Overview
This lecture covers the fundamentals of financial markets in macroeconomics, focusing on money, the banking system, monetary policy, and key financial market graphs.
Financial Assets & Money
- Stocks represent ownership in a corporation.
- Bonds are certificates for loans to firms or governments, paid back with interest.
- Bond prices and interest rates are inversely related.
- Money is the most liquid financial asset, easily spent.
Functions & Measures of Money
- Money must serve as a medium of exchange, unit of account, and store of value.
- M0 includes currency and bank reserves (monetary base).
- M1 includes currency, checkable, and some savings deposits.
- M2 is the broadest: M1 + small time deposits and money market funds.
The Fisher Formula & Interest Rates
- Fisher formula: nominal interest rate ≈ real interest rate + inflation rate (i ≈ r + π).
- Unexpected inflation helps borrowers (repay with less valuable money) and hurts lenders (receive lower real returns).
Bank Balance Sheets
- Assets: what the bank owns (reserves, loans, other assets).
- Liabilities: what the bank owes (demand deposits, savings, other liabilities).
- Required reserves are set by the central bank; excess reserves can be loaned out.
- Assets and liabilities must balance.
Money Creation & the Multiplier
- Money multiplier = 1 / reserve requirement.
- Excess reserves multiplied by the money multiplier gives maximum new loans and deposits.
- Actual money creation is lower due to banks holding excess reserves and people holding cash.
The Money Market
- Demand for money decreases as nominal interest rates rise due to higher opportunity cost.
- Money demand includes asset demand (to hold wealth) and transaction demand (to buy goods/services).
- Money supply is fixed by the central bank, shown as a vertical line on the graph.
- Equilibrium where money demand and supply meet determines the nominal interest rate.
Monetary Policy Tools
- Central banks use open market operations, discount rate, and reserve requirements to target policy rates.
- Open market operations involve buying/selling government securities to change reserves.
- In ample reserve systems (e.g., US Federal Reserve), main tool is the interest on reserves.
Expansionary & Contractionary Policy
- To reduce unemployment (recessionary gap): buy bonds, lower reserve requirements/discount rate, or decrease interest on reserves.
- To fight inflation (inflationary gap): sell bonds, raise reserve requirements/discount rate, or increase interest on reserves.
- These tools shift aggregate demand, affecting output, unemployment, and price level.
Loanable Funds Market
- Demand: investment by businesses, downward sloping with respect to real interest rate.
- Supply: household and foreign savings, upward sloping with respect to real interest rate.
- Shifts in investment demand or savings supply change the real interest rate and quantity of funds.
- Crowding out: increased government borrowing drives up interest rates, reducing private investment.
Key Terms & Definitions
- Stock — Ownership certificate of a corporation.
- Bond — Certificate of debt issued to a lender by a business or government.
- Liquidity — Ease with which an asset can be converted to cash.
- M0/M1/M2 — Measures of money supply, from narrowest (M0) to broadest (M2).
- Fisher Formula — Relationship: nominal rate ≈ real rate + inflation.
- Required Reserves — Minimum reserves banks must hold, set by the central bank.
- Excess Reserves — Bank reserves above the required minimum, available for lending.
- Money Multiplier — Factor showing potential money creation from excess reserves.
- Monetary Policy — Central bank actions to influence money supply and interest rates.
- Crowding Out — Government deficit spending raises interest rates, reducing private investment.
Action Items / Next Steps
- Review key graphs: money market, reserves market, loanable funds market.
- Practice bank balance sheet and money multiplier calculations.
- Prepare examples of monetary policy actions and their effects.
- Read additional unit materials or complete assigned practice problems.