The Financial Sector and The Economy: - Walter Bagehot

CHAPTER 30
The Financial Sector and

the Economy
The peculiar essence of our banking system
is an unprecedented trust between man and
man; and when that trust is much weakened
by hidden causes, a small accident may
greatly hurt it, and a great accident for a
moment may almost destroy it.
Walter Bagehot
McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
the Economy 30
Chapter Goals
Explain why the financial sector is central to almost

all macroeconomic debates
Demonstrate graphically how the long-term interest

rate is determined
Explain what money is
Enumerate the three functions of money
30-2
the Economy 30
Chapter Goals
State the alternative measures of money and their

primary components
Explain how banks create money
Calculate both the simple money multiplier and the

money multiplier
Explain why people hold money and how the short-term

interest rate is determined in the money market
30-3
the Economy 30
The Financial Sector and the Economy

The financial sector is central to almost all macroeconomic
debates
The real sector is the market for the production and
exchange of goods and services
The financial sector is the market for the creation and
exchange of financial assets
Financial assets include money, stocks, and bonds
Plays a central role in organizing and coordinating
our economy
30-4
the Economy 30
Why is the Financial Sector Important to Macro?

For every real transaction, there is a financial transaction
that mirrors it
The financial sector channels savings back into spending
For every financial asset, there is a corresponding
financial liability
Financial assets are assets such as stocks or bonds,
whose benefit to the owner depends on the issuer of
the asset meeting certain obligations
Financial liabilities are obligations by the issuer of
the financial asset
30-5
the Economy 30
The Financial Sector as a Conduit for Savings
Financial institutions channel savings back into the spending

stream as loans
Saving is outflows from the spending stream from
government, households, and corporations
Savings deposits, bonds, stocks, life insurance
Loans are made to government, households, and
corporations
Business loans, venture capital loans, construction
loans, investment loans
30-6
the Economy 30
The Financial Sector as a Conduit for Savings

Financial institutions channel saving (outflows from the
spending stream) back into the spending stream as loans
GOVERNMENT GOVERNMENT
Outflow Savings Loans Inflow
HOUSEHOLDS FINANCIAL SECTOR HOUSEHOLDS
BUSINESS BUSINESS
30-7
the Economy 30
The Role of Interest Rates in the Financial Sector
The interest rate is the price paid for use of a financial

asset
The long-term interest rate is the price paid for financial
assets with long maturities,
The market for long-term financial assets is called
the loanable funds market
The short-term interest rate is the price paid for financial
assets with short maturities,
Short-term financial assets are called money
30-8
the Economy 30
Market for Loanable Funds

Interest Rate
The long-term interest rate
is determined in the market
for loanable funds
S = Savings At equilibrium, the quantity
of loanable funds supplied
(savings) is equal to the
4% quantity of loanable funds
demanded (investment)
D = Investment
Q of Loanable Funds
Q
30-9
the Economy 30
The Definition and Functions of Money
Money is a highly liquid financial asset that serves as a:

Medium of exchange
Unit of account
Store of wealth
Liquid means to be easily changeable into another asset
or good
Money is a financial asset that makes the real economy
function smoothly
30-10
the Economy 30
The U.S. Central Bank: The Fed
The Federal Reserve Bank (the Fed) is the U.S. central

bank
Federal Reserve notes are liabilities of the Fed that
serve as cash in the U.S.
A bank is a financial institution whose primary function is
holding money for, and lending money to, individuals and
firms
Individuals deposits in savings and checking accounts
serve the same function as does currency and are also
considered to be money
30-11
the Economy 30
Alternative Measures of Money
Economists have developed different measures of money
Two are M1 and M2
M1 is a measure of the money supply; it consists of

currency in the hands of the public plus checking
accounts and travelers checks
M2 is a measure of the money supply; it consists

of M1 plus other relatively liquid assets
30-12
the Economy 30
Alternative Measures of Money

M1 M2
30-13
the Economy 30
Distinguishing Between Money and Credit
Credit cards are not money
Credit card balances are assets of a bank in the form of

a prearranged loan and liabilities of the credit card user
Generally credit card holders carry less cash
A debit card is part of the monetary system because it

serves the same function as a checkbook
30-14
the Economy 30
Banks and the Creation of Money
The first step in the creation of money
The Fed creates money by simply printing currency

Currency is a financial asset to the bearer
and a liability to the Fed
The bearer deposits the currency in a checking
account at the bank
The form of money has changed from
currency to a bank deposit
30-15
the Economy 30
Banks and the Creation of Money
The second step in the creation of money
The bank lends a fraction of the deposit

The amount of money has expanded:
Initial deposit + new loan
The amount of money is multiplied
30-16
the Economy 30
The Money Multiplier
Reserves are currency and deposits a bank keeps on

hand or at the Fed or central bank, to manage the
normal cash inflows and outflows
The reserve ratio is the ratio of reserves to deposits a

bank keeps as a reserve against cash withdrawals
Banks can keep more reserves: excess reserve ratio
Reserve ratio = required reserve ratio + excess reserve

ratio
30-17
the Economy 30
Calculating the Money Multiplier
We will call the ratio 1/r the simple money multiplier

The simple money multiplier is the measure of
the amount of money ultimately created per dollar
deposited in the banking system, when people
hold no currency
It tells us how much money will ultimately be created by

the banking system from an initial inflow of money
The higher the reserve ratio, the smaller the money

multiplier, and the less money will be created
30-18
the Economy 30
Determining How Many

Demand Deposits Will Be Created
To find the total amount of deposits that will be created,
multiply the original deposit by 1/r, where r is the
reserve ratio
If the original deposit is $100 and the reserve ratio is

10 percent (0.1), the amount of money ultimately
created is:
$100 x 1/0.1 = $1000
New money created = $1000 $100 = $900
30-19
the Economy 30
An Example of the Creation of Money

Round Bank Gets Bank Keeps (r = 20%) Bank Loans (80%)
1 $10,000 $2,000 $8,000
2 $8,000 $1,600 $6,400
3 $6,400 $1,280 $5,120
4 $5,120 $1,024 $4,069
Infinite $50,000 = $10,000 + $40,000
30-20
the Economy 30
Calculating the Money Multiplier

when People Hold Currency
The simple money multiplier reflects the assumption
that only banks hold currency
When firms and individuals hold currency, the
money multiplier in the economy is:
(1 + c)
(r + c)
Where r is the percentage of deposits banks hold in
reserve and c is the ratio of money people hold in
currency to the money they hold as deposits
30-21
the Economy 30
Why People Hold Money
The only reason people would be willing to hold money is

if they get some benefit from doing so
The transactions motive is the need to hold money
for spending
The precautionary motive is holding money for
unexpected expenses and impulse buying
The speculative motive is holding cash to avoid
holding financial assets whose prices are falling
30-22
the Economy 30
Equilibrium in the Money Market
Interest Rate
The demand for money is

S downward-sloping: as the interest
rate falls the cost of holding money
falls
i0 When interest rates rise, bonds

and other financial assets become
more attractive, so you hold more
D financial assets and less money
Q of Money
30-23
the Economy 30
The Many Interest Rates in the Economy
The economy doesnt have just a single interest rate;

it has many
Each financial asset will have an implicit interest rate
associated with it
In a multiple-asset market, the potential for the interest
rate in the loanable funds market to differ from the
interest rate in the market for a particular asset is large
The result can be what is sometimes called a
financial asset market bubble
30-24
the Economy 30
The Many Interest Rates in the Economy

An example of a financial asset market bubble:
In the early 2000s prices of houses increased by
10% to 15% per year
Many people bought houses for speculative
purposes
In 2007, people lowered their expectations of
housing price appreciation
The demand for housing decreased substantially,
and the equilibrium price fell
30-25
the Economy 30
Chapter Summary
The financial sector is the market where financial assets
are created and exchanged
The financial sector channels flows out of the circular flow
and back into the circular flow
Every financial asset has a corresponding financial liability
The economy has many interest rates
The long-term rate is determined in the market for
loanable funds, while the short-term rate is
determined in the money market
30-26
the Economy 30
Chapter Summary
Money is a highly liquid financial asset that serves as a
unit of account, a medium of exchange, and a store of
wealth
The measures of money are:
M1 is currency in the hands of the public, checking
account balances, and travelers checks
M2 is M1 plus savings deposits, small-
denomination time deposits, and money market
mutual fund shares
Banks create money by loaning out deposits
30-27
the Economy 30
Chapter Summary
The simple money multiplier is 1/r

The money multiplier tells you the amount of money
ultimately created per dollar deposited in the banking
system
The money multiplier when people hold cash is
(1+c)/(r+c)
People hold money for the transactions motive, the
precautionary motive, and the speculative motive
Financial asset market bubbles can cause problems
for an economy
30-28
the Economy 30
Preview of Chapter 31:

Monetary Policy
Demonstrate how monetary policy works in the AS/AD model
Summarize the structure and duties of the Fed
Describe how the Fed changes the supply of money primarily through
open market operations
Define the Federal funds rate and discuss how the Fed uses it as an
intermediate target
Explain the Taylor rule and its relevance to monetary policy
Define the yield curve and explain how its shape reflects the limit of
the Feds ability to control the economy
30-29
the Economy 30
CHAPTER 31
Monetary Policy
There have been three great inventions since the beginning of

time: fire, the wheel and central banking.
Will Rogers
McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
the Economy 30
Chapter Goals
Explain how monetary policy works in the AS/AD

model
Summarize the structure and duties of the Fed
Describe how the Fed changes the supply of

money primarily through open market operations
31-31
the Economy 30
Chapter Goals
Define the Federal funds rate and discuss how the

Fed uses it as an intermediate target
Explain the Taylor rule and its relevance to monetary

policy
Define the yield curve and explain how its shape

reflects the limit of the Feds ability to control the
economy
31-32
the Economy 30
Monetary Policy
Monetary policy is a policy of influencing the economy
through changes in the banking systems reserves that
influence the money supply and credit availability in the
economy
Fiscal policy is controlled by the government directly
Monetary policy is controlled by the U.S. central
bank, the Federal Reserve Bank (the Fed)
Monetary policy works through its influence on credit
conditions and the interest rate in the economy
31-33
the Economy 30
Monetary Policy
Price level
Monetary policy affects both
real output and the price level
Expansionary monetary
SAS policy shifts the
AD curve to the right
P1
P0 AD1 Contractionary monetary
P2 policy shifts the
AD0 AD curve to the left
AD2
Real output
Y2 Y0 Y1
31-34
the Economy 30
Monetary Policy
Price level If the economy is at or above

LAS potential, expansionary monetary
policy will cause input costs to rise
SAS1
Rising input costs will eventually
shift the SAS curve up so that
P1
SAS0 real output remains unchanged
AD1 The only long-run effect of

P0 expansionary monetary policy when
the economy is above potential is to
AD0 increase the price level
YP Real output
31-35
the Economy 30
Monetary Policy and the Money Market
Money Market Loanable Funds Market
Interest Rate Interest Rate
M0 M1 S0
an increase in
Expansionary loanable funds S1
monetary policy
leads to
i0 i0
i1 i1
D
D
Q of Money Q of Loanable Funds
The decline in interest rates increases investment spending, which

shifts the aggregate demand curve out to the right
31-36
the Economy 30
Monetary Policy
Expansionary monetary policy is a policy that increases
the money supply and decreases the interest rate and it
tends to increase both investment and output
M i I Y
Contractionary monetary policy is a policy that decreases

the money supply and increases the interest rate, and it
tends to decrease both investment and output
M i I Y
31-37
the Economy 30
Monetary Policy and the Fed

A central bank is a type of bankers bank whose financial
obligations underlie an economys money supply
The central bank in the U.S is the Fed
If commercial banks need to borrow money, they go
to the central bank
If theres a financial panic and a run on banks, the
central bank is there to make loans
The ability to create money gives the central bank the
power to control monetary policy
31-38
the Economy 30
Structure of the Fed
Board of Governors Regional Reserve Banks

7 members appointed by the Oversees and Branches
president and confirmed by 12 regional Federal Reserve
the senate banks and 25 branches
Federal Open Market

Committee (FOMC)
Board of Governors plus 5 Federal
Reserve bank presidents
Open Market Operations Provides Services
FINANCIAL SECTOR GOVERNMENT
31-39
the Economy 30
Duties of the Fed
Conducts monetary policy (influencing the supply of

money and credit in the economy)
Supervises and regulates financial institutions
Lender of last resort to financial institutions
Provides banking services to the U.S. government
Issues coin and currency
Provides financial services to commercial banks, savings
and loan associations, savings banks, and credit unions
31-40
the Economy 30
The Conduct of Monetary Policy
The Fed influences the amount of money in the economy

by controlling the monetary base
Monetary base is vault cash, deposits of the Fed,
and currency in circulation
Monetary policy affects the amount of reserves in the
banking system
Reserves are vault cash or deposits at the Fed
Reserves and interest rates are inversely related
31-41
the Economy 30
Open Market Operations
Open market operations are the primary way in which the

Fed changes the amount of reserves in the system
Open market operations are the Feds buying and
selling of government securities
To expand the money supply, the Fed buys bonds
To decrease the money supply, the Fed sells bonds
31-42
the Economy 30
An open market purchase is expansionary monetary policy

that tends to reduce interest rates and increase income
When the Fed buys bonds, it deposits money in
banks account with the Fed
Bank reserves are increased, and when banks loan
out the excess reserves, the money supply
increases
31-43
the Economy 30
An open market sale is a contractionary monetary policy

that tends to raise interest rates and lower income
When the Fed sells bonds, it receives checks
drawn against banks
The banks reserves are reduced and the money
supply decreases
31-44
the Economy 30
The Reserve Requirement and the Money Supply
The reserve requirement is the percentage the Fed sets as

the minimum amount of reserves a bank must have
The money multiplier is (1+c)/(r+c)
The Fed can increase the money supply by decreasing
the reserve requirement, which increases the money
multiplier
The Fed can decrease the money supply by increasing
the reserve requirement, which decreases the money
multiplier
31-45
the Economy 30
Borrowing from the Fed and the Discount Rate
In case of a shortage of reserves, a bank can borrow

reserves directly from the Fed
The discount rate is the interest rate the Fed charges for
those loans it makes to banks
An increase in the discount rate makes it more
expensive to borrow from the Fed and may decrease
the money supply
A decrease in the discount rate makes it less expensive
to borrow from the Fed and may increase the money
supply
31-46
the Economy 30
The Fed Funds Market

Banks with surplus reserves loan these reserves to banks
with a shortage in reserves
Fed funds are loans of excess reserves banks make
to each other
Fed funds rate is the interest rate banks charge each
other for Fed funds
By selling bonds, the Fed decreases reserves, causing the
Fed funds rate to increase
By buying bonds, the Fed increases reserves, causing the
Fed funds rate to decrease
31-47
the Economy 30
The Fed Funds Rate
and the Discount Rate since 1990
The Federal Reserve Bank follows expansionary
9% or contractionary monetary policy by targeting a
8% lower or higher Fed funds rate
7%
Fed funds rate
6%
5%
4%
3% Discount rate
2%
1%
0%
1990 1994 1998 2002 2006 2010
31-48
the Economy 30
Offensive and Defensive Actions

Defensive actions are designed to maintain the current
monetary policy
The Fed buys bonds during emergencies
Reserves would otherwise decrease because
individuals and businesses dont get to the bank
with their cash
Offensive actions are designed to have expansionary or
contractionary effects on the economy
31-49
the Economy 30
The Fed Funds Rate as an Operating Target

Monetary policy affects interest rates
The Fed looks at the Federal funds rate and other
targets to determine whether monetary policy is tight
or loose
If the Fed funds rate is above the Feds target range,
it buys bonds to increase reserves and lower the Fed
funds rate
If the Fed funds rate is below the Feds target range,
it sells bonds to decrease reserves and raise the Fed
funds rate
31-50
the Economy 30
The Complex Nature of Monetary Policy

While the Fed focuses on the Fed funds rate as its operating
target, it also has its eye on its ultimate targets: stable prices,
acceptable employment, sustainable growth, and moderate
long-term interest rates
Fed tools Operating target Intermediate targets Ultimate targets

Open market Stable prices
Consumer confidence
operations, Sustainable growth
Stock prices
Discount rate, Fed funds rate Acceptable
Interest rate spreads
and Reserve employment
Housing starts
requirement Moderate i rates
31-51
the Economy 30
The Taylor Rule

The Taylor rule is a useful approximation for predicting
Fed policy
Formally the Taylor rule is:
Fed funds rate = 2% + Current inflation

+ 0.5 x (actual inflation less desired inflation)
+ 0.5 x (percent deviation of aggregate
output from potential)
31-52
the Economy 30
The Effective Supply Curve for Money

Interest Rate
When the Fed chooses a monetary

S1 S2 S3 rule that targets the interest rate, it
creates an effective money supply
curve that is horizontal
8% at the target rate
Effective
Money Supply
5%
The Fed adjusts the supply
of money to changes in the
D2 D3 demand for money at the
D1 targeted rate
Q of Money
31-53
the Economy 30
Limits to the Feds Control of the Interest Rate
The Fed may not be able to shift the entire yield curve
up or down, but may make it steeper, flatter or inverted
A yield curve is a curve that shows the relationship

between interest rates and bonds time to maturity
When faced with a financial crisis, the Fed may use

quantitative easing, Fed policy that does not directly
affect the interest rate
An example is buying assets other than bonds
31-54
the Economy 30
Maintaining Policy Credibility

Policy makers are very concerned about establishing
policy credibility because they believe that it is necessary
to prevent inflationary expectations from becoming built
into the system
Nominal interest rates are the rates you actually see
and pay
Real interest rates are nominal interest rates adjusted
for expected inflation
Nominal interest rate = Real interest rate
+ Expected inflation rate
31-55
the Economy 30
Maintaining Policy Credibility

The real interest rate cannot be observed since it
depends on expected inflation, which cannot be directly
observed
Making a distinction between nominal and real rates
adds another uncertainty to the effect of monetary policy
If expansionary policy leads to expectations of increased
inflation, nominal rates will increase and leave real rates
unchanged
31-56
the Economy 30
Monetary Policy Regimes

Most economists believe that a monetary regime, not a
monetary policy, is the best approach to policy
A monetary regime is a predetermined statement of
the policy that will be followed in various situations
A monetary policy is a response to events chosen
without a predetermined framework
Monetary regimes are now favored because rules can
help generate market expectations
An explicit monetary policy regime has problems because
special circumstances arise where it makes sense to
deviate from the regime
31-57
the Economy 30
Chapter Summary
Monetary policy influences the economy through changes
in the banking systems reserves that affect the money
supply and credit availability
Expansionary monetary policy works as follows:
M i I Y
Contractionary monetary policy works as follows:
M i I Y
The Federal Open Market Committee (FOMC) makes the
actual decisions about monetary policy
31-58
the Economy 30
Chapter Summary
The Fed is the central bank of the U.S; it conducts
monetary policy and regulates financial institutions
Open market operations are the Feds most important
policy tool
To expand the money supply, the Fed buys
bonds, which increases their price and decreases
interest rates
To decrease the money supply, the Fed sells
bonds, which decreases their price and increases
interest rates
31-59
the Economy 30
Chapter Summary
When the Fed buys bonds, the price of bonds rises and
interest rates fall. When the Fed sells bonds, the price
of bonds falls and interest rates rise
A change in reserves changes the money supply by the
change in reserves times the money multiplier
The Federal funds rate is the rate at which one bank
lends reserves to another bank
It is the Feds primary operating target
31-60
the Economy 30
Chapter Summary
The Taylor rule states: Set the Fed funds rate at 2 plus
current inflation plus half the difference between actual
and desired inflation plus half the percent difference
between actual and potential output
The yield curve shows the relationship between interest
rates and bonds time to maturity
Although the Fed controls short-term interest rates more
directly, its effect on long-term rates is indirect
Fed policy intended to shift the yield curve might instead
change its shape and therefore not have the intended
impact on investment
31-61
the Economy 30
Preview of Chapter 32:

Financial Crises, Panics, and Macroeconomic Policy
Explain why economists worry more about the collapse of the financial
sector than the collapse of other sectors
List the three stages of a financial crisis
Discuss how herding and leverage can lead to a bubble
Explain how extrapolative expectations can lead to bubbles and
depressions
Distinguish between nonsystemic and systemic risk
Describe the three stages by which an economy gets out of a financial
crisis
Explain the importance of the moral hazard problem, the law of
diminishing control, and the bad precedent problem
31-62

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CHAPTER 30

The Financial Sector and

Explain why the financial sector is central to almost

Demonstrate graphically how the long-term interest

Explain what money is

Enumerate the three functions of money

State the alternative measures of money and their

Explain how banks create money

Calculate both the simple money multiplier and the

Explain why people hold money and how the short-term

The Financial Sector and the Economy

Why is the Financial Sector Important to Macro?

The Financial Sector as a Conduit for Savings

Financial institutions channel savings back into the spending

The Financial Sector as a Conduit for Savings

Outflow Savings Loans Inflow

HOUSEHOLDS FINANCIAL SECTOR HOUSEHOLDS

The Role of Interest Rates in the Financial Sector

The interest rate is the price paid for use of a financial

Market for Loanable Funds

The Definition and Functions of Money

Money is a highly liquid financial asset that serves as a:

The U.S. Central Bank: The Fed

The Federal Reserve Bank (the Fed) is the U.S. central

Alternative Measures of Money

Economists have developed different measures of money

Two are M1 and M2

M1 is a measure of the money supply; it consists of

M2 is a measure of the money supply; it consists

Alternative Measures of Money

Distinguishing Between Money and Credit

Credit cards are not money

Credit card balances are assets of a bank in the form of

Generally credit card holders carry less cash

A debit card is part of the monetary system because it

Banks and the Creation of Money

The first step in the creation of money

The Fed creates money by simply printing currency

Banks and the Creation of Money

The second step in the creation of money

The bank lends a fraction of the deposit

The Money Multiplier

Reserves are currency and deposits a bank keeps on

The reserve ratio is the ratio of reserves to deposits a

Banks can keep more reserves: excess reserve ratio

Reserve ratio = required reserve ratio + excess reserve

Calculating the Money Multiplier

We will call the ratio 1/r the simple money multiplier

It tells us how much money will ultimately be created by

The higher the reserve ratio, the smaller the money

Determining How Many

If the original deposit is $100 and the reserve ratio is

New money created = $1000 $100 = $900

An Example of the Creation of Money

1 $10,000 $2,000 $8,000

2 $8,000 $1,600 $6,400

3 $6,400 $1,280 $5,120

4 $5,120 $1,024 $4,069

Infinite $50,000 = $10,000 + $40,000

Calculating the Money Multiplier

Why People Hold Money

The only reason people would be willing to hold money is

Equilibrium in the Money Market