financial markets, money, and the federal reserve

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Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Markets, Money, and the Federal Reserve

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Financial System

High rates of saving and investment Are crucial for economic growth and

increased productivityAre not sufficient

Successful economies save and use saving wiselyFree markets allow saving to be allocated

by a decentralized, financial system

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Improving Allocation of Savings

Market-oriented financial systems improve the allocation of savingsProvide information

To savers about which ways to use the funds are the most productive

Help savers share the risksOf individual investment projects

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The Banking System

Consists of financial intermediariesExtend credit to borrowers using funds

raised from saversCommercial banksSavings-and-loans

Bring together savers and investorsGather important information necessary

for profitable lendingProvide credit

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BondsBonds

A legal promise to repay a debt, usually including both the principal amount and regular interest payments

Principal amountThe amount originally lent

Coupon rateThe interest rate promised when a bond is issued

Coupon paymentsRegular interest payments made to the

bondholder

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Bonds

Firms and governments often raise funds by issuing bonds and selling them to savers

SupposeThe principal amount of a bond is $1,000,000Coupon rate is 5%Annual coupon payment is $50,000

$50,000 = (0.05)($1,000,000)

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BondsThe coupon rate on new bond issues depends

uponThe bond’s term

The longer the length, the higher the interest requiredIts credit risk

A higher risk requires a higher interest rate“junk bonds” are high yield because of their greater

riskIts tax treatment

Interest paid on local government bonds are exempt from federal taxes, although municipal bonds have a lower yield

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Bond Market

People holding bonds do not have to keep them until maturityThey can be sold in bond markets

An organized market run by professional bond traders

Price of a bondThe market value of a particular bond at any

given point in timeAn inverse relationship exists between the price of a

bond and the interest rate

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Bond Prices and Interest Rates

A new 2-year government bondPrincipal = $1,000Coupon rate = 5% annuallyCoupon payment

Year one = $50 (5% of $1,000)Year two = $1050

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SupposeThe bondholder sells the bond after

receiving the first coupon paymentThe prevailing interest rate in the bond

market for 1-year bonds is 6%How much will it sell for?

The bondholder won’t get the full $1000Currently, a new 1-year bond will pay $1060

in one year

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Someone will buy the used bond for only a price that allows at least a 6% return The prevailing market interest rate

The buyer of the used bond will receive $1050The $1,000 plus $50 interest

The price for her bond that allows a 6% return must satisfy the equation:

Bond priceBond price

106. $1050$991

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What if the prevailing interest rate is 4%?

The price of the used bond must satisfy the bond price equation

Bond prices and interest rates are inversely related. Thus

Bond priceBond price

104010

. $1050$1,

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StocksStock (or Equity)

A claim to partial ownership of a firmIf a corporation has 1 million shares of stock

outstanding, ownership of one share means ownership of one-millionth of the company

Stockholders receive returns on their financial investment in two formsCapital gains

When the price of their stock increasesAnnual dividends

Annual payments

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Dividends

DividendA regular payment received by stockholders for

each share that they ownDetermined by the firm’s management and normally

depend on recent profits

Today’s stock price is affected by this year’s dividend, next year’s dividend, and so on…The ability to pay dividends depends upon the

firm’s future earnings

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Stock Price Determination

Prices of stocks are determined through trading on a stock exchangeNew York Stock Exchange, NASDAQ

Stock prices rise and fall as demand for the stock changesDemand for stocks depend on prospects of

the company

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Maximum Stock PriceSupposeYou know that you can get a $1.00 dividend from

owning a share of stock that will be valued at $80 in one year

The riskiness of the stock is zero so that your expected rate of return is that of what is offered by government bonds, say 6%

The maximum price one is willing to pay for a share of stock

Stock priceStock price

10642

. $81$76.

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Stock Prices and Expected Dividends

SupposeThe dividend will be $5.00


10619

. $85$80.

Higher expected dividends in the future increases the value of the stock today

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Stock Prices and Expected Dividends

SupposeThe expected future price of stock is

$84 with a dividend will be $5.00Stock priceStock price

10619

. $85$80.

Higher expected future stock raises the price of the stock today

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Stock Prices and Interest Rates

Suppose that the stock is riskyThe expected future price of stock is $80

with a dividend will be $1.00But, the rate of return you require

increases to 10% (4% risk premium)

Increases in interest rates tend to depress stock prices as well as bond prices


11064

. $81$73.

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Bond and Stock MarketsProvides a way of channeling funds

From savers to borrowers with productive investment opportunities

Corporations can Borrow from banksIssue new bonds

Sold in bond marketsIssue new shares in itself

Sold in stock marketsProceeds can then be used to finance capital

investment

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Bond and Stock Markets and Allocation

Both marketsProvide information

About the most profitable financial investments

Share risksDiversification

The practice of spreading one’s wealth over a variety of different financial investments to reduce overall risk

Via Mutual funds--a financial intermediary that sells shares in itself to the public, then uses the funds raised to buy a wide variety of financial assets

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MoneyMoney: Any asset that can be used directly in

making purchasesCurrency and coinChecking account balance

Principal usesMedium of exchangeUnit of accountStore of value

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Medium of Exchange

Medium of exchangeAn asset used in purchasing goods and

servicesReduces transaction costs

BarterThe direct trade of goods or services for

other goods or servicesHas very high transaction costs

Requires double coincidence of wants

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Uses of Money

Unit of accountA basic measure of economic valueA yardstick for measuring valueUses dollars in the U.S.

Store of valueAn asset that serves as a means of holding wealthNot a particular good way to hold wealth unless

one wants to avoid the Internal Revenue System

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Measuring Money

How much money?M1

Sum of currency outstanding and balances held in checking accounts

Narrow definitionM2

All the assets in M1 plus some additional assets that are usable in making payments but at greater costs or inconvenience than currency or checks

Broader definition

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Determining the Money Supply

The money supply consists of CurrencyDeposit balances held by commercial

banksThe determination of the money supply

depends in part on the behavior of commercial banks

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Bank’s Balance SheetAssets

What banks ownLiabilities

What banks oweBank reserves

Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawls and payments

Not part of the money supply

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Reserve Banking

100 percent reserve bankingA situation in which banks’ reserves equal

100 percent of their depositsBanks realize they don’t need to keep

100 percent of their depositsMost of the deposits sit thereSolution: Banks can keep 10% and loan

up to 90%

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Fractional-Reserve Banking

Reserve-deposit ratio Bank reserves divided by deposits

Fractional-reserve banking systemA banking system in which bank reserves

are less than deposits so that the reserve-deposit ratio is less than 100

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Money Creation

When a bank lends out reserves it creates money

Process of expansion of loans and deposits ends when all excess reserves are loaned outWhen the actual ratio of bank reserves to

deposits equals the desired reserve-deposit ratio

Bank deposits bank reservesdesired reserve deposit ratio

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Federal Reserve SystemFederal Reserve System, “Fed”

The central bank of the U.S.Two main responsibilities

Regulate monetary policyDetermines how much money circulates in the

economyInfluence key macro variables

Regulate financial markets

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History of the Fed

A government agency created by the 1913 Federal Reserve ActPursuing public goals of growth, low

inflation, and smooth operation of financial markets

Oversees private commercial banks Trying to make a profit

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The FedConsists of 12 regional banks

Each represent a geographic area in national policymaking

Each provides services like check clearingHeadquarters is in Washington D.C.Board of Governors

The leadership of the Fed, consisting of seven governors appointed by the president to staggered 14-year terms

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FOMC

Federal Open Market CommitteeThe committee that makes decisions

concerning monetary policyMeets 8 times a year to determine

monetary policy

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Fed and the Money Supply

The Fed controls the money supply indirectlyThrough changing the supply of reserves

held by commercial banksOpen-market operations

Open-market purchase and open-market sales are the Fed’s most convenient and flexible tools

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Open Market OperationsOpen market purchase

Buying government bonds from the publicIncreasing the supply of bank reserves and the

money supplyOpen market sale

Selling government bonds to the publicReducing bank reserves and the money supply

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Discount Window LendingDiscount window lending

The lending of reserves by the Fed to commercial banks when banks are short on reserves

The lending of reserves directly increase reserves in the banking system, thereby increasing the money supply

Discount rateThe interest rate the Fed charges commercial

banks that borrow reserves

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Reserve Requirements

Reserve requirementsSet by the Fed, the minimum values of the

ratio of bank reserves to bank deposits that commercial banks are allowed to maintain

With an increase in reserve requirementsBanks lend out a smaller share of their

depositsThe money supply falls

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Banking PanicBanking panic

An episode in which depositors, spurred by news or rumors of the imminent bankruptcy of one or more banks, rush to withdraw their deposits from the banking system

With fractional-reserve bankingBanks do not keep 100% of depositsIf everyone shows up and wants his or her deposits, a

bank will run out of cash1930-1933 saw the worst bank panics in the U.S.

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Deposit Insurance

Deposit insuranceA system under which the government

guarantees that depositors will not lose any money even if their bank goes bankrupt

In 1934 policymakers wanted to stop the banking panics

Incentives for banks changeLess concerned about the solvency of the

loans made

financial markets, money, and the federal reserve

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