Transcript Bank reserves - McGraw Hill Higher Education

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 higherreturn, 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
investments
 When 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 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
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Bonds
 Corporations and governments issue bonds
 The coupon rate depends on
 The

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

bond's term
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) = $1,050
Bond 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
increases
Prices 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 = $73.64
 Risk 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 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
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Benefits of Diversification
 Vikram has $200 to invest in stocks, each $100
Increase in Stock Price per Share
Actual Weather
Smith Umbrella
Jones Suntan Lotion
Rainy (50%)
+$10
$0
Sunny (50%)
$0
+$10
 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
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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
Medium of exchange
Unit of account
1.
2.

Basic measure of economic value
Store of value
3.

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 broad
M1
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
Assets
Currency
1,000,000 g
Deposits
Liabilities
1,000,000 g
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
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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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Consolidated Bank Balance Sheet – Part 2
 Currency held in the vault is the bank reserves
Assets
Liabilities
Currency
100,000 g
Loans
900,000 g
Deposits
1,000,000 g
 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%
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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
Assets
Currency
Liabilities
1,000,000 g
Loans
Deposits
1,900,000 g
900,000 g
 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
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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
Assets
Currency
1,000,000 g
Loans
1,710,000 g
 Loan

Liabilities
Deposits
2,710,000 g
are spent and re-deposited
Excess reserves are created and re-loaned
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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
Assets
Currency
1,000,000 g
Loans
9,000,000 g
Liabilities
Deposits
10,000,000 g
Beginning with 1,000,000 guilders in cash,
the money supply is now 10,000,000
guilders
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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
Bank reserves
Bank deposits
= Desired reserve – deposit ratio
Solving for bank deposits we get
Bank deposits =
Bank reserves
Desired reserve – deposit ratio
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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 reserves
Desired 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 OpenMarket 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
dirhams
 Central 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
Velocity =
Nominal GDP
Money supply
(P) (Y)
V=
M
Nominal GDP is the price level (P) times
real GDP (Y)
M is the money supply
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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
V and Y, respectively
 The quantity equation becomes
MV=PY
 An
increase in the money supply by a given
percentage would increase prices by the same
percentage
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Approximating a Percentage Change
MV=PY
% 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
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