1 frank & bernanke 4 th edition, 2009 ch. 9: the financial system, money, and prices

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Frank & BernankeFrank & Bernanke44thth edition, 2009 edition, 2009

Ch. 9: The Ch. 9: The Financial System, Financial System, Money, and PricesMoney, and Prices

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OutlineOutline

SavingsSavingsBondsBondsStocksStocksMoneyMoney

BanksBanksFedFedInflationInflation

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Savings and InvestmentsSavings and Investments

National savings done by governments, National savings done by governments, households and businesses will not be households and businesses will not be channeled into investments if there is no channeled into investments if there is no intermediary to bring the two sides intermediary to bring the two sides together.together.

Even if there were intermediaries, Even if there were intermediaries, investments may not be productive and investments may not be productive and resources may be wasted, condemning resources may be wasted, condemning the future generations to poverty.the future generations to poverty.

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SavingsSavings Lack of options for households may force them Lack of options for households may force them

to keep their wealth in money form.to keep their wealth in money form. A relatively high inflation would wipe out most of their A relatively high inflation would wipe out most of their

wealth.wealth. In many poor countries, households keep their In many poor countries, households keep their

wealth in gold.wealth in gold. In 1980-81, gold prices reached $800/oz.. On Feb. In 1980-81, gold prices reached $800/oz.. On Feb.

24, 2004, gold was $403.45 per ounce; on Feb. 15, 24, 2004, gold was $403.45 per ounce; on Feb. 15, 2010: $1105.34.2010: $1105.34.

A financial system that can provide trust and A financial system that can provide trust and security to small savers can increase the security to small savers can increase the amount of savings in a poor country.amount of savings in a poor country.

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InvestmentsInvestments Those that need funds to bring new products or Those that need funds to bring new products or

to expand operations (entrepreneurs and to expand operations (entrepreneurs and managers) are taking risks. They do not know managers) are taking risks. They do not know what the future will hold but given their present what the future will hold but given their present day knowledge they are betting on a positive day knowledge they are betting on a positive outcome.outcome.

If all investments are done through a central If all investments are done through a central office, an unfortunate turn of events can render office, an unfortunate turn of events can render the investment worthless and savings wasted.the investment worthless and savings wasted.

Concentration of risk, political decision-making, Concentration of risk, political decision-making, limited knowledge can waste scarce resources limited knowledge can waste scarce resources and render investments unproductive.and render investments unproductive.

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Financial SystemFinancial System A well-developed financial system provides A well-developed financial system provides

many many alternatives for saversalternatives for savers.. Different risk levels; different size levels; different Different risk levels; different size levels; different

maturities; different liquidity levels.maturities; different liquidity levels.

A well-developed financial system provides A well-developed financial system provides scarce and costly information for lendersscarce and costly information for lenders, thus , thus reducing the overall risk.reducing the overall risk.

A well-developed financial system channels A well-developed financial system channels savings to most productive usesavings to most productive use..

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Financial InstitutionsFinancial Institutions

Asymmetric information creates a need Asymmetric information creates a need for specialized institutions to evaluate for specialized institutions to evaluate risk.risk.

Comparative advantage leads to Comparative advantage leads to specialization.specialization.

Economies of scale allows financial Economies of scale allows financial institutions to collect information and to institutions to collect information and to channel savings into loans at low cost.channel savings into loans at low cost.

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BondsBonds

A bond is an IOU that indicates the A bond is an IOU that indicates the principal to be paid at maturity (face value), principal to be paid at maturity (face value), the rate of interest to be earned per year on the rate of interest to be earned per year on the principal (coupon rate), and the date the principal (coupon rate), and the date the bond will mature (date the principal will the bond will mature (date the principal will be paid).be paid).

Bonds are issued by borrowers and bought Bonds are issued by borrowers and bought by lenders.by lenders.

During the life of the bond, the holders may During the life of the bond, the holders may decide to sell the bond to someone else.decide to sell the bond to someone else.

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BondsBonds

Bonds issued by different entities carry Bonds issued by different entities carry different coupon rates. Credit risk is the different coupon rates. Credit risk is the most important reason that determines most important reason that determines the variations in coupon rates in same the variations in coupon rates in same maturity bonds.maturity bonds.

Municipal bonds usually have lower Municipal bonds usually have lower coupon rates because they are exempt coupon rates because they are exempt from federal taxation.from federal taxation.

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BondsBonds Joe buys a 5-year government bond (Treasury note) issued Joe buys a 5-year government bond (Treasury note) issued

on Jan. 1, 2010 with a face-value of $1,000 and a coupon on Jan. 1, 2010 with a face-value of $1,000 and a coupon rate of 4%.rate of 4%.

Who is the lender and who is the borrower?Who is the lender and who is the borrower? On Jan. 1, 2011 and on Jan. 1, 2015 how much will the On Jan. 1, 2011 and on Jan. 1, 2015 how much will the

government pay to the holder of this bond?government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2012, what price If Joe wants to sell his bond on Jan. 2, 2012, what price

does he expect to get for his bond ifdoes he expect to get for his bond if similar bonds pay an interest rate of 4%?similar bonds pay an interest rate of 4%? similar bonds pay an interest rate of 3%?similar bonds pay an interest rate of 3%? similar bonds pay an interest rate of 5%?similar bonds pay an interest rate of 5%?

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Bond Prices and Interest RatesBond Prices and Interest Rates

When interest rates rise, bond prices When interest rates rise, bond prices fall.fall.

When interest rates fall, bond prices When interest rates fall, bond prices rise.rise.

If Joe expects to see higher interest If Joe expects to see higher interest rates in the future, should he buy or sell rates in the future, should he buy or sell bonds today? (Hint: think about capital bonds today? (Hint: think about capital gains and losses).gains and losses).

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StocksStocks

Stocks are shares in the ownership of a Stocks are shares in the ownership of a public company.public company.

Stockholders are paid dividends from Stockholders are paid dividends from the profits of the company.the profits of the company.

If future profits are expected to If future profits are expected to increase, dividends are expected to increase, dividends are expected to increase, creating an extra demand for increase, creating an extra demand for the stock and pushing the price of the the stock and pushing the price of the stock up today.stock up today.

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StocksStocks When a company issues stock it receives When a company issues stock it receives

the funds to use for expansion, investment.the funds to use for expansion, investment. When existing stocks are bought and sold in When existing stocks are bought and sold in

the stock market, the company gets nothing the stock market, the company gets nothing except a signal that if it wants to raise funds except a signal that if it wants to raise funds would it be cheaper or more expensive. would it be cheaper or more expensive.

Since stocks and bonds are substitutes, a Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond rise in interest rates that reduces the bond prices also reduces the stock prices.prices also reduces the stock prices.

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Stock PricesStock Prices Suppose you expect the stock price of IBM to be Suppose you expect the stock price of IBM to be

$100 a year from now and also you expect dividends $100 a year from now and also you expect dividends per share to be $5, then.per share to be $5, then.

Assuming that given the riskiness of IBM, you desire Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, what price to have a return of 8% on your savings, what price are you willing to pay for this stock?are you willing to pay for this stock?

Hint: If you were to sell the stock a year from now, Hint: If you were to sell the stock a year from now, how much would you get and what is the present how much would you get and what is the present value today that will yield 8% to bring this amount?value today that will yield 8% to bring this amount?

P (1.08) = $105P (1.08) = $105 P = $105/1.08 = $97.22P = $105/1.08 = $97.22

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Stock PricesStock Prices

If in general, interest rates have risen If in general, interest rates have risen because of inflation, so that you expect because of inflation, so that you expect 10% return rather than 8%, how much 10% return rather than 8%, how much would you pay for the same IBM stock?would you pay for the same IBM stock?

P = $105/1.1 = $95.45P = $105/1.1 = $95.45 What if you expected IBM price to be What if you expected IBM price to be

$110?$110? What if you expected dividends to be What if you expected dividends to be

$10?$10?

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Newly Issued Stocks and Newly Issued Stocks and BondsBonds

In order to raise funds (to borrow) In order to raise funds (to borrow) businesses can go to the banks or issue businesses can go to the banks or issue new stocks or bonds.new stocks or bonds.

If the future of the business is considered If the future of the business is considered risky, the bonds will carry a high interest risky, the bonds will carry a high interest rate and the stocks will sell at a low price.rate and the stocks will sell at a low price.

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What Is Money?What Is Money?

Does Bill Gates have a lot of money?Does Bill Gates have a lot of money?Does LeBron James make a lot of money?Does LeBron James make a lot of money?Anything accepted by a community in Anything accepted by a community in

exchange of goods and services and for exchange of goods and services and for settlements of debts.settlements of debts.

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Functions of MoneyFunctions of Money

Unit of accountUnit of account Increase in variety of goods requires a Increase in variety of goods requires a

common unit to quote and compare prices.common unit to quote and compare prices.3 goods: 2 prices3 goods: 2 prices4 goods: 6 prices4 goods: 6 prices5 goods: 24 prices5 goods: 24 pricesN goods: N goods: N!/2(N-2)! PricesPrices

Money had to be invented.Money had to be invented.

A Proposed Unit of AccountA Proposed Unit of Account

We could [have] labels providing a product or service’s We could [have] labels providing a product or service’s “daily energy calories.” Along with physical labels, “daily energy calories.” Along with physical labels, imagine a smartphone app — we’ll call it “Decal” for imagine a smartphone app — we’ll call it “Decal” for short — that would scan a product’s bar code and report short — that would scan a product’s bar code and report how much energy it took to produce that item.how much energy it took to produce that item.

Like the nutritional data on the backs of food products, Like the nutritional data on the backs of food products, Decal would give consumers a user-friendly, universal Decal would give consumers a user-friendly, universal measure that they could use to compare products or measure that they could use to compare products or count their daily energy intake. count their daily energy intake.

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http://www.nytimes.com/2011/03/09/opinion/09Little.html?partner=rss&emc=rss

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Medium of exchangeMedium of exchangeBarter requires double coincidence of wants.Barter requires double coincidence of wants.Exchange makes both parties better-off.Exchange makes both parties better-off.Money had to be invented.Money had to be invented.

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Store of ValueStore of ValuePostponing consumption by storing wealth in Postponing consumption by storing wealth in

an asset for future use.an asset for future use.Today we have many different assets for Today we have many different assets for

wealth storage.wealth storage.Depending on the ability of these assets to be Depending on the ability of these assets to be

easily converted to cash (liquidity) these easily converted to cash (liquidity) these assets are near or far to “money.”assets are near or far to “money.”

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Financial Assets Savers Can HoldFinancial Assets Savers Can Hold

CurrencyCurrency Checking accountChecking account Savings accountSavings account Certificate of DepositCertificate of Deposit Foreign currencyForeign currency BondsBonds StocksStocks Options on stocks, bonds, foreign currencyOptions on stocks, bonds, foreign currency Futures on commodities, foreign currencyFutures on commodities, foreign currency

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Assets According to LiquidityAssets According to Liquidity

CurrencyCurrencyChecking AccountChecking AccountSavings AccountSavings AccountMoney Market Mutual FundMoney Market Mutual FundBondsBonds

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Measuring MoneyMeasuring Money

http://research.stlouisfed.org/publications/mt/page16.pdf

In billions of dollars

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Components of M1 and M2,Components of M1 and M2,July 2002 (billions of dollars)July 2002 (billions of dollars)

M1

Currency

Demand deposits

Other checkable deposits

Travelers’ checks

M2

M1

Savings deposits

Small-denomination time deposits

Money market mutual funds

1,197.8

615.1

303.8

270.3

8.6

5,641.2

1,197.8

2,552.8

920.8

969.8

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Banks and the Creation of MoneyBanks and the Creation of Money

When depositors put money in the bank, When depositors put money in the bank, the bank turns around and loans part of the bank turns around and loans part of the money to others.the money to others.

Both the depositor and the borrower have Both the depositor and the borrower have funds to spend.funds to spend.

Money has been created.Money has been created.

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Banks and the Creation of MoneyBanks and the Creation of Money

We will show the changes in assets and We will show the changes in assets and liabilities of a bank in response to deposit liabilities of a bank in response to deposit and loan activities.and loan activities.

Deposits into checking accounts are Deposits into checking accounts are liabilities of a bank.liabilities of a bank.

Cash is an asset.Cash is an asset.Assets = Liabilities for a Balance Sheet to Assets = Liabilities for a Balance Sheet to

be in balance.be in balance.

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Creation of MoneyCreation of Money

Ally deposits $1000 into her checking Ally deposits $1000 into her checking account with First National.account with First National.

First National holds only 10% as reserves First National holds only 10% as reserves and loans the rest to Billy.and loans the rest to Billy.

Billy buys a snow blower for $900 from Billy buys a snow blower for $900 from Carl.Carl.

Carl deposits $900 with Second National.Carl deposits $900 with Second National.Second National loans how much to Second National loans how much to

Deyna if it also holds 10% as reserves?Deyna if it also holds 10% as reserves?

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If this process goes on for thirty rounds, If this process goes on for thirty rounds, how much checking deposits will be in the how much checking deposits will be in the banking system?banking system?

1000 + 1000(.9) + 1000(.9)(.9)+…1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^+1000(.9)^3030

1000 + 900 + 810 + … + 0.041000 + 900 + 810 + … + 0.041000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

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The banking system used the initial The banking system used the initial deposit of $1000 as the reserves and deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create multiplied it by (1/reserve ratio) to create checking deposits for the economy.checking deposits for the economy.

What would be the deposits created by the What would be the deposits created by the same $1000 deposit, if the banks kept 5% same $1000 deposit, if the banks kept 5% as the reserve ratio?as the reserve ratio?

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Narrow Money, M1Narrow Money, M1

M1 is defined as currency outside of the M1 is defined as currency outside of the banks plus bank deposits.banks plus bank deposits.

Monetary Base is defined as Currency + Monetary Base is defined as Currency + Reserves.Reserves.

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•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?


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Banks and the Creation of Banks and the Creation of MoneyMoney

SummarySummaryBank reserves/bank deposits = desired Bank reserves/bank deposits = desired

reserve-deposit ratioreserve-deposit ratioBank deposits = bank reserves/desired Bank deposits = bank reserves/desired

reserve-deposit ratioreserve-deposit ratio

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The Money Supply with Both Currency The Money Supply with Both Currency and Depositsand DepositsCB provides 1 million in cash to residents CB provides 1 million in cash to residents Residents choose to hold 500,000 as Residents choose to hold 500,000 as

currencycurrencyDeposit 500,000 in the banksDeposit 500,000 in the banksReserve-deposit ratio = 10%Reserve-deposit ratio = 10%Bank deposits = 500,000/.10 = 5,000,000Bank deposits = 500,000/.10 = 5,000,000

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The Money Supply with Both Currency The Money Supply with Both Currency and Depositsand DepositsMoney supply = currency + bank deposits Money supply = currency + bank deposits

5,500,000 = 500,000 + 5,500,000 = 500,000 + 5,000,0005,000,000

Money is increased by 4,500,000 when the Money is increased by 4,500,000 when the residents hold 500,000 in bank depositsresidents hold 500,000 in bank deposits

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The Money Supply at ChristmasThe Money Supply at ChristmasCurrency = 500Currency = 500Bank reserves = 500Bank reserves = 500Reserve-deposit ratio = 0.20Reserve-deposit ratio = 0.20Money supply = 500 + 500/.20 = 500 + 2,500 Money supply = 500 + 500/.20 = 500 + 2,500

= 3,000= 3,000

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The Money Supply at ChristmasThe Money Supply at Christmas If Xmas shoppers withdraw 100If Xmas shoppers withdraw 100Money supply = 600 + 400/.20 = 600 + 2,000 Money supply = 600 + 400/.20 = 600 + 2,000

= 2,600= 2,600

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The Money Supply at ChristmasThe Money Supply at ChristmasObservationObservation

When the reserve-deposit ratio = 0.20, every $1 When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money reduction in reserves may reduce the money supply by $5.supply by $5.

In general, when people make withdraws, the In general, when people make withdraws, the money supply contracts by a multiple of the money supply contracts by a multiple of the withdrawal.withdrawal.

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The Federal Reserve SystemThe Federal Reserve System

The Central Bank of the United States.The Central Bank of the United States.The Fed is responsible for monetary The Fed is responsible for monetary

policy.policy.Amount of money supplied to the system.Amount of money supplied to the system.Affects interest rates, inflation, unemployment Affects interest rates, inflation, unemployment

and exchange rates.and exchange rates.The Fed oversees and regulates the The Fed oversees and regulates the

financial markets.financial markets.

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The FedThe Fed

Fed was established in 1913 in the hopes Fed was established in 1913 in the hopes of eliminating banking panics of the 19th of eliminating banking panics of the 19th century by providing credit to the financial century by providing credit to the financial markets.markets.

In order to disperse power 12 regional In order to disperse power 12 regional Federal Reserve Banks were formed.Federal Reserve Banks were formed.

The seven members of the Board of The seven members of the Board of Governors are appointed by the President Governors are appointed by the President for 14-year terms every other year.for 14-year terms every other year.

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Monetary PolicyMonetary Policy

Federal Open Market Committee (FOMC) Federal Open Market Committee (FOMC) is the group that sets the monetary policy.is the group that sets the monetary policy.

Fed Chairman (4-year term) plus Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC.Presidents of Fed banks comprise FOMC.

FOMC meets eight times a year.FOMC meets eight times a year.

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Controlling the Money SupplyControlling the Money Supply

Open-Market Operations: buying and selling of Open-Market Operations: buying and selling of financial assets.financial assets. BuyingBuying government bonds from the public government bonds from the public increasesincreases

bank reserves, hence money supply.bank reserves, hence money supply. SellingSelling bonds bonds decreasesdecreases money supply. money supply.

Discount window lending: Lending to banks Discount window lending: Lending to banks increases bank reserves.increases bank reserves.

Changing reserve requirements: Raising Changing reserve requirements: Raising reserve-deposit ratio decreases money supply.reserve-deposit ratio decreases money supply.

New Tools: New Tools: http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html

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Open-Market OperationOpen-Market Operation

Suppose an economy has $100 currency, Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit $100 reserves and 0.1 as reserve-deposit ratio.ratio.

What is the money supply?What is the money supply? If the Central Bank purchased $5 worth of If the Central Bank purchased $5 worth of

bonds, what will be the money supply?bonds, what will be the money supply? If the CB sold $10 worth of bonds, what If the CB sold $10 worth of bonds, what

will be the money supply?will be the money supply?

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ExampleExampleCurrency = 1,000 Currency = 1,000 Reserves = 200Reserves = 200Reserve-deposit ratio = 0.2Reserve-deposit ratio = 0.2What is M1?What is M1?

Money supply = 1,000 + 200/0.2 = 2,000Money supply = 1,000 + 200/0.2 = 2,000

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ExampleExample Increasing the money supply by open-Increasing the money supply by open-

market operationsmarket operationsOpen market purchase = 100Open market purchase = 100Reserves increase to 300Reserves increase to 300Money supply = 1,000 + 300/0.2 = 2,500Money supply = 1,000 + 300/0.2 = 2,500

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Controlling the Money Supply: Discount Controlling the Money Supply: Discount Window LendingWindow LendingThe discount rateThe discount rate

The interest rate charged on these loansThe interest rate charged on these loans

Discount lending will increase reserves and Discount lending will increase reserves and the money supply.the money supply.

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Controlling the Money Supply: Changing Controlling the Money Supply: Changing Reserve RequirementsReserve RequirementsThe Fed sets the reserve-deposit ratioThe Fed sets the reserve-deposit ratio

Called the reserve requirementCalled the reserve requirement

A reduction in the reserve requirement A reduction in the reserve requirement would allow the money supply to increase.would allow the money supply to increase.

An increase in the reserve requirement may An increase in the reserve requirement may reduce the money supply.reduce the money supply.

5050http://www.federalreserve.gov/monetarypolicy/default.htm

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Primary Credit RatePrimary Credit Rate

http://research.stlouisfed.org/publications/mt/page9.pdf

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The Fed’s Role in Stabilizing Financial The Fed’s Role in Stabilizing Financial Markets: Banking PanicsMarkets: Banking PanicsSuppose:Suppose:

Depositors lose confidence in their bank.Depositors lose confidence in their bank.They attempt to withdraw their funds.They attempt to withdraw their funds.Bank may not have enough reserves (fractional) Bank may not have enough reserves (fractional)

to meet the depositors demand.to meet the depositors demand.The bank fails and further erodes depositor The bank fails and further erodes depositor

confidence which triggers additional failures.confidence which triggers additional failures.

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The Fed’s Role in Stabilizing Financial The Fed’s Role in Stabilizing Financial Markets: Banking PanicsMarkets: Banking PanicsThe Fed to the rescue:The Fed to the rescue:

Instill confidenceInstill confidenceDiscount lendingDiscount lendingOpen Market OperationsOpen Market Operations

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Money and Price LevelMoney and Price Level

In the long run, prices adjust to pressures In the long run, prices adjust to pressures in the economy.in the economy.

The “quantity theory of money” captures The “quantity theory of money” captures the long-run relationship.the long-run relationship.

MV = PY

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Quantity TheoryQuantity Theory

M is money stock, like M1 or M2.M is money stock, like M1 or M2.V is velocity, the number of times money V is velocity, the number of times money

stock exchanges hands in creating the stock exchanges hands in creating the nominal GDP.nominal GDP.

P is price level, like 1.00 or 1.26 (price P is price level, like 1.00 or 1.26 (price index)index)

Y is real GDP.Y is real GDP.PY is nominal GDP.PY is nominal GDP.

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Long Run InflationLong Run Inflation

In the long-run, the economy will operate In the long-run, the economy will operate at full-employment; so Y will not change if at full-employment; so Y will not change if there is no growth. If there is growth, then there is no growth. If there is growth, then Y is predictable: Y is known.Y is predictable: Y is known.

Velocity is also thought predictable in the Velocity is also thought predictable in the long-run.long-run.

Therefore, any growth in money supply will Therefore, any growth in money supply will be reflected in inflation.be reflected in inflation.

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Money and PricesMoney and Prices

VelocityVelocityThe speed at which money circulatesThe speed at which money circulates

stockMoney

GDP Nominal

stockMoney

nstransactio of Value Velocity

M

x YP

supply)(money M

GDP) (real x Y level) (price P (V)Velocity

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Velocity in 2001Velocity in 2001M1 = M1 = $1,177.9 billion$1,177.9 billionM2M2 = $5,449.1 billion = $5,449.1 billionNominal GDP = $10,082.2 billionNominal GDP = $10,082.2 billion

8.56 billion $1,117.9

billion $10,082.2 V M1,

1.85 billion $5,499.1

billion $10,082.2 V M2,

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Money and Inflation in the Money and Inflation in the Long RunLong RunQuantity equationQuantity equation

M x V = P x YM x V = P x Y

Assume Assume V & YV & Y are constant over the time are constant over the time periodperiod

Y x P V x M %Δ M + % Δ V = % Δ P + % Δ Y

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Money and Inflation in the Money and Inflation in the Long RunLong Run If the Fed increases If the Fed increases MM by 10%, then prices by 10%, then prices

must increase by 10%.must increase by 10%.High rates of money growth are associated High rates of money growth are associated

with high rates of inflation (too much money with high rates of inflation (too much money chasing too few goods).chasing too few goods).

%Δ M + % Δ V = % Δ P + % Δ Y

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Inflation and Money Growth in Inflation and Money Growth in Latin America, 1995-2001Latin America, 1995-2001

1 frank & bernanke 4 th edition, 2009 ch. 9: the financial system, money, and prices

Documents

investments national

investments unproductive

savings lack of options

gold prices

money form

limited knowledge

concentration of risk

scarce resources