Chapter 19&22

Chapter 19&22
The Financial System,

Money, Interest Rates, and the
Price Level
“Will dumping money from a helicopter improve a country’s standard of
living?”
1
©2012 The McGraw-Hill Companies, All Rights Reserved
Learning Objectives
1. Discuss the structure of the financial system and its two

most important markets: The bond market and the stock
market
2. Understand the role of financial intermediaries such as banks
and mutual funds
3. Learn the definition and functions of money in the economy
4. Understand the role of banks and the Central Bank in the
money supply process
5. Learn the basics of the neo-Keynesian school of thought
(also known as the Keynesian Macro-model)
6. Understand the role of monetary policy
7. Learn the basics of the neo-Classical school of thought (also
known as the Classical Macro-model).
2
The Financial System
 The financial system is the group of institutions in

the economy that help to match one person’s
savings with another person’s investment.
 Savings and investments are key ingredients of

long-run economic growth.
3
Financial Markets
 Financial markets are the institutions within the

financial system through which a person who
wants to save can directly supply funds to persons,
firms, or government who require funds to make
investments. The two most important financial
markets are:
 1.- The bond market

 2.- The stock market
4
The Bond Market
 When a firm wants to borrow to finance construction of a

new factory, it can raise funds by borrowing directly from
the public. It does this by selling bonds. A bond is a
certificate of indebtness that specifies it’s obligation to the
holder of the bond (the buyer). The bond identifies the
amount borrowed, the time at which the firm will repay the
loan, called the date of maturity and the rate of interest
(called the coupon rate) that will be paid periodically until
the loan matures.
 To the holder (or the lender), the bond represents an asset.
5
Interested in Buying a Bond Today?
 Option 1: An old $ 1,000 face value government bond

with 5% per year coupon rate with one year left to
maturity.
 Option 2: a new one-year government bond with face
value of $1,000 and coupon rate of 6%.
 Calculate the PV of the bonds in option 1 and 2 (think of
your opportunity cost). The PV is the maximum you are
willing to pay.
 Other things equal, what is the maximum you are willing
to pay for the bond in option 1, so that you earn the 6%
offered by the coupon of bond in option 2?
 Bond prices and interest rates are inversely related.
6
The Stock Market
 Another way a firm can raise funds is to sell

company’s stock. Stocks are certificates of
ownership in a firm and is, therefore, a claim to
the profits that the firm makes. If a firms sells
1,000,000 shares of stocks, each stock represents
ownership of 1/1,000,000.
7
Interested in Buying a Share of Stock Today?
 The estimated price per share one year from today is $80 (today’s
price), and the company expects to earn $1 per share in one year.
 Thus, to you, the value the stock is expected to be $81 in one year.
How much is the maximum you should pay for the stock today if
your opportunity cost is 6% per year? In other words, what is the
PV of this stock?
 FV = PV (1 + i)n
(Stock price today) (1.06) = $81
Stock price today = $76.42
 Value of stock today would be higher if
 Expected earning per share was higher
 Price of stock in one year were higher
 Opportunity cost (or interest rates) were lower
8
Riskiness and Stock Prices
 Suppose interest on a safe investment is 6%.

 Assume that a10% return is required on a risky investment.
 If the estimated stock price one year from today is $80 with
expected earning per share of $1 in one year is risky, how
much are you willing to pay for the stock today?
 (Stock price today) (1.10) = $81
Stock price today = $73.64
 Risk aversion increases the return required of a risky stock thus
lowering the selling price.
9
Financial Intermediaries
 Financial intermediaries are financial institutions

through which savers can indirectly provide funds
to borrowers. The two most important financial
intermediaries are:
 1.- Banks
 2.- Mutual funds
10
Banks
 Small business owners (small firms) may find difficult

to borrow or raise funds from the bond or stock
markets. Most buyers of stocks and bonds prefer to
buy those issued by larger, more familiar companies.
 A small business owner is more likely to get the funds

from a bank.
 The primary job of banks is to take in deposits from

people who want to save and use these deposits to
make loans to firms who wants to borrow.
11
Mutual Funds
 A mutual fund is an institution that sells shares to

the public and uses the proceeds to buy a
selection, or portfolio, of various types of stocks,
bonds, or both.
12
Money
 Money is the set of assets in the economy that
people regularly use to buy goods and services
from other people.
 According to the economists definition, money

includes only those few types of assets that are
regularly accepted by sellers in exchange for goods
and services.
13
The Functions of Money
 Money has three functions in the economy:

 1.- A medium of exchange
 2.- A unit of account
 3.- A store of value
14
The Kinds of Money
 When money takes the form of a commodity with

intrinsic value, it is called commodity money. The
term intrinsic value means that the item has value
even if it is not used as money. (i.e., gold coins).
 Money without intrinsic value is fiat money. A fiat

is simply an order or decree. A fiat money is
established as money by government decree and
this is the money we use in today’s world.
15
Money in the Economy
 The quantity of money circulating in the economy

is called the money stock or money supply and
has a powerful influence in many economic
variables. Before we consider why this is true, we
must first address the following question:
 What is the quantity of money? In particular,
suppose I ask you to go and measure how much
money there is in the UAE economy, what
would you include in your measure?
16
 The most obvious asset to include is currency. The paper
bills and coins in the hand of the public.
 However, currency is not the only asset that you can use to
buy goods and services. Many stores also accept personal
checks. Assets held in your checking or savings account is
almost as convenient for buying things as assets held in your
wallet.
 To measure the money supply (that is the quantity of money

in the economy), you may want to include demand deposits.
(Balances in bank accounts that depositors can access by
writing a check or by using an ATM card).
17
 Once you start considering balances in checking
and saving accounts as part of the money supply,
you are led to consider the large variety of other
accounts that people hold at banks and other
financial institutions (certificate of deposits,
money market mutual fund accounts, etc.)
 The two most important measures of the money

supply are the M1 and M2.
18
Measuring Money
Definitions of money range from narrow to broad. M1 includes the most liquid forms of
money. M2 includes M1 plus other less liquid assets that can be used as money.
M1
Currency
Checkable Deposits
M2
M1
Small Time Deposits
Money Market Mutual Funds
19
Introduction of Neo-Keynesian
Economics: The demand and supply of
Money
 Interaction of the demand for money and the supply of
money determines the nominal interest rate.
 The money demand curve shows the relationship between

the quantity of money demanded, M, and the nominal
interest rate.
 An increase in the nominal interest rate

increases the opportunity cost of holding money, thus
the demand for money slopes downward.
20
The Money Demand Curve
Nominal interest rate (i)
MD
Money (M)
21
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 income.
 Increase in the price level.
MD'
MD
Money (M)
22
Supply of Money
 The supply of money is fixed by the Central Bank, thus it is vertical.

 Equilibrium, E, occurs at the
intersection of MS and MD.
MS
i E
MD
M Money (M)
23
The Central Bank
 In most countries, the Central Bank is the institution

in charge of overseeing the banking system and
regulate the quantity of money in the economy.
 The Central Bank has two important jobs:
 Regulate banks and ensure the health of the
financial system.
 Regulate the quantity of money available in the
economy, called the money stock or the money
supply.
24
The Banks and the Money
Supply
 Private banks also play an important role in the
monetary system.
 Because demand deposits and other deposits are
held in banks, the behavior of banks can influence
the money supply.
 When banks decide to make fewer loans, other
things equal, the money supply falls.
 When banks decide to lend more, other things
equal, the money supply increases.
25
Monetary Policy:
The Simple Deposit Multiplier and the Money Supply
Process
 The money supply (MS) is equal to the monetary base (H)

times the money multiplier (MM), thus,
 MS = H x MM, where MS refers to M1 money
supply.
 Define H = C + R, where C = currency in circulation and R
= total reserves.
 MS = C + D, where C = currency in circulation and D =
total deposits (see slide 19).
 The Central Bank can affect the quantity of money
circulating in the economy by changing H or MM.
 The simple deposit multiplier model assumes C= 0.
26
Monetary Policy in the New- Keynesian model:
The Simple Deposit Multiplier and the Money Supply
Process (Cont.)
 We can re-arrange the money supply equation and solve

for MM. Thus MM = MS / H
 Given H = C + R, where C = currency and R = reserves
and,
 MS = C + D, where C = currency and D = deposits (see
slide 19), then
 MM = C + D / C + R and since the model assumes C = 0, then
MM = D/R. By assumption e = 0, then R = RR or rr x D, leading
to MM = 1/rr. So the money multiplier (MM) is the reciprocal of
the reserve requirement ratio.
 The Central Bank can affect the quantity of money
circulating in the economy by changing H or MM.
27
Fractional-Reserve Banking
 Fractional-reserve banking is a banking system in which banks
hold only a fraction of deposits as reserves, thus banks create
money – do not confuse money creation with wealth creation.
This is the system in which banks operate across the world.
 The fraction of total deposits that a bank holds as reserves is
called the reserve ratio (r) and the amount of total reserves the
banking system holds are called total reserves (R). Deposits
that banks have received but have not yet loaned out are called
reserves. Alternatively, currency is banks’ vault are called
reserves.
 Central Banks usually place a minimum on the amount of
reserves that banks hold called a reserve requirement (RR). RR
is equal to the reserve requirement ratio (rr) which is set by
law, times total deposits (D), thus RR = rr x D.
28
 By changing the reserve requirement ratio (rr) on
banks, the central bank can partially control the
money supply. Increasing rr is contractionary.
Decreasing rr is expansionary.
 In reality, however, changing the money supply by
increasing (or decreasing) rr maybe difficult for
the Central Bank since it does not control the other
important component of r, that is, e.
 For simplicity, the simple deposit multiplier model
assumes that e is zero.
29
The Reserve Ratio
 The reserve ratio (r) is given by adding the reserve

requirements ratio (rr) and excess reserves ratio
(e).
 r = rr + e
30
 Excess reserves (ER) are reserves in excess of the reserve
requirements (RR). Banks holds excess reserves so they can be
more confident that they will not run short of cash to run the bank’s
daily operation and cover deposit outflows. ER is equal to the
excess reserve ratio (e) set by banks themselves, times total
deposits (D), thus ER = e x D.
 Total reserves in the banking system is equal to required reserves
plus excess reserves, OR:
 R = RR + ER
 The Central Bank cannot control the amount of excess reserves
(ER) private banks decide to hold.
 The Central bank only control the required reserves (RR) because
rr is set by law.
31
The Case of 100-Percent Reserve
Banking
 100-percent reserve banking is a banking system
in which private banks are required by law to send
to the Central Bank 100 percent of deposits
received. That is, rr = 1 or 100%.
 Under 100-percent reserve banking, private banks
cannot make loans. This is because if the Central
Bank sets rr =1or 100%, then R = 1 x D, or R =
D, as all deposits will be held as reserves.
 No country today operates a 100-percent reserve
banking system.
32
The Central Bank’s
Open Market Operations
 Open market operations (OMO), allow the Central Bank to
increase or decrease the money supply as it deemed
necessary by affecting the level of H.
 How does the Central Bank increases the money supply?
How does it decrease it?
 An open market purchase (buying back government bonds in
the hands of the public) increases H. Known as
expansionary monetary policy and implemented during
recessionary periods.
 An open market sale (selling government bonds to the
public) decreases H. Known as contractionary monetary
policy and implemented when the economy risks
overheating.
33
The Money Multiplier
 The money multiplier is the amount of money the banking

system generates with each dollar of reserves.
 What determines the size of the money multiplier? As
shown previously, the money multiplier is the reciprocal of
the reserve ratio. If r is the reserve ratio for all banks in
the economy, then each dollar of reserves generates 1/r
dollars of money. If for example, r = 10%, then the
money multiplier is equal to 10.
 In other words, a $100 in reserves generates $1,000.-
of money.
34
Creation of Deposits (assuming 10% reserve requirement and $100 in H)
35
Problems in Controlling
the Money Supply
 The first problem is that the Central Bank cannot
control the amount of money that households
choose to hold as deposits in banks. If the public
begin to lose confidence in the banking system
and, therefore, decide to withdraw deposits and
hold more currency, the money supply falls even
with central bank action.
36
Problems in Controlling
the Money Supply
 The second problem is that the Central Bank does
not control the amount bankers choose to lend. If
banks choose to hold excess reserves, the money
supply falls. If bankers become more cautious
about economic condition and decide to make
fewer loans, the money supply falls
37
Introduction to Neo-Classical Economics:
Velocity and the Quantity Equation
 Neo-classical economics argues that any monetary

action on the part of the Central Bank will be
reflected in the price level and will not affect
output or employment. Neo-classical economics
questions Central Bank intervention in the
economy.
38
 To make this point, neo-classical economists developed
what it is known as the quantity equation, given as:
 MxV= PxY
 Where M is the money supply, V is the velocity of money,
the rate at which money changes hands. In economics, the
velocity of money refers to the speed at which the typical
dirham bill travels around the economy from wallet to
wallet. P is the price level and Y is the nominal output.
39
 Example:
 Imagine a simple economy that produces only pizza. Suppose that the
economy produces 100 pizzas in a year, that a pizza sells for $10.-, and that
the quantity of money in the economy is $50.- Then the velocity of money is:
V = ( 10 x 100 ) / 50 = 20
 In this economy, people spend a total of $1,000.- Per year on pizza. For this
$1,000 of spending to take place with only $50 of money, each dirham bill
must change hands on average 20 times per year.
40
 The quantity equation shows that an increase in the quantity of money in an
economy must be reflected in one of the other three variables.
 We now have all the elements necessary to explain the equilibrium price
level and inflation:
 The velocity of money is relatively stable over time, thus we treat V as constant.
 Because velocity is stable, when the Central Bank changes the quantity of money (M), it
causes proportionate changes in the nominal value of output ( P x Y ).
 As discussed in a previous chapter, the economy’s output goods and services (Y) is
primarily determined by factors of production such, physical capital, human capital, natural
resources, and technology.
41
 With output (Y) determined by factors of
production and technology, when the Central Bank
alters the money supply (M) and induces
proportional changes in the nominal value of
output ( P x Y ), these changes are reflected in
changes in the price level (P).
 Therefore, when the Central Bank increases the

money supply rapidly, the result is a high rate of
inflation.
42
Monetary Policy in the Neo-
Classical Model
 Let’s now consider the effect of monetary policy.
 Imagine that the economy is in equilibrium and the Central

Bank doubles the supply of money in the economy.
 This money gets into the system through open markets

operations or lower reserve requirements.
 What happens after such a monetary injection? How does

the new equilibrium compare to the old one?
43
An Increase in the Money Supply
Value of Price Level
Money
MS1 MS2
(High) 1 1 (Low)
1. An increase in
the money
supply...
3/4 1.33
2. ...Decreases 3. ...and
the value of increases
A
money... 1/2 2 the price
level.
1/4 B 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
44

Chapter 19&22 - The Financial System, Money, Interest Rates, and The Price Level

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Chapter 19&22 - The Financial System, Money, Interest Rates, and The Price Level

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The Financial System,

1. Discuss the structure of the financial system and its two

 The financial system is the group of institutions in

 Savings and investments are key ingredients of

 Financial markets are the institutions within the

 1.- The bond market

 When a firm wants to borrow to finance construction of a

 Option 1: An old $ 1,000 face value government bond

 Another way a firm can raise funds is to sell

 Suppose interest on a safe investment is 6%.

 Financial intermediaries are financial institutions

 Small business owners (small firms) may find difficult

 A small business owner is more likely to get the funds

 The primary job of banks is to take in deposits from

 A mutual fund is an institution that sells shares to

 According to the economists definition, money

 Money has three functions in the economy:

 When money takes the form of a commodity with

 Money without intrinsic value is fiat money. A fiat

 The quantity of money circulating in the economy

 To measure the money supply (that is the quantity of money

 The two most important measures of the money

 The money demand curve shows the relationship between

 An increase in the nominal interest rate

Nominal interest rate (i)

 Changes in factors other than

Nominal interest rate (i)

 The supply of money is fixed by the Central Bank, thus it is vertical.

 In most countries, the Central Bank is the institution

 The money supply (MS) is equal to the monetary base (H)

 We can re-arrange the money supply equation and solve

 The reserve ratio (r) is given by adding the reserve

 The money multiplier is the amount of money the banking

 Neo-classical economics argues that any monetary

 Therefore, when the Central Bank increases the

 Imagine that the economy is in equilibrium and the Central

 This money gets into the system through open markets

 What happens after such a monetary injection? How does

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