Bank Capital and Leverage

Bank's Capital

• Bank Capital is the owner’s equity and resources provided to generate profit.
• Bank Capital = Total Assets - Liabilities

Leverage

• Leverage is using borrowed funds to boost investment resources.
• Leverage Ratio = Total Assets / Bank Capital
• Capital Requirement is the minimum bank capital that is mandated through government regulation.

Interpretation of Leverage

• A leverage ratio of 20 amplifies the effect by 20 times
• A 5% increase in asset value results in a 100% increase in bank capital
  • For example, from $50 to $100.

Case Study: Asset Rise

• Bank assets appreciate by 5%, increasing from $1000 to $1050.
• Securities rise to $150.
• Bank capital increases from $50 to $100.

Case Study: Asset Fall

• Bank assets decrease by 5%, from $1000 to $950.
• Borrowers default on $50 loans.
• Bank capital decreases from $50 to $0.

Case Study: Significant Asset Fall

• Bank assets decrease by 30%, from $1000 to $700.
• Borrowers default on $250 loans and securities lose $50 in value.
• Bank capital declines from $50 to -$150.
  • This results in the bank becoming insolvent if asset reduction exceeds 5%.

Financial Crisis (2008-2009)

• Banks faced losses on mortgage loans and securities
• 166 banks failed during this period.
• Reduced lending led to a credit crunch and severe economic downturn because of the bank failures.

Federal Reserve (Fed) & U.S. Treasury Response

• Hundreds of billions were injected into the banking system to ease the credit crunch.
• U.S. taxpayers were made part-owners of banks temporarily.
• The banking system was successfully recapitalized, restoring normal lending levels by 2009.

Fed Tools for Controlling Money Supply (Monetary Policy)

• Open Market Operations (OMOs)
  • Consists of Purchase and sale of U.S. government bonds.
  • Buying bonds increases the money supply, selling bonds decreases it.
• Reserve Requirements
  • Banks must hold a minimum amount against deposits.
  • Increasing the reserve requirement decreases the money supply; decreasing it increases the money supply.
• Interest on Reserves
  • Pays interest on commercial banks' reserves.
  • Higher interest leads to more reserves being held, reducing the money supply.
• Discount Rate
  • Is the interest rate on loans that the Fed makes to banks.
  • Lowering the discount rate encourages borrowing, which in turn increases the money supply.

Limitations of Fed's Control

• The Fed does not fully control the amount banks lend.
• The Fed does not fully control the amount households hold as deposits.

Effects of Bank Runs

• A bank run is when depositors rush to withdraw funds when they fear bank failure.
• Bank runs during 1929-1933 contributed to the Great Depression.
• Federal deposit insurance (FDIC) now protects deposits up to $250,000.

Federal Funds Rate

• This is the interest rate at which banks lend reserves to one another overnight
• Managed by the Federal Open Market Committee (FOMC) through OMOs.
• Changes to the target for the federal funds rate can alter the money supply.

Interest Rate Trends

• Interest rates often move with the Federal Funds Rate.
• Interest rate movement can impact broader economic conditions.

What Is Money?

• Money satisfies three functions.
• Money can be fiat or commodity money.
• Money is important.

Fed Structure

• The Federal Reserve is the central bank of the U.S.
• The Federal Open Market Committee exists.

Functions of Money

• Money is an asset regularly used to purchase goods and services.
• Money serves as medium of exchange for goods and services.
• Money is a unit of account for pricing and recording debts.
• Money stores value by transferring purchasing power from the present to the future.

Additional Monetary Concepts

• Wealth measures total stores of value, including money, and non-monetary assets.
• Liquidity measures the ease of converting an asset into money.

Need For Money

• Without money, trade requires barter
  • Trade would then entail a double coincidence of wants
  • High search costs would be present to find trade partners.
• Money eliminates these inefficiencies.

Kinds of Money

• Commodity money has intrinsic value (e.g., gold, silver).
• Fiat money has no intrinsic value.
  • Established by government decree (e.g., U.S. Dollar).

Federal Reserve (The Fed)

• The Fed is the central bank of the U.S.
• Jerome Powell chairs the Fed, overseeing banking and money supply regulation.
• A Board of Governors has 7 members serving 14-year terms.
  • They are appointed by the president and confirmed by the Senate.
• There are 12 Regional Federal Reserve Banks
  • They are located in major cities.
  • Presidents are chosen by the banks' boards.
• The Federal Open Market Committee (FOMC) includes the Board of Governors and regional bank presidents.
  • Meets every 6 weeks to discuss economic conditions and adjust the money supply.

Fed Functions

• Regulation of banks to ensure a healthy banking system.
• Act as a bank for banks, lending funds as needed.
• Act as lender of last resort to maintain banking stability.
• Control money supply to maintain low inflation and low unemployment.

Money Supply

• Money supply is the quantity of money available in an economy.
• Money supply includes currency, which are physical bills and coins.
• Money Supply includes demand deposits
  • These accounts are bank balance accessible via check.
• Formula: Money Supply (MS) = Currency + Bank Deposits

Fractional Reserve Banking

• Households deposit savings with banks
• Banks hold a fraction in reserves and lend the rest.
• System allows for money creation.

Banking Terms

• Reserves are deposits which are note loaned out
• Reserve Ratio (R) is the fraction of deposits held as reserves.
• Required Reserves = Reserve Ratio × Deposits

Monetary System Example

• Consider $100 injected into circulation.
• Case 1: No Bank Involved
  • Money Supply = $100
  • This is due to no deposits or loans
• Case 2: 100% Reserve Banking
  • Money Supply = $100
  • $100 is held as reserves and there are no loans
• Case 3: Fractional Reserve Banking
  • A reserve ratio of 10% yields money supply of $190
  • Reserves = $10, Loans = $90.
  • Money Supply = Currency ($90) + Deposits ($100) = $190.

Continuous Money Creation

• Money continues to multiply through loans in a fractional reserve banking system.

Money Multiplier

• Money Multiplier defines the amount of money generated from each dollar of reserves.
• Formula: Money Multiplier (mm) = 1/R
• A higher reserve ratio leads to a smaller money multiplier and total money supply.
• For a Required Reserves Ratio (R) of 10%, if reserves are $15:

Savings & Investment

• Financial System: Group of institutions that help match one person's savings with someone else's investment.

Financial Institutions

• Financial Markets: Connect savers and borrowers directly
  • Examples: Bond market, stock market
• Financial Intermediaries: Connect savers to borrowers indirectly
  • Examples: Banks, mutual funds

Supply Side

• Private Savings: Income after taxes and consumption.
  • Examples: Buying equity or corporate bonds, investing in mutual funds, and getting certificates of deposit.
• Government Saving (Public Savings)
  • Budget Surplus arises as an excess of tax revenue over government spending.
  • Budget Deficit arises as a shortfall of tax revenue relative to spending.

Demand Side: Investment

• Investment is the purchase of new physical capital goods
  • Examples: Building a new factory, buying business equipment, or building a new house.

Savings & Investment Relation to GDP

• GDP Equation: Y = C + I + G + NX
  • C = Consumption
  • I = Investment
  • G = Government Purchases
  • NX = Net Exports
• Open Economy: Interacts with other economies ((NX ≠ 0)).
• Closed Economy: Implies (NX = 0), thus: [ Y = C + I + G ]
• National Saving = Y - C - G
• Total savings equals investment in a closed economy.

Loanable Funds Model

• Single financial market (bank).
• One interest rate determines the return for savers and cost for borrowers.
• Equilibrium output is determined in the goods market.
• Equilibrium interest rates are in the loanable funds market.
• Saving and Investment Identity = S = 1
• National savings contributes to investments, connecting the product market and the loanable funds market.
• If (T > G): Budget Surplus
• If (T < G): Budget Deficit

Loanable Funds Equilibrium

• Interest rates equalize the supply of loanable funds (savings) with the demand for loanable funds (investments).
• The intersection of supply and demand curves determines equilibrium interest rates.

Impacts of Government Policies

• Saving Incentives which are tax incentives will increase the supply of loanable funds
• Investment incentives are investment tax credits, which increase demand for loanable funds.
• Budget Deficits reduce national saving and increase interest rates, leading to crowding out.

Crowding Out

• Crowding out is the decrease in private investment due to government borrowing.
• It results in less available loanable funds for private borrowers

U.S. Government Debt

• Deficits are financed via government borrowing (e.g., issuing bonds).
• Persistent deficits can lead to a troubling debt-to-GDP ratio.
• Debt-to-GDP ratios rise during wartime and fall during peacetime.

Factors to Improve Productivity and Living Standards

• Productivity is the amount of goods/services produced per labor hour
  • This has a direct impact on a nation's living standards.
• Key factors affecting productivity include physical capital, human capital, natural resources per worker, and technological knowledge.
• Economic policies that can raise productivity and living standards include:

Education

• Education involves human capital investment.
• Education reduces wage gaps between educated and uneducated workers due to positive externalities.
• Developing countries can suffer from brain drain.

Health and Nutrition

• Health improves human capital investment.
• Healthier workers increase productivity.
• South Korea's caloric intake rise coincides with its historic economic growth.
• Vicious Circle: Poverty leads to poor health, perpetuating low productivity.
• Virtuous Circle: Economic growth improves health, further promoting growth.

Property Rights and Political Stability

• Enforcing property rights is important for economic growth
• Corruption and political instability negatively affect investment.
• Court systems can enforce property rights and promote stability.

Trade

• Trade benefits all parties.
• Inward-oriented policies (import restrictions) often lead to failure
  • For example, Argentina.
• Outward-oriented policies (free trade) promote economic integration and growth
  • For example, South Korea and Singapore.

Research & Development

• Promoting technological progress is crucial for long-term growth.
• Policies to promote R&D include patent laws and grants for research.

Population

• A balance between population growth and resource availability influences long-term productivity.

Investment

• Domestic investment comes from savings and is crucial for increasing physical capital.

Kinds of Investment

• Foreign Direct Investment (FDI): Investment by foreign entities (e.g., factories).
• Foreign Portfolio Investment (FPI): Investments in financial assets by foreigners.
• Returns on the investment may flow back to the originating countries.

Domestic Investment

• Increased productivity can be achieved via increases to physical capital per worker.
• Higher domestic savings supports increased investment
  • This creates a trade-off between current consumption and future consumption (savings).

Diminishing Returns

• Increased physical capital raises productivity.
• Returns diminish with high capital levels.
• Government policies can enhance savings and investment, thereby creating growth to a point
  • These policies are not indefinite as returns diminish.

Physical Capital

• Productivity and potential growth between countries vary with levels of capital per worker.

The Catch Up Effect

• The Catch-up Effect arises as poor countries grow faster than richer ones, due to lower initial productivity.
• This is characterized by poor countries high return on capital investments where small capital investments can significantly increase productivity.
• Poor countries' productivity growth on K/L graph demonstrates faster growth than wealthier nations.

Economic Growth & Living Standards

• There are vast differences in living standards across countries.
• Real GDP Per Person (2020 dollars)
  • Countries like China, Japan, and the U.S. Growth over time.

Variations in Standards

• Average income (GDP per capita) in wealthy countries is about ten times that of poorer countries.
• Quality of life indicators include nutrition, housing, healthcare, and life expectancy.

Historical Context

• Countries can experience significant changes in income rankings over time
  • Examples: Japan and Singapore's economic transformations.

Country Statistics in 2014

• United Kingdom: GDP per capita was $36,040, child mortality rate was 0.5%, life expectancy was 80 years, high school enrollment was 98%.
• Mexico: GDP per capita was $16,640, child mortality rate was 1.6%, life expectancy was 76 years, high school enrollment was 71%.
• Mali: GDP per capita was $1,510, child mortality rate was 17.6%, life expectancy was 52 years, high school enrollment was 31%.

Productivity

• Productivity is the quantity of goods and services produced from each unit of labor (labor hour).
• A nation’s standard of living is directly linked to workers productivity.

Measuring Productivity

• Productivity = Y / (L × h)
  • Y = Real GDP (total output produced)
  • L = Number of workers
  • h = Hours worked by each worker
• Practical examples include phones produced per hour, words typed per hour, or customers serviced per hour.

Importance

• Key Determinants of Living Standards:
  • High productivity leads to higher real GDP and income.
  • Better living standards associate with high productivity growth.
• An improved productivity grants access to better education, housing, healthcare, and lower infant rates.
• There is higher life expectancy through improved productivity.

Factors That Determine Output

• The relationship between output and inputs can be expressed: Y = A × F(L, K, H, N)
  • F reflects how inputs produce output

Factors Influencing Productivity

• Physical Capital (K): Stock of equipment and structures used for production.
  • Increasing (K/L) leads to greater productivity.
• Human Capital (H): Knowledge and skills obtained through education and training.
  • Increasing (H/L) raises productivity.
• Natural Resources (N): Inputs provided by nature (e.g., land, minerals).
  • Additional natural resources enhance productivity.
• Technological Knowledge (A): Society's understanding of the best practices for producing goods.
  • Advances in technology boost productivity (e.g., assembly lines, patent rights).