Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans Charter One, New York Community Bank Insurance Companies Firms that offer policies through which individuals pay premiums to insure against lose Prudential, New York Life, Northwestern Mutual, Hartford Mutual Fund Companies Firms that pool customer deposits to purchase stocks or bonds Fidelity, Vanguard, Putnam, Janus, T Rowe Price Pension Funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits TIAA-CREF, Teamsters’ Union, CalPERs Securities Firms Firms that offer security advice and buy and sell stocks and bonds for clients Merrill Lynch, TD Ameritrade, Charles Schwab Investment Banks Firms that help corporations and governments raise money by selling stocks and bonds Goldman Sachs, Morgan Stanley, Deutsche Bank, Credit Suisse Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-20 Post-Crisis U.S. Financial Services Continued • Wall Street Reform and Consumer Protection Act • Passed to help prevent many of the practices that led to the crisis • Critics say it adds heavy regulatory costs LO8 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34-21 Extend and Pretend • Fed had to act as lender of last resort for both solvent and insolvent firms • Increased moral hazard 34-22 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Explanation & Answer

Attached.

Key Components of Chapters -Outline
Thesis: The chapter deals with the functions of money and definitions of the money supply. The
main functions of money include its use as a medium of exchange, a unit of account and store of
value.
The paper analyzes various chapters as follows:
I.

Chapter 14

II.

Chapter 15

III.

Chapter 16

IV.

Chapter 17


Running head: KEY COMPONENTS OF CHAPTERS

Key Components of Chapters
Name
Institution

1

KEY COMPONENTS OF CHAPTERS

2

Key Components of Chapters
Chapter 14
The chapter deals with the functions of money and definitions of the money supply. The
main functions of money include its use as a medium of exchange, a unit of account and store of
value. Money can either be in the form of currency or checkable deposits offered by commercial
banks, mutual savings banks, credit unions and savings and loan associations. Money is backed
by the guarantee of the government's ability to keep value stable. Money is therefore valuable
due to its ...


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