©2012 the mcgraw-hill companies, all rights reserved 1 chapter 19: the financial system, money, and...

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 19: The Financial System, Money, and Prices


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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


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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


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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


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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


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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


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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

investmentsWhen banks make loans, they earn

interest which, in turn, is paid to the bank's depositors


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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


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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


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Bonds and Stocks

A bond is a legal promise to repay a debtEach 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


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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


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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


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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) = $1,050Bond price = $991

Bond prices and interest rates are inversely related


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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 increasesPrices are determined in the stock

market Reflect supply and demand


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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


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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 = $73.64Risk aversion increases the return required

of a risky stock and lowers the selling price


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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 investmentLike 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


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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

$0Diversify 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


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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


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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 exchange2. Unit of account Basic measure of economic value3. Store of value Means of holding wealth

Money makes barter unnecessary Barter is trading goods directly


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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


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Measuring Money

Definitions of money range from narrow to broadM1

Currency

Demand deposits

Other checkable deposits

Traveler's checks

M2

M1

Savings deposits

Small-denomination time notes

Money market mutual funds


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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.


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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


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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

Assets Liabilities

Currency 1,000,000 g Deposits 1,000,000 g


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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


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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


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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 guildersBanks are again holding excess reserves

on deposits of 1,900,000 guilders

Assets Liabilities


Loans 900,000 g


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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


Loans 1,710,000 g


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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


Loans 9,000,000 g


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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.


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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 reservesBank deposits

= Desired reserve – deposit ratio

Bank reservesDesired reserve – deposit ratio

Bank deposits =


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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 reservesDesired reserve – deposit ratio


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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


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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


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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


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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 dirhamsCentral 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


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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


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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 GDPMoney supply

V = (P) (Y) M


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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.


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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


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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

©2012 the mcgraw-hill companies, all rights reserved 1 chapter 19: the financial system, money, and...

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