Frank & BernankeFrank & Bernanke

Ch. 11: Financial Markets, Money, and the Federal Reserve

Savings and InvestmentsSavings and InvestmentsNational 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.

SavingsSavings Lack of options for households may force them to

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

wealth. In many poor countries, households keep their wealth

in gold.– In 1980-81, gold prices reached $800/oz.. On Feb. 24,

2004, gold was $403.45 per ounce. A financial system that can provide trust and security

to small savers can increase the amount of savings in a poor country.

InvestmentsInvestments 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.

Financial SystemFinancial SystemA 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.

Financial Assets Savers Can Financial Assets Savers Can HoldHold

Currency Checking account Savings account Certificate of Deposit Foreign currency Bonds Stocks Options on stocks, bonds, foreign currency Futures on commodities, foreign currency

Financial AssetsFinancial AssetsVaried risk levels.Varied maturity levels.Varied liquidity levels.Varied returns.

Financial InstitutionsFinancial InstitutionsWhat if someone comes and gives a

brilliant talk on how she can make you a millionaire if you only gave her $100,000?

Can someone with savings of $1000 have the means to investigate the validity of high rate of returns promised?

What if special skills and knowledge is required to evaluate claims (Enron, notwithstanding).

Financial InstitutionsFinancial InstitutionsAsymmetric 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.

Financial InstitutionsFinancial Institutions

Assets According to LiquidityAssets According to LiquidityCurrencyChecking AccountSavings AccountMoney Market Mutual FundBondsStocks

Three Classes of AssetsThree Classes of AssetsBondsStocksMoneyThey all respond to interest rates.The higher the interest rates, the lower is

the quantity of money demanded.The higher the interest rate, the lower is the

quantity of bonds and stocks supplied.

BondsBondsA 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.

BondsBondsBonds 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.

BondsBonds Joe buys a 2-year government bond (Treasury note) issued on

Jan. 1, 2002 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, 2003 and on Jan. 1, 2004 how much will the

government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2003, 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%?

Bond Prices and Interest Bond Prices and Interest RatesRates

When interest rates rise, bond prices fall.When interest rates fall, bond prices rise.If Lydia expects to see higher interest rates

in the future, should she buy or sell bonds today? (Hint: think about capital gains and losses).

StocksStocksStocks 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.

StocksStocksWhen 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.

Stock PricesStock 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

Stock PricesStock PricesIf 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 = $95.45What if you expected IBM price to be

$110?What if you expected dividends to be $10?

Newly Issued Stocks and Newly Issued Stocks and BondsBonds

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.

DiversificationDiversificationFor lenders, to put all their eggs in the

basket of one borrower is very risky.Diversification, that is holding assets that

behave differently under similar economic conditions, would reduce the risk.

Look at Problem #4 on p. 302.

Answers to Problem #4Answers to Problem #44a. DonkeyInc pays 10% with a 40% probability, zero otherwise. The expected average return is 40% times 10%, or 4%. ElephantInc pays 8% with 60% probability, zero otherwise, an expected average return of 4.8%. To maximize expected return, invest all your funds in ElephantInc.b.      If Democrats win your dollar return is $50 (10% of the $500 invested in DonkeyInc). If Republicans win your dollar return is $40 (8% of the $500 invested in ElephantInc). Since the Democrats win with probability of 40% and the Republicans win with a probability of 60%, your expected dollar return is (40%)($50) + (60%)($40) = $44, or a 4.4% expected return on your $1000 initial investment.

Answers to Problem #4Answers to Problem #4c.    The strategy in part b gives a lower expected return than the strategy in part a. However the strategy in part a is riskier, since you receive nothing if the Democrats win. The advantage of the strategy in part b is that you receive a reasonable return no matter which party wins (that is, it is less risky, which compensates for the lower expected return).d.       To achieve a guaranteed 4.4% return, you need a strategy that guarantees you at least $44 no matter who wins the election. $44 = x(0.1)(.4) + (1000-x)(.08)(.6). 44 = .04x + 48 - .048x x=$500.e.          Let D be the number of dollars you “bet” on the Democrats and $1000 – D be the number of dollars you bet on the Republicans. If the Democrats win you receive a dollar return of 10% x D. If the Republicans win you receive a dollar return of 8%($1000 – D). You want these two returns to be equal. Setting 10% x D = 8%($1000 – D) and solving for D we find D = $80/0.18 = $444.44. So invest $444.44 in DonkeyInc and $555.56 in ElephantInc to guarantee a return of 4.44% no matter who wins.

Money: A Special Financial Money: A Special Financial AssetAsset

If bonds and stocks provide a return for holders why would anyone hold money?

Liquidity.Money has three uses.

– Unit of account– Medium of exchange– Store of value

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

Banks and the Creation of Banks and the Creation of MoneyMoney

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.

Banks and the Creation of Banks and the Creation of MoneyMoney

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.

Creation of MoneyCreation of MoneyAlly 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?

Creation of MoneyCreation 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 + … + 0.041000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

Creation of MoneyCreation of MoneyThe 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?

Narrow Money, M1Narrow Money, M1M1 is defined as currency outside of the banks

plus bank deposits.Monetary Base is defined as Currency +

Reserves.What was the amount of currency in January

2003?What was the amount of bank deposits in

January 2003?What was the reserve ratio in January 2003?

Problem #8, p. 303Problem #8, p. 3038a. Deposits equal bank reserves/(desired reserve/deposit ratio) = 100/0.25 = 400. The money supply equals currency held by the public + deposits = 200 + 400 = 600.b.      Let X = currency held by the public = bank reserves. Then the money supply equals X + X/(reserve/deposit ratio), or500 = X + X/0.25 = 5XX = 100So currency and bank reserves both equal 100.c.     As the money supply is 1250 and the public holds 250 in currency, bank deposits must equal 1000. If bank reserves are 100, the desired reserve/deposit ratio equals 100/1000 = 0.10.

The Federal Reserve SystemThe 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.

The FedThe FedFed 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.

Monetary PolicyMonetary PolicyFederal 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.

Controlling the Money SupplyControlling the Money SupplyOpen-Market Operations: buying and selling

of financial assets.– Buying government bonds from the public

increases bank reserves, hence money supply.– Selling bonds decreases money supply.

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

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

Open-Market OperationOpen-Market OperationSuppose 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?

The Great DepressionThe Great DepressionThe Fed did not prevent the Great Depression.Both currency held by the public and reserve-

deposit ratio rose, reducing money supply.The Fed increased the reserves but not

enough.Lack of enough reserves forced bank

bankruptcies.

MONETARY STATISTICS DURING GREAT DEPRESSIONCurrency rr Reserves M1

Dec-29 3.85 0.075 3.15 45.9Dec-30 3.79 0.082 3.31 44.1Dec-31 4.59 0.095 3.11 37.3Dec-32 4.82 0.109 3.18 34.0Dec-33 4.85 0.133 3.45 30.8

Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, (McGraw-Hill, 2001), p. 299.