FS - Financial Sector Overview

Financial Sector

Introduction

To understand how monetary policy works, we must understand the definitions of both the money supply and money demand and the factors that affect each of them. Here, we will look at the definition of money and other financial assets, such as bonds and stocks, the time value of money, measures of the money supply, fractional reserve banking, and the Federal Reserve System.

Module Lessons Preview

In this module, we will study the following topics:

Functions of Money: Money is generally accepted in payment for goods and services and serves as an asset to its holder. Money is anything that serves three important functions: a medium of exchange, a unit of account, and a store of value.

Banks and the Money Supply: The loanable funds market is made up of borrowers, who demand funds, and lenders, who supply funds.

The Federal Reserve Bank: The Federal Reserve System is the central bank of the United States. A central bank is an institution that oversees and regulates the banking system and controls the money supply. The Federal Reserve System (known as “the Fed”) is made up of 12 privately owned District Federal Reserve Banks and a federal government agency that oversees the system, called the Board of Governors.

Monetary Policy: Monetary Policy is the action of the Federal Reserve (the Fed) to prevent or address extreme economic fluctuations. The Fed uses its monetary policy tools to influence equilibrium interest rates in the money market through its control of bank reserves.

Key Terms

Financial System - The firms Links to an external site. and institutions that together make it possible for money Links to an external site. to make the world go round. This includes financial markets, securities Links to an external site. exchanges, banks Links to an external site., pension funds, mutual funds, insurers, national regulators, such as the Securities and Exchange Commission (SEC) in the United States, central banks Links to an external site., governments and multinational institutions, such as the IMF and world bank Links to an external site..

Transaction Costs - The costs incurred during the process of buying or selling, on top of the PRICE Links to an external site. of whatever is changing hands. If these costs can be reduced, the PRICE MECHANISM Links to an external site. will operate more efficiently.

Risk - The chance of things not turning out as expected. Risk taking lies at the heart of CAPITALISM Links to an external site. and is responsible for a large part of the GROWTH Links to an external site. of an economy. In general, economists assume that people are willing to be exposed to increased risks only if, on AVERAGE Links to an external site., they can expect to earn higher returns than if they had less exposure to risk. How much higher these EXPECTED RETURNS Links to an external site. need to be depends partly on the PROBABILITY Links to an external site. of an undesirable outcome and partly on whether the risk taker is RISK AVERSE Links to an external site., RISK NEUTRAL Links to an external site. or RISK SEEKING Links to an external site..

Liquidity - How easily an ASSET Links to an external site. can be spent, if so desired. Cash is wholly liquid. The liquidity of other assets is usually less; how much less may be measured by the ease with which they can be exchanged for cash (that is, liquidated).

Financial Markets - Markets in SECURITIES Links to an external site. such as BONDS Links to an external site. and SHARES Links to an external site.. Governments and companies use them to raise longer-term CAPITAL Links to an external site. from investors, although few of the millions of capital-market transactions every day involve the issuer of the security. Most trades are in the SECONDARY MARKETS Links to an external site., between investors who have bought the securities and other investors who want to buy them. Contrast with MONEY MARKETS Links to an external site., where short-term capital is raised.

Financial Intermediaries - A middleman. An individual or institution that brings together investors (the source of funds) and users of funds (such as borrowers).

Bonds/Securities/T-Bills - A bond is an interest Links to an external site.-bearing security Links to an external site. issued by governments, companies and some other organizations. Bonds are an alternative way for the issuer to raise capital to selling shares or taking out a bank Links to an external site. loan. Like shares in listed companies, once they have been issued bonds may be traded on the open market. A bond's yield Links to an external site. is the interest rate Links to an external site. (or coupon) paid on the bond divided by the bond's market price Links to an external site.. Bonds are regarded as a lower risk Links to an external site. investment Links to an external site.. government Links to an external site. bonds, in particular, are highly unlikely to miss their promised payments. Corporate bonds issued by blue-chip "investment grade" companies are also unlikely to default; this might not be the case with high-yield "junk" bonds issued by firms Links to an external site. with less healthy financials.

Stocks - Financial SECURITIES Links to an external site., each granting part ownership of a company. In return for risking their CAPITAL Links to an external site. by giving it to the company’s management to develop the business, shareholders get the right to a slice of whatever is left of the firm’s revenue after it has met all its other obligations. This money is paid as a DIVIDEND Links to an external site., although most companies retain some of their residual revenue for INVESTMENT Links to an external site. purposes. Shareholders have voting rights, including the right to vote in the election of the company’s board of directors. Shares are also known as equities. They can be traded in the public FINANCIAL MARKETS Links to an external site. or held as PRIVATE EQUITY Links to an external site..

Assets - Things that have earning power or some other value to their owner.

Crowding Out - When the state does something it may discourage, or crowd out, private-sector attempts to do the same thing. At times, excessive GOVERNMENT Links to an external site. borrowing has been blamed for low private-sector borrowing and, consequently, low INVESTMENT Links to an external site. and (because the economic returns on public borrowing are typically lower than those on private DEBT Links to an external site., especially corporate debt) slower economic GROWTH Links to an external site.. This has become less of a concern in recent years as government indebtedness has declined and, because of GLOBALISATION Links to an external site., FIRMS have become more able to raise CAPITAL Links to an external site. outside their home country. Crowding out may also come from state spending on things that might be provided more efficiently by the private sector, such as health care, or even through CHARITY Links to an external site., redistribution.

Money - Makes the world go round and comes in many forms, from shells and beads to GOLD Links to an external site. coins to plastic or paper. It is better than BARTER Links to an external site. in enabling an economy's scarce resources to be allocated efficiently. Money has three main qualities:

- as a medium of exchange, buyers can give it to sellers to pay for goods and services;

- as a unit of account, it can be used to add up apples and oranges in some common value;

- as a store of value, it can be used to transfer purchasing power into the future.
A farmer who exchanges fruit for money can spend that money in the future; if he holds on to his fruit it might rot and no longer be useful for paying for something. INFLATION undermines the usefulness of money as a store of value, in particular, and also as a unit of account for comparing values at different points in time. HYPER-INFLATION Links to an external site. may destroy confidence in a particular form of money even as a medium of exchange. Measures of LIQUIDITY Links to an external site. describe how easily an ASSET Links to an external site. can be exchanged for money (the easier this is, the more liquid is the asset).

Medium of Exchange - A medium of exchange is an intermediary instrument used to facilitate the sale, purchase or trade of goods between parties. For an instrument to function as a medium of exchange, it must represent a standard of value accepted by all parties. In modern economies, the medium of exchange is currency.

Unit of Account - a nominal monetary Links to an external site. unit of measure or currency Links to an external site. used to represent the real value (or cost) of any economic item; i.e. goods, services, assets, liabilities, income, expenses. It is one of three well-known functions of money Links to an external site..^{[1]
Links to an external site.} It lends meaning to profits, losses, liability, or assets.

Store of Value - Any form of wealth that maintains its value without depreciating. Commodities such as gold and other forms of metal are good stores of value, as their shelf lives are essentially perpetual, whereas a good such as milk is a terrible store of value due to its natural process of spoilage.

Commodity Money - money whose value comes from a commodity of which it is made. Commodity money consists of objects that have value in themselves (intrinsic value) as well as value in their use as money.

Fiat Money - currency that a government has declared to be legal tender Links to an external site., but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of.

M0, M1, M2, M3: M0 and M1, for example, are also called narrow money and include coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 includes M1 and, in addition, short-term time deposits in banks and certain money market funds. M3 includes M2 in addition to long-term deposits. However, it is no longer included in the reporting by the Federal Reserve. MZM, or money zero maturity, is a measure that includes financial assets with zero maturity and that are immediately redeemable at par. The Federal Reserve relies heavily on MZM data because its velocity is a proven indicator of inflation.

Money Market - where financial instruments Links to an external site. with high liquidity and very short maturities Links to an external site. are traded.

Federal Reserve (Fed) - America's central bank Links to an external site.. Set up in 1913, and popularly known as the Fed, the system divides the United States into 12 Federal Reserve districts, each with its own regional Federal Reserve bank. These are overseen by the Federal Reserve Board, consisting of seven governors based in Washington, DC. monetary policy Links to an external site. is decided by its Federal Open Market Committee.

Reserves - MONEY Links to an external site. in the hand, available to be used to meet planned future payments or if some other need arises. FIRMS Links to an external site. may put their reserves in a BANK Links to an external site., as a deposit. For a bank, reserves are those deposits it retains rather than lending them out.

Reserve Ratio - The fraction of its deposits that a BANK Links to an external site. holds as RESERVES Links to an external site..

Required Reserve Ratio or Reserve Requirement - Regulations governing the minimum amount of RESERVES Links to an external site. that a BANK Links to an external site. must hold against deposits.

Money Multiplier - the amount of money that banks generate with each dollar of reserves.

Open Market Operations - CENTRAL BANKS buying and selling SECURITIES Links to an external site. in the open market, as a way of controlling INTEREST Links to an external site. rates or the GROWTH Links to an external site. of the MONEY Links to an external site. SUPPLY Links to an external site.. By selling more securities, they can mop up surplus MONEY Links to an external site.; buying securities adds to the money supply. The securities traded by central banks are mostly GOVERNMENT Links to an external site. BONDS Links to an external site. and TREASURY BILLS Links to an external site., although they sometimes buy or sell commercial securities.

Fed Funds Rate - the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.

Discount Rate - the rate of INTEREST Links to an external site. charged by a CENTRAL BANK Links to an external site. when lending to other financial institutions. It also refers to a rate of interest used when calculating DISCOUNTED CASHFLOW Links to an external site..

Quantity Theory of Money - The foundation stone of MONETARISM Links to an external site.. The theory says that the quantity of MONEY available in an economy determines the value of money. Increases in the SUPPLY are the main cause of INFLATION Links to an external site.. This is why Milton FRIEDMAN Links to an external site. claimed that 'inflation is always and everywhere a monetary phenomenon'.

The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867-1947). M is the stock of money, V is the VELOCITY OF CIRCULATION Links to an external site., P is the average PRICE level and T is the number of transactions in the economy. The equation says, simply and obviously, that the quantity of money spent equals the quantity of money used. The quantity theory, in its purest form, assumes that V and T are both constant, at least in the short-run. Thus, any change in M leads directly to a change in P. In other words, increase the money supply and you simply cause inflation.
In the 1930s, KEYNES Links to an external site. challenged this theory, which was orthodoxy until then. Increases in the money supply seemed to lead to a fall in the velocity of circulation and to increases in real INCOME Links to an external site., contradicting the classical dichotomy (see MONETARY NEUTRALITY Links to an external site.). Later, monetarists such as Friedman conceded that V could change in response to variations in M, but did so only in stable, predictable ways that did not challenge the thrust of the theory. Even so, monetarist policies did not perform well when they were applied in many countries during the 1980s, as even Friedman has since conceded.

Velocity of Money - the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a given period of time. Velocity of money is usually measured as a ratio of GNP to a country's total supply of money.

Quantity Equation - MV = PY

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