Money, Banking, Credit and Financial Flows

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Money, Banking, Creditand Financial Flows

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Flow of FundsSources Uses

• Income
• Credit

• Buy goods services
• Service debt
• Pay taxes
• Save

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Balance SheetAssets Liabilities

• Financial
• Cash, deposits, NOW and money market accounts
• Government securities, stocks, bonds, mutual
  funds
• Mortgages
• Insurance and pension reserves
• Tangible
• Real estate, cars, appliances, electronics, art,
  jewelry, etc.
• Plant and equipment

• Payables, mortgages, installment debt, loans,
  etc.
• Payables, loans, commercial paper, bonds, etc.
• Equity and Net Worth

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Functions of Money

• A standard of deferred payment or medium of
  exchange
• A store of value (in competition with other
  assets)
• Issues of liquidity and debasement through
  inflation
• Unit of account (prices are quoted in )
• Commodity versus fiat monies

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Why hold money?

• Transactions demand
• Speculative demand
• Portfolio choice and asset allocation
• Considers transactions and opportunity costs
• Considers risks and returns
• It is sufficient to have money demand directly
  related to income (and expenditure) and
  indirectly related to interest rates
• Think of income/expenditure in price and quantity
  terms

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The Stock of Money Defined

• M1 (Narrow) - currency held by the public,
  non-bank travelers checks, demand deposits at
  banks and SLs, NOW accounts, credit union
  drafts
• M2 - M1 plus small denomination savings accounts
  (aka, time deposits), money market accounts,
  overnight repurchase agreements
• M3 - M2 plus large denomination time deposits,
  institutional money market accounts
• L (Broad) - M3 plus short-term Treasury
  securities, savings bonds, bankers acceptances,
  commercial paper

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Money Stocks
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Federal Reserve Responsibilities

• Functional
• Mint currency
• Clear checks
• Serve as the bank for the US government
• Regulatory
• Economic stabilization
• Control inflation
• Limit the adverse consequences of recession
• Ensure liquidity as lender of last resort

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Bank Balance SheetAssets Liabilities

• Reserves (cash and due from banks)
• Vault cash
• Deposits at Fed
• Deposits at member banks
• Loans
• Investments
• Other
• Plant and equipment

• Transaction deposits
• Other deposits
• Equity and Net Worth

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Federal Reserve Balance SheetAssets Liabiliti
es

• Gold
• Loans to banks
• US securities
• Other
• Plant and equipment

• Currency outstanding
• Deposits
• Reserves
• US Treasury
• Other
• Net Worth

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Federal Reserve Policy Instruments

• Reserve requirements ratio
• Legal reserves (LR), required reserves (RR)
• The Federal Reserve discount rate
• Rate on overnight bank loans borrowed reserves
  (BR) from Fed
• Excess reserves (ER) LR - RR
• Net free reserves (NFR) ER - BR
• Open market operations
• The purchase and sale of US government securities
  previously issued by the US Treasury and sold by
  the Fed to the public

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Financial Market Fundamentals

• Interest rates and bond prices vary inversely
• Rising rates mean lower bond prices and visa
  versa
• Fundamentally, bond prices and stock prices vary
  directly
• Lower bond prices (higher interest rates) should
  coincide with lower stock prices
• Think discounted present value (DPV) and expected
  future cash flows
• What are the effects of higher rates on the
  components of firm value

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Bond Prices and Yields
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Stock and Bond Prices
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Monetary Policy

• Monetary policy is transmitted through financial
  markets to effect change in the markets for real
  goods and services
• Think bond market!
• Bond market!
• BOND MARKET!!!

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The Monetary Policy Sequence

• Bond market - prices, yields, interest rates
• Stock prices and exchange rates
• Reserve and deposit growth
• Loanable and investable funds
• Credit sensitive spending
• Income growth
• Income sensitive spending

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The Monetary Policy Sequence

• The characteristics of income growth
• Labor compensation and profits
• Government spending and revenue
• Goods services, transfers, debt service and tax
  receipts
• The foreign sector - exports and imports
• Personal and business saving
• Recall the composition of business saving