Download Section 5 Lecture

AP Macroeconomics
Section 5 Lecture
December 2016
Mr. Gammie
MONEY
Module 22: Saving, Investment, and
the Financial System
Simple Economy
Total Income = Total Spending
Total Spending =
You have $500 of disposable income for the
month of December. What can you do with it?
MPC + MPS = 1
Spend or Save
Some Math…
Total Income = Total Spending
Total Income = C + S
Total Spending = C + I
C+S=C+I
Therefore….. S = I
Savings = Investment
+ Government
Budget Balance
= tax revenue – gov’t spending – transfer
payments
Budget surplus (+)
Budget deficit (-)
National Saving = S + BB
+ Other Countries
Capital Inflow = the total inflow of foreign funds
minus the total outflow of domestic funds to
other countries
I=S
S = National Saving + Capital Inflow
Three Tasks of a Financial System
1. Reduce Transaction Costs
vs.
Three Tasks of a Financial System
2. Reducing Risk
Diversification: investing in several assets with
unrelated, or independent risks. It allows a business
owner to lower his/her total risk of loss.
Key Takeaway: The desire of individuals to reduce
their total risk by engaging in diversification is why
we have stocks and the stock market.
Three Tasks of a Financial System
3. Providing Liquidity
Financial Assets
Financial Asset: A paper claim that entitles the
buyer to future income from the seller.
Four Types:
1. Loans
2. Bonds
3. Loan Backed Securities
4. Stocks
Financial Intermediaries
Financial Intermediary: an institution that
transforms funds gathered from many
individuals in financial assets.
Three Key Types:
1. Mutual Funds
2. Pension Funds and Life Insurance Companies
3. Banks
Review Question
Economists view investment spending as which
of the following:
a. Stocks
b. Bonds
c. Spending on physical capital
d. Mutual investment spending
e. Spending on human capital
Review Question
Given: Closed Economy S=I
In a closed economy suppose that GDP is $12
trillion. Consumption is $8 trillion, government
spending is $2 trillion, and taxes are $0.5 billion.
How much is national saving?
a. $2 trillion
b. $3 trillion
c. $3.5 trillion
d. $4 trillion
e. None of the above
Review Questions
Financial markets:
a. Increase transaction costs
b. Reduce diversification
c. Provide liquidity
d. Determine tax rates
e. Are the same as resource markets
Module 22 Summary
• The saving investment identity tells us that, in a simple economy
without gov’t or foreign trade, that private dollars saved must equal
private dollars invested.
• When the gov’t is included we discover that they can also
contribute to the national savings if there is a budget surplus, and
can detract from national savings if there is a budget deficit.
• Money can also flow into Canada from foreign citizens and money
can flow out of Canada into foreign economies. This inflow or
outflow affects domestic saving and investment.
• If more money flows into Canada than leaves Canada to other
nations, there is a capital inflow. This increases domestic
investment. (Vice versa applies).
• The financial system facilitates transactions between savers and
investors and provides three key roles in this process: reducing
transaction costs, reducing risk, and increasing liquidity.
Module 23: The Definition and
Measurement of Money
Define:
money
Defined:
money is any
asset that can easily be
used to purchase
goods and services.
Roles of Money
1. Medium of Exchange
Roles of Money
2. Store of Value
Roles of Money
3. Unit of Account
Types of Money
1. Commodity Money ex.
2. Commodity-backed Money ex.
3. Fiat Money ex.
Measuring the Money Supply
• M1: currency and coin in circulation +
checking deposits + travelers checks
• M2: M1 + savings accounts + short term CDs +
money market accounts
*Review this section in your textbook.
Review Question
Suppose you transfer $500 from your checking
account to your savings account. With this
transaction M1 _____ and M2 _____.
a. Increased; stayed the same
b. Stayed the same; increased
c. Decreased; stayed the same
d. Decreased; increased
e. Increased; decreased
Review Question
The narrowest definition of money excludes:
a. Currency in the vault at a bank
b. Traveler’s checks
c. Currency in circulation
d. Checkable bank deposits
e. Coins in circulation
Review Question
The medium of exchange function means that
money is used:
a. As the common denominator of prices
b. As the common denominator of future
payments.
c. To save and earn interest income.
d. To accumulate purchasing power.
e. To pay for goods and services.
Module 23 Summary
• Money is not the same as wealth. Money is essentially
anything that is easily exchangeable for goods and
services.
• Many things have been used as money by different
human civilizations. All successful forms of money
must serve as a medium of exchange, a store of value,
and unit of account.
• Two aggregate measures of the money supply are M1
and M2.
• M1 is the narrowest definition. You will most often
work with this definition.
• M2 adds several other assets, known as near-moneys,
that can easily be converted into cash.
Module 24: The Time Value of Money
What if you could invest $10,000 now and
receive a guaranteed $20,000 later.
Is this a good deal?
$1 today > $1 tomorrow
Lending
• Why should you receive interest if you lend
money?
• What would be repayment of $100 after 1
year?
• What about after 2 years?
In Context
• Your friend, a borrower, must pay you $21 to
compensate you for the fact he has your $100
for 2 years.
• You, as a saver, could put $100 in the bank
today, and two years from now, you would
have $121 to spend on goods and services.
• Therefore, we can say you would be
completely indifferent to having $100 today,
or $121 2 years from now.
Key Takeaway
These are equivalent measures of purchasing
power, just measured at two different points in
time.
Defining Present Value
To see the difference between dollars today
(present value or PV) and dollars 1 year from
now (future value or FV) we apply an equation.
FV = PV*(1+r)
r = interest rate
FV = 100*1.10 = 110
Defining Present Value
Rearranging the formula we can solve for
present value when we know the FV.
PV = FV/(1+r)
PV = 110/(1+0.1) = 100
1 Year
2 Years
3 Years
20 Years
PV and FV Formulas
PV = FV/(1+r)t
FV = PV
t
(1+r)
Applications of PV
What if you could invest $10,000 now and
receive a guaranteed $20,000 later.
Is this a good deal?
Applications of PV
• $10,000 today or $20,000 10 years from now
• Interest rate of 8% could be earned if you
invest the money.
• Should you take the 10,000 today, or the
$20,000 in 10 years?
Applications of PV
Applications of PV
Applications of PV
M24 Summary
• Money today is more valuable than the same
amount of money in the future.
• The present value of $1 one year from now is
$1/(1+r)
• The future value of $1 invested today is $1*(1+r)
• Interest paid on savings and interest charged on
borrowing are designed to equate the values of
dollars today with the value of future dollars.
Module 25: Banking and Money
Creation
The Monetary Role of Banks
M1 = currency + coin + traveler’s checks + checking deposits
What Banks Do
• Banks are financial intermediaries in business
to earn a profit.
• In the process, banks actually do make more
money.
• Banks are a safe place for deposits.
• Banks offer lending services.
• Interest is paid or earned.
Banks take liquid assets (cash) and turn them
into illiquid assets (homes and capital
equipment).
T Accounts
Assets
Liabilities
Jim’s Jerseys
Assets
Equipment
Cloth
$50,000
$10,000
Liabilities
Loan
$25,000
Main Street Bank
Assets
Loans
$2,000,000
Cash Reserves $200,000
Liabilities
Deposits
$2,000,000
Bank Regulation
1.
2.
3.
4.
Deposit Insurance
Capital Requirements
Reserve Requirements
Discount Window
Determining the Money Supply
How Banks Make Money
• Eli has $5000 in cash and decides that he
needs to open a checking account at Main
Street Bank. The t-account shows assets and
liabilities of the bank.
How Banks Make Money
• Main Street keeps 10% of Eli’s deposit in
reserve, and makes a $4500 loan to Max so he
can buy some furniture at Melanie’s Mega
Mart.
• The loan has the following effect:
How Banks Make Money
• Melanie Banks at the First Bank of Sherman,
so when Melanie receives $4500 from Max for
the furniture, she deposits the money at the
FBS. The effect on the t-account for FBS is:
How Banks Make Money
• The FBS must also keep 10% of Melanie’s
deposit in reserve, and then can make a $4050
loan to Fekru.
• How much did the initial deposit of $5000
result in?
Summary
1. Eli deposits $5000.
2. Max borrows $4500 to buy furniture.
3. Melanie receives the payment for her
furniture, and then deposits $4500.
4. Fekru borrows $4050.
Money Multiplier
Excess reserves = total reserves – required reserves
Money Multiplier (MM) = 1/rr
rr = reserve ratio
What was the money multiplier from our last
example?
Money Market in Reality
In theory
10
In reality
1.9
M25 Summary
• Banks create money by taking a deposit from
one customer (a saver) and lending a fraction
of that deposit to another customer (a
borrower).
• Through the process of lending, when money
is deposited into a bank, that initial deposit
multiplies into an amount much greater than
the initial deposit.
• This is known as the money multiplier.