THE FINANCIAL SYSTEM, MONEY, AND PRICES: PART I

Chapter 9

Financial System and Allocation of Saving

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 improves the allocation of saving

Money

Money—Any asset that can be used in making purchases.

Difference between Money and Income.

1) Income—A flow of earning per unit of time. $500.00 of income per week.

2) Money—a stock at a certain point in time. $50.00 of cash in your pocket.

3 Functions of Money

1) Medium of Exchange—money is an asset used in purchasing goods and services.

This is the most important function of money.

3 Functions of Money

2) Unit of Account—money is a basic measure of economic value. Money is used to “keep score.”

3 Functions of Money

3) Store of Value—money is an asset that serves as a means of holding wealth.

Definition of a Monetary Economy

Let us see how a monetary economy

comes about.

Example

We begin with an economy with N commodities. These commodities are C1, C2, C3, - - - Cn. Ci is commodity i.

Example

Assume the Following Notation

E = exchanges for

E = does not exchange for

Example

C1 E C2 means that C1 exchanges for C2

C1 E C2 means that C1 does not

exchange for C2

Barter Economy

In a barter economy, each good exchanges for every other good. Barter is the direct trade of goods and services for other goods and services.

Barter Economy

C1 C2 C3

C1 E E E

C2 E E E

C3 E E E

In a barter economy, each and every good serves as money.

That is, each and every good is an asset that can be used in making purchases.

Barter Economy

Monetary Economy

C1 C2 C3

C1 E E E

C2 E E E

C3 E E E

This is an example of a monetary economy. C1 serves as money, while C2 and C3 do not.

Monetary Economy

In a monetary economy, at least one good, but not all goods, serve as money.

That is, at least one good, but not all goods, is an asset that can be used in making purchases.

Another Monetary Economy C1 C2 C3 C4

C1 E E E E

C2 E E E E

C3 E E E E

C4 E E E E

Only C1 is money because only C1 trades for all other goods.

C3 and C4 are a barter subset.

C3 and C4 trade directly for each other.

C3 and C4 are not money.

Some goods don’t trade for other goods because of exchange costs.

Exchange costs exist in both barter economies and monetary economies, but they are higher in barter economies.

Exchange costs

1) Opportunity cost of time spent in exchange.

2) Resource costs—transportation costs and the wastage of goods in the exchange process.

3) Waiting costs—The costs of delaying consumption.

4) Trading costs—The cost of not making the best possible trade.

Exchange costs are higher in a barter economy because barter requires a double coincidence of wants.

Double coincidence of wants—you must find someone who has what you want and wants what you have.

U.S. Money Supply Measures: M1 and M2

M1 – a measure of funds that are available for immediate spending.

M1 = currency outstanding + checkable deposits

Checkable Deposits

1) Demand deposits2) NOW accounts and super NOW accounts3) ATS accounts4) Travelers’ checks

M2 – a measure of funds available for immediate spending + funds that can be converted quickly into funds that can be spent immediately.

M2 = M1 + savings deposits + small-denominated time deposits + money market mutual funds

Savings deposits—savings accounts with no fixed time limit.

Small denominated time deposits—savings accounts with a fixed term to maturity (interest penalty for early withdrawal). Small < $100,000.

Example: Certificate of Deposit

Money Market Mutual Funds—organizations that sell shares, use the proceeds to buy safe assets, and often allow check-writing privileges.

Banking System

Financial intermediaries are firms that extend credit to borrowers using funds raised from savers

Banks have lower cost of evaluating opportunities than an individual would

Banks pool the savings of many individuals to make large loans

Two types of intermediaries Traditional & Market-based (recent

development)

Banking System

Banks gather and evaluate potential investments to 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

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

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

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

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, 1/1/09 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

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) = $1,050Bond price = $991

Bond prices and interest rates are inversely related

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

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

Selling price of stock will be $80 in 1 year Interest rate on safe asset (government bond) 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

Risk Premium

Risk premium is the rate of return investors require of risky asset minus the rate of return on a safe asset

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) = $81Stock price = $73.64

Risk aversion increases the return required of a risky stock and lowers the selling price

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 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

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 Weathe

r

Smith Umbrella

Jones Suntan Lotion

Rainy (50%)

+$10 $0

Sunny (50%)

$0 +$10

Apple Stock

Lehman Brothers

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

Rise and Fall of the US Stock MarketStandard & 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 And then…..

Increase in stock prices can be due to Increased optimism about future value A fall in required return

Rise and Fall of the US 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 US

Dow Jones vs. S&P 500

A Closer Look…

Other Financial Products

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

Closed-End funds Structured similar to a mutual fund, however is traded

on the exchange like a stock and has a fixed number of shares outstanding (thus can trade at a premium or discount to market value)

Exchange-Traded Funds Similar to a closed-end fund, however the amount of

shares outstanding is allowed to fluctuate (trades close to its market value)