Transcript Frank & Bernanke - Hiram Reads! — Where Hiram College

Frank & Bernanke
4th edition, 2009
Ch. 9: The Financial
System, Money,
and Prices
1
Outline

Savings
Bonds
 Stocks
 Money

 Banks
 Fed
 Inflation
2
Savings and Investments
National savings done by governments,
households and businesses will not be
channeled into investments if there is no
intermediary to bring the two sides
together.
 Even if there were intermediaries,
investments may not be productive and
resources may be wasted, condemning
the future generations to poverty.

3
Savings

Lack of options for households may force them
to keep their wealth in money form.


In many poor countries, households keep their
wealth in gold.


A relatively high inflation would wipe out most of their
wealth.
In 1980-81, gold prices reached $800/oz.. On Feb.
24, 2004, gold was $403.45 per ounce; on Feb. 15,
2010: $1105.34.
A financial system that can provide trust and
security to small savers can increase the amount
of savings in a poor country.
4
Investments



Those that need funds to bring new products or
to expand operations (entrepreneurs and
managers) are taking risks. They do not know
what the future will hold but given their present
day knowledge they are betting on a positive
outcome.
If all investments are done through a central
office, an unfortunate turn of events can render
the investment worthless and savings wasted.
Concentration of risk, political decision-making,
limited knowledge can waste scarce resources
and render investments unproductive.
5
Financial System

A well-developed financial system provides
many alternatives for savers.



Different risk levels; different size levels; different
maturities; different liquidity levels.
A well-developed financial system provides
scarce and costly information for lenders, thus
reducing the overall risk.
A well-developed financial system channels
savings to most productive use.
6
Financial Institutions
Asymmetric information creates a need
for specialized institutions to evaluate
risk.
 Comparative advantage leads to
specialization.
 Economies of scale allows financial
institutions to collect information and to
channel savings into loans at low cost.

7
Bonds
A bond is an IOU that indicates the
principal to be paid at maturity (face value),
the rate of interest to be earned per year on
the principal (coupon rate), and the date
the bond will mature (date the principal will
be paid).
 Bonds are issued by borrowers and bought
by lenders.
 During the life of the bond, the holders may
decide to sell the bond to someone else.

8
Bonds
Bonds issued by different entities carry
different coupon rates. Credit risk is the
most important reason that determines
the variations in coupon rates in same
maturity bonds.
 Municipal bonds usually have lower
coupon rates because they are exempt
from federal taxation.

9
Bonds




Joe buys a 5-year government bond (Treasury note) issued
on Jan. 1, 2010 with a face-value of $1,000 and a coupon
rate of 4%.
Who is the lender and who is the borrower?
On Jan. 1, 2011 and on Jan. 1, 2015 how much will the
government pay to the holder of this bond?
If Joe wants to sell his bond on Jan. 2, 2012, what price
does he expect to get for his bond if
 similar bonds pay an interest rate of 4%?
 similar bonds pay an interest rate of 3%?
 similar bonds pay an interest rate of 5%?
10
Bond Prices and Interest Rates
When interest rates rise, bond prices
fall.
 When interest rates fall, bond prices
rise.
 If Joe expects to see higher interest
rates in the future, should he buy or sell
bonds today? (Hint: think about capital
gains and losses).

11
Stocks
Stocks are shares in the ownership of a
public company.
 Stockholders are paid dividends from
the profits of the company.
 If future profits are expected to
increase, dividends are expected to
increase, creating an extra demand for
the stock and pushing the price of the
stock up today.

12
Stocks
When a company issues stock it receives
the funds to use for expansion, investment.
 When existing stocks are bought and sold
in the stock market, the company gets
nothing except a signal that if it wants to
raise funds would it be cheaper or more
expensive.
 Since stocks and bonds are substitutes, a
rise in interest rates that reduces the bond
prices also reduces the stock prices.

13
Stock Prices





Suppose you expect the stock price of IBM to be
$100 a year from now and also you expect dividends
per share to be $5, then.
Assuming that given the riskiness of IBM, you desire
to have a return of 8% on your savings, what price
are you willing to pay for this stock?
Hint: If you were to sell the stock a year from now,
how much would you get and what is the present
value today that will yield 8% to bring this amount?
P (1.08) = $105
P = $105/1.08 = $97.22
14
Stock Prices
If in general, interest rates have risen
because of inflation, so that you expect
10% return rather than 8%, how much
would you pay for the same IBM stock?
 P = $105/1.1 = $95.45
 What if you expected IBM price to be
$110?
 What if you expected dividends to be
$10?

15
Newly Issued Stocks and
Bonds
In order to raise funds (to borrow)
businesses can go to the banks or issue
new stocks or bonds.
 If the future of the business is considered
risky, the bonds will carry a high interest
rate and the stocks will sell at a low price.

16
What Is Money?
Does Bill Gates have a lot of money?
 Does LeBron James make a lot of money?
 Anything accepted by a community in
exchange of goods and services and for
settlements of debts.

17
Functions of Money

Unit of account
Increase in variety of goods requires a
common unit to quote and compare prices.
 3 goods: 2 prices
 4 goods: 6 prices
 5 goods: 24 prices
 N goods: N!/2(N-2)! Prices


Money had to be invented.
18
A Proposed Unit of Account


We could [have] labels providing a product or service’s
“daily energy calories.” Along with physical labels,
imagine a smartphone app — we’ll call it “Decal” for
short — that would scan a product’s bar code and report
how much energy it took to produce that item.
Like the nutritional data on the backs of food products,
Decal would give consumers a user-friendly, universal
measure that they could use to compare products or
count their daily energy intake.
http://www.nytimes.com/2011/03/09/opinion/09Little.html?partner=rss&emc=rss
19
Functions of Money

Medium of exchange
Barter requires double coincidence of wants.
 Exchange makes both parties better-off.
 Money had to be invented.

20
Functions of Money

Store of Value
Postponing consumption by storing wealth in
an asset for future use.
 Today we have many different assets for
wealth storage.
 Depending on the ability of these assets to be
easily converted to cash (liquidity) these
assets are near or far to “money.”

21
Financial Assets Savers Can Hold









Currency
Checking account
Savings account
Certificate of Deposit
Foreign currency
Bonds
Stocks
Options on stocks, bonds, foreign currency
Futures on commodities, foreign currency
22
Assets According to Liquidity
Currency
 Checking Account
 Savings Account
 Money Market Mutual Fund
 Bonds

23
Measuring Money
In billions of dollars
http://research.stlouisfed.org/publications/mt/page16.pdf
24
Measuring Money
25
Components of M1 and M2,
July 2002 (billions of dollars)
M1
1,197.8
Currency
615.1
Demand deposits
303.8
Other checkable deposits
270.3
Travelers’ checks
8.6
M2
5,641.2
M1
1,197.8
Savings deposits
2,552.8
Small-denomination time deposits
920.8
Money market mutual funds
969.8
26
Banks and the Creation of Money
When depositors put money in the bank,
the bank turns around and loans part of
the money to others.
 Both the depositor and the borrower have
funds to spend.
 Money has been created.

27
Banks and the Creation of Money
We will show the changes in assets and
liabilities of a bank in response to deposit
and loan activities.
 Deposits into checking accounts are
liabilities of a bank.
 Cash is an asset.
 Assets = Liabilities for a Balance Sheet to
be in balance.

28
Creation of Money
Ally deposits $1000 into her checking
account with First National.
 First National holds only 10% as reserves
and loans the rest to Billy.
 Billy buys a snow blower for $900 from
Carl.
 Carl deposits $900 with Second National.
 Second National loans how much to
Deyna if it also holds 10% as reserves?

29
Creation of Money
If this process goes on for thirty rounds,
how much checking deposits will be in the
banking system?
 1000 + 1000(.9) +
1000(.9)(.9)+…+1000(.9)^30
 1000 + 900 + 810 + … + 0.04
 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

30
Creation of Money
The banking system used the initial
deposit of $1000 as the reserves and
multiplied it by (1/reserve ratio) to create
checking deposits for the economy.
 What would be the deposits created by the
same $1000 deposit, if the banks kept 5%
as the reserve ratio?

31
Narrow Money, M1
M1 is defined as currency outside of the
banks plus bank deposits.
 Monetary Base is defined as Currency +
Reserves.

32
Measuring Money
33
Measuring Money
•What was the amount of currency in January 2010,
January 2011?
•What was the amount of bank deposits in January 2010,
January 2011?
•What was the reserve ratio in January 2010, January
2011?
34
Banks and the Creation of
Money

Summary
Bank reserves/bank deposits = desired
reserve-deposit ratio
 Bank deposits = bank reserves/desired
reserve-deposit ratio

35
Banks and the Creation of
Money

The Money Supply with Both Currency
and Deposits
CB provides 1 million in cash to residents
 Residents choose to hold 500,000 as
currency
 Deposit 500,000 in the banks
 Reserve-deposit ratio = 10%
 Bank deposits = 500,000/.10 = 5,000,000

36
Banks and the Creation of
Money

The Money Supply with Both Currency
and Deposits
Money supply = currency + bank deposits
5,500,000 = 500,000 + 5,000,000
 Money is increased by 4,500,000 when the
residents hold 500,000 in bank deposits

37
Banks and the Creation of
Money

The Money Supply at Christmas
Currency = 500
 Bank reserves = 500
 Reserve-deposit ratio = 0.20
 Money supply = 500 + 500/.20 = 500 + 2,500
= 3,000

38
Banks and the Creation of
Money

The Money Supply at Christmas
If Xmas shoppers withdraw 100
 Money supply = 600 + 400/.20 = 600 + 2,000
= 2,600

39
Banks and the Creation of
Money

The Money Supply at Christmas

Observation
 When
the reserve-deposit ratio = 0.20, every $1
reduction in reserves may reduce the money
supply by $5.
 In general, when people make withdraws, the
money supply contracts by a multiple of the
withdrawal.
40
The Federal Reserve System
The Central Bank of the United States.
 The Fed is responsible for monetary
policy.

Amount of money supplied to the system.
 Affects interest rates, inflation, unemployment
and exchange rates.


The Fed oversees and regulates the
financial markets.
41
The Fed
Fed was established in 1913 in the hopes
of eliminating banking panics of the 19th
century by providing credit to the financial
markets.
 In order to disperse power 12 regional
Federal Reserve Banks were formed.
 The seven members of the Board of
Governors are appointed by the President
for 14-year terms every other year.

42
Monetary Policy
Federal Open Market Committee (FOMC)
is the group that sets the monetary policy.
 Fed Chairman (4-year term) plus
governors, plus NY Fed President, plus 4
Presidents of Fed banks comprise FOMC.
 FOMC meets eight times a year.

43
Controlling the Money Supply

Open-Market Operations: buying and selling of
financial assets.



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Buying government bonds from the public increases
bank reserves, hence money supply.
Selling bonds decreases money supply.
Discount window lending: Lending to banks
increases bank reserves.
Changing reserve requirements: Raising
reserve-deposit ratio decreases money supply.
New Tools:
http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html
44
Open-Market Operation
Suppose an economy has $100 currency,
$100 reserves and 0.1 as reserve-deposit
ratio.
 What is the money supply?
 If the Central Bank purchased $5 worth of
bonds, what will be the money supply?
 If the CB sold $10 worth of bonds, what
will be the money supply?

45
The Federal Reserve System

Example
 Currency
= 1,000
 Reserves = 200
 Reserve-deposit ratio = 0.2
 What is M1?
Money supply = 1,000 + 200/0.2 = 2,000
46
The Federal Reserve System

Example

Increasing the money supply by openmarket operations
 Open
market purchase = 100
 Reserves increase to 300
 Money supply = 1,000 + 300/0.2 = 2,500
47
The Federal Reserve System

Controlling the Money Supply: Discount
Window Lending

The discount rate
 The

interest rate charged on these loans
Discount lending will increase reserves and
the money supply.
48
The Federal Reserve System

Controlling the Money Supply: Changing
Reserve Requirements

The Fed sets the reserve-deposit ratio
 Called
the reserve requirement
A reduction in the reserve requirement
would allow the money supply to increase.
 An increase in the reserve requirement may
reduce the money supply.

49
http://www.federalreserve.gov/monetarypolicy/default.htm
50
Primary Credit Rate
http://research.stlouisfed.org/publications/mt/page9.pdf
51
The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

Suppose:
 Depositors
lose confidence in their bank.
 They attempt to withdraw their funds.
 Bank may not have enough reserves (fractional)
to meet the depositors demand.
 The bank fails and further erodes depositor
confidence which triggers additional failures.
52
The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

The Fed to the rescue:
 Instill
confidence
 Discount lending
 Open Market Operations
53
Money and Price Level
In the long run, prices adjust to pressures
in the economy.
 The “quantity theory of money” captures
the long-run relationship.

MV = PY
54
Quantity Theory
M is money stock, like M1 or M2.
 V is velocity, the number of times money
stock exchanges hands in creating the
nominal GDP.
 P is price level, like 1.00 or 1.26 (price
index)
 Y is real GDP.
 PY is nominal GDP.

55
Long Run Inflation
In the long-run, the economy will operate
at full-employment; so Y will not change if
there is no growth. If there is growth, then
Y is predictable: Y is known.
 Velocity is also thought predictable in the
long-run.
 Therefore, any growth in money supply will
be reflected in inflation.

56
Money and Prices

Velocity

The speed at which money circulates
Value of transactions Nominal GDP
Velocity 

Money stock
Money stock
P (pricelevel) x Y (real GDP) P x Y
Velocity (V) 

M (money supply)
M
57
Money and Prices

Velocity in 2001
M1 = $1,177.9 billion
 M2 = $5,449.1 billion
 Nominal GDP = $10,082.2 billion

$10,082.2 billion
M1, V 
 8.56
$1,117.9 billion
$10,082.2 billion
M2, V 
 1.85
$5,499.1billion
58
Money and Prices

Money and Inflation in the Long Run

Quantity equation
M

xV=PxY
Assume V & Y are constant over the time
period
M xV  P x Y
%Δ M + % Δ V = % Δ P + % Δ Y
59
Money and Prices

Money and Inflation in the Long Run
If the Fed increases M by 10%, then prices
must increase by 10%.
 High rates of money growth are associated
with high rates of inflation (too much money
chasing too few goods).

%Δ M + % Δ V = % Δ P + % Δ Y
60
Inflation and Money Growth in
Latin America, 1995-2001
61