Analysis of the Financial System and the Economy

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Chapter 4

• Analysis of the Financial System and the Economy

Money is always there but the pockets change it
is not in the same pockets after a change, and
that is all there is to say about money. -
Gertrude Stein
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How the financial system fits into the overall
economy

• Spending
• Consumption by households and businesses
• Saving
• Surplus income not spent or invested
• Borrowing
• Used by DSUs to finance deficit of income
  compared to spending (bonds)
• Lending
• SSUs purchase interest-earning financial claims

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Decisions of spending units

• To be DSU or SSU?
• If DSU
• Then decide how to finance deficit
• If SSU
• Then decide how to invest surplus
• Financial system channels and coordinates
• flow of funds resulting from these decisions

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Financial Statement of J. P. Young, January 1,
2002 through December 31, 2002
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Financial Statement of All Purpose Enterprise
Inc., January 1, 2002 through December 2002 (in
Millions of Dollars)

• (A) Total expenses 5,400 Total
  sales 5,900
• Wages and salaries 5,700
• Interest on debt 200
• Cost of raw materials purchased
• from other firms 500
• Net income (sales expenses) 500
• minus dividends 300
• equals retained earnings 200
• (C) Business investment spending
  500 Financing
• Financing (new capital goods plant and New
  bonds issued 300
• equipmentand/or additions to
  Retained earnings 200
• inventories 500

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Aggregation Economy as a Whole

• National income sum of earnings in each sector
• Domestic product sum of expenditures in each
  sector
• National income Domestic product
• Whatever is spent is received
• Surplus of households deficits of businesses

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National Income and Expenditures for Our
Hypothetical Economy, 2001 (in Billions of
Dollars)
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Market Arenas

• Product market
• Firms produce/sell goods/services (supply)
• Households purchase goods/services (demand)
• Firms purchase capital goods/inventory (demand)

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Market Arenas

• Factor market (labor, capital, natural resources)
• Households supply labor
• Firms demand labor
• Financial market
• DSUs demand funds
• SSUs supply funds

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Circular FlowIncome, Expenditures, Funds

• Flows of income, expenditures, funds
• Link markets to
• Producing
• Spending
• Savings
• Borrowing
• Lending of firms and households

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The Circular Flow Diagram
Money Flows from Households to Firms to Pay for
Goods and Services
PRODUCT MARKETS
Products Flow from Firms to Households
Surplus Funds Flow from SSUs to DSUs
HOUSEHOLDS
FIRMS
FINANCIAL MARKETS
Supply
Interest Rate
Demand
Loanable Funds
Labor and Other Factors Flow from Households to
Firms
FACTOR MARKETS
Factor Payments (Wages, etc.) Flow from Firms to
Households
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Roles of firms

• Supply goods/services to product market
• Demand goods supplied by other firms
• Demand factor services from factor market
• Demand funds from financial system

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Roles of households

• Demand goods/services in product market
• Supply labor in factor market
• Supply funds to financial system

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Roles of markets

• Coordinate and balance supply and demand
• Based on plans of firms and households to
  produce, spend, borrow, lend
• Change in supply/demand in one market creates
  spillover effects into other markets
• Cannot analyze financial system in isolation from
  other markets

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Product Market

• Equilibrium price/quantity of goods sold
• Changes in factors determining supply or demand
  alters equilibrium price
• Aggregate for economy
• Overall price level in economy
• Total quantity of goods/services produced and sold

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Product Market

• Aggregate demand
• Consumption and investment behavior of households
  and firms
• Quantity of real GDP rises as price level falls
• Aggregate supply
• Production of goods and services behavior of
  firms
• As prices rise, firms willing to increase output

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Product Market

• Changes in quantities supplied/demanded
• From changes in price level
• Changes in supply and demand
• From changes in outside factors

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The Product Market Aggregate Demand and
Aggregate Supply
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Factor Market

• Labor chief factor of production
• Demand downward sloping
• As wages fall, households less willing to work
  (opportunity cost)
• Supply upward sloping
• As wages fall, firms more willing to hire

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Factor Market

• Equilibrium determines wage rate and aggregate
  labor hours worked
• Relationship with output market
• Increase in aggregate demand for goods
• As inventories fall, prices rise, production
  increases
• Increased production needs more labor, so wages
  rise

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The Factor Market The Demand for and Supply of
Labor
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Financial System

• Facilitates flow of funds from SSUs to DSUs
• Facilitates efficient allocation of financial
  resources
• Offers variety of options to both borrower and
  lender
• Minimizes risk and costs of transactions

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Loanable funds market

• Interest rate
• Reward for lending
• Cost for borrowing
• Determined by quantity of funds borrowed and lent
• Demand
• Behavior of DSUs
• Supply
• Behavior of SSUs
• Actions of Federal Reserve

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Loanable funds market

• Interaction with output market
• Fed increases money supply during recession
• Excess supply of funds in financial system at
  original equilibrium interest rate
• Fall in interest rates encourages more borrowing
  by both households and firms
• Increases consumption and investment spending
• Increase in aggregate demand in output market
• Etc.

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The Financial System The Demand for and Supply
of Loanable Funds
Interest Rate (Percent)
S
C
4
D
300
Loanable Funds (in Billions)
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Interest rate determination

• Supply of and demand for money
• Supply of and demand for loanable funds
• Which theory correct to determine interest
  rates?
• Supply/demand for money based on stocks
• Supply/demand for loanable funds based on flows
• Complementary theories

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Maximization Plans, Revisions, Actions

• Goals guide spending, saving, financing decisions
• Households goals
• Maximize satisfaction over time
• Firms goals
• Maximize profits
• Both have constraints on satisfaction/profits
  that force a decision

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Constrained maximization

• Theres no such thing as a free lunch
• Spending constrained by access to means of
  payment
• Can use existing holdings of money
• Can earn income by selling labor or goods
• Can sell holdings of financial or real assets
  accumulated by past saving
• Can borrow

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Goals of Various Spending Units
Households
Maximize Utility (Satisfaction)
Firms
Maximize Profits
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Interaction with markets

• Households plan to work, spend, save
• Firms plan to produce, hire workers, invest
• ? Based on economic and financial situations,
  expectation about prices, interest rates, income
  and overall objectives

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SSU surplus DSU deficit?

• Do plans of households coincide with plans of
  firms?
• Rarely!
• Mismatch leads to revision of plans
• Through market dynamics

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Revision example

• Households plan to lend 300 billion
• Firms plan to borrow 400 billion
• Quantity demanded gt quantity supplied
• Interest rates rise
• Increased interest rates leads firms and
  households to revise plans
• Firms reduce investment spending
• Households reduce consumption/save more
• Result quantity demanded quantity supplied