Introduction to Economics International Relations and International Organization
Week 5: Lecture 9 - Money, banks and the money market
Finance, saving and investment (p. 535-549)
Financial institutions and financial markets
An important distinction to make here is the one between:
- Finance and money: finance is the activity of providing funds that finance expenditures on capital.
Money is what is used to pay for goods, factors of production etc. and to make financial transactions.
- Physical and financial capital: physical capital consists of tools, machines etc., while financial capital
are the funds firms use to buy physical capital and that households use to buy a home etc..
The quantity of capital changes because of investment (+) and depreciation (-). The total amount
spent on new capital is called gross investment; the change in the value of capital is called net
investment. Thus, as a formula: net investment = gross investment - depreciation
Wealth is the value of all the things that people own. It is not the same as someone’s income, which
is the amount he or she receives during a given time period. Saving is amount of income not paid in
taxes or spent on consumption; and thus increases wealth. Wealth increases when the market value
of assets rises - capital gains - and decreases when market value of assets decreases - capital losses.
-> the wealth of a nation at the end of a year equals its wealth at the beginning of a year plus its
saving during that year, which equals income minus consumption expenditure
To make real GDP grow, saving and wealth must be transformed into investment and capital, which
happens in the markets for financial capital and through the activities of financial institutions. Saving
is the source of the funds that are used to finance investment, and these funds are supplied and
demanded in three types of financial markets:
1. Loan markets: firms often want short-term finance to extend their businesses. These funds are
usually obtained as a loan that is secured by a mortgage: legal contract that gives ownership of a
home to the lender in the event that the borrower fails to meet the agreed loan payments.
2. Bond markets: a bond is a promise to make payments on specified dates. Buyers of bonds make a
loan to the company and are entitled to the payments promised by the bond. Bonds issued by firms
and governments are traded in the bond market. short-term bonds are called commercial paper.
3. Stock markets: a stock is a certificate of ownership and claim to the firm’s profits. Unlike a
stockholder, a bondholder does not own part of the firm (and profits) that issued the bond.
A financial institution is a firm that operates on both sides of the markets for financial capital; it is a
borrower in one market and a lender in another. The key financial institutions are:
1. Commercial banks
2. Mortgage companies: financial institutions that specialise in making loans for property purchases.
Loans for house purchase are packaged into mortgage-backed securities and sold to banks.
3. Pension funds
4. Insurance companies
5. Bank of England and other central banks
- A financial institution’s net worth is the market value of its assets (what it has lent) minus the
market value of its liabilities (what it has borrowed). If positive, the institution is solvent. If negative,
the institution is insolvent. The owners of an institution - usually its stockholders - bear the loss. A
financial institution both borrows and lends, so it could be that its net worth might become negative.
- Sometimes, a financial institution is solvent but illiquid. A firm is illiquid if it has made long-term
loans which borrowed funds and is faced with a sudden demand to repay more of its loan than its
available cash. When other institutions do not have the same problem, the firm can borrow money
from another institution to repay its loans.
Stocks, bonds, short-term securities and loans are collectively called financial assets. The interest
rate on a financial asset is the interest received expressed as a percentage of the price of the asset.
,Introduction to Economics International Relations and International Organization
The loanable funds market
In macroeconomics, all the financial markets described above are grouped together as a single
loanable funds markets, which is the aggregate of all the individual financial markets. The circular
flow model, which was examined in the previous week, can be extended to include flows in the
loanable funds market that finance investment.
Households’ income, Y, is spent on consumption, C, saved, S, or paid in taxes, T. So, Y = C + S + T.
- Y also equals sum of the items of aggregate expenditure: consumption expenditure, C, investment,
I, government expenditure, G, and exports, X, minus imports, M. That is: Y = C + I + G + X - M
- By using these two equations,
you can see that: I + G + X = M +
S + T or I = S + (T - G) + (M - X)
-> this equation tells us that
investment I is financed by
household saving (S), the
government budget balance (T -
G) and borrowing from the rest
of the world (M - X).
- The sum of private saving, S,
and government saving (T - G) is
called national saving. Thus,
national saving and foreign
borrowing finance investment.
The nominal interest rate is the number of euros that a borrower pays and a lender receives in
interest in a year expressed as a percentage of the number of euros borrowed and lent. The real
interest rate is the additional goods and services that the lender can buy with the interest received;
so, real interest rate is approximately nominal interest rate minus inflation rate. The real interest rate
is the opportunity cost of loanable funds. How is this rate determined?
Demand for loanable funds
- The demand for loanable funds is the relationship between the quantity demanded and the real
interest rate, which can be summarized in (an always downwards sloping) demand curve DLF.
- What determines investment and the demand for loanable funds to finance it? These two factors
are most important: (1) the real interest rate; and (2) expected profit.
-> ceteris paribus, the higher the real interest rate, the smaller the quantity of loanable funds
demanded; the lower the real interest rate, the higher the quantity of loanable funds demanded.
-> ceteris paribus, the greater the expected profit from new capital, the greater the amount of
investment and the greater the demand for loanable funds. When the expected profit changes, the
curve shifts - while a change in real interest rate causes a movement along the curve.
Supply for loanable funds
- The supply of loanable funds is the relationship between the quantity of loanable funds supplied
and the real interest rate, ceteris paribus. The curve SLF is the supply of loanable funds curve.
- Decision (not) to save is influenced by many factors, of which these are the most important:
1. The real interest rate: ceteris paribus, the higher the real interest rate, the greater is the quantity
of loanable funds supplied; the lower the real interest rate, the smaller is the quantity supplied.
-> a change in real interest rate results in a movement along the SLF curve
2. Disposable income: the greater a household’s disposable income, the greater its saving
3. Expected future income: the higher the expected future income, the smaller its saving today
4. Wealth: the higher a household’s wealth, the smaller is its saving. If a person’s wealth increases
because of a capital gain, the person sees less need to save.
, Introduction to Economics International Relations and International Organization
5. Default risk: risk that a loan will not be repaid. The greater that risk, the higher is the interest rate
needed to induce a person to lend and the smaller is the supply of loanable funds.
-> if any of the last four factors change, the SLF curve will shift
If we combine the SLF curve and the DLF curve, we will arrive at an equilibrium: which shows us the
quantity of loanable funds and the real interest rate. Regardless of whether there is a surplus or a
shortage of loanable funds (in the first place), the real interest rate will change and is pulled towards
an equilibrium level.
Financial markets are highly volatile in the short-run but remarkably stable in the long run. Volatility
in the market comes from fluctuations in either the demand for loanable funds or the supply of
loanable funds. These fluctuations bring fluctuations in the real interest rate and in the equilibrium
quantity of funds lent and borrowed.
- An increase in demand: with an increase in the demand for loanable funds, but no change in the
supply if loanable funds, there is a shortage of funds. As borrowers compete for funds, the interest
rate rises and lenders increase the quantity of funds supplied.
- An increase in supply: if one of the influences on saving plans changes and increases saving, the
supply of loanable funds increases. With no change in the demand for loanable funds, the market is
flush with loanable funds. Borrowers find bargains and lenders find themselves accepting a lower
interest rate. At this lower rate, borrowers find additional projects profitable and increase the
quantity of loanable funds that they borrow.
The government in the loanable funds market
A government enters the loanable funds market when it has a budget surplus or budget deficit:
- A government budget surplus: a surplus increases supply of loanable funds. Real interest rate falls,
which decreases household saving and decreases the quantity of private funds supplied. The lower
real interest rate increases the quantity of loanable funds demanded and increases investment.
- A government budget deficit: a deficit increases demand for loanable funds. Real interest rate rises,
which increases household saving and increases quantity of private funds supplied. The higher real
interest rate decreases investment and quantity of funds demanded by firms to finance investment.
- A decrease in investment resulting from a government budget deficit is called the crowding-
out effect. The budget deficit crowds out investment by competing with businesses for scare
financial capital.
- The Ricardo-Barro effect holds that both of the effects just shown are wrong, and that the
government budget has no effect on the interest rate or investment: private saving and
private supply of loanable funds increase to match the quantity of loanable funds demanded
by the government.
-> most economists regard the Ricardo-Barro effect too extreme
Money, the price level and inflation (p. 557-569)
What is money?
Money is any commodity or token that is generally acceptable as a means of payment. But money
has three other functions:
- Medium of exchange: object that is generally accepted in exchange for goods and services. Without
money, it would be necessary to exchange goods directly for other goods - a barter - which requires a
double coincidence of wants. A medium of exchange overcomes the need for a double coincidence.
- A unit of account: an agreed measure for stating the prices of goods and services. Because of this,
you can also state the price of one good in units of another good
- A store of value: money can be held and exchanged later for goods and services. If money were not
a store of value, it could not serve as a means of payment. Money is not the only store of value
Today, money consists of:
1. M1 = currency: notes and coins held by the public (individuals and firms) are known as currency
Week 5: Lecture 9 - Money, banks and the money market
Finance, saving and investment (p. 535-549)
Financial institutions and financial markets
An important distinction to make here is the one between:
- Finance and money: finance is the activity of providing funds that finance expenditures on capital.
Money is what is used to pay for goods, factors of production etc. and to make financial transactions.
- Physical and financial capital: physical capital consists of tools, machines etc., while financial capital
are the funds firms use to buy physical capital and that households use to buy a home etc..
The quantity of capital changes because of investment (+) and depreciation (-). The total amount
spent on new capital is called gross investment; the change in the value of capital is called net
investment. Thus, as a formula: net investment = gross investment - depreciation
Wealth is the value of all the things that people own. It is not the same as someone’s income, which
is the amount he or she receives during a given time period. Saving is amount of income not paid in
taxes or spent on consumption; and thus increases wealth. Wealth increases when the market value
of assets rises - capital gains - and decreases when market value of assets decreases - capital losses.
-> the wealth of a nation at the end of a year equals its wealth at the beginning of a year plus its
saving during that year, which equals income minus consumption expenditure
To make real GDP grow, saving and wealth must be transformed into investment and capital, which
happens in the markets for financial capital and through the activities of financial institutions. Saving
is the source of the funds that are used to finance investment, and these funds are supplied and
demanded in three types of financial markets:
1. Loan markets: firms often want short-term finance to extend their businesses. These funds are
usually obtained as a loan that is secured by a mortgage: legal contract that gives ownership of a
home to the lender in the event that the borrower fails to meet the agreed loan payments.
2. Bond markets: a bond is a promise to make payments on specified dates. Buyers of bonds make a
loan to the company and are entitled to the payments promised by the bond. Bonds issued by firms
and governments are traded in the bond market. short-term bonds are called commercial paper.
3. Stock markets: a stock is a certificate of ownership and claim to the firm’s profits. Unlike a
stockholder, a bondholder does not own part of the firm (and profits) that issued the bond.
A financial institution is a firm that operates on both sides of the markets for financial capital; it is a
borrower in one market and a lender in another. The key financial institutions are:
1. Commercial banks
2. Mortgage companies: financial institutions that specialise in making loans for property purchases.
Loans for house purchase are packaged into mortgage-backed securities and sold to banks.
3. Pension funds
4. Insurance companies
5. Bank of England and other central banks
- A financial institution’s net worth is the market value of its assets (what it has lent) minus the
market value of its liabilities (what it has borrowed). If positive, the institution is solvent. If negative,
the institution is insolvent. The owners of an institution - usually its stockholders - bear the loss. A
financial institution both borrows and lends, so it could be that its net worth might become negative.
- Sometimes, a financial institution is solvent but illiquid. A firm is illiquid if it has made long-term
loans which borrowed funds and is faced with a sudden demand to repay more of its loan than its
available cash. When other institutions do not have the same problem, the firm can borrow money
from another institution to repay its loans.
Stocks, bonds, short-term securities and loans are collectively called financial assets. The interest
rate on a financial asset is the interest received expressed as a percentage of the price of the asset.
,Introduction to Economics International Relations and International Organization
The loanable funds market
In macroeconomics, all the financial markets described above are grouped together as a single
loanable funds markets, which is the aggregate of all the individual financial markets. The circular
flow model, which was examined in the previous week, can be extended to include flows in the
loanable funds market that finance investment.
Households’ income, Y, is spent on consumption, C, saved, S, or paid in taxes, T. So, Y = C + S + T.
- Y also equals sum of the items of aggregate expenditure: consumption expenditure, C, investment,
I, government expenditure, G, and exports, X, minus imports, M. That is: Y = C + I + G + X - M
- By using these two equations,
you can see that: I + G + X = M +
S + T or I = S + (T - G) + (M - X)
-> this equation tells us that
investment I is financed by
household saving (S), the
government budget balance (T -
G) and borrowing from the rest
of the world (M - X).
- The sum of private saving, S,
and government saving (T - G) is
called national saving. Thus,
national saving and foreign
borrowing finance investment.
The nominal interest rate is the number of euros that a borrower pays and a lender receives in
interest in a year expressed as a percentage of the number of euros borrowed and lent. The real
interest rate is the additional goods and services that the lender can buy with the interest received;
so, real interest rate is approximately nominal interest rate minus inflation rate. The real interest rate
is the opportunity cost of loanable funds. How is this rate determined?
Demand for loanable funds
- The demand for loanable funds is the relationship between the quantity demanded and the real
interest rate, which can be summarized in (an always downwards sloping) demand curve DLF.
- What determines investment and the demand for loanable funds to finance it? These two factors
are most important: (1) the real interest rate; and (2) expected profit.
-> ceteris paribus, the higher the real interest rate, the smaller the quantity of loanable funds
demanded; the lower the real interest rate, the higher the quantity of loanable funds demanded.
-> ceteris paribus, the greater the expected profit from new capital, the greater the amount of
investment and the greater the demand for loanable funds. When the expected profit changes, the
curve shifts - while a change in real interest rate causes a movement along the curve.
Supply for loanable funds
- The supply of loanable funds is the relationship between the quantity of loanable funds supplied
and the real interest rate, ceteris paribus. The curve SLF is the supply of loanable funds curve.
- Decision (not) to save is influenced by many factors, of which these are the most important:
1. The real interest rate: ceteris paribus, the higher the real interest rate, the greater is the quantity
of loanable funds supplied; the lower the real interest rate, the smaller is the quantity supplied.
-> a change in real interest rate results in a movement along the SLF curve
2. Disposable income: the greater a household’s disposable income, the greater its saving
3. Expected future income: the higher the expected future income, the smaller its saving today
4. Wealth: the higher a household’s wealth, the smaller is its saving. If a person’s wealth increases
because of a capital gain, the person sees less need to save.
, Introduction to Economics International Relations and International Organization
5. Default risk: risk that a loan will not be repaid. The greater that risk, the higher is the interest rate
needed to induce a person to lend and the smaller is the supply of loanable funds.
-> if any of the last four factors change, the SLF curve will shift
If we combine the SLF curve and the DLF curve, we will arrive at an equilibrium: which shows us the
quantity of loanable funds and the real interest rate. Regardless of whether there is a surplus or a
shortage of loanable funds (in the first place), the real interest rate will change and is pulled towards
an equilibrium level.
Financial markets are highly volatile in the short-run but remarkably stable in the long run. Volatility
in the market comes from fluctuations in either the demand for loanable funds or the supply of
loanable funds. These fluctuations bring fluctuations in the real interest rate and in the equilibrium
quantity of funds lent and borrowed.
- An increase in demand: with an increase in the demand for loanable funds, but no change in the
supply if loanable funds, there is a shortage of funds. As borrowers compete for funds, the interest
rate rises and lenders increase the quantity of funds supplied.
- An increase in supply: if one of the influences on saving plans changes and increases saving, the
supply of loanable funds increases. With no change in the demand for loanable funds, the market is
flush with loanable funds. Borrowers find bargains and lenders find themselves accepting a lower
interest rate. At this lower rate, borrowers find additional projects profitable and increase the
quantity of loanable funds that they borrow.
The government in the loanable funds market
A government enters the loanable funds market when it has a budget surplus or budget deficit:
- A government budget surplus: a surplus increases supply of loanable funds. Real interest rate falls,
which decreases household saving and decreases the quantity of private funds supplied. The lower
real interest rate increases the quantity of loanable funds demanded and increases investment.
- A government budget deficit: a deficit increases demand for loanable funds. Real interest rate rises,
which increases household saving and increases quantity of private funds supplied. The higher real
interest rate decreases investment and quantity of funds demanded by firms to finance investment.
- A decrease in investment resulting from a government budget deficit is called the crowding-
out effect. The budget deficit crowds out investment by competing with businesses for scare
financial capital.
- The Ricardo-Barro effect holds that both of the effects just shown are wrong, and that the
government budget has no effect on the interest rate or investment: private saving and
private supply of loanable funds increase to match the quantity of loanable funds demanded
by the government.
-> most economists regard the Ricardo-Barro effect too extreme
Money, the price level and inflation (p. 557-569)
What is money?
Money is any commodity or token that is generally acceptable as a means of payment. But money
has three other functions:
- Medium of exchange: object that is generally accepted in exchange for goods and services. Without
money, it would be necessary to exchange goods directly for other goods - a barter - which requires a
double coincidence of wants. A medium of exchange overcomes the need for a double coincidence.
- A unit of account: an agreed measure for stating the prices of goods and services. Because of this,
you can also state the price of one good in units of another good
- A store of value: money can be held and exchanged later for goods and services. If money were not
a store of value, it could not serve as a means of payment. Money is not the only store of value
Today, money consists of:
1. M1 = currency: notes and coins held by the public (individuals and firms) are known as currency
