©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 19: The Financial System, Money, and Prices

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Describe the role of financial intermediaries, such as commercial banks, in the financial system 2.Differentiate between bonds and stocks and why their prices are inversely related to interest rates 3.Explain how the financial system improves the allocation of savings to productive uses

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Learning Objectives 4.Discuss the three functions of money and how money supply is measured 5.Analyze how the lending behavior of commercial banks affects the money supply 6.Understand how the central bank controls the money supply and how control of the money supply is related to inflation in the long run

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Money in Economics The term "money" in economics has a specific meaning different from every day use To an economist  Your paycheck is income  The income you don't spend is savings  The increase in the value of your stock is capital gains  When your house appreciates, your wealth increases

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Financial System and Allocation of Saving to Productive Uses 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 is expected to improve the allocation of saving  Provides information to savers about the possible uses of their funds  Help savers share the risks of individual investment projects  Risk sharing makes funding possible for projects that are risky but potentially very productive

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Banking System Financial intermediaries are firms that extend credit to borrowers using funds raised from savers  Thousands of commercial banks accept deposits from individuals and businesses and make loans  Banks and other intermediaries specialize in evaluating the quality of borrowers  Principle of Comparative Advantage  Banks have lower cost of evaluating opportunities than an individual would  Banks pool the savings of many individuals to make large loans

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Banking System Banks gather information, evaluate potential investments, and 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

©2012 The McGraw-Hill Companies, All Rights Reserved 8 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

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Japanese Banking Crisis, 1990s Japanese banks fell into severe trouble  Property values decreased and some loans on real estate went into default  Banks held stocks and the stock values decreased In Japan, banks were the main way saving was translated into investment  Thin financial markets  Borrowers had difficulty obtaining credit  Small- and medium-sized businesses suffered  Credit shortages prolonged the recession as businesses struggled to fund new projects

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Bonds and Stocks 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

©2012 The McGraw-Hill Companies, All Rights Reserved 11 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

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Bond Prices and Interest Rates 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

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Selling a Bond Offer for sale: a 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

©2012 The McGraw-Hill Companies, All Rights Reserved 14 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

©2012 The McGraw-Hill Companies, All Rights Reserved 15 How Much Should You Pay for a Share of menanews.com? New company with estimated dividend of $1 in 1 year  Selling price of stock will be $80 in 1 year  Interest rate 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

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Riskiness and Stock Prices Risk premium is the difference between the required rate of return to hold risky assets and the rate of return on safe assets Suppose interest on a safe investment is 6%  Assume that menanews.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

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Bond Markets and Stock Markets and The Allocation of Savings 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

©2012 The McGraw-Hill Companies, All Rights Reserved 18 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 UmbrellaJones Suntan Lotion Rainy (50%) +$10$0 Sunny (50%) $0+$10

©2012 The McGraw-Hill Companies, All Rights Reserved 19 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 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

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Money and Its Uses Money is any asset that can be used in making purchases  Examples include coins and currency, checking account balances, and traveler's checks  Shares of stock are not money Money has three principal uses 1. Medium of exchange 2. Unit of account  Basic measure of economic value 3. Store of value  Means of holding wealth Money makes barter unnecessary  Barter is trading goods directly

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Private Money: Ithaca Hours and LETS Money is usually issued and controlled by the government Private money can develop in certain circumstances An Ithaca Hour is worth $10, the average hourly wage of workers  1,600 individuals have earned and spent this currency  Encourages local shopping LETS (Local Electronic Trading System) is electronic money from buying and selling goods and services  Used in UK, Australia, and New Zealand

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Measuring Money Definitions of money range from narrow to broad M1 Currency Demand deposits Other checkable deposits Traveler's checks M2 M1 Savings deposits Small-denomination time notes Money market mutual funds

©2012 The McGraw-Hill Companies, All Rights Reserved 23 M1 and M2, 2005 – 2010 (in billions of local currency) Note that in 2010, for example, M1 (as a share of M2) is 23% in Egypt, 85% in Morocco, 21% in Kuwait, and 26% in Qatar.

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Commercial Banks and The Creation of Money Republic of Marhaba begins with no banking system  Government issues 1 million guilders  Banks are created to store cash  Payments are made by withdrawing cash or writing checks Checks tell bankers of change in ownership of the specified number of guilders  Without interest, banks earn profits by charging depositors fees

©2012 The McGraw-Hill Companies, All Rights Reserved 25 Consolidated Bank Balance Sheet – Part 1 All guilders (g) are deposited Bank reserves are cash or similar assets held by banks  Used to meet depositors' withdrawals and payments  Marhaba's banks have 100% reserves  100% reserve banking is when banks' reserves equal 100% of their deposits AssetsLiabilities Currency1,000,000 gDeposits1,000,000 g

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Bank Reserves Cash in a bank's vault is not part of the money supply  Unavailable for payments  Bank deposits available for use in transactions are part of the money supply  Depositing a $100 bill in your checking account does not change the money supply Bankers realize that inflows and outflows from vaults leave some guilders unused  Only 10% of deposits are needed for transactions  90% can be lent to borrowers for a fee -- interest

©2012 The McGraw-Hill Companies, All Rights Reserved 27 Consolidated Bank Balance Sheet – Part 2 Currency held in the vault is the bank reserves The reserve – deposit ratio is bank reserves divided by total deposits Fractional reserve banking system holds less bank reserves than deposits  The reserve – deposit ratio is less than 100% AssetsLiabilities Currency100,000 gDeposits1,000,000 g Loans900,000 g

©2012 The McGraw-Hill Companies, All Rights Reserved 28 Consolidated Bank Balance Sheet – Part 3 Farmers borrow 900,000 guilders to buy supplies  Farmers spend the 900,000 guilders which are then deposited in the banks Bank deposits are the entire money supply  Loan of 900,000 guilders increased the money supply by 900,000 guilders Banks are again holding excess reserves on deposits of 1,900,000 guilders AssetsLiabilities Currency1,000,000 gDeposits1,900,000 g Loans900,000 g

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Consolidated Bank Balance Sheet – Part 4 With deposits of 1,900,000 guilders and a reserve – deposit ratio of 10%, banks want only 190,000 guilders in reserves  Currently holding 1,000,000 guilders  Loan 810,000 guilders  Loan are spent and re-deposited  Excess reserves are created and re-loaned AssetsLiabilities Currency1,000,000 gDeposits2,710,000 g Loans1,710,000 g

©2012 The McGraw-Hill Companies, All Rights Reserved 30 Consolidated Bank Balance Sheet – The End Expansion of loans and deposits stops when reserves are 10% of deposits  1,000,000 guilders available as reserves  Deposits stabilize at 10,000,000 guilders Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders AssetsLiabilities Currency1,000,000 gDeposits10,000,000 g Loans9,000,000 g

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Money Multiplier We see that the existence of a fractional-reserve banking system has multiplied the money supply by a factor of 10, relative to the economy with no banks or the economy with 100 percent reserve banking. This can be expressed with the money multiplier (MM): MM = 1/R = 1/0.10 = 10 where R represents the reserve-deposit ratio of 10 percent.

©2012 The McGraw-Hill Companies, All Rights Reserved 32 Money Creation With 10% reserves, each guilder supports 10 guilders in deposits The general case of money creation with fractional reserve banking is Solving for bank deposits we get Bank reserves Bank deposits = Desired reserve – deposit ratio Bank reserves Desired reserve – deposit ratio Bank deposits =

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Money Supply with Currency and Deposits Marhaba residents hold 500,000 guilders as currency  Deposit 500,000 guilders in the banks  Reserve-deposit ratio = 10%  Bank deposits = 500,000 / 0.10 = 5,000,000 guilders  Money supply = 500,000 cash + 5,000,000 deposits = 5,500,000 guilders Money supply = Currency held by public + Bank reserves Desired reserve – deposit ratio

©2012 The McGraw-Hill Companies, All Rights Reserved 34 Central Banks, The Money Supply, and Prices Central banks in general have two main responsibilities:  Responsible for monetary policy, which means that a country’s central bank determines how much money circulates in the economy  Oversight and regulation of financial markets In particular, central banks play important roles during periods of crisis in financial markets

©2012 The McGraw-Hill Companies, All Rights Reserved 35 Controlling The Money Supply with Open- Market Operations Monetary policy is deciding and managing the size of the nation's money supply  Money supply is controlled indirectly  Open-market purchase of government bonds from the pubic by the central bank increases bank reserves and the money supply  Open-market sale of government bonds by the central bank to the public decreases reserves and money supply

©2012 The McGraw-Hill Companies, All Rights Reserved 36 Open Market Operations When the Central Bank purchases a bond from the public  The central bank pays bond holder with new money  Receipts are deposited and this leads to a multiple expansion of the money supply When the central bank sells a bond to the public  Bondholder pays with checking funds  Bank reserves decrease and this leads to a multiple contraction of the money supply

©2012 The McGraw-Hill Companies, All Rights Reserved 37 Increasing the Money Supply An economy has 1,000 dirhams in currency and bank reserves of 200 dirhams  Reserve-deposit ratio = 0.2  Money supply = 1,000 + (200 / 0.2) = 2,000 dirhams Central bank pays 100 dirhams for a bond held by the public  Assume that all 100 dirhams are deposited  Money supply = 1,000 + (300/ 0.2) = 2,500 dirhams  100 dirham increase in reserves leads to a 500 dirham increase in the money supply

©2012 The McGraw-Hill Companies, All Rights Reserved 38 Money and Prices In the long run, the amount of money circulating and the level of prices are closely linked  Sustained high inflation rates occur with a comparably high growth rate of the money supply

©2012 The McGraw-Hill Companies, All Rights Reserved 39 Velocity of Money (V) Velocity is the speed money changes hands in transaction for final goods and services Nominal GDP is the price level (P) times real GDP (Y) M is the money supply Velocity = Nominal GDP Money supply V = (P) (Y) M

©2012 The McGraw-Hill Companies, All Rights Reserved 40 Velocity of M1 and M2, 2008  Except for Morocco, velocity of money of M1 is substantially higher than that of M2.  New technologies have increased velocity over time.

©2012 The McGraw-Hill Companies, All Rights Reserved 41 Money and Inflation in the Long Run Quantity equation states (M) (V) = (P) (Y)  Restatement of the velocity definition The quantity equation relates the money supply to price levels  Suppose velocity and real GDP are constant The quantity equation becomes  An increase in the money supply by a given percentage would increase prices by the same percentage V and Y, respectively M V = P Y

©2012 The McGraw-Hill Companies, All Rights Reserved 42 Approximating a Percentage Change M V = P Y % change in (M V) = % change in (P Y) The percentage change in a product is the sum of the percentage changes in each variable Consequently % change in M + % change in V ≈ % change in P + % change in Y If the M grows 4% per year and V grows 1% per year, nominal GDP (P Y) grows approximately 5% per year  If Y grows 3% per year, then the percentage change in price is approximately 2% per year