THE FINANCIAL SYSTEM, MONEY, AND PRICES: PART I Chapter 9

Financial System and Allocation of Saving  A successful economy uses its savings for investments that are likely to be the most productive  The interest on deposits is one important reason people put savings in banks  The financial system improves the allocation of saving

Money Money—Any asset that can be used in making purchases.

Difference between Money and Income. 1) Income—A flow of earning per unit of time. $ of income per week. 2) Money—a stock at a certain point in time. $50.00 of cash in your pocket.

3 Functions of Money 1) Medium of Exchange—money is an asset used in purchasing goods and services. This is the most important function of money.

3 Functions of Money 2) Unit of Account—money is a basic measure of economic value. Money is used to “keep score.”

3 Functions of Money 3) Store of Value—money is an asset that serves as a means of holding wealth.

Definition of a Monetary Economy Let us see how a monetary economy comes about.

Example We begin with an economy with N commodities. These commodities are C 1, C 2, C 3, C n. C i is commodity i.

Example Assume the Following Notation E = exchanges for E = does not exchange for

Example C 1 E C 2 means that C 1 exchanges for C 2 C 1 E C 2 means that C 1 does not exchange for C 2

Barter Economy In a barter economy, each good exchanges for every other good. Barter is the direct trade of goods and services for other goods and services.

Barter Economy C 1 C 2 C 3 C 1 E E E C 2 E E E C 3 E E E

In a barter economy, each and every good serves as money. That is, each and every good is an asset that can be used in making purchases. Barter Economy

Monetary Economy C 1 C 2 C 3 C 1 E E E C 2 E E E C 3 E E E

This is an example of a monetary economy. C 1 serves as money, while C 2 and C 3 do not.

Monetary Economy In a monetary economy, at least one good, but not all goods, serve as money. That is, at least one good, but not all goods, is an asset that can be used in making purchases.

Another Monetary Economy C 1 C 2 C 3 C 4 C 1 E E E E C 2 E E E E C 3 E E E E C 4 E E E E

Only C 1 is money because only C 1 trades for all other goods.

C 3 and C 4 are a barter subset. C 3 and C 4 trade directly for each other. C 3 and C 4 are not money.

Some goods don’t trade for other goods because of exchange costs. Exchange costs exist in both barter economies and monetary economies, but they are higher in barter economies.

Exchange costs 1) Opportunity cost of time spent in exchange. 2) Resource costs—transportation costs and the wastage of goods in the exchange process. 3) Waiting costs—The costs of delaying consumption. 4) Trading costs—The cost of not making the best possible trade.

Exchange costs are higher in a barter economy because barter requires a double coincidence of wants.

Double coincidence of wants—you must find someone who has what you want and wants what you have.

U.S. Money Supply Measures: M1 and M2 M1 – a measure of funds that are available for immediate spending. M1 = currency outstanding + checkable deposits

Checkable Deposits 1) Demand deposits 2) NOW accounts and super NOW accounts 3) ATS accounts 4) Travelers’ checks

M2 – a measure of funds available for immediate spending + funds that can be converted quickly into funds that can be spent immediately.

M2 = M1 + savings deposits + small-denominated time deposits + money market mutual funds

Savings deposits—savings accounts with no fixed time limit.

Small denominated time deposits—savings accounts with a fixed term to maturity (interest penalty for early withdrawal). Small < $100,000. Example: Certificate of Deposit

Money Market Mutual Funds—organizations that sell shares, use the proceeds to buy safe assets, and often allow check-writing privileges.

Banking System  Financial intermediaries are firms that extend credit to borrowers using funds raised from savers Banks have lower cost of evaluating opportunities than an individual would Banks pool the savings of many individuals to make large loans  Two types of intermediaries  Traditional & Market-based (recent development)

Banking System  Banks gather and evaluate potential investments to direct savings to higher-return, more productive investments  Service provided to depositors  Banks provide access to credit for small businesses and homeowners  May be the only source of credit for some investments  When banks make loans, they earn interest which, in turn, is paid to the bank's depositors

The Banking System  Having bank deposits makes payments easier  Checks  ATMs  Debit card  Checks and debit cards are safer than cash  Banks provide a record of your transactions

Bonds  A bond is a legal promise to repay a debt  Each bond specifies  Principal amount, the amount originally lent  Maturation date, the date when the principal amount will be repaid The term of a bond is the length of time from issue to maturation  Coupon payments, the periodic interest payments to the bondholder  Coupon rate, the interest rate that is applied to the principal to determine the coupon payments

Bonds  Corporations and governments issue bonds  The coupon rate depends on  The bond's term 30 days to 30 years; longer term, higher coupon rate  The issuer's credit risk Probability the issuer will default on repayment Higher risk, higher coupon rate  Tax treatment for the coupon payments Municipal bonds are free from federal taxes Lower taxes, lower coupon rates

Bond Market  Bonds can be sold before their maturation date  Market value at any time is the price of the bond  Price depends on the relationship between the coupon rate and the interest rate in financial markets  A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09  Coupon rate is 5%  $50 will be paid 1/1/10  $1,050 will be paid 1/1/11  Bond's price on 1/1/10 depends on the prevailing interest rate

Selling a Bond  Offer for sale: one government bond with payment of $1,050 due in one year  The competition: a new one-year bond with principal of $1,000 and coupon rate of 6%  Pays $1,060 in one year  Year-old bond with 5% coupon rate is less valuable than the new bond  Price of the used bond will be less than $1,000 (Bond price) (1.06) = $1,050 Bond price = $991  Bond prices and interest rates are inversely related

Stocks  A share of stock is a claim to partial ownership of a firm  Receive dividends, a periodic payment determined by management  Receive capital gains if the price of the stock increases  Prices are determined in the stock market  Reflect supply and demand

FortuneCookie.com Example  New company with estimated dividend of $1 in 1 year  Selling price of stock will be $80 in 1 year  Interest rate on safe asset (government bond) is 6%  Value of the new stock is $81 in 1 year (Stock price) (1.06) = $81 Stock price = $76.42  Value would be higher if Dividend were higher Price of stock in one year were higher Interest rate were lower

Risk Premium  Risk premium is the rate of return investors require of risky asset minus the rate of return on a safe asset  Suppose interest on a safe investment is 6%  FortuneCookie.com is risky, so 10% return is required  Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64  Risk aversion increases the return required of a risky stock and lowers the selling price

Bond Markets and Stock Markets  Channel funds from savers to borrowers with productive investment opportunities  Sale of new bonds or new stock can finance capital investment  Like banks, bond and stock markets allocate savings  Provision of information on investment projects and their risks  Provide risk sharing and diversification across projects Diversification is spreading one's wealth over a variety of investments to reduce risk

Benefits of Diversification  Vikram has $200 to invest in stocks, each $100  Buy 2 shares of either stock  50% chance of $20 gain and 50% chance of $0  Diversify and buy 1 share of each  One stock will be worth $100 and the other will be worth $110 Return is $10 with no risk Increase in Stock Price per Share Actual Weather Smith Umbrella Jones Suntan Lotion Rainy (50%) +$10$0 Sunny (50%) $0+$10

Apple Stock

Lehman Brothers

Stock and Bond Markets  Savers can put savings into a variety of financial assets  Diversification makes risky but potentially valuable projects possible No individual saver bears the whole risk Society is better off

Rise and Fall of the US Stock Market  Standard & Poor's 500 index rose 60% between 1990 and 1995  More than doubled 1995 – 2000  Lost 40% of its value Jan 2001 – Jan 2003  Returned to Jan 2000 level by Jan 2008  And then…..  Increase in stock prices can be due to  Increased optimism about future value  A fall in required return

Rise and Fall of the US Stock Market  In the 1990s, optimism was high  Strong dividends  Promise of new technologies  Risk premium declined  Increased diversification through mutual funds  Investors may have underestimated risk  Optimism and risk premium trends reversed in 2000  Many high-tech firms less profitable than expected  Corporate accounting scandals of 2002  Terrorist attack in US

Dow Jones vs. S&P 500

A Closer Look…

Other Financial Products  A Mutual fund is a variety of financial assets sold to the public as shares in a single financial intermediary  Diversified asset for the saver  Less costly than buying many stocks and bonds directly  Closed-End funds  Structured similar to a mutual fund, however is traded on the exchange like a stock and has a fixed number of shares outstanding (thus can trade at a premium or discount to market value)  Exchange-Traded Funds  Similar to a closed-end fund, however the amount of shares outstanding is allowed to fluctuate (trades close to its market value)