1. Money, Prices, and the Financial System
Chapter 20
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. Learning Objectives
Describe the role of financial intermediaries such as commercial banks in the financial system
Differentiate between bonds and stocks and show why their prices are inversely related to interest rates
Explain how the financial system improves the allocation of saving to productive uses
Discuss the three functions of money and how the money supply is measured
Analyze how the lending behavior of commercial banks affects the money supply
Explain how a central bank controls the money supply and how control of the money supply is related to inflation in the long run

3. 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 saving
The increase in the value of your stock is a capital gain
When your house appreciates, your wealth increases

4. The Allocation of Saving
A successful economy allocates its saving to the most productive investments
The interest on deposits is one important reason people put their saving in banks
The financial system improves 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

5. 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

6. 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

7. 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

8. 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
Japan had relied on banks to allocate its saving
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

9. 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

10. 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

11. 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

12. 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

13. 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

14. FortuneCookie.com New company with estimated dividend of $1 in 1 year
Estimated 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

15. Risk Premium
Risk premium is the rate of return investors require to hold risky assets minus the rate of return on safe assets
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

16. 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

17. 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%)

18. 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

19. Rise and Fall of the U.S. 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
Increase in stock prices can be due to
Increased optimism about future value
A fall in required return

20. Rise and Fall of the U.S. 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 U.S.

21. 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
Medium of exchange
Unit of account
Store of value
Money makes barter unnecessary
Barter is trading goods directly

22. Private Money 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

23. Measuring Money in the U.S., April 2013
Definitions of money range from narrow to broad
M1 ($B)
$2,523.2
Currency
$1,108.9
Demand deposits
952.9
Other checkable deposits
457.7
Traveler's checks
3.7
M2 ($B)
$10,525.7 M1
$2,523.2
Savings deposits
6,778.5
Small-denomination time notes
590.1
Money market mutual funds
633.8

24. Commercial Banks Create Money
Republic of Gorgonzola 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

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
Gorgonzola's banks have 100% reserves
100% reserve banking is when banks' reserves equal 100% of their deposits
Assets
Liabilities
Currency
1,000,000 g
Deposits

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

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%
Assets
Liabilities
Currency
100,000 g
Deposits
1,000,000 g
Loans
900,000 g

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
Assets
Liabilities
Currency
1,000,000 g
Deposits
1,900,000 g
Loans
900,000 g

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
Assets
Liabilities
Currency
1,000,000 g
Deposits
2,710,000 g
Loans
1,710,000 g

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
Assets
Liabilities
Currency
1,000,000 g
Deposits
10,000,000 g
Loans
9,000,000 g

31. Desired reserve – deposit ratio
Money Creation
With 10% reserves, each guilder supports 10 guilders in deposits
Deposits in the banking system satisfy this relationship
Solving for bank deposits we get
Bank reserves
Bank deposits
= Desired reserve – deposit ratio
Bank reserves
Desired reserve – deposit ratio
Bank deposits =

32. Money Supply with Currency and Deposits
Gorgonzola 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

33. Money Supply at Christmas
Suppose banks hold $500 billion in reserves and the public holds $500 billion in cash
Reserve-deposit ratio = 0.20
Money supply = $500 + (500 / 0.20) = $3,000
As Christmas approaches, consumers reduce bank deposits by $100 billion
Banks have $400 billion in reserves; public holds $600 billion cash
Money supply = $600 + ($400 / 0.20) = $2,600
Reducing bank deposits reduces the money supply

34. The Central Banks
The Fed, Bank of Japan, Monetary Authority of Singapore, and People's Bank of China are the central banks of the United States, Japan, Singapore and China respectively
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

35. 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

36. Increasing the Money Supply
An economy has 1,000 shekels in currency and bank reserves of 200 shekels
Reserve-deposit ratio = 0.2
Money supply = 1,000 + (200 / 0.2) = 2,000 shekels
Central bank pays 100 shekels for a bond held by the public
Assume that all 100 shekels are deposited
Money supply = 1,000 + (300/ 0.2) = 2,500 shekels
100 shekel increase in reserves leads to a 500 shekel increase in the money supply

37. 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

38. 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

39. Velocity in the U.S., 2012 M1 = $2,445.6 billion
Nominal GDP = $15,684.8 billion
Using M1, velocity is 6.41
Using M2, velocity is 1.51
Velocity is determined by a number of factors including technology such as ATMs and debit cards
V =
$15,684.8
2,445.6
= 6.41
V =
$15,684.8
10,409.0
= 1.51

40. 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

41. Money, Prices, and the Financial System
Quantity Equation
Financial System
Open Market Operations
Money
Stocks
Diversification
Bonds
Federal Reserve System
Reserves
Banks