McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16: Money, Prices, and the Financial System 1.Describe the role of financial intermediaries 2.Differentiate between bonds and stocks and show why their prices are inversely related to interest rates 3.Explain how the financial system improves the allocation of saving to productive uses 4.Discuss the three functions of money and how the money supply is measured 5.Analyze how the lending behavior of commercial banks affects the money supply 6.Explain how the central bank controls the money supply and its relation to inflation in the long run

16-2 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 a lower cost of evaluating opportunities than an individual would Banks pool the saving of many individuals to make large loans

16-3 Banking System Banks gather information about potential investments –Evaluate the options –Direct saving –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 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

16-4 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 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: the higher risk, higher coupon rate –Tax treatment for the coupon payments: lower taxes, lower coupon rates Municipal bonds are free from federal taxes

16-5 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, 1/1/12 –Coupon rate is 5% –$50 will be paid 1/1/13 –$1,050 will be paid 1/1/14 Bond's price on 1/1/10 depends on the prevailing interest rate

16-6 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 Risk Premium Risk premium is the rate of return investors require to hold risky assets minus the rate of return on safe assets Risk aversion increases the return required of a risky stock and lowers the selling price

16-7 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 saving –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

16-8 Stock and Bond Markets Savers can put saving 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 financial intermediary that sells shares in itself to the public, then uses the funds raised to buy a wide variety of financial assets. –Diversified asset for the saver –Less costly than buying many stocks and bonds directly

16-9 Money 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 3.Store of value Money makes barter unnecessary –Barter is trading goods directly

16-10 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

16-11 The Federal Reserve System The Fed is the central bank of the US –Responsible for monetary policy and the oversight and regulation of financial markets 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 Fed increases bank reserves and the money supply Open market sale of government bonds by the Fed to the public decreases reserves and money supply

16-12 Open Market Operations When the Fed purchases a bond from the public –Fed pays bond holder with new money Receipts are deposited and this leads to a multiple expansion of the money supply When the Fed 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

16-13 Velocity of Money (V) Velocity is a measure of the speed money changes hands in transactions for final goods and services Nominal GDP is the price level (P) times real GDP (Y) M is the money stock Velocity = Nominal GDP Money stock V = P x Y M

16-14 Money and Inflation in the Long Run The quantity equation states that money times velocity equals nominal GDP, M x V = P x Y –Restatement of the velocity definition Shows a relationship between money and price level –Suppose velocity and real GDP are constant The quantity equation becomes –An increase in the money supply by a given percentage would increase the price level by the same percentage V and Y, respectively M x V = P x Y

16-15 Money, Prices, and the Financial System DiversificationDiversification MoneyMoney ReservesReserves Financial System BanksBanks BondsBonds StocksStocks Federal Reserve System Open Market Operations Quantity Equation