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Money, Prices, and the Financial System

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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


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