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Money & Banking

Kenneth R. Szulczyk, Ph.D .

December 1, 2007 A Rough Draft

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Table of Contents

Table of Contents .................................................................................................................2

Preface ............................................................................................................................5

Acknowledgements ..............................................................................................................6

1. Introducing Money and the Financial System..........................................................7

1.1. Financial Markets.........................................................................................7 1.2. Central Banks ...............................................................................................8

2. Money and the Payments System ............................................................................10

2.1. Barter and Functions of Money....................................................................10 2.2. Forms of Money...........................................................................................12 2.3. Money Supply Definitions ...........................................................................14

3. Overview of the Financial System ...........................................................................16

3.1. Financial Intermediation ..............................................................................16 3.2. Financial Innovation and Globalization .......................................................18 3.3. The Derivatives Market................................................................................19 3.4. Financial Instruments ...................................................................................19

4. Present Value Formula, Interest Rates, and Rates of Return ...................................23

4.1. Single Investment.........................................................................................23 4.2. Multiple Investments....................................................................................24 4.3. Changing Time Units ...................................................................................25 4.4. Amortization Table ......................................................................................25 4.5. Fisher Equation ............................................................................................27

5. Valuation of Bonds...................................................................................................29

5.1. Overview of Bonds.......................................................................................29 5.2. Valuation of Bonds.......................................................................................30 5.3. Yield to Maturity and Rate of Return...........................................................33

6. Valuation of Stocks ..................................................................................................36

6.1. Overview of Stocks ......................................................................................36 6.2. Valuation of Stocks ......................................................................................38

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7. Determining Market Interest Rates ..........................................................................43

7.1. Supply and Demand Functions for Bonds....................................................43 7.2. Interest Rates and the Business Cycle..........................................................49 7.3. The Fisher Effect ..........................................................................................50 7.4. Bond Prices in an Open Economy................................................................51

8. Risk Structure and Term Structure of Interest Rates................................................53

8.1. Default Risk and Bond Prices ......................................................................53 8.2. Liquidity and Bond Prices............................................................................54 8.3. Information Costs and Bond Prices..............................................................55 8.4. Taxes and Bond Prices .................................................................................56 8.5. Term Structure of Interest Rates ..................................................................57

9. Derivative Securities and Derivative Markets .........................................................60

9.1. Forward and Spot Transactions....................................................................60 9.2. Futures and Forward Contracts ....................................................................60 9.3. Options Contract ..........................................................................................63 9.4. Hedging and Speculation .............................................................................65

10. The Types of Financial Institutions..........................................................................67

10.1. Securities Market Institutions ......................................................................67 10.2. Investments Institutions................................................................................67 10.3. Contractual Saving .......................................................................................68 10.4. Depository Institutions .................................................................................70 10.5. Government Financial Institutions ...............................................................71

11. The Banking Business..............................................................................................73

11.1. A Bank’s Balance Sheet ...............................................................................73 11.2. Bank Failure .................................................................................................75 11.3. Interest Rate Risk .........................................................................................78 11.4. Securitization................................................................................................80

12. The Banking Industry...............................................................................................82

12.1. The United States Banking System..............................................................82 12.2. Federal Deposit Insurance Corporation (FDIC)...........................................83 12.3. Innovations in the Banking Industry ............................................................84

13. Banking in the International Economy.....................................................................87

13.1. Functions of International Banks .................................................................87 13.2. Becoming an International Bank..................................................................88 13.3. Exchange Rate Risk .....................................................................................89

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13.4. International Financial Securities.................................................................90 13.5. International Transaction Currency and Regulatory Oversight ...................91

14. The Money Supply Process......................................................................................94

14.1. The Fed’s Balance Sheet ..............................................................................94 14.2. Multiple Deposit Expansion and Contraction ..............................................96 14.3. Money Supply Multipliers ...........................................................................99

15. Changes in the Monetary Base.................................................................................104

15.1. The Fed’s Balance Sheet ..............................................................................104 15.2. Check Clearing Process................................................................................105 15.3. Changes in the Monetary Base.....................................................................107 15.4. Does U.S. Treasury Affect the Monetary Base? ..........................................108

16. Organization of Central Banks.................................................................................111

16.1. Why the U.S. Government Created Federal Reserve System......................111 16.2. Structure of the Federal Reserve System .....................................................112 16.3. Is the Federal Reserve Independent of the U.S. Government? ....................113

17. Monetary Policy Tools .............................................................................................115

17.1. Expanding and Contracting the Money Supply ...........................................115 17.2. Federal Open Market Committee.................................................................117 17.3. Discount Policy ............................................................................................118 17.4. Reserve Requirements..................................................................................121

18. The Conduct of Monetary Policy.............................................................................124

18.1. Monetary Policy Goals.................................................................................124 18.2. Time Lags.....................................................................................................125

19. The International Financial System and Monetary Policy.......................................128

19.1. How a Central Bank Intervenes in its Currency Exchange Rate..................128 19.2. Balance of Payments ....................................................................................130 19.3. Gold Standard...............................................................................................131 19.4. Bretton Woods System.................................................................................133 19.5. Current Exchange Rate Regime ..................................................................133 19.6. International Monetary Fund (IMF). ............................................................134

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Preface

I taught Money & Banking many times and converted my lecture notes into a book. This book is free to the public. If you have valuable suggestions and comments, that

could enhance this book, please send them to me. Please do not complain about his book if you do not like it. Remember, this book is free and you get what you pay for.

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Acknowledgements

The author thanks the following people for their feedback and contributions to this book:

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1. Introducing Money and the Financial System

After reading this chapter, you should understand the following:

• The purpose of financial markets and financial institutions.

• The process of financial intermediation.

• The primary functions of a central bank.

• Why the money supply is a very important component of the economy

1.1. Financial Markets

Money and the financial system are intertwined and cannot be separated. They both influence and affect the whole economy, such as the inflation rate, business cycles, and interest rates. Understanding how the financial markets and money influences the economy, can help consumers, investors, savers, and government officials to make better informed decisions.

First, you need some definitions. A financial market is where buyers and sellers come together to buy and sell bonds, stocks, and other financial instruments. The buyers of financial securities are investing their savings, while sellers of financial securities are borrowing funds. The financial market can be a physical place like the New York Stock Exchange where buyers and sellers come face-to-face or the market can be like the NASDAQ where buyers and sellers are connected together by computer networks. A financial institution is a business that links savers and borrowers. The most common is banks. For example, if you deposited $100 into your savings account, the bank will lend this $100 to a borrower and the borrower will pay interest to the bank. In turn, the bank will pay you interest on your account. The bank’s profits are the difference between the interest rate charged to the borrower and the interest rate paid on your savings account.

Why would you want to deposit money at a bank instead of directly buying securities through the financial markets? A bank, being a financial institution, can provide three benefits to the depositor. First, the bank will collect information about borrowers, and will only lend to borrowers who have a low chance defaulting on their loans. This is a bank’s specialty, rating its borrowers. Second, the bank lowers your investment risk. The bank will lend to a variety of borrowers, such as for home mortgages, business loans, and credit cards. If one business bankrupts or several customers do not pay their credit cards, this does not financially hurt the bank. The bank is earning interest income on its other investments. Third, your bank deposit has liquidity. If you have an emergency and need your bank deposit, you can readily convert your bank deposit into cash.

Liquidity means that an asset is easily exchanged for goods and services without high transaction costs. Liquidity is a very important concept in defining money. For example, take all your assets and list them in terms of liquidity. Liquidity forms a scale in Figure 1.1

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Figure 1.1. Ranking assets by liquidity

Money or the money supply is defined as anything that is accepted for payment of goods and services or paying off debts. In developing countries, money is essentially cash. In countries with sophisticated financial markets like the United States, the definition of money can be very complicated. Money includes cash and checking account balances, but what about assets like savings accounts and government securities? These assets are so easily converted into cash with little transaction costs, that essentially this could be included in the definition of money. An asset like a $50,000 home is not included in the definition of money. The house can be converted into cash, but it could take time and there is a high transaction cost. To get money quickly, the house may have to be sold for a lower value than its worth.

1.2. Central Banks

Every country uses some form of money and therefore every country has a government institution that measures and influences the money supply. This institution is referred to as the central bank. For example, the central bank in the United States is the Federal Reserve System, or commonly referred to as the “Fed.” The Federal Reserve regulates banks, grants loans to banks, and can influence the money supply. However, the money supply and the financial markets are intertwined. When the Fed influences the money supply, it also indirectly influences the financial markets. Therefore, when the Fed influences the financial markets, the Fed can indirectly affect the interest rates, exchange rates, inflation, and the output growth rate of the U.S. economy. When the Fed uses its management of the money supply to influence the economy, economists call this monetary policy. This whole course is to explain how the Federal Reserve System can influence the economy through the financial markets. This analysis can also be extended to any central bank in the world.

The central bank influences three very important variables in the economy. The variables are:

1. Inflation is a sustained rise in the average prices for goods and services in an economy.

Increasing the money supply leads to inflation. For example, if you place a $100 in a shoe box and bury it in your yard for one year. That $100 is losing value, because, on average, all the prices for goods and services in the United States are increasing approximately 2% each year. After one year, that $100 will buy on average, 2% less goods and services.

2. Business cycles mean the economy is experiencing strong growth. The most common measure of the business cycle is the Gross Domestic Product (GDP). GDP is the total value of goods and services produced in an economy in one year. When businesses are rapidly increasing production, more goods and services are produced in the economy. If GDP is growing rapidly, then the economy is in a business cycle. During business cycles,

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people more easily find jobs, so the number of unemployed people decreases (i.e. the unemployment rate decreases). If the money supply grows too fast, then inflation results.

The opposite can also occur. GDP can grow slowly or actually decrease, so businesses produce less goods and services in the economy. When a economy has fewer goods and services being produced, people have difficulties in finding jobs. The unemployment rate increases, and the economy is in a recession. If the money supply grows too slowly or even contracts, it can cause the economy to enter a recession.

Economists distinguish two types of GDP. The first is called nominal GDP and the second is called real GDP. Nominal GDP has no adjustment for inflation. When more goods and services are produced in a year or inflation causes prices to increase, then nominal GDP increases. Real GDP removes the effect of inflation. When real GDP increases, it means more goods and services are being produced and inflation has no effect on real GDP. Economists define many variables in terms of real or nominal, such as interest rates and wage rates.

3. Interest rates are the cost of borrowing money. Americans borrow money to buy cars,

houses, stereos, and computers. Corporations and businesses borrow money to build factories, buy machines, and expand production. Governments borrow money when they spend more than what they collect in taxes. There are many ways to borrow money, so there are many different types of interest rates. Usually economists refer to “the interest rate,” because interest rates tend to move together. The growth rate of the money supply is related to (nominal) interest rates.

Chapter 1 Review Questions

1. What is the purpose of financial markets and financial institutions?

2. What advantages do financial institutions provide compared to the financial markets?

3. Why is liquidity so important in defining the money supply for a country with sophisticated financial markets?

4. What is monetary policy?

5. What three variables of the economy can central banks influence?

6. What are inflation, gross domestic product, and interest rates?

7. What is the difference between real and nominal?

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2. Money and the Payments System


• Why an economy that uses a barter system would produce a limited number of goods and services.

• How the functions of money overcome the problems in a barter system.

• The desirable characteristics of money, so people will use money to buy goods and services.

• The different kinds of payment systems.

• How central banks measure the money supply.

2.1. Barter and Functions of Money

What would an economy be like, if there were no money? Without money, the only way buyers and sellers could exchange goods is by directly exchanging one good for another good. This type of system is called barter, and barter has many problems. First, there is a double coincidences of wants. If you produce shoes and you wanted Coca-Cola, you would have to search for a person who produced Cola-Cola and needs shoes. There could be considerable search time in finding that person. Second, many goods, like fruits and vegetables, deteriorate over time. Growers of perishable goods would have a difficult time storing their purchasing power. Third, there is no common unit of price measurement among goods. If a store had 1,000 products and there was money, this store would have 1,000 price tags. Customers could easily compare products. With barter, there would be 499,500 price exchange ratios. Each good’s price is stated in terms of all other goods. Finally, business people would have difficulty in writing contracts for future payments of goods and services under a barter system. As a result, a barter society would be only able to produce a limited number of goods and services. Below are examples of price exchange ratios and the formula for calculating the number of price ratios.

Example of price exchange ratios: • 1 apple = 3 bananas • 2 Coca-Colas = 1 apple . . • 1 cup of coffee = 1 Coca-Cola The number of price exchange ratios is:

( )2

1−=

nnE

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where E is number of price ratios and n is the number of products under a barter system, Money eliminates many problems with barter and has four functions.

1. The first function of money is a medium of exchange. Money is used for payments of goods and services and repayment of debts. The medium of exchange function promotes efficiency. For example, the author is an economics instructor. Under a barter system, the author would have to go to the market and teach another person for goods and services that he need. In the author’s case, he could have considerable search costs for people wanting economics instruction. With money, the author does what he does best and teach for money. Then he takes this money to the market, and buys goods and services that he wants. This function of money allows the specialization of labor to occur and eliminates the problem of double coincidence of wants under a barter system.

2. The second function of money is unit of account. Money conveniently allows a way of placing specific values on goods and services. For example, a two-liter of Coca-Cola costs $0.89 while Pepsi costs $0.99. Customers can easily judge which product is cheaper. This function is extremely important for businesses. Business people place values on buildings, machines, computers, and other assets. Then they record this information in financial statements. Investors read the financial statements and can gauge which companies are profitable. Finally, this function of money eliminates the massive number of price exchange ratios that would occur under a barter system.

3. The third function of money is the store of value. Money has to retain its value. For example, if a two-liter of Coca-Cola costs $0.99 today, then it should cost $0.99 tomorrow. Inflation erodes the “store of value” of money. As the price level increases, the value of money decreases, because each unit of money buys less goods and services. Inflation causes consumers to lose their purchasing power over time. If the inflation rate becomes too high, then money as a “medium of exchange” breaks down too! In countries that have high inflation rates, people will use barter more and immediately exchange their local money for more stable money, such as Euros or U.S. dollars. However, people are still required to use money as a medium of exchange, because government laws legally require people to accept money as a means of payment to pay off a debt or to pay taxes. This legal requirement is “legal tender.”

4. The fourth and final function of money is the standard of deferred payment. This function combines the “medium of exchange” and “unit of account” of money. Debts are stated in terms of a “unit of account,” and paid by “medium of exchange.” This function of money is extremely important for business transactions that will occur in the future. Businesses and people can borrow or lend money based on future transactions.

Money needs six desirable properties for people and businesses to use money. The desirable properties are:

1. Acceptable: The businesses and public accept it as payment for goods and services.

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2. Standardized quality: The same units of money must be the same size, quality, color, so people are certain what they are getting.

3. Durable: Has to be physically durable or it may lose its value quickly.

4. Valuable relative to its weight: People can easily carry large amounts of money and use is in transactions.

5. Divisible: Money must be broken down into smaller units to purchase low value goods and services.

All countries today use coins and paper bills as money, which has the five desirable properties. The value of paper bills and coins is currency.

People become psychological dependent on a currency, because people use a particular currency for a long time. For example, U.S. citizens used dollars as their currency units for two centuries. If the U S. government wanted to introduce a new currency with a new name, the public may resist adoption of the new currency (Gold Standard, p. 5).

2.2. Forms of Money

Money facilitates business transactions. The mechanism guiding the transactions is the payment system. Four types of money systems facilitate business transactions. The payment systems are:

1. Commodity Money is government selects one commodity to be money, such as gold and

silver. If society did not use this commodity as money, this commodity still has a purpose. Commodity money could be anything. For example, in U.S. prisons, prisoners use cigarettes as money. Commodity money has two forms. The first form is called full-bodied money, which is money whose value as a good in non-money purpose is equivalent to its value as a medium of exchange. For example, if the market value of 1 ounce of gold is $400 and the government made one-ounce gold coins, then the face value of the coin would equal $400. The coin is full-bodied commodity money. If gold was not used as money, it still has other uses, such as jewelry, teeth fillings, wires. etc.

Governments made an unusual discovery about commodity money. What if the government made one-ounce gold coins and the face value of the coin is equal to $500, while the market value of the gold is $400? The government created a value of $100 out of thin air! The process of creating value by “printing money” is called seigniorage. This can be a source of revenue for the government and can cause extremely high inflation rates if government depends this revenue source too much.

Government can debase its currency, if government relies on seigniorage. Over the life of the ancient Roman Empire, the Roman government “printed money” by recalling its gold and silver coins, and re-minting them with less gold and silver. Towards the end of the empire, Roman coins contained specks of gold and silver. Let’s do an example of debasing coins. If government issued one-ounce gold coins for $500 and the coins were 98% pure gold, government can “print money.” Government takes this gold coin, create new coins with a value

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of $500 but the coin only contain 49% gold. Then government uses cheap metals to fill the remaining 51% of the coin.

The second form of commodity money is representative full-bodied money: A type of money that inherently has little value, such as paper bills, but the money can be converted into a commodity, such as gold and silver. For example, in the United States before 1933, if you had dollar bills, you could exchange the bills for gold at the government’s exchange rate of $20 per ounce. Most of humankind used some form of commodity money before the 20th century, but commodity money has been replaced by fiat money.

2. Fiat Money is issued by governments and central banks. Most money used in the world

today is this type and fiat money is a 20th century invention. In the United States, the Federal Reserve System is the authority that issues U.S. dollars. This money cannot be used as anything else, and cannot be exchanged for another commodity from government. For example, if the U.S. dollar bill was not used as money, it has no other functions other than being fancy paper. No authority limits how much money the Federal Reserve System issues. If the Fed wanted to inject an additional $1 trillion into the economy, it could do so. However, there would be drastic consequences. Countries that have very high inflation rates or hyperinflation are caused by rapid growths in the money supply. A noble prize laureate in economics, Milton Friedman, concluded that “Inflation is always and everywhere a monetary phenomenon.”

3. Checks are credit money issued by financial institutions. Banks, credit unions, and other financial institutions offer checking accounts to people and businesses. The checks are the medium of exchange and is used to purchase goods and services. Checks have many benefits. People and businesses do not have to carry cash, the check provides proof of a business transaction, and checks are convenient in transactions, such as buying a house or car. The buyer does not have to bring a suitcase of cash for this type of transaction. However, checks have two problems. First, the financial institution may charge fees for using checks or the check writer abuses their account and writes checks for a greater amount than what is in the account. Some businesses and people do not accept checks, because they cannot verify if this person has sufficient funds in his account.

4. Electronic Funds improve the efficiency of the payments system. Two major innovations were introduced. The first is the automated teller machine (ATM). ATMs are connected together through networks. One of the largest networks is Cirrus. The Cirrus network allows customers to not only access their accounts at financial institutions 24 hours a day, 7 days a week, but from almost every city in the United States and 67 foreign countries around the world. The second innovation is the debit card. Many retail and grocery stores are linked to banks. When a customer makes a purchase, the customer can pay for his goods and services by having the store electronically transfer funds from the customer’s checking account to the store’s account. The debit card removes the uncertainty that the customer has sufficient funds in his account for the transaction. Some businesses do not accept checks anymore; they prefer debit cards.

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2.3. Money Supply Definitions

There are two approaches in defining the money supply. The first approach is called the transaction approach. This emphasizes the money’s function as a medium of exchange. Only a few assets possess this property. The reason is a total increase in the money supply by the central bank would cause people to increase their spending, causing national output, income, employment, and inflation to increase.

The second approach is the liquidity approach. If you take all your assets and rank them by the degree of liquidity, include all assets in a measure of money, which can be easily sold at a future time at a known price with minimum costs. Therefore, the money supply includes all assets that have high liquidity. This approach emphasizes money’s function as a “store of value,” because if the liquid asset retains its value and is highly liquid, it can easily be used to purchase goods and services directly or indirectly. The reason for using this approach is people have portfolios of assets. When the central bank increases the money supply, people will adjust their portfolios of assets, which affects consumer spending, national output, income, and employment.

The Federal Reserve System defines money supply as M1, M2, M3, and L. Many central banks in the world measure their money supply similarly to United States. However, the types of financial instruments that are included in these measures may differ. The different kinds of financial instruments that are used in a country depend on its legal structure, types of financial market regulations, and customs. The U.S. definitions of money supply are:

1. M1 is the narrowest definition of the money supply and uses the transaction approach in

defining what financial instruments are included. Add the following 3 items together.

a. Currency held by the public and in bank vaults. It does not include currency held by the government.

b. All forms of checking accounts.

c. Traveler’s Checks that are held by people and not by the banks.

2. M2 is a broader definition than M1 and uses the liquidity approach of defining the money supply. Add the following items together.

a. Include everything from M1

b. Include all small denomination savings deposits and time accounts at all financial institutions. Small denomination in the U.S. means the account is less than a $100,000. Examples are Certificates of Deposit or Savings accounts at banks.

3. M3 is a broader definition than M2. Add the following items together:

a. Include everything from M2.

b. Include large denomination savings and time accounts, and liquid securities with longer investment time than the financial instruments included in M2. An example is a corporation holding a $1 million Certificate of Deposit.

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4. L is broadest measure of the money supply and includes all liquid assets. The Fed does not try to control this measure. The “L” means liquidity. Add all the following items together.

a. Include everything from M3.

b. Includes all short-term securities, such as Treasury Bills issued by the U.S. Federal government. (Refer to the Appendix at the end of Chapter 3 for short-term securities).

The Fed stopped publishing the M3 definition of the money supply in March 23, 2006. The Fed stated M3 does not provide any useful purpose and M3 is not used in formulating monetary policy. Some international investors believe the Fed stopped publishing M3, because of international fears of a U.S. dollar collapse on the international markets. The M3 definition contains the amount of U.S. dollars outside the United States.

What is the “Best” definition of the Money Supply? The four monetary aggregates grow at different rates, at different times, and even in different directions. Before 1981, a stable relationship existed between M1 and GDP, but the deregulation of the financial markets in the 1970s and early 1980s obscured this relationship. Currently, many economists use the M2 definition of the money supply to explain changes in the GDP, inflation, and employment. Also the Fed does not try to control M1 by formulating targets and concentrates on M2 and M3 instead.


1. What are the problems with a barter economy?

2. How do the functions of money overcome the problems associated with barter?

3. What is seigniorage?

4. What are the differences among the different payment systems?

5. Which is the difference between the transaction approach and liquidity approach of defining the money supply?

6. What are the differences between M1, M2, M3, and L?

References

Federal Reserve Statistical Release. March 9, 2006. “Discontinuance of M3.” Available at http://federalreserve.gov/releases (accessed on 7/3/2007).

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3. Overview of the Financial System


• The purpose of the financial system.

• How savers and borrowers are linked in the financial markets.

• The key financial markets.

• The difference between primary and secondary markets.

• Financial innovation and regulation of the financial markets.

• The main financial instruments.

3.1. Financial Intermediation

The financial system transfers funds from savers to borrowers. The savers and borrowers can be anybody. Some households, businesses, and governments are net savers; they spend less than their income. Other households, businesses, and governments are net borrowers. The spend more than their income. For example, many college students are net borrowers. Students’ income tends to be lower than their yearly expenses and use student loans to pay the difference. Then the students enter the workforce and begin to pay off their loans. As the former students’ income continually increases over time, the former students will pay back their loans and become net savers, saving funds for retirement. Another example is governments. Many local and state governments have laws, requiring them to have balanced budgets. This fiscal responsibility causes many local and state governments to be net savers, while the U.S. Federal government has been a net borrower for the last 35 years.

Two routes connect the savers to the borrowers. The financial institutions perform the first route by transferring funds. The first route is financial intermediation. The most common financial intermediaries are banks, mutual funds, and insurance companies. For example, you purchased fire insurance for your home. When you pay your premium, the insurance company transfers your payment to the financial markets, and invests in financial securities. The financial intermediaries only provide this function for one reason - to earn profits. For example, banks transfer your funds to borrowers and the banks’ profit is the difference between the interest rate paid by the borrowers and the interest rate the bank pays on your accounts.

The second route linking savers to the borrowers is direct finance. The net savers, like households, can lend directly to businesses through the financial markets. There are two broadly defined financial instruments. The first is common stock. If you buy common stock, you have partial ownership in a corporation. (The ownership is also called equity). A stock certificate is shown in Figure 3.1. You and the stockholders have the right to vote on certain corporate policies and elect the Board of Directors. Each share of stock you own entities you to one vote.

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If you own 100 shares of stock and this corporation has sold a billion shares, your vote will have little impact on corporate policy. Also, you and the stockholders receive a share of the profits, called dividends. The second financial instrument is a bond. A bond is essentially an IOU. A bond is fancy paper giving bondholders legal rights that the corporation promises to pay back a long-term loan plus interest to the bondholders.

Source: www.oldstockresearch.com/faq.htm

Figure 3.1. An example of a stock certificate

Bonds and stocks have two markets. The first is the primary market. The primary

market is when corporations or government issues new securities by selling them directly to security dealers. The second is the secondary market. The secondary market is where investors sell and buy securities. A famous secondary market for stock is the New York Stock Exchange. Secondary markets are important, because these markets increase the liquidity of financial instruments. Investors can easily sell or buy financial securities on secondary markets. Moreover, when government or corporations issue new securities, the prices from the secondary market set the prices for the new securities.

Why would savers want to deposit their money into banks, instead of investing directly into the financial markets? The financial intermediaries provide three functions. First, your

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bank account has liquidity. If an emergency arises, you can easily withdraw funds from your account. If you directly purchased stock and bonds from the financial markets, you could experience time delays and pay a transaction cost to retrieve yours funds. Second, financial intermediaries have specialist who collect information about borrowers. The financial intermediaries lend to borrowers who have a low chance of defaulting on their loan. Finally, the financial intermediaries lower risk. They will lend to a variety of borrowers. This process is called diversification. For example, banks will issue credit cards, grant mortgages, grant loans to a variety of businesses, and buy U.S. government securities. If several credit card holders default, several households stop paying their mortgages, and one business bankrupts, over all, the banks could still earn profits, because the majority of bank customers are paying their loans. If you directly invested in a company that bankrupts, then you lose all of your investment.

Another process can occur which is called financial disintermediation. Financial disintermediation is savers withdraw their money out of the financial intermediaries and invest directly in the financial markets, such as buying U.S. government securities. Savers have two reasons for investing directly in government. Government may offer a higher interest rate than a bank. You savings account may earn 2% interest, while a U.S. Treasury bill can earn 5% interest. The second reason is the U.S. government has a low risk of default, because governments have the power to tax and “print” money (i.e. seigniorage). If the government gets into financial trouble, it can raise taxes, issue more government securities, or print money. One problem does occur. If government is running up a massive debt, it usually gets money for loans first. Businesses usually come second. If there are limited funds, businesses might not get the money that they need for investing in machines and equipment. A large government debt could have a large impact in the financial markets and hamper business investment. A large government debt crowds out private investment.

3.2. Financial Innovation and Globalization

The financial markets and institutions are constantly changing. The first change is financial innovation. If a new financial instrument lowers risk, increases liquidity, or increases information, then investors are attracted to the new security. For example, mutual funds were one financial innovation. A mutual fund pools together money from many people into a fund and the fund manager invests the fund in a variety of stocks. This method lowers investors’ risk through diversification of stocks. For example, you started you own mutual fund and bought 30 different corporate stock. Your Coca-Cola stock may go up one day, while the value of your IBM stock goes down. Overall, the average of the fund’s 30 stocks will earn a return to the fund investors. If you bought only one type of corporate stock, like Kodak, your investment can bankrupt, if this corporation bankrupts.

Another change that is affecting the financial markets is globalization. In the last 35 years, savers and borrowers are linked through international financial markets. For example, Japanese bank transfers funds from savers in Japan to build a new factory in China. Three factors account for the rise of international financial markets. First and most important, many countries repealed laws that restricted savers from investing in foreign countries. Second, the industrialized countries have been growing. As countries grow, people earn higher incomes and save more. The increase in savings is funneled into the financial markets. Third, corporations became global. A corporation produces goods in one country and transports the goods to another country. The corporation needs financing to build the new factory and needs financing

19

to transport goods to other countries. The international financial markets are a source of funds for international business investment.

The transfer of funds from savers to borrowers is very important for the economy. If the borrowers invest the funds by purchasing machines and equipment, the borrowers can produce more goods and services. When more goods and services are produced, the economy grows. Consumers buy more goods and services, causing the living standards to increase. The beauty in the U.S. financial system is if there are 10,000 savers that have $200 in their savings accounts, the bank can potentially loan a business $2 million. The business can buy new machines and equipment and increase its production level, causing the U.S. economy to grow.

The financial sector is extremely important sector of the economy and every country around the world regulates its financial markets. Government has three reasons to regulate financial markets. First, the financial markets depend on accurate information. Governments want to ensure borrowers are providing accurate information to the investors. In the United States, the Securities and Exchange Commission (SEC) requires publicly traded companies (i.e. sells stock to the public) to disclose financial information based on acceptable accounting standards. Second, governments want the financial system to be stable. Many economists believe the Great Depression would not have been so severe, if there was not a massive bankruptcy of financial institutions. Third, the money supply and financial markets are intertwined. If the central bank influences the money supply in order to influence the inflation, business cycle, or interest rates, the central bank also influences the financial markets. Consequently, central banks need government regulations to use effectively monetary policy.

3.3. The Derivatives Market

Financial markets have two methods to complete a transaction. Up to this point, you assumed when a buyer and seller completed a financial transaction, money is immediately exchanged for the financial instrument. This is referred to as cash markets or spot markets.

Buyers and sellers have another option to complete a transaction. The buyer and seller of a financial instrument can negotiate a price today, but money is exchanged for the financial instrument on a future specific date. This is referred to as the derivatives market.

For example, you negotiate a price today to buy 10 Treasury bills from a seller for $9,000 each in 6 months. You are entering into a contract with the seller for a future transaction. Investors can buy and sell these contracts on secondary markets. The derivatives market is extensively explained in Chapter 9.

3.4. Financial Instruments

Financial instruments are categorized into two broadly defined classes. The first class is referred to as the money market. The money market includes short-term securities that have a maturity less than 1 year. (Maturity is the expiration date of a security). These types of securities are very popular and are simply a loan of funds from party to another. The second category is referred to as the capital market. It includes long-term securities that have a maturity of one year or more. The capital market includes common stock, because stock has no expiration date and stock is considered a long-term security.

You do need to memorize the following securities, because throughout this book, the author continually refers to these financial instruments. The key to understanding these securities is who issues the security and does it belong in the money market or capital market.

20

All these securities have one purpose. One party owes another party money plus interest. There is only one exception, which are stocks. Stocks are ownership in a corporation and are not a loan.

Every financial instrument, except stock, has a principal, interest, and maturity. The principal is how much money the borrower received from the lender. The interest is the periodic payments paid to the lender, because the lender is allowing the borrower to use the funds. The interest is a cost to the borrower, but income to the lender. The maturity is the date when the final payment of all the principal plus last interest payment is paid to the lender.

Money Market Instruments are securities with maturities less than one year.

1. Treasury bills (T-bills) are loans to the U.S. Government. The maturities range from 15 days to 1 year. The T-bills do not state the interest rate and the minimum denomination is $10,000. If an investor bought a $20,000 T-bill (face value) with a maturity of 6 months for $19,000, then six months later, the government pays $20,000. The $1,000 reflects the interest rate.

2. Commercial Paper is a loan to well-known banks and corporations for a short-time period. Commercial paper is an alternative to raising funds, instead of selling more stock and bonds. Commercial paper is a form of direct finance and the loan has no collateral.

3. Banker’s Acceptances are used for international trade. A firm wants to buy from a foreign exporter. The firm deposits money at a bank, and the bank guarantees payment by issuing this security. If the firm does not deposit money at the bank and the bank guarantees payment, then the bank has to pay the foreign exporter, even if the firm bankrupts. These securities are liquid, because they are sold on the secondary market.

4. Negotiable Bank Certificates of Deposit (CDs) are loans to banks and sold to depositors. CDs have fixed time period. If the CD is withdrawn early, then the investor does not receive the interest. CDs tend to pay a higher interest rate than a savings account.

5. Repurchase Agreements are short-term loans. For example, a bank sells T-bills to a customer and promises to buy it back the next day for a higher price. The higher price reflects interest. Another example is IBM has excess funds in their checking account. The bank uses these funds and sells IBM T-bills. The next day the bank deposits the funds back into IBM’s account with interest, and takes back the T-bills back. REPOs were a way to circumvent the law, so banks could pay businesses interest on their checking accounts.

6. Federal (Fed) Funds are overnight loans between banks. A bank that has excess funds deposited at the central bank can lend these funds to another bank. Market analysts and the Fed scrutinize the interest rate in this market closely.

7. Eurodollars are U.S. dollars that are deposited in foreign commercial banks outside the U.S. and in foreign branches of U.S. banks. Eurodollars are an important source of funds in the international market.

Capital Market Instruments are securities that have maturities longer than a year.

21

1. U.S. Treasury securities are loans to the U.S. government. The securities are Treasury

Notes (T-notes) which are issued from 1 to 10 years, and Treasury bonds which have maturities greater than 10 years. U.S. Treasury securities have a stated interest rate, and government pays interest every 6 months.

2. U.S. Government Agency issues securities. For example, Sallie Mae is a quasi-government agency. Sallie Mae buys student loans. The student loans are packaged together as a fund. Sallie Mae issues new securities to investors based on this fund. The investors own a portion of the fund and earn the interest from the students’ payments. Thus, Sallie Mae makes student loans more liquid.

3. State and Local Government Bonds are loans to state and local governments. These bonds are also called municipal bonds. The bonds are tax-exempt and bondholders do not pay U.S. government taxes on the interest earned. Municipal bonds fall into two categories:

• General-Obligation Bonds: Government guarantees the bonds by the taxing power, where they are issued.

• Revenue Bonds: Bonds are secured by the revenues that will be obtained from the project. For example, a college builds a new dormitory, using revenue bonds. When students pay to live there, some of the money goes to the bondholders.

4. Stocks and Bonds were already defined in this chapter.

5. Mortgage is a loan for a house or property and the loan duration is usually for 15 - 30 years. The property is the collateral. If a homeowner loses his job and cannot pay the mortgage, the bank takes his house. This property taking process is called foreclosure. Mortgages are the largest debt market and funds for mortgages come from savings institutions and banks. The U.S. government helped to create secondary markets, causing mortgages to become more liquid.

6. Commercial Bank Loans are bank loans to businesses. These loans do not have well developed secondary markets.


1. Which financial instruments are in the money market? Which financial instruments are in the capital markets?

2. Why do people deposit their savings into financial intermediaries, instead of directly investing in the financial markets?

3. What is the difference between stocks and bonds?

4. What is the difference between the primary and secondary markets?

22

5. Why are the secondary markets so important?

6. What is financial disintermediation? Why does it occur?

7. Why did the financial markets become international?

8. Why do governments regulate the financial markets?

9. What is the difference between a money market and capital market?

23

4. Present Value Formula, Interest Rates, and Rates of Return


• Time value of money

• Present value of multiple future withdrawals and payments

• Amortization table for a fixed payment mortgage

• The relationship among the market price of securities, market interest rates, and term to maturity

• The difference between a market interest rate and rate of return

• The Fisher Equation.

4.1. Single Investment

Financial analysts use the present value formula to price financial securities or calculate mortgage payments. The present value formula places a value of future cash flows in terms of money today. Therefore, net present value emphasizes the present. For example, if you deposit $100 into a bank at 5% interest rate, you earn the interest:

• After one year, you earn 0.05($100) = $5 in interest. Your ending balance is $105.00.

• After two years, you earn 0.05($105.00) = $5.25. Your ending balance is $110.25.

We can use compounding to determine the ending balance:

( )( ) ( ) 25.110$05.01100$05.0105.01100$2 =+=++

If you let the money earn interest after T years, then you can build the sequence:

( )( ) ( ) ( )T05.01100$05.0105.0105.01100$ +=+++ ⋯

For example, in one-hundred years, $100 grows into $13,150.13 at 5% interest. The

mathematical notation is:

• FV stands for Future Value

• PV stands for Present Value

• i is the discount rate or interest rate

24

• The subscripts refer to time with the final time period is T

The formula is:

( ) ( ) 13.150,13$05.01100$1100

0100 =+=+= TiPVFV

One hundred years is very far away. You would rather have the money today. The

present value of $13,150.13 in one hundred years is worth $100 to today. You can take that $100 today, invest it in a savings account with 5% interest, and let it grow to $13,150.13. If you receive a payment in the future, then the present value is:

( )TT

i

PVPV

+=1

0

4.2. Multiple Investments

Let us change the analysis, so you receive multiple future payments. Every year, you deposit $500 into the bank account at 6% interest.

• After the first year, you earn $500(0.06) = $30. Your balance is $500 + $30 + $500 = $1,030. You have the original $500 and then you deposit another $500 into your account.

• After the second year, you earn $1,030( 0.06 ) = $61.80. Your balance is $1,030 + $61.80 + $500 = $1,591.80.

• After the third year, you earn $1,591.80(0.06) = $95.508. Your balance is $1,591.80 + $95.508 + $500 = $2,187.308

The equation for the bank account is:

( ) ( ) ( ) ( ) 31.187,2$06.01500$06.01500$06.01500$06.01500$0123

3 =+++++++=FV

How much are these cash flows worth to you today, if you receive $500 today, $500 in

one year, $500 in two years, and $500 in three years? The present value is:

( ) ( ) ( ) ( )51.836,1$

06.01

500$

06.01

500$

06.01

500$

06.01

500$32100 =

++

++

++

+=PV

If you received $1,836.51 today, you can invest in a savings account and earn $2,187.31

in three years at 6% interest. This net present value formula is flexible. The formula can handle uneven withdrawals

and investments. For example, you have a bank account with the activities listed in Table 4.1.

Table 4.1. Withdrawals and Deposits for a Bank Account

25

Year Activity Amount Interest + Balance

0 Deposit $100 $148.15 1 Deposit $300 $389.88 2 Withdrawal $50 -$57 2 Deposit $100 $114.00 3 Withdrawal $75 -$75

Total $520.03

How much are these cash flows worth to you today if interest rate is 14%? Table 4.1

shows the interest and balance for each activity in the last column. At Time 0, you deposit $100 into the account, that $100 grows into $148.15 in 3 years at 14% interest. Withdrawals have negative balance because you removed the money from the account. These cash flows are worth to you:

( ) ( ) ( ) ( )

01.351$14.01

75$

14.01

50$100$

14.01

300$

14.01

100$32100 =

+

−+

+

−+

++

+=PV

If you invest $351.01 today at 14% interest, then in 3 years, you will have $520.04,

which is the balance of your bank account.

4.3. Changing Time Units

Interest rates are defined as Annual Percentage Rate (APR). For example, is 1% a good interest rate for a borrower? Which period of time does this 1% apply? If 1% is annual, then it is a good interest rate for a loan. If it is daily, then the rate is terrible for a loan. The borrower borrowed money from a loan shark. For this book, all interest rates are defined in annual terms, unless otherwise stated.

Banks and finance companies usually calculate loan payments and bank interests monthly. They can calculate loans and interest in semi-annually (two payments per year) or quarterly (four payments per year). The net present value can be adjusted for different time units.

For example, what is the present value if you receive $50 within a month, $100 within six months, $75 in exactly one year and one month, and the interest rate is 10%? The smallest time unit is the month, so you need to adjust the time units for interest and time.

• Interest rate is in APR, so divide by 12 to obtain interest for a month.

• All time subscripts are monthly.

( ) ( ) ( ) 06.212$

121.01

75$

121.01

100$

121.01

50$13610 =

++

++

+=PV

4.4. Amortization Table

Banks use an amortization Table for home mortgages and is easy to derive from the present value formula. A mortgage is a bank loan and the asset is the collateral. For instance, if

26

a person has a mortgage for a house and defaults on the loan, the bank can legally take possession of the house. The mathematical notation for a mortgage is:

• All FVt are future mortgage payments and is usually monthly.

• i is interest rate (loan rate) and fixed throughout life of the loan.

• PV0 is the bank loan. The time the bank loaned you the money for the house

The mortgage is a stream of cash flows to the bank:

( ) ( ) ( ) ( )TT

i

FV

i

FV

i

FV

i

FVPV

121

121

121

121

33

22

11

0

+++

++

++

+= ⋯

All loan payments are the same, so FV = FV1 = FV2 = FV3 = ... = FVT. The FV can be

factored from all interest terms:

( ) ( ) ( ) ( )

+++

++

++

+=

Tiiii

FVPV

121

1

121

1

121

1

121

13210 ⋯

Solving for FV, which is the loan payment, yields:

( ) ( ) ( ) ( )

+++

++

++

+

=

Tiiii

PVFV

121

1

121

1

121

1

121

1321

0

⋯

For example, bank granted a mortgage for $60,000 at an interest rate of 12% APR. The

mortgage is a six-year loan and paid yearly. Solving for FV, your annual payment is $14,594. The calculation is below:

( ) ( ) ( ) ( ) ( ) ( )594,14$

12.01

1

12.01

1

12.01

1

12.01

1

12.01

1

12.01

1

000,60$

654321

=

++

++

++

++

++

+

=

FV

FV

You can use the mortgage loan information to build an amortization table. At the end of

Year 1, you have $60,000 outstanding. Your interest is 12% multiplied by $60,000, which is $7,200. Your payment is $14,594. After subtracting the interest of $7,200, the remainder is the principal paid, and it reduces the loan balance.

For Year 2, and beyond, repeat the sequence. The complete amortization table for this mortgage is Table 4.2.

27

Table 4.2. Amortization Table

Payment Interest Principal Paid Loan Balance

Year 0 - - - $60,000

Year 1 $14,594 $7,200 $7,394 $52,606

Year 2 $14,594 $6,313 $8,281 $44,325

Year 3 $14,594 $5,319 $9,275 $35,050

Year 4 $14,594 $4,206 $10,388 $24,662

Year 5 $14,594 $2,959 $11,635 $13,027

Year 6 $14,594 $1,563 $13,027 $0

If the mortgage is monthly, then divide the interest rate by 12 and multiply the number of

years by 12. For instance, a 20-year mortgage will have 240 payments. Banks and financial analysts use computer programs to calculate amortization table for long time periods.

The amortization table can also handle balloon payments and variable interest rate mortgages. However, these topics are not included in this textbooks.

4.5. Fisher Equation

The interest rates discussed so far has been nominal interest rates. Nominal interest rates are not adjusted for inflation. Inflation can have a significant influence on the financial markets. Investors and savers are concerned about the real interest rate. The real interest rate is the true cost of borrowing. The Fisher Equation relates nominal and real interest rates. The notation is:

• i is the nominal interest rate

• r is the real interest rate.

• πe is the expected inflation rate.

The Fisher Equation is:

( ) ( )( )eri π++=+ 111

When inflation and interest rates are low, then you can use the approximation:

eri π+≈

For example, you expect the inflation rate to be zero ( πe = 0 ) and you grant a loan for 5% for one year. At the end of Year 1, you have 5% more money in real terms. You can purchase 5% more in goods and services. The calculation is:

%5%0%5 =−≈−≈ eir π

28

What if you believe inflation will increase to 5% ( πe = 5% ) and you grant a loan for one year for 5%. At the end of year 1, you will have 5% more money, but prices became 5% higher too, so in real terms, your purchasing power does not change. The calculation is:

%0%5%5 =−≈−≈ eir π Therefore, the real interest rate reflects the true cost of borrowing and it is a better

indicator of incentives to lend and borrow. Many financial analysts use nominal interest rates, because inflation is low in the United States, averaging 3% per year.


29

5. Valuation of Bonds


• Why corporations issue bonds to expand operations

• The bond types

• How to calculate the market price of bonds

• The difference between yield to maturity and the rate of return

5.1. Overview of Bonds

Corporations often borrow money by issuing bonds. A bond is a written promise to pay interest and principal and is similar to notes payable. A picture of a bond is in Figure 5.1.

Bond

$1,000

10%

February 1, 2010

Figure 5.1. A picture of a bond

The face value of this bond is $1,000 and this bond matures on February 1, 2010. Who

holds this bond will receive $1,000 on this date. The bondholder will also receive $100 ( 0.1 X $1,000) per year in interest. Most bonds pay the interest twice a year or $50 every six months for this example.

Bonds are different from notes payable. Notes payable is a loan from a single creditor such as a bank. A bond is a loan that corporations issue in denominations of $1,000, $2,000, etc. and many different lenders can purchase them. Moreover, investors can buy and sell these bonds on the financial markets before the bonds mature.

Bonds are different from corporate stock. A share of stock represents ownership in a corporation. For example, if a shareholder owns 1,000 shares out of 10,000, then he owns 10% of the corporation’s equity. The shareholder also receives 10% of the corporation’s earnings, when dividends are declared. A bond represents a debt or a liability to the corporation. For example, a person owns a bond with a face value of $1,000, 11% coupon interest rate, and 20-year maturity, then the bondholder has two legal rights. The bondholder has the legal right to receive 11% or $110 interest each year the bond is outstanding. The bondholder has legal right to be paid $1,000 when the bond matures in 20 years.

30

Why would a corporation issue bonds instead of stock? A corporation that needs long-term funds may consider issuing additional shares of stock or issuing bonds. If the corporation issues new stock, then old stockholders share control with new stockholders. Thus, old stockholders lose part of control of the corporation. Bondholders do not share in the management or earnings of the corporation. However, the bond interest must be paid, whether or not there are any profits. Bonds reduce net income, thus lowering a corporation’s taxes. U.S. corporations usually pay about 40% of their net income in taxes. Bond interest payment is an expense, which lowers the corporation’s net income. If a corporation issues new bond, the common stockholders may increase their dividend earnings.

An example of a corporation expanding operations is in the Table 5.1. This corporation has 300,000 shares of common stock outstanding and needs $2 million to expand its operations. After the expansion, management estimates the company can earn $1,000,000 annually. The corporation has two plans. Plan A, the corporation issues 200,000 new shares of the corporation’s stock at $10 per share. Plan B, the corporation issues $2 million of bonds with a 10% interest rate. The interest expense is $200,000 per year.

Table 5.1. A Corporation Financing an Expansion through Bonds or Stocks

Plan A Plan B

Earnings before bond interest and income taxes $1,000,000 $1,000,000

Deduct interest expense (200,000)

Income before corporation income taxes $1,000,000 $800,000

Deduct income taxes (assumed 40% rate) (400,000) (320,000)

Net income $600,000 $480,000

Plan A income per share (500,000 shares) $1.20

Plan B income per share (300,000 shares) $1.60

Looking at these two plans, plan B will result in a higher income per share. The bond’s

interest lowered the tax burden by $60,000 and the shares outstanding did not increase. The stockholders potentially could earn higher dividends per share under Plan B.

5.2. Valuation of Bonds

A discount bond is shown in Figure 5.2. This treasury bill has a face value of $10,000, and T-bill is the short name. No interest rate is listed on this instrument. The T-bill is sold at a discount (lower price).

Treasury Bill

U.S. Government $10,000

August 10, 2008

Figure 5.2. A picture of a Treasury Bill

31

For example, if the U.S. federal government sold this T-bill to you for $9,500, then the

present value, PV0, becomes the market price. On August 10, 2008, the federal government will give you $10,000 for this instrument. The $500 difference is the interest on this loan. The interest rate is 10.5% if the T-bill matures in 180 days. (Financial analysts use 360 days for one year). The calculation is below:

( )

( )

%5.10

500,9$

000,10$

2

11

3601801

000,10$500,9$

3601

10

=

=+

+=

+=

i

i

i

iT

FVPV

Coupon bonds are bonds with coupons at the bottom of the certificate. When it is time to

receive an interest payment, the bondholder detaches one coupon and mails it to the corporation. The corporation will send a check to the bondholder. An example of a coupon bond is Figure 5.3.

Treasury Note U.S. Government

$20,000 10%

August 10, 2010

Figure 5.3. An example of a coupon bond

This coupon bond is a U.S. Treasury note with a face value of $20,000. T-note is the

short name and pays 10% interest. U.S. government pays interest every six months; the person who has this instrument will clip off one coupon and send it to the U.S. federal government for payment. The interest payment is 0.1 x $20,000 x 0.5 = $1,000. When the T-note matures on August 10, 2010, the owner gets $20,000.

The other types of bonds are listed below:

1. Registered Bonds - Most bonds are registered, which means that the corporation has the names and addresses of all the bondholders. This offers some protection from loss or theft of the bonds.

32

2. Bearer Bonds - Who has possession of the bonds will receive the interest payment. Coupon bonds tend to be bearer bonds.

3. Debentures Bonds (i.e. unsecured) - The corporation does not pledge assets for the bond issues. These bonds depend on the credit standing of the corporations. A corporation has to be strong to issue this type of bonds.

4. Mortgage Bonds - Some corporations pledge the corporation's assets to the bondholders

5. Convertible Bonds – Bondholder has right to exchange corporate bond into corporate stock on a specified date.

6. Consuls or Perpetuity - Government or corporation issues a bond and bond never matures. The bond has no maturity date, but pays interest. These bonds are rarely issued, but they have nice mathematical properties.

For example, government sold a consul that pays $50 interest per year. The bond never matures and the market interest rate is 8%. What is the market price, PV0, of the consul? The future values, FV, are the same and so are the interest payments. The present value becomes an infinite sequence, which reduces to FV / i. The market price of this consul is $625.

( ) ( ) ( )

625$08.0

50$

111

0

320

==

=++

++

++

=

PV

i

FV

i

FV

i

FV

i

FVPV ⋯

The market interest rate rarely equals the bond’s stated interest rate. If the market interest

rate is lower than the stated interest rate, the corporation or government can sell the bond for a higher price. The higher price reduces the interest earned on the bond. The bonds are sold for a premium.

For example, a corporation has a $1,000 bond that pays interest twice a year. The interest on the bond is 8%, which is $80 a year or $40 every six months. The bond matures in two years (4 periods). The market interest rate is 4% a year (2% for a payment period). If the market interest rate is 4%, the corporation would not issue this bond at 8%. Why issue at a higher interest rate? The corporation can sell this bond for a higher price, reflecting the market interest rate. The bond market price is calculated as:

. ( ) ( ) ( ) ( )76.930$

02.01

000,1$40$

02.01

40$

02.01

40$

02.01

40$

0

43210

=

+

++

++

++

+=

PV

PV

Corporations and governments sell bonds at a discount, if the market interest rate is

higher than the bond’s interest rate. For example, a corporation sells a $1,000 bond that pays interest twice a year. The interest on the bond is 8%, which is $80 a year or $40 every six months. The bond matures in two years (4 periods). The market interest rate is 12% a year (6% for a payment period). If the market interest rate is 12%, no investor would buy this bond at face

33

value that earns 8% interest. The corporation sells this bond for a lower price, reflecting the market interest rate. The bond market price is:

( ) ( ) ( ) ( )19.076,1$

06.01

000,1$40$

06.01

40$

06.01

40$

06.01

40$

0

43210

=

+

++

++

++

+=

PV

PV

5.3. Yield to Maturity and Rate of Return

When investors pay for a financial security, they know:

• The face value

• The maturity date

• Number of interest payments per year

• The amount of interest payments

The only information investors do not know is the discount rate. However, investors can substitute all this information into the present value formula and solve for the discount rate. Investors can calculate the discount rate for several different bonds and select the bond that has the highest discount rate.

If investors hold the bond until maturity, then the discount rate is called yield to maturity. Economists consider yield to maturity the most accurate measure of the interest rates. The yield to maturity allows the easy comparison of different bonds.

For example, you want to buy a coupon bond today for $1,600. The bond pays $400 interest per year and matures in three years. The bond pays $1,000 on maturity date. What is the yield to maturity?

( ) ( ) ( )%11.14

1

000,1$400$

1

400$

1

400$600,1$

321

=⇒

+

++

++

+=

i

iii

As you can see, this calculation is very complicated. If you have to calculate the discount

rate manually, then you calculate the PV0 below by selecting various discount rates, such as 0%, 5%, 10%, and 20%. Then select the discount rate that has a present value, PV0, that is closes to $1,600. The setup is below:

( ) ( ) ( )32101

000,1$400$

1

400$

1

400$

iiiPV

+

++

++

+=

The yield to maturity yields two rules:

34

1. Market interest rate (yield to maturity) and market price (present value) of the securities are inversely related. For example, look at the consul formula, as interest rate increases, the market price decreases. This is also true for all bonds.

2. The shorter the term to maturity of a bond, the less its price will fluctuate for a change in the market interest rate. For example, two bonds have a face value of $5,000 with coupon interest rates of 10%. Interest is paid annually, which is $500. The first bond matures in one year and the other bond matures in 10 years. If the market interest rate changes to 16%, what are the bond market prices?

The 1-year bond has a market price of $4,741 while the 10-year bond has a market value of $3,550. The interest rate change had larger affect on the 10-year bond. The calculations are below:

One –year bond: ( )

38.741,4$16.01

000,5$500$10 =

+

+=PV

10-year bond: ( ) ( ) ( )

03.550,3$16.01

000,5$500$

16.01

500$

16.01

500$10210 =

+

++

++

+= ⋯PV

For this book, the discount rate is referred to rate of return. Investors are likely to sell

securities before they mature. Thus, the rate or return includes the interest rate and capital gains or losses. A capital gain is an investor sells a financial security for higher price, while a capital loss is an investor sells a financial security for a lower price. Investors do not want capital losses, but they can occur. If investor has to sell an asset whose market price is decreasing or needs cash. The net present value still works for capital gains and losses.

For example, a bond has a face value of $2,000 with a coupon interest rate of 5%. The bond has a 10-year maturity. You bought this bond for $2,000 and resold it two years later for $2,400. Thus, you collected two years of interest. What is your rate of return? The rate of return is 14.33% and is calculated below:

( ) ( )

( ) ( )%33.14

1

400,2$100$

1

100$000,2$

11

2

22

11

0

=⇒

+

++

+=

++

+=

i

ii

i

FV

i

FVPV

A capital loss is similar. You bought this security for $2,000 with a coupon interest rate

of 5% and held it for two years. You earned two years of interest. However, this company reported financial trouble and the bond price dropped to $1,000. What is your return on the investment? Your rate of return is -23.3%, which is a loss. The calculation is below:

( ) ( )%3.23

1

000,1$100$

1

100$000,2$

2

−=⇒

+

++

+=

i

ii

35


36

6. Valuation of Stocks


• How corporations issue stocks to expand operations

• Stock market indices and stock market crashes

• How to apply net present value to stock dividend cash flows.

6.1. Overview of Stocks

Investors have two sources of corporate stock: Investment banks and organized exchanges. An investment bank helps corporations issue new stock and bonds, and they are part of the primary market. In the United State, an investment bank is not a regular bank. It is a marketing agent for new securities. Investment banks may also help one corporation take over another. Some prestigious investment banks are Merrill Lynch, Goldman Sachs, and First Boston.

The process of issuing new stock is called underwriting. Underwriting lowers information costs. The investment bank guarantees a stock or bond price for corporation. Then the investment bank tries to sell the new stock or bond for a higher price. The higher price is the investment banker’s profit. Investment banks may work together, which are called syndicates. One investment bank acts as the manager and keeps part of the profits while other investment banks sell the new securities.

The U.S. government requires investment bankers to disclose information to investors, which help prevent risk and fraud. Investment bankers have inside information about corporate mergers. When a corporation takes over another corporation, the merger causes the company’s stock price to increase. Investment bankers can secretly buy stock or share information with friends. Insiders can earn large amount of profit. Insider information is illegal in the United States and the Securities Exchange Commission investigates these cases.

Investors can buy or sell corporate stock through organized exchanges. Exchanges are secondary markets and they increase the liquidity of securities. Organized exchanges come as two types. The first is an exchange, which has a physical location, and buyers and sellers of securities meet face to face. Only members, called specialist, can enter these exchanges. For example, if you want to buy Coca-Cola stock, you have to contact a broker who will contact a specialist at the New York Stock Exchange. The specialist matches prices and quantity of stock for the buyers and sellers. The broker and specialist earn commission from each transaction. The oldest and largest U.S. corporations are listed on the New York Stock Exchange, while less well-known corporations are listed on American Stock Exchange.

The second organized exchange is over-the-counter (OTC) market. Over-the-counter market does not have a physical location. Telephones and computers connect dealers and brokers together. Either new or small firms are likely to be traded in the over-the-counter market. The OTC market in the United States is the National Association of Securities Dealers' Automated Quotation (NASDAQ) or commonly referred to as NASDAQ. Many new high-tech

37

firms started in NASDAQ, such as Microsoft. Europe has their equivalent of NASDAQ, which Europeans call EASDAQ.

Financial analysts compile market indices, which are measures of broad movements in a financial market. The most popular and the oldest market index used today is the Dow Jones Industrial Averages, and also called the “Dow” or “the industrials.” The Wall Street Journal invented the Dow in 1882. The Wall Street Journal calculates the Dow by calculating a weighted average of 30 representative stocks of New York Stock Exchange. The representative stocks include Coca-cola, IBM, Proctor & Gamble, and Exxon. The Dow includes adjustments from corporate mergers, corporate bankruptcies, and stock splits. Another popular market index is Standard and Poor's 500 (S&P 500). Standard & Poor’s index includes 500 stocks. The major stock exchanges in the world are listed in Table 6.1 along with their market indices.

Table 6.1. Major Stock Exchanges in the World

Country Name Major Market Index City

Australia Australian Securities Exchange Australian EXchange (AEX) Sydney Canada Toronto Stock Exchange S&P/TSX 60 Toronto China Hong Kong Stock Exchange Hang Seng Index Hong Kong China Shanghai Stock Exchange Shanghai Stock Exchange (SSE) 180 Shanghai England London Stock Exchange Financial Times Stock Exchange (FTSE) 100 London France Euronext Paris Cotation Assistée en Continu (CAC) 40 Paris Germany Frankfurt Stock Exchange Deutsche Aktien Xchange (DAX) 30 Frankfurt Italy Borsa Italiana MIBTEL Milan Japan Tokyo Stock Exchange Nikkei 225 Tokyo Mexico Bolsa Mexicana de Valores Bolsa Mexicana de Valores (BMV) Mexico City Netherlands Euronext Amsterdam Amsterdam EXchange (AEX) Amsterdam United States New York Stock Exchange Dow Jones Industrial Average New York United States NASDAQ NASDAQ -

Note: The numbers in the market indices are the number of stocks included in the calculation Note: The Amsterdam Stock Exchange, Brussels Stock Exchange, and Paris Stock Exchange merged to form Euronext.

Market indices provide two benefits. First, the market indices are fast information.

Financial analysts calculate a market index in seconds and dispense to investors instantly. Second, private companies calculate the market indices. Thus, government does not influence the market indices.

A stock market crash is a dramatic drop in stock prices during a short period of time. A stock market crash bankrupts investment companies, insurance companies, and commercial banks. Commercial banks grant loans to investors that investors cannot repay. A stock market crash in one market can lead to other stock market crashes to other markets, even in foreign countries.

The market crashed on October 24, 1929, October 28, 1929, and October 29, 1929. The market crash was the start of the Great Depression. The unemployment rate peaked at 26% in the U.S. The New York Stock Exchange also crashed on October 19, 1987. The Dow Jones fell by 508 points (or 27.8%) in one day. This was the largest loss in U.S. history. However, the United States did not enter into a recession. Finally, the dot-com crashed in March 2000. Dot-com refers to internet companies. The U.S. economy went into a recession in 2001.

38

Stock market crash is also called financial bubble. A bubble is a dramatic, fast rise in assets prices. Assets price reaches a peak where prices rapidly fall, bankrupting institutions in this market. The United States along with other industrial countries are experiencing a real estate bubble in 2007.

The stock market has psychology. Investors are human! Investors see the Dow Jones increasing quickly; they put more money into the stock market. More money into the stock market causes stock prices to increase further. If investors see stock market prices decreasing, then they take their money out of the stock market, and stock prices decrease further. Thus, the market moves in cycles.

6.2. Valuation of Stocks

The value of an asset equals the present value of all the asset's future cash flows. Thus, the present value of all future cash flows is the asset’s market price. The equation below is the market price of stock per share. P is the market price, D is dividends, and i is rate of return. The subscripts are time.

( ) ( )iP

i

DP

++

+=

1111

0

The market price of a stock at time 0 is the discounted dividends received next year and

the price the investor receives if he sells the stock next year. Likewise, if the investor is in the first time period, the investor faces the same choices for Year 2:

( ) ( )iP

i

DP

++

+=

1122

1

If P1 is substituted into P0, then the equation becomes:

( ) ( ) ( )22

221

0111 i

P

i

D

i

DP

++

++

+=

We can keep building this sequence. We substitute P2 into P0, and so and until:

( ) ( ) ( )⋯+

++

++

+=

33

221

0111 i

D

i

D

i

DP

If all dividends are the same, ⋯=== 21 DDD , then the market price becomes a

perpetuity, and reduces to:

i

DP =0

39

Example 1 - You want to purchase stock as a long-term investment. Your rate of return is 5% and you expect the corporation to pay $2 per share indefinitely. What is the market value of this stock?

00.40$05.0

2$0 ===

i

DP

What is the value of this stock in one year? This is a trick question. You are expecting to receive the same dividends year after year,

so the market price is still $40.00. There are neither capital gains nor losses. What if the dividends grow over time? If the dividend grows at the same rate, then the

present value formula is updated to include a growth rate. The first equation reflects different dividends. The second equation reflects that dividends increase with a growth rate of g, and is an infinite sequence. The second equation reduces to the third equation, because the sequence is a perpetuity.

( ) ( ) ( )( )( )

( )( )

( )( )

gi

DP

i

gD

i

gD

i

gDP

i

D

i

D

i

DP

−=

++

++

+

++

++

=

++

++

++

=

0

3

3

2

2

0

33

221

0

1

1

1

1

1

1

111

⋯

⋯

Example 2 - You want to purchase stock as a long-term investment. Your rate of return

is 10%, you expect the corporation to pay $2 dividends with a dividend growth rate of 5%. What is the market value of this stock?

00.40$05.010.0

2$0 =

−=

−=

gi

DP

What if dividends grow at 2%?

00.25$02.010.0

2$0 =

−=

−=

gi

DP

Why is it less? Two forces affect future cash flows. The first force is the discount rate,

which lowers the future value of cash flows. The second force is the dividend growth rate, which increases the value of future cash flows. If dividends grow faster than the rate of return (g > r), then future cash flows become more valuable over time. Thus, the present value becomes negative.

Example 3 - You want to purchase stock as a long-term investment. Your rate of return is 12%, you expect the corporation to pay $5 at Time 1, and dividends grow at 5%. What is the market value of this stock?

40

43.71$05.012.0

5$0 =

−=

−=

gi

DP

What is the value of stock at Time 1? Stock prices grow 5% per year.

( ) ( ) 00.75$05.0143.71$101 =+=+= gPP

Example 4 - If the stock price is $100 per share, dividends are $3, and dividends grow

5% per year, what is the rate of return on this investment? The rate of return is calculated below and equals 8%.

08.0

05.0

3$100$0

=

−=⇒

−=

i

igi

DP

Some corporations, especially in high-tech industries, initially pay low dividends. As

corporation grows rapidly, corporation pays higher dividends. We can modify the net present value to handle this situation. The net present value has two components:

1. Non-steady state - use present value to write out all cash flows. The dividend growth rate

is not constant.

2. Steady state - dividends increase at a constant rate. This portion has a constant dividend growth rate. Then we calculate a perpetuity.

Example 5 – The rate of return is 10%. A corporation pays a dividend of $6 at time 1, dividend grows 2% for first year, 4% for second year, and 6% for year 3. After Year 3, dividends grow at a constant rate of 6%. What is the market value of the stock price?

First, solve for dividends for each year with no constant growth rate. The calculations are below:

Year 1: D1 = $6(1+0.02) = $6.12 Year 2: D2 = $6.12(1+0.04) = $6.3648 Year 3: D3 = $6.3648(1+0.06) = $6.746688 Second, Year 3 becomes the perpetuity. Remember the time subscripts. The stock price,

P, is one period before the dividend payment, D. The calculation is:

67.168$06.010.0

746688.6$32 =

−=

−=

gi

DP

Finally, construct the net present value of cash flows, which are:

41

( ) ( ) ( )22.150$

1.01

67.168$

1.01

3648.6$

1.01

12.6$220 =

++

++

+=P

Example 6 - A new startup internet company will not pay dividends for the first three

years. In year 4, the company will start to pay a dividend of $10 and will grow at 5% per year. The rate of return is 8%. What is the market value of the stock?

First, D1 = D2 = D3 = 0 Second, in Year 4, then D4 = $10; and calculate the perpetuity is below:

33.333$05.008.0

10$43 =

−=

−=

gr

DP

However, stock price is for Year 3. Use the net present value to obtain the stock price in

Time 0, which is:

( )61.264$

08.01

33.333$30 =

+=P


1. What is the Dow Jones Industrial Average? Why is it so useful?

2. What are stock market crashes? Why are they so bad?

References

Australian Securities Exchange. 2007. “Australian Securities Exchange – Stock Market Information, Stock Quotes – ASX.” Available at http://www.asx.com.au (access date: 11/30/07).

Bolsa Mexicana de Valores. 2007. “Bolsa Mexicana de Valores.” Available at

http://www.bmv.com.mx (access date: 11/30/07). Borsa Italiana. 2007. “Finanza Quotazioni Azioni Eft Obbligazioni Fondi Notizie.” Available at

http://www.borsaitaliana.it/homepage/homepage.htm (access date: 11/30/07). Educational Service Bureau. 1992. How to Read Stock Market Quotations and The Dow Jones

Averages: A Non-professional's guide. Dow Jones & Company, Inc. Frankfurt Stock Exchange. “Deutsche Borse Group.” Available at http://deutsche-

boerse.com/dbag/dispatch/de/kir/gdb_navigation/home (access date: 11/29/07).

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Hong Kong Exchange. 2004. “Hong Kong Exchanges and Clearing Limited.” Available at http://www.hkex.com.hk/index.htm (access date: 11/29/07).

London Stock Exchange. 2007. “London Stock Exchange.” Available at

http://www.londonstockexchange.com/en-gb/ (access date: 11/29/07). NYSE Euronext. 2007. “Euronext.com, the official website of the Amsterdam, Brussels, Lisbon,

Paris stock exchanges.” Available at http://www.euronext.com/index-2166-EN.html (access date: 11/30/07).

Shanghai Stock Exchange. 2007. “Welcome to Shanghai Stock Exchange.” Available at

http://www.sse.com.cn/sseportal/en_us/ps/home.shtml (access date: 11/29/07). Tokyo Stock Exchange. 2007. “Tokyo Stock Exchange.” Available at

http://www.tse.or.jp/english (access date: 11/30/07). Toronto Stock Exchange. 2007. “The Stock Market, Canadian Stock Exchange | TSX Group.”

Available at http://www.tsx.com/ (access date: 11/30/07). Wikipedia. September 2007. “List of stock market crashes.” Available at

http://en.wikipedia.org/wiki/List_of_stock_market_crashes (access date: 9/28/06).

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7. Determining Market Interest Rates


• How the supply and demand for bonds influence the market interest rates and bond prices.

• The factors that shift the supply and demand functions for the bond market and how these shifts affect market interest rates and bond prices.

• Using demand and supply functions to explain why interest rates are high during a business cycle.

• How changes in the demand and supply in the bond market leads to the Fisher Effect.

• How the world’s real interest rate cause loanable funds to enter or leave a small country.

7.1. Supply and Demand Functions for Bonds

Interest rates have been fluctuating substantially in the United States during the second half of the 20th century. For example, interest rates on 3-month T-bills were 1% in the early 1950s. Then in 1981, the interest rates on T-bills increased to over 15% and then fell to below 6% in the mid-1980s and 1990s.

Interest rates are the most closely watched variables in the economy. Interest rates determine whether to consume or save, buy a house, or purchase bonds. Interest rates also affect business decisions to invest in new equipment or invest their money into financial securities. From Chapter 3, you learned the major financial instruments. All these instruments are credit market instruments. All these instruments are loans, where one party lends funds to another party. The only exception is corporate stock. Stock conveys ownership in a corporation and is not a loan.

Each credit instrument has different maturities and issued by different companies and governments. Therefore, each credit instrument has an interest rate associated with it. The financial markets have hundreds of financial instruments, which create hundreds of interest rates. The good news is all interest rates tend to move together. If one interest rate increases, the other interest rates increase too.

The interest rate in the bond market is determined by supply and demand for bonds. The bond is considered the good. Investors buy bonds, while businesses and government supply bonds. The market price of bonds and the quantity bought and sold are determined in the bond market.

The first function is the demand function. The demand function is the relationship between the quantity demanded and the market price of bonds, when all other economic variables are held constant. A demand function is shown in Figure 7.1. The demand function has a negative slope, because as you move from point A to point B, the price of bonds is cheaper, so investors will buy more bonds for a cheaper price. Just imagine bonds like any other good. For example, if the price of Coca-cola becomes cheaper, then consumers will buy more Coca-

44

cola. Please note as you move from point A to point B, the price of bonds decreases, so using the present value formula, the market interest rates increase. The investors are also attracted to the higher interest rate.

Figure 7.1. Demand function for bonds

The second function is the supply function. The supply function shows the relationship

between the quantity supplied and the market price, when all other economic variables are held constant. A supply function is shown in Figure 7.2. The supply function has a positive slope, because as you move from point A to point B, the price is higher (and the market interest rate is lower). Now businesses and firms are willing to borrow more funds, because the interest rates are cheaper. (Remember the bond’s interest rates move in the opposite direction of bond prices).

Figure 7.2. Supply function for bonds

The demand and supply functions intersect at one point, which is called the equilibrium

point. The supply and demand functions are shown in Figure 7.3. At this point, the quantity demanded equals the quantity supplied for bonds. The market is at rest, and prices and quantity

45

for the bond market do not change. The Q* and P* are equilibrium quantity and price. Using the present value formula, the market interest rate is solved from the market price of the bonds.

Figure 7.3. Supply and demand for bonds

What happens to the market, if the bond price is higher than the equilibrium price?

Quantity supplied is greater than quantity demanded, which is called a surplus. Businesses and government want to sell more bonds because the price of bonds is high (and interest rates are low). However, investors do not want to buy these bonds because the prices are too high and interest rates are too low. The price of bonds falls until equilibrium is restored at P* again.

What happens to the market, if the price of bonds is lower than the equilibrium price? The quantity supplied is less than quantity demanded, which is called a shortage. The bond prices are low and interest rates are high, so investors have a large demand for bonds; the bonds are a good investment. However, businesses and government do not want to sell bonds for a low price and high interest rate. The price of bonds increases until equilibrium is restored at P* again (market interest rates decrease). The market is always in equilibrium and shortages and surpluses are always eliminated, as long as government does not interfere in the market.

The demand function can shift, because other factors can change. Please know the difference between a movement along a demand curve and a demand function shift. A decrease in quantity demanded is shown in Figure 7.4. Investors demand more bonds as we move from point A to point B. Economists call this a change in “quantity demanded.” Investors increase quantity demanded, because the price of bonds became cheaper. Nothing changed in the model. If some outside factor changes, then the demand function shifts. Economists call a shift to the right an “increase in demand,” while a shift to the left is a “decrease in demand.” Demand function shifts are shown in Figure 7.5.

46

Figure 7.4. A decrease in quantity demanded

Figure 7.5. Shifts in the demand function

Six factors cause the demand function to shift. The factors are listed in a way that cause

the demand function to increase and shift to the right. The increase in the demand function is shown in Figure 7.6. When investors increase their demand for bonds, the following occurs in the bond market:

• The demand function shifts to the right.

• Investors buy more bonds (Q* increases).

• The market price of bonds increases (P* increases).

• When bonds are discounted using the present value formula, the market interest rate for the bonds decreases.

47

Figure 7.6. Increase in the demand function

Factors that increase the demand function:

1. An increase in wealth causes the demand function to shift right. When an economy is growing, wealth is increasing. The demand for bonds increases too, because investors and the people have more wealth and invest more in the bond market.

2. A decrease in the expected returns on investment causes the demand function to shift right. If investors believe the interest rates will be lower in the future, then investors will buy more bonds. For example, if you believe interest rates are going to decrease in the future, then the bond prices would increase. You buy bonds now, because you are buying bonds for a cheap price (high interest rate) and could resell the bonds in the future for a higher price, when market interest rate decrease.

3. A decrease in expected inflation causes the demand function to shift right. Inflation erodes the purchasing power of households, businesses, and governments. Inflation also erodes the value of investments, such as stocks and bonds. Investors invest less, if they believe the inflation rate will increase, especially long-term investments likes bonds. The converse is also true. If investors believe inflation will decrease in the future, then investors will increase their investment in bonds.

4. A decrease in the risk of bonds will cause the demand function to shift to the right. Investors want to loan their funds to borrowers, who will not default on their loans. Investors are usually risk averse. If investors believe the bond market becomes more stable and “safer,” then the investors buy more bonds.

5. An increase in liquidity of the bond market causes the demand function to shift to the right. Investors are attracted to bonds that are liquid. The future is uncertain and investors want the ability to sell an asset fast for little transaction cost. If the bond market becomes more liquid, such as U.S. government securities, then investors increase their demand for U.S. government bonds.

48

6. A decrease in information costs causes the demand function to shift to the right. Investors continuously need information, so they can evaluate their investments. For example, firms like Standard & Poor’s evaluate the financial strength of large corporations and the corporations’ ability to pay their debts. The information costs for large corporations are low, causing a higher demand for bonds of large corporations.

Please note that the demand function can shift to the left. The same six factors are responsible and you only have to reverse the logic for the six factors. For example, an increase in expected inflation causes the demand function to decrease and shift left. The bond price decreases and interest rate increases.

Four factors cause the supply function to shift. The factors are listed in a way that causes the supply function to increase and shift to the right. A supply increase is shown in Figure 7.7. When businesses and government issue more bonds, the following occur in the bond market:

• The supply function shifts to the right.

• The bond market has more bonds (Q* increases).

• The market price of bonds decreases (P* decreases).

• When bond prices are discounted using the present value formula, the market interest rate for the bonds increases.

Figure 7.7. An increase of the supply function

The factors that increase the supply function:

1. An increase in expected profits causes the supply function to increase and shift to the right. A business is willing to borrow and increase its outstanding debt to buy assets like machines and equipment, if the business expects to increase profits. Usually businesses issue bonds for machines and equipment during business cycle, because of the expectations of profit. The opposite occurs during recessions.

49

2. A decrease in business taxes causes the supply function of bonds to increase and shift to the right. If a business is subjected to high taxes, then the business has a low incentive to neither invest in machines and equipment, nor expand production. More investment, such as borrowing funds through the bond market, causes the firm to be bigger and hence subjected to more taxes. If government lowers the tax burden on businesses, businesses may invest more by using bonds, causing the supply of bonds to increase and to shift right.

3. An increase in expected inflation causes the supply function of bonds to increase and shift to the right. Inflation erodes the value of the dollar, so over time, the value of debt decreases. If businesses and government believe inflation will become higher, they are willing to borrow more funds by issuing bonds. They can repay their loans with “cheaper” dollars.

4. An increase in government borrowing causes the supply function of bonds to increase and shift to the right. When government spends more than what it collects in taxes, the government can borrow by issuing government bonds. The United State federal government has had budget deficits for the last 30 years. Each year, the U.S. government issues more debt (and bonds) and the supply of bonds keeps increasing. Increasing the supply of bonds causes bond prices to be low and interest rates to be high. The market interest rates have been higher in the last 30 years than during the 1950s and 1960s, when the U.S. government had balanced budgets.

7.2. Interest Rates and the Business Cycle

The empirical evidence indicates that market interest rates tend to rise during a business cycle and fall during recessions. During a business cycle, the amount of goods and services produced in the economy increases. Businesses are optimistic about future profits and invest in machines and equipment by issuing more bonds. The supply of bonds increases. If an economy produces more goods and services, the economy has more wealth. Investors save more and invest in the financial markets. The demand for bonds increases and the demand function shifts to the right. This scenario is shown in Figure 7.8.

50

Figure 7.8. Supply and demand functions both increase

When both the supply and demand functions both shift, either the price or quantity is

known, while the other variable becomes indeterminate. In this case, both function increase, causing the quantity of bonds to increase, but bond prices and interest rates are unknown. If you do not believe me, then experiment with the supply and demand functions. First, increase the demand function by a lot and increase the supply function by a little. Second, increase the demand function by a little and increase the supply function by a lot. As you will see, the market price is higher in the first case and lower in the second case. Therefore, changes in bond prices and interest rates are ambiguous.

7.3. The Fisher Effect

The Fisher Effect can be explained by using the bond market. If investors and businesses expect higher inflation in the future, then investors buy less bonds and businesses are willing to sell more bonds. The demand for bonds shifts to the left, while the supply for bonds shifts to the right. The impact on the bond market is shown in Figure 7.9. The result is the price of bonds decreases and the interest rates increases. In this case, the amount of bonds (Q*) in the market is ambiguous. You can prove this by shifting the demand curve by a lot and shift the supply curve by a little. Then shift the demand curve by a little and the supply curve by a lot. Thus, higher inflationary expectations cause higher bonds prices, and hence lower bond interest rates, when bond prices are discounted.

Figure 7.9. Explaining the Fisher Equation using supply and demand analysis

The interest rates for financial instruments are always written in nominal terms. If there

are higher expectations of inflations ( πe ), then nominal interest rates ( i ) are higher. If the government wants low nominal interest rates, then the public must believe the inflation rate will be low.

51

7.4. Bond Prices in an Open Economy

In the previous models, the bond was considered the good in the market. However, there is another analysis that uses the loanable funds as the good. The bond market and loanable funds markets will give the same results; it is another way at looking at the same picture. Here is the difference between the two models. If an investor wants to buy bonds, then he has a demand for bonds. However, the investor is a source of loanable funds, because he trades funds for a bond. The investor is the supply function in the loanable funds market. If a business or government wants to sell bonds, then this means it needs (i.e. demands) funds. The business or government issues a bond for funds. The business or government is the demand function for loanable funds. The price in the loanable funds market is the interest rate and the quantity is the amount of loanable funds.

The previous examples looked at the bond market as a closed economy. A closed economy has no financial transactions with other countries; it is isolated. The next model allows international investors in the market. When a country allow goods, services, and financial securities to flow in or out of a country, then this is called an open economy. This model uses the loanable funds approach. The quantity is the amount of loanable funds, while the price is the real interest rate. The real interest rate is used, because every country has a different inflation rate. The real interest rate could be the same for all countries; however the nominal interest rates are different, because each country has different inflation rates.

If this small country was a closed economy, the loanable funds market would be at equilibrium. The real interest rate would be 5% and the amount of funds in the market would be L*. The loanable funds market is shown in Figure 7.10.

What if the world real interest rate was 9%? The domestic investors would invest their funds in the international market, earning a higher interest rate. However, businesses and government would not want to borrow funds at this interest rate. It is too high. The difference between quantity supplied and quantity demanded is the amount of funds that would leave the country at 9% real interest rate.

What if the real interest rate was 1%? Firms and government would want to borrow at the cheap rates; however, the domestic investors would not want to lend at that rate. The difference between quantity demanded and quantity supply is the amount of funds that would enter the country. In this case, there are no shortages or surpluses of funds, because funds can enter or leave the country.

52

Figure 7.10. Loanable funds in an open economy

This example assumes the country is a small open economy. This country is too small to

influence the world’s real interest rate. Many countries, like the Netherlands and Belgium would fall into this category. However, a country like the United States, Germany, or Japan with a large economy could affect the world’s real interest rate.

If you find the loanable funds and bond markets confusing, just know how the bond market works for a closed economy and how the loanable funds market works for the small open economy.


1. Which six factors cause the demand for bonds to shift and in which direction?

2. Which four factors cause the supply for bonds to shift and in which direction?

3. How do the demand and supply functions shift during a business cycle and during a recession? What is the impact on the market interest rates and bond prices?

4. How do the demand and supply functions shift in the bond market, when inflation expectations change? You are proving the Fisher Equation.

5. What is the difference between the loanable funds market and bond market?

6. How does the world’s real interest rate influence the loanable funds market in a small open economy?

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8. Risk Structure and Term Structure of Interest Rates


• How risk of default, liquidity, information costs, and taxes cause interest rates to differ among different markets for financial securities.

• The term structure of interest rates.

• The yield curve.

• The three theories that explain the characteristics of the yield curve.

8.1. Default Risk and Bond Prices

Default risk is the possibility a borrower will not pay back the principle and/or interest on the loans. For instance, U.S. government bonds have little risk of default, and are called default-risk-free instruments. The reason is government can raise taxes, “print money,” or issue new debt, when it gets into financial trouble. Business corporations have some risk of default. The business can bankrupt and not be able to pay off its debt. The difference between the interest rate on the U.S. government bonds and corporate bonds is called the default risk premium. The risk premium is the additional interest investors must earn in order to hold a “risky” bond and the risk premium is always positive. Private firms such as Standard & Poor’s Corporation and Moody’s Investor Service determine the size of the default risk of corporations. These companies calculate a single statistic, called the bond rating. The bond rating is based on a corporation’s net worth, cash flow, and ability to meet its debt obligations.

Start the model with government and corporate bonds that have zero risk. Bond prices and interest rates are the same for both markets. The bond markets are shown in Figure 8.1. Corporations have financial trouble, so investors think there is a risk of default. Some investors demand less corporate bonds (demand curve shifts left), and invest in government bonds. The government bonds are considered default-free and the demand curve shifts right.

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Corporate Bonds U.S. Government Bonds

Figure 8.1. The impact of a risk premium on the bond markets

The first thing you notice is the government bonds have a higher bond price, while

corporate bonds have a lower bond price. The market interest rate always moves in the opposite direction of bond prices, because of the net present value formula. Consequently, corporations pay higher interest rates for their bonds, while the U.S. government pays a lower interest rate. The difference between the government bond and corporate bond interest rates is the risk premium. As the default risk increases, then the risk premium increases too. During recessions, when some businesses start failing, the default risk increases, so the risk premium increases, and the difference between government and corporate interest rates increase too.

8.2. Liquidity and Bond Prices

Liquidity can cause bond prices and hence interest rates to differ. U.S. government securities are the most liquid and widely traded, so they are the easiest to buy and sell. Corporate bonds are not as liquid and not as widely traded, so there could be difficulties in quickly selling them. This model is very similar to the risk of default model that was depicted for default risk. Start the model with the same liquidity in the government bond and corporate bond markets. The market is shown in Figure 8.2. Both bond markets have the same bond price, which is P*.

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Corporate Bonds U.S. Government Securities

Figure 8.2. The impact of liquidity on the bond markets

The secondary markets become stronger for government bonds, so liquidity increases for

these securities. The investors are attracted to the government bonds, because they are more liquid and demand increases (demand function shifts to the right). Investors decrease their trading of corporate bonds, because they are less liquid, causing the demand function to shift left. The government bond prices increase, causing the interest rate for government bonds to decrease. The corporate bond prices decrease, causing the market interest rate for corporate bonds to increase. The difference between the two interest rates reflects the degree of liquidity. However, the difference in interest rates is still called a risk premium.

8.3. Information Costs and Bond Prices

Information costs cause bond prices and interest rates to differ. The more time and money to acquire information on securities imposes high information costs. These costs are included in the interest rate and are the cost of borrowing. For example, U.S. government securities are well known and have the lowest information costs out of all securities. Large corporations are well-known and have low information costs. The information costs for new and small companies are high and therefore, these companies will pay a higher interest rate when they borrow funds. Using a model to demonstrate this, start the model for high and low-information-cost bond markets with the same level of information. The bond markets are shown in Figure 8.3 Both bonds have the same market price, P*. The liquidity and risk of default for these two markets are the same.

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High Information Costs Low Information Costs

Figure 8.3. The impact of information costs on the bond markets

The cost of acquiring information increases, causing investors to be attracted to the low-

information-cost bonds. The demand increases for low-information-cost bonds, causing the market price to increases and market interest rate to decrease. The high-information-cost bonds are not as attractive as an investment, so investors buy fewer bonds, causing bond prices to decrease and interest rates to increase. Therefore, low-information-cost bonds have a lower interest rate.

8.4. Taxes and Bond Prices

Taxes can cause bond prices and interest rates to differ. U.S. government bonds have lower risk of default and higher liquidity than municipal bonds (state and local government bonds). For the last 50 years, the interest rates of municipal bonds have been lower than U.S. government bonds. The reason is the interest earned on municipal bonds is exempt from U.S. government taxes, while U.S. government securities are taxed. If you bought municipal bonds, you would earn less interest than U.S. government securities. However, you pay no taxes, which compensates you for the higher risk and lower liquidity.

The bond markets are shown in Figure 8.4. The government taxes both the municipal and non-municipal bonds. Moreover, the default risk, liquidity, and information costs are equivalent for both markets. The bond market prices are P*.

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Taxed Bonds Municipal Bonds

Figure 8.4. The impact of taxes on the bond markets

The government passes laws that exempt municipal bonds from taxation. Investors are

attracted to municipal bonds and demand increases, causing the market price to increases and market interest rate to decrease. The taxed bonds are not as attractive as an investment, so investors buy less bonds, causing bond prices to decrease and interest rates to increase. Therefore, municipal bonds have a lower interest rate.

8.5. Term Structure of Interest Rates

If securities have the same risk, same liquidity, same information costs, and same taxes, the interest rates will differ by the maturity, which is called the term structure of interest rates. The term structure of interest rates is usually defined by U.S. securities, because the U.S. government issues a variety of securities with maturities ranging from 15 days to 30 years. No other finance company or business comes close to issuing a wide range of securities that differ by maturity. The interest rates for U.S. government securities are shown for July 31, 2000 in Figure 8.5.

Term Structure of Interest Rates U.S. Government Securities

July 31, 2000

3-month T-bill 6.27% 1-month T-bill 6.07% . . .

5-year T-note 6.16% . . .

30 year T-bond 5.79% Source: Federal Reserve

Figure 8.5. Term Structure of Interest Rates

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Economists usually plot U.S. government securities by the market interest rates and

maturity. The graph is called a yield curve. The yield curve can be upward sloping, flat, or downward sloping. There are two characteristics of yield curves. First, the yield curve is usually upward sloping. Long-term securities (e.g. T-bonds) have higher interest rates than short-term securities (T-bills). Second, all interest rates tend to move together, so the yield curve can shift up or down. Three theories have been proposed to explain why the yield curve has these two characteristics.

The first theory is the segmented markets theory. U.S. government securities are broken down into specific and separate markets based on maturities. The interest rate is determined by supply and demand in each market. One group of investors will only invest in T-bonds, while another group will invest only in T-bills. The yield curve usually slopes upward, because people prefer to hold short-term bonds rather than long-term bonds. This theory has one problem. If the markets of different maturities are completely separated and independent, a change in short-term interest rates will have no effect on long-term ones. This theory cannot explain why short-term and long-term interest rates move together, causing the yield curve to shift.

The second theory is the expectations theory. Investors view all securities that have the same liquidity, risk, information costs, and taxes as perfect substitutes. The interest rate on a long-term bond will equal the average of short-term interest rates that people expect to occur over the life of the security. For example, the current market interest rate on a one-year bond is 9%. You expect the interest rate to increase to 11% next year, so when you buy another one-year bond next year, the average interest rate you expect to earn is 11%. If you decide to hold a two-year bond, the interest rate must be 10%, because the interest rate will be 9% for the first year and you believe interest rates will increase to 11% for the second year. The average interest rate for these two year is 10%. If investors expect that short-term interest rates will increase, then the yield curve has a positive slope. If investors expect that short-term interest rates will decrease, then the yield curve has a negative slope. If investors expect that short-term interest rates will not change, then the yield curve is flat. The expectations theory explains well why short-term and long-term interest rates move together, but there is one problem. The yield curve usually has a positive slope, indicating that investors think short-term interest rates will increase, but the short-term interest rate could as likely decrease or increase.

The last theory is the preferred habitat theory. This theory is the most widely accepted and combines the expectations theory and segment markets theory together. This theory can explain why the yield curve is usually upward sloping. Investors prefer to hold short-term bonds (preferred habitat) with a low expected return, but will hold long-term bonds if they are paid a term premium (i.e. higher interest rate). The term premium causes the yield curve tends to be upward sloping. This theory can explain why long and short-term interest rates move together The interest rates on a long-term bond will equal the average of short-term interest rates expected to occur over the life of the long-term bond (plus the term premium). If investors expect that short-term interest rates will increase, then the yield curve has a positive slope. If investors expect that short-term interest rates will decrease, then the yield curve has a negative slope. If investors expect that short-term interest rates will rise or fall very little, then the yield curve can still be upward sloping, because the term premium is high enough to cancel the effect of changing interest rates.

The yield curve is a useful indicator of economic activity. When a yield curve is downward sloping, specifically a three-month T-Bill has a higher interest rate than a 10-year T-

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bond, a recession usually occurs one year later. Investors are pessimistic about the future. Figure 8.6 shows a downward sloping yield curve. The U.S. economy entered a recession in 2001.

Figure 8.6. Yield Curve for July 31, 2000

The yield curve had a negative slope for 2006, and the economic indicators show the

United States is entering a recession for 2007. Chapter 8 Review Questions

1. How does a lower risk of default affect the bond markets? One market is high risk, while the other is low default risk.

2. How does higher liquidity affect the bond markets? One market is highly liquid, while the other has low liquidity.

3. How does information cost affect the bond markets? One market has high information costs, while the other has low costs.

4. How do taxes affect the bond markets? One market is taxed, while the other is not.

5. What is the term structure of interest rates and the yield curve?

6. What are the three theories that explain the characteristics of the yield curve? Which theory is more plausible?

7. If the yield curve has a negative slope, what economic phenomenon does this predict?

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9. Derivative Securities and Derivative Markets


• The purpose of the derivatives market.

• The difference between spot and forward transactions.

• The difference between futures contracts and options contracts.

• The difference between hedging and speculation.

9.1. Forward and Spot Transactions

Derivatives have received bad publicity from two famous bankruptcies. In 1995, Orange County, California, had the biggest bankruptcy for a municipal government. The losses approximated $2 billion. The press concentrated on derivatives as the cause of the bankruptcy, but the fund manager made bad decisions. Another famous case was Barings P.L.C. Barings was a London Investment firm that was founded in 1763. One trader, Nick Leeson, lost about $1 billion in the derivatives market, causing Barings to bankrupt.

Derivatives are simply a contract, where the transaction occurs today, but the actual good is exchange for money at a future date. Financial derivatives protect investors from price uncertainty. The previous chapters focused on spot transactions. A buyer and seller completed a transaction, and they exchanged money for the financial security immediately. However, forward transactions delay the money and assets exchange into the future. For example, a bread company believes it will need 6 tons of flour in 6 months. Many things can occur within 6 months. A drought could occur which causes the price of wheat to increase or plenty of rain could cause a bumper crop, causing the price of wheat to decrease. The bread company wants to protect itself from fluctuating prices. The bread company enters into contracts with wheat farmers, where the bread company and farmers negotiate a price of wheat today. However, the bread company will actually pay the farmers for the wheat when the wheat is harvested 6 months from now. The contract can protect the bread company from price fluctuations.

The price of derivatives receive (i.e. derive) their value from assets. The assets can be commodities like coffee, corn, petroleum, pork bellies, and wheat, or the assets can be stocks, bonds and other financial instruments, such as currencies, Eurodollars, and government bonds. Derivatives are contracts. The contract is what is exchanged between buyers and sellers in the derivative markets and not the asset. Derivative securities are futures, forwards, and options contracts.

9.2. Futures and Forward Contracts

The first class of derivatives is futures and forward contracts. All futures and forward contracts specify size, maturity date, and the price. The size is the number of units in each contract, the maturity date is the day when transaction is completed, and the futures price is the selling price of the asset on the maturity date. The difference between futures and forwards is

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forward contracts are tailor-made contracts. The issuer’s reputation and collateral guarantees the contract. Futures contract is a standardized contract. The maturity, size, and collateral are the same for all contracts. Standardized contracts allow investors to buy and sell futures on organized exchanges. The Chicago Board of Trade allows futures for agricultural products and precious metals. The New York Mercantile Exchange allows the exchange for energy commodities like petroleum and electricity.

Futures and forward contracts allow the buyer and seller to agree on a price for an asset today and the exchange of money for the asset will occur on a specific date in the future. For example, you want to buy a government bond one year from now. You can enter into a futures contract where you and the seller agree on the price today, but you actually pay for the government bond one year from now. The futures contract is a legal document that assigns rights. Your right as the buyer is the obligation to pay for the government bond, which is called the long position. The seller’s right is the obligation to sell you the government bond, which is called the short position.

The price of the futures contract is determined in the derivatives market. The futures price reflects the expectations of the investors and savers. For example, you buy a futures contract for petroleum. You negotiated a price of $80 per barrel and the oil will be delivered in 6 months. You can sell your futures contract on the derivatives market. If investors and savers believe that oil will be $90 per barrel, then the market value of your futures contract will be high. You can either sell your futures contract for a higher price or wait until you receive the oil and sell the oil for $10 per barrel profit. However, the opposite can occur. If investors and savers believe the price of oil will be $70 per barrel, then the market value of your futures contract will be low. You will end up buying oil for $80 per barrel, when it only will cost $70 in the future. As the date of the delivery approaches for your oil futures contract, the futures contract market price will approach the price of oil. On day of delivery, no one will buy a futures contract for oil when the market price of the futures contract is higher than the price of oil. No one will sell the futures contract, when the market price of the futures contract is lower than the price of oil.

Buyers and sellers do not know each other when they buy or sell futures contract through an exchange. Consequently, buyer or seller deposits money with a broker to cover possible losses from a futures or forward contract, when market price of the asset changes. This settling of the account is called marking to market. Margin accounts help guarantee the contract will be honoured. Usually the market price has to exceed some threshold before marking to mark is imposed.

Example 1 - Marking to Mark A petroleum refinery buys 10 futures contracts of petroleum in six months. The contract

size is 10,000 barrels of petroleum and the contract price is $75 per barrel. What if petroleum price is $90 per barrel?

The seller deposits ( ) 000,150$75$90$000,1010 =−⋅⋅ with his broker. If this contract

matured today, then the buyer purchases this oil for $75 and could sell it for $90, earning a large profit.

What if petroleum price is $60 per barrel?

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The buyer deposits ( ) 000,150$60$75$000,1010 =−⋅⋅ with his broker. If this contract

matured today, then the seller could buy oil on the spot market for $60 per barrel and sell it to the buyer for $75, earning a large profit.

Derivatives can protect investors from interest rate risks. The interest rate risk is banks

borrow funds for a higher interest rate than the interest rate on their loans. Remember, banks loan money for a higher interest rate than the funds they borrow, earning profits. The interest rate risk reverses this.

Example 2 – Interest Rate Risk You manage a money market mutual fund and now it is June 2007. Money market fund

is a fund of financial securities with maturities of less than a year. You expect an inflow of $1 million in funds in June 2008. You can buy a futures contract now that earns a 10% return for your fund in June 2008. If interest rates decrease, the derivatives contract guarantees you a 10% return, protecting your fund. A futures contract can be for Certificates of Deposit (CDs). A CD is when a bank customer deposits money into an account for a fixed time period. If the customer withdraws his funds early, then he forfeits the interest on the account.

Example 3 – Interest Rate Risk A bank grants a loan for $1 million to a customer for June 2007 at 12% interest rate. The

bank could issue a Certificate of Deposit on the futures market at 10%. The bank has a guaranteed source of funds for next year for this loan. If interest rates increase next year, then the futures contract protects the bank from interest rate risk. The bank “locked” in a source of funds at 10%.

Futures and forward contract reduces exchange rate risk. If a corporation has operations in a foreign country, that corporation could use derivative to protect itself from currency exchange rate fluctuations.

Example 4 - Currency Futures Exxon has U.S. dollars and wants to purchase petroleum from Kazakhstan. Exxon needs

tenge and enters into a futures contract. Exxon needs to make a 1,000,000 tenge payment in 90 days. A Kazakh bank issued a contract and the contract specifies the exchange rate as $1 = 122 tenge.

What if the exchange rate is $1 = 130 tenge? The dollar appreciated, while tenge depreciated. Exxon has U.S. dollars and contracted

to pay a lower exchange rate. Exxon has to deposit money into the margin account, because Exxon “locked” into a higher exchange rate. The bank benefits from this contract.

Spot market: 31.692,7$130

1$000,000,1 =

tengetenge

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Futures market: 72.196,8$122

1$000,000,1 =

tengetenge

What if the exchange rate is $1 = 110 tenge? The tenge appreciated, while dollar depreciated. The Kazakh bank would have to put

money into a margin account and Exxon benefits from the exchange rate.

Spot market: 91.090,9$110

1$000,000,1 =

tengetenge

Futures market: 72.196,8$122

1$000,000,1 =

tengetenge

9.3. Options Contract

The options contract is the second class of derivatives. The options contract is very similar to the futures contract. The only difference is the options contract gives you the option if you want to buy or sell an asset. For example, you entered into an options contract, giving you the right to buy a barrel of oil for $80 per barrel in 6 months. On the day of delivery, if the price of oil is $70 per barrel, you do not have to honor the option contract. That is your option! If oil is $90 per barrel on the day of delivery, then you are most likely going to honor your options contract. The investor who sold you this contract is obligated to sell the oil for $80 per barrel to you. There are two types of options contracts. The first is the call option. The contract gives you the right to buy an asset for a specific price in the future. The second is the put option. This contract gives you the right to sell an asset for a specific price in the future.

All options have an exercise or strike price. This is the listed price of the asset on option. The option has an expiration date, which is the date the right to buy or sell expires. Options are either American or European. American options allow the option holder to exercise the option anytime before the expiration date. European options restricts the right to exercise the option on the expiration date. Options are not free. Option holders are charged a fee, which is called the option premium. Calculating premiums and exercising options are different between American and European options. To keep the chapter simple, all examples are for European options.

The amount paid for an option premium depends on the probability that the buyer of the option will exercise his right. An option is insurance. For example, a driver with a history of car accidents will tend to have a higher probability of having future accidents. His car insurance company will charge a higher premium. The factors that influence an option premium:

1. The higher the strike price and/or spot market price, the larger the premium.

2. The greater the asset’s price fluctuates on spot market, the higher the chance that an investor will exercise the option. The price fluctuation is called volatility, and the more volatile the asset’s price, the higher the option premium. For example, the market price of Asset A fluctuates between $20 and $100, while Asset B fluctuates between $60 and $70. The option premiums for Asset A is higher, because large swings in price increase likelihood the option is exercised.

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3. An option with a longer time duration has a higher option premium. For example, Option A has a maturity of one year while Option B has a maturity of one month. Option A has higher option premium, because more uncertainty in asset’s prices.

4. Interest rates affect options just like bonds and stock. A higher interest rate reduces the present value of the option, increasing the value of the call option and decreasing the value of the put option

Example 1 - European call option The strike price is $80 per barrel of petroleum and the option premium is $0.1 per barrel.

The option size is 10,000 barrels. A company wants to buy 10 call options. The total quantity of

petroleum is 100,000 barrels. Thus, the company pays 000,10$10000,101.0$ =⋅⋅ for the

premium.

• If the market price (spot) exceeds $80 (strike price), the company exercises the call options. The company could buy petroleum at $80 and re-sell petroleum on the spot market to earn a large profit.

• If market price (spot) is below $80 per barrel, then company does not exercise the option.

Example 2 - European put option The strike price is $40 per ton of corn and the premium is $0.07 per ton. Each option

contract specifies a quantity of 10,000 tons. A farmer buys 5 put options. The corn quantity is

50,000 tons and the farmer pays 500,3$5000,1007.0$ =⋅⋅ in premiums.

• If market (spot) price exceeds $40 (strike price), company does not exercise put option. The farmer can sell corn for a higher price on spot market.

• If market price (spot) is below $40 per ton, then farmer exercises put option. Farmer could buy corn from spot market and sell to party that paid the put option.

Currency options have two markets. The first market is the Interbank (OTC) market and it is located in London, New York, and Tokyo. OTC options are tailor-made as to size, maturity, and exercise price. The other market for currency options is located in Philadelphia. The exchange fixes maturities at 1, 3, 6, and 12 months.

Currency options are more complicated. The trick is to calculate both scenarios, whether you would exercise or not exercise the option. Then choose the scenario that gives the higher benefit.

Example 3 - European call option Person wants to buy 1 million tenge and the person has dollars. The call option has a

strike price of 0.00833 U.S.D. / tenge. The premium is $0.05 per tenge and the contract size is

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50,000 tenge. The person pays 000,50$105.0$

=⋅ tengemilliontenge

for premium. The person needs

20 contracts. On the expiration date:

• If exchange rate is 0.001 U.S.D. / tenge, then calculate both scenarios: If person exercises call option, person needs $8,330 dollars for the 1 million tenge. If person does not exercise call option, person needs $10,000 for the 1 million tenge. Thus, person exercises call option

• If exchange rate is 0.0005 U.S.D. / tenge, then calculate both scenarios: If person exercises call option, person needs $8,330 dollars for the 1 million tenge If person does not exercise call option, person needs $5,000 for the 1 million tenge. Thus, this person does not exercise call option.

Example 4 - European put option An investor wants to sell 500 thousand Euros and investor has dollars. The strike price is

0.8 U.S.D. / Euro, the premium is $0.03 per Euro, and contract size is 25,000 Euros. The

investor pays 000,15$000,50003.0$

=⋅ EurosEuro

for premium. The investor needs 20 contracts.

On the expiration date:

• If exchange rate is 0.9 U.S.D. / Euro, then calculate both scenarios. If investor exercises put option, the person collects $400,000 for selling Euros. If investor does not exercise put option, person collects $450,000 for selling Euro. Thus, investor does not exercise put option

• If exchange rate is 0.7 U.S.D. / tenge, then calculate both scenarios. If investor exercises put option, person collects $400,000 for selling Euros. If investor does not exercise put option, person collects $350,000 for selling Euros. Thus, investor exercises put option

Did you notice investors exercise call and put options “as opposites” when investor exercises option?

9.4. Hedging and Speculation

Investors have two broad strategies for investing and the strategies apply to all financial markets. The first principal is hedging. Investors buy and sell securities in order to lower risk or use long-term investing strategies. The hedger protects himself in three ways by using derivatives. First, he locks in a future price today, protecting himself from price fluctuations. Second, derivatives are liquid markets. If an investor needs money now, he easily sells his futures contract in a derivatives market. Finally, derivative exchanges are organized and the market price of derivatives is easy to monitor and gather information.

The second investment strategy is speculation. Some investors buy or sell securities believing they can sell the securities for a higher price in the future. Speculators are looking for quick profits. As you guessed, an investor can gain or lose lots of money from the derivatives

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market. Speculators are important to the market, because their presence can increase the liquidity of the securities.

One investor, Nick Leeson, bankrupted Barings, P.L.C. Nick Lesson made an observation about the Tokyo stock market. The market price of Tokyo stocks fluctuated over a narrow range. Nick Leeson issued an equal number of call and put options for the Tokyo stock market. Investors did not exercise the options, because the stock prices did not change much. Essentially, the option premiums were pure profit to Barings. The profits were so high, top management at Barings let Nick Leeson continue his speculation. Then an earthquake occurred in Kobe, Japan and stock prices fell on the Tokyo stock exchange. Leeson speculated that stock prices would increase and bought futures contracts. The stock prices continued to fall, resulting in a $1 billion loss for Barings. Barings was forced to buy Tokyo stock for a high price, when stock prices were low.

Chapter 9 Questions

1. What is the difference between spot and forward transactions?

2. Where do derivatives get their value?

3. What is the difference between a futures and options contract?

4. What is the difference between long and short positions.

5. What is marking to mark?

6. What is the difference between hedging and speculation?

7. What is the difference between a call option and a put option?

8. Which factors determine the value of an option’s premium?

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10. The Types of Financial Institutions

After reading this chapter, you should understand the following the differences among the five categories of financial institutions:

• Securities market institutions

• Investments institutions

• Contractual saving

• Depository institutions

• Government financial institutions

10.1. Securities Market Institutions

Securities market institutions includes investment bankers, brokers, dealers, and organized exchanges. The securities market institutions improve the liquidity of the secondary markets. These institutions are not financial intermediaries and do not link the savers to the borrowers. Instead, the securities market institutions help the savers locate the borrowers. For example, Ford wants to build a new factory and decides to issue new stock. The new stock will provide funds that Ford can use to build the factory. Ford will go to an investment bank and the investment bank will assist Ford in creating the new securities. Refer to Chapter 6 for more information on securities market institutions.

10.2. Investments Institutions

Mutual funds and finance companies are the investment institutions. Mutual funds pool together funds from many people into a fund, and invest the money in a variety of stocks. This method allows the diversification of stocks, and lowers investors’ risk. For example, you start your own mutual fund and offer investors a chance to invest in this fund. You take the money and buy 30 different corporate stocks. The Coca-Cola stock may go up one day, while the value of IBM stock goes down. Overall, the average of the fund’s 30 stocks will probably earn a return to your fund and to the investors. If you bought only one type of corporate stock, like Apple Computers, you will loose your investment if this company bankrupts.

The most well known mutual fund companies are Fidelity, Vanguard, and Dreyfres. Mutual fund companies have different strategies and characteristics. The mutual fund companies may only buy stock in certain industries, large companies, or foreign company stock. The mutual fund company may issue a fixed number of shares to the fund, which is called closed-end mutual funds. Then, investors may buy and sell these shares in over-the-counter markets, just like stock. The mutual fund company does not buy shares back for closed-end mutual funds. The mutual fund company may offer open-ended mutual funds. The mutual fund company will buy back shares to the fund and the price of the shares is tied to the value of the stock in the fund. Mutual fund managers are paid in two ways. The first is called no-load funds. The managers of

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the fund charge management fees, which are usually 0.5% of assets. The second method is load funds. The fund managers charge a commission for selling or purchasing of shares.

Money market mutual funds are very similar to mutual funds. However, the fund manager buys only money market financial instruments and does not buy corporate stock. The theory behind money market mutual funds is simple. If you have five friends with $2,000 each who want to buy a Treasury bill and the minimum face value of a Treasury bill is $10,000, then your friends can pool their money together and buy one T-bill. When the T-bill matures, your friends split the interest among them.

Money market mutual funds are very popular, because these funds offer check writing privileges. The value of the fund does not change much, when interest rates changes. In 1998, money market mutual funds had assets of $1,154 billion. Another financial instrument is identical to money market mutual funds. They are money market deposit accounts and are offered by commercial banks. The only difference between these two fund are money market deposit accounts are insured by the federal government, while money market mutual funds are not insured. If your bank bankrupts and you invested in money market deposit accounts, you will get your money back from the federal government.

Finance companies are the second type of investment institution and raise money by selling stock, bonds, and commercial paper. Commercial paper is short-term loans issued by well-known banks and corporations for a maximum maturity of 270 days. Commercial paper is a form of direct finance and has no collateral. Finance companies make loans to consumers, so they can buy furniture, appliances, cars, home improvement loans, or the loan can be to a small business. Some corporations have started their own finance companies that help consumers buy their product. For example, General Motors Acceptance Corporation lends money to people, so they can buy cars from General Motors.

10.3. Contractual Saving

Contractual saving institutions include insurance companies and pension funds. Insurance companies provide protection for people who buy insurance policies. The insurance policy prevents financial hardship that results from a medical emergency, car accident, or the death of a family member. Insurance companies are financial intermediaries, because they link the funds from the policyholders to the financial markets. The policyholders make periodical payments to the insurance company called premiums. The insurance company will invest the premiums in the financial markets. For the insurance company to earn a profit, the amount of interest earned in the financial markets plus the total amount of premiums has to be greater than the amount paid for claims. The largest insurance companies are Allstate, Aetna, and Prudential. Most states established commissions that regulate insurance companies. The commissions may limit premiums, minimize fraud, and prevent the insurance companies from investing in risky securities.

The insurance companies use the law of large numbers and insure a large number of people. On average, statisticians can accurately predict how much the insurance company will pay out in claims, because on average the death, illness, injury, and property damage can be accurately predicted. Statisticians do not know which specific individuals will experience hardship, but they can predict how often it occurs. Insurance companies do have problems when selling insurance policies. The first problem is adverse selection and it occurs when the person buying insurance has more information than the insurance company. For example, a person knows he has a heart problem and decides to buy a very large life insurance policy. The second

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problem is moral hazard and it occurs when the person buying insurance becomes more careless. For example, a person buys theft insurance for his home and this person stops locking his windows and doors when he leaves, increasing the risk that a burglar will break into his home.

Insurance companies lower the problems of moral hazard and adverse selection by gathering information about the policyholders, such as driving records, medical records, and credit histories. The insurance company will charge a higher premium to a person who is more likely to make claim. This is called a risk-based premium. Another technique is the deductible. When a person makes a claim, this person is responsible for the first $500. This passes some of the responsibility to the person holding the insurance policy.

The first type of insurance company is life insurance companies. These companies tend to purchase long-term corporate bonds and commercial mortgages, because they can predict with high accuracy future payments. Insurance companies are organized in two ways. The first is a mutual company. The insurance policyholders own these companies. The insurance policy functions as corporate stock. The other type of insurance company is the stock company. These companies issue stock. The insurance policyholders do not own these companies, the shareholders do. The stock company is more popular, because the company can raise more funding. They receive funding from stockholders by selling stock and receive funding from selling insurance policies. Most polices issued are called term life policies. The person buying the life insurance has to pay the premium for the rest of his life. These policies are popular, because the policyholder can borrow against the value of the life insurance policy, when he retires. This borrowing is called annuities. Annuities pay a retired person a specific amount of money each year.

The second type of insurance company is property and casualty insurance companies. They can be organized as a stock or mutual companies and insure against theft, illness, fire, earthquakes, and car accidents. These companies tend to purchase highly liquid, short-term assets, because these companies cannot accurately predict the amount of future claims. The premiums that are charged correspond to the chance of the event occurring. For example, a homeowner in California will pay a higher premium for earthquake insurance than a homeowner in the Midwest of the United State, because California has more earthquakes.

Pension funds are the second type of contractual saving. For many people, pension funds are the most important form of saving. People save for retirement in two ways: Pension funds sponsored by employers or through personal savings accounts. Financial companies manage pension funds and they invest pension funds into the financial markets. The pension fund managers can accurately predict when people will retire and usually invest in long-term securities, such as stocks, bonds, and mortgages. A person can only receive benefits from the pension fund if the person is vested. Vested is the time period required for a person to receive the benefits of the pension plan. The time period varies for the pension fund. Some city governments require a person to be employed by the city for 10 years before this person is 100% vested in the city’s pension plan. Employers prefer to offer pension plans to employees for three reasons. First, pension fund managers can more efficiently manage the fund, lowering the pension funds’ transaction costs. Second, the pension funds may offer benefits such as life annuities. Life annuities could be more expensive if the retire person bought them individually. Finally, the pension fund is not taxed. If the employer offered higher wages and no pension plan to the employees, these wages are taxed.

There are two types of ownership of a pension plan. The first is called a defined contribution plan. The employees own the value of the funds in the pension plan. If the pension

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fund is profitable, retired employees will receive higher pension income. If the pension fund is not profitable, then the retired employees will receive a low pension income. Companies that have a defined contribution plan like to invest the pension funds into the companies’ own stock. That way, employees have an incentive to be more productive, because the value of their pension plan depends on their company’s profitability. The second type of ownership of a pension plan is called the defined benefit plan. This is the most common type of plan and an employee is promised a specific amount of benefits based on the employee’s earnings and years of service to the company. If this pension fund is profitable, the company pays the promised benefits and keeps the remaining funds from the pension plan that is not paid to the employee. If the pension fund is unprofitable, the company has to pay the promised benefit out of its own pocket.

Federal and state governments regulate the pension funds. The regulations require the managers of the pension funds to disclose all investments. That way, employees know which securities the pension fund is invested in. The regulations prevent fraud and mismanagement. Many pension funds will bankrupt, when the companies where the employees work bankrupt. Congress created the Pension Benefit Guaranty Corporation, which insures pension fund benefits up to a limit if the company cannot meet its obligations. Some economists believe a pension fund disaster will occur.

A recent trend in pension funds allows the employees to manage their own pension plans. The name of the retirement plan is called the 401(k) plans. (401(k) is a section of law in the Internal Revenue Service’s regulations). The benefit of this pension plan is the employee can take his pension plan with him when he finds a new job. The 401(k) has one risk. The amount of money a person has at retirement depends how much money he invested in the plan and how well the investments have done.

10.4. Depository Institutions

Depository institutions accept deposits and make loans. These institutions are intermediaries, linking savers to borrowers. The largest component of depository institutions are commercial banks. Commercial banks accept deposits from the public. Many depositors prefer to put their savings in a bank than directly into the financial markets, because of three reasons. First, these deposits are liquid. The depositor can quickly exchange his deposit for cash. Second, the banks gather information about its borrowers, lowering the risk of loan default. You may need to spend a lot of time and effort monitoring your investments in the financial markets. Banks have financial specialist that monitors investments. Third, banks lower risk by lending to a variety of borrowers.

Many borrowers seek bank loans, because it costs too much to issue stock or bonds. To issue stock and bonds, the company has to follow SEC regulations and pay commissions to the investment bankers. For a small loan of $500,000 and less, these fees can average 20% of the loan.

Savings institutions are the second type of depository institution. Originally, these institutions would take deposits and only would lend for home mortgages. These institutions provided low-cost financing for homebuyers. During the 1980s and 1990s, many savings institutions experienced financial crisis, because of higher interest rates. For example, if you borrowed $10,000 at 5% interest rate and loaned it out at 10%, you can earn a profit. If you borrowed $10,000 at 10% interest rate and loaned it out at 5%, you will earn a loss. This is what happened to the saving institutions. During the 1980s, the interest rates rose, so the savings institutions had to pay a greater interest rate to the depositors than what these institutions were

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earning on the mortgages. Mortgages are usually 30-year loans and these loans were locked into low interest rates from the 1960s.

Credit unions are the last type of depository institution. Credit unions are very similar to commercial banks except membership is restricted. Membership is only extended to people who share a common interest. Usually the people work for a particular company or industry. For example, many states have credit unions for school teachers. These institutions only allow school teachers to open accounts. Originally, credit unions offered savings deposits and made consumer loans for cars and boats. Now, credit unions are very similar to banks and offer the same services, such as checking accounts and loans for mortgages. Commercial banks and credit unions have a conflict, because credit union’s profit is not subjected to income taxes. The commercial banks want credit unions on equal grounds with banks.

10.5. Government Financial Institutions

The U.S. government can lend funds to the public in two ways. The first is through direct financing. The U.S. government sells bonds and commercial paper to investors in the financial markets. The U.S. government will take the investors’ money and lend to borrowers directly. For example, the Farm Credit System, a U.S. government agency, lends to farmers. The loans can be for crops, equipment, or mortgage loans. The second example is the U.S. government lends money to students who are pursuing an education. The agency is the Student Loan Market Association, otherwise known as “Sallie Mae.” This agency may lend directly to students or buy their student loans from banks.

The second method the U.S. government can lend to the public is through loan guarantees. This is really a form of insurance. For example, a bank can lend to a student for an education and the Department of Education will guarantee the loan. If the student defaults, the U.S. Department of Education pays for the loan.

Some people do question the federal government’s role in financing. When the federal government directly grants loans, the government is squeezing the financial institutions out of the loan market. Further, federal government loan guarantees may increase the problem of moral hazard. The financial institutions receiving the loan guarantees may not screen borrowers as much, granting loans to borrowers with high risk of default. In the 1990s, the loan guarantees were about $100 billion. If many borrowers started defaulting on their loans, the federal government will have large losses.

The financial institutions are classified into five categories. Please do not think these categories are etched into stone and any financial company can be classified into only one category. One company could be defined in three or more categories, because the company offers services like a bank, sells insurance, and acts like a broker. Financial institutions expanded into new activities, because the U.S. federal government deregulated the financial market during the 1980s and 1990s. Competition became very strong, causing financial institutions in one sector to start competing with other institutions in other sectors.


1. What are main differences among the institutions in this chapter?

2. What kind of institutions falls under Securities Market Institutions?

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3. What kind of institutions falls under Investment Institutions?

4. What kind of institutions falls under Contractual Saving Institutions?

5. What kind of institutions falls under Depository Institutions?

6. What kind of institutions falls under Government Financial Institutions?

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11. The Banking Business


• A bank’s assets, liabilities, and capital.

• How changes in a bank’s balance sheet are recorded in T-accounts.

• How a bank may become insolvent.

• How interest rate risk affects a bank’s balance sheet.

11.1. A Bank’s Balance Sheet

Checking and savings accounts are very popular in the United States U.S. households invest about 1/4 of their wealth in banks. Most payments are made by check drawn from one bank and deposited into another bank. One reason for the popularity is federal deposit insurance insures all bank deposits. If the bank bankrupts and customers cannot cash in their accounts, then the federal government will step in and pay the depositors their accounts. The deposit insurance guarantees payment for each customer up to $100,000.

A bank’s fund sources are listed on a balance sheet. A balance sheet is a financial statement that lists all the bank’s assets and liabilities. Assets are things a bank owns, while liabilities are things a bank owes to other people. Assets are listed on the left, while liabilities are listed on the right. Also, accounting transactions conform to the equation:

Total Assets = Total Liabilities + Capital

Capital is total assets minus total liabilities. Capital has many names. It is also called net

equity, net worth, or net assets. If the business is a corporation, then capital is stockholders’ equity.

The first item on a bank’s balance sheet is liabilities. Liabilities are the source of funds for a bank. The first liability is checkable deposits. This includes every form of checking account. If you needed money and went to a bank, the bank has to give you the money from your checking account immediately on demand. This is a liability to the bank, because the bank owes you this money. Checking accounts earn the lowest interest rate and are usually the cheapest source of funds for a bank.

The second liability is nontransaction deposits. These deposits are the various types of savings accounts. These accounts earn interest and do not allow check writing. These deposits require less bank services, and earn higher interest rates than checking accounts. The nontransaction deposits are:

1. Savings account is the most common, and pays a higher interest than interest on

checking accounts. However, savings accounts have less services than checking accounts.

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2. Small-denomination time deposits (Also called Certificates of Deposit) have maturities from several months to over 5 years. They are less liquid than savings account, but they pay higher interest.

3. Large-denomination time deposits are denominated with values over $100,000. Corporations and other banks invest in these securities. These time deposits allow investors to buy and sell these securities in a secondary market before maturity. Therefore, they are liquid and an alternative to T-bills.

The last liability is bank borrowings. A bank borrows funds if the bank can lend the funds to a borrower for a higher interest rate than the interest rate paid on the borrowings. Borrowings are not deposit accounts. Banks can borrow from the Federal Reserve or from other banks. The loans from the Federal Reserve are called discount loans.

Another source of borrowings is through the federal funds market. Each bank is required to hold cash in the vault or deposits at the Federal Reserve and the amount is based on the percentage of deposits a bank has. If one bank has excess deposits at the Fed and another bank has a shortage of deposits at the Fed, then the bank with the excess deposits can loan the excess funds to the other bank. This is the federal funds market and usually it is an overnight loan. The interest rate for this market is called the federal funds rate.

The second item on a bank’s balance sheet is assets. The bank takes funds from depositors and loans these funds to borrowers. These loans are assets that earn interest. This is the source of income for the bank. The first and most liquid asset is reserves. The reserves are composed of three items. The bank holds vault cash, has deposits at other banks, and has deposits at the Federal Reserve System. Vault cash is simply cash the bank has in its safe. A bank has money, so the bank can pay meet a depositor’s account withdrawal. A bank holds deposits at another bank, because these deposits can help check clearing and are also used in foreign exchange transactions. Finally, the bank holds deposits at the Federal Reserve. Banks are legally required to hold a percentage of the bank’s checkable deposits. This is called required reserves. The Federal Reserve wants to ensure that banks have enough reserves to meet depositors’ withdrawal demands.

Marketable securities are the second asset. Banks hold U.S. government securities, such as T-bills, T-notes, T-bonds, and municipal bonds. These securities are very liquid and are sometimes called secondary reserves. If banks need more reserves fast, then the bank can easily sell its marketable securities.

Loans are the third asset and the most important source of income. In 1998, loans represented roughly 67% of total assets. Loans have higher probability of default than other assets, a lower liquidity, and more information costs. However, banks are compensated for this risk by earning higher interest rates. Loans earn higher interest rates than marketable securities. The majority of loans are for commercial and industrial loans, and mortgages.

The last assets earn no interest and include physical capital, such as the bank’s building, computers, and other equipment.

The third item on a bank’s balance sheet is bank net worth. When liabilities are subtracted from assets, the remainder is called bank net worth or equity capital. All banks are organized into corporations. A corporate bank’s net worth would be the stock sold to the investors and the bank’s profit. If a bank failed and the bank paid all its liabilities, then the only thing that is left to the stockholders is net worth. Net worth is also important to the investors,

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because net worth can act like a cushion for bank losses. Usually net worth for banks averages between 7 and 9% in the United States.

11.2. Bank Failure

A bank failure is a bank develops financial problems and fails. The bank is not able to return all money to the depositors. Government regulations encourage banks to hold a large amount of reserves, marketable securities, and equity capital, which decrease the chance of bank failures.

In this analysis, T-accounts are used. A T-account is a simplified balance sheet and only lists changes on the balance sheet. For example, you open a checking account at your bank and deposit $100 cash. The transaction is recorded as:

Your Bank

Assets Liabilities

+$100 Reserves +$100 Checking account The central bank requires commercial banks to hold 10% of deposits in the form of vault

cash and/or reserves at the central bank. Therefore, $10 of your money becomes required reserves and the remaining become excess reserves. Excess reserves are funds the bank has and can loan these funds to borrowers. The transaction is recorded below:

Your Bank

Assets Liabilities

+$10 Required reserves +$90 Excess reserves

+$100 Checking account

The bank earns no interest on reserves, so the bank makes a loan to someone for $90.

The loan is the bank’s source of income. The transaction is recorded below:

Your Bank Assets Liabilities

+$10 Required reserves +$90 Loans

+$100 Checking account

For the bank to earn a profit, the bank has to earn a higher interest rate on the loan than

the amount of interest the bank is paying on your checking account. What happens if the borrower defaults and does not repay the loan. The bank is still obligated to pay your $100 back, when you demand it. The $90 would come from the bank’s net worth and $10 from required reserves.

How a bank manages liquidity risk is very important. Liquidity risk is the possibility that depositors may withdraw more money from their accounts than the amount of cash in a bank’s vault Banks developed two strategies to prevent liquidity risk. The first is called asset management. First, banks look for borrowers, who will pay high interest rates and not default on their loans. Second, banks purchase securities that have high returns, are very liquid, and have low risk. If depositors withdrawals are very high, the banks can easily cash in the liquid securities. The second strategy is liability management. Banks cannot force customers to open

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checking and savings accounts. Banks cannot influence these funding sources. Through innovation, banks created new financial instruments, which opened new funding sources, such as certificates of deposits, Eurodollars, federal funds market, and repurchase agreements. Now banks are not restricted in raising funds.

The first example shows liquidity risk for your bank and your bank’s balance sheet is listed below. The Federal Reserve requires your bank to hold 10% of deposits as required reserves. The bank should have enough funds to meet depositors’ withdrawals.

Your Bank

Assets Liabilities

Required reserves $10 million Excess reserves $10 million Loans $80 million Securities $10 million

Deposits $100 million Bank Capital $10 million

Depositors withdraw $10 million. Deposits decrease by $10 million, and the bank pays

the funds from excess reserves, which is $10 million. This bank has met withdrawal demands. Both bank deposits and excess reserves decrease by $10 million. Below shows changes to the balance sheet:

Your Bank

Assets Liabilities



Depositors now withdraw another $10 million. Now the bank has no required reserves.

Both deposits and required reserves decrease by $10 million. This transaction is shown in the T-account below:

Your Bank

Assets Liabilities



The bank is still required to hold 10% of deposits as reserves. The bank needs to find $8

million. The bank has the following options:

1. The bank sells $8 million of securities.

2. The bank reduces loans by $8 million by calling in loans or selling the loans to other banks.

3. The bank borrows the funds from the central bank or another commercial bank.

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Your bank decides to borrow the $8 million from the Federal Reserve as a loan. Your bank managed the liquidity risk well. Below is how the balance sheet changes.

Your Bank

Assets Liabilities



Fed loan $8 million

How does a bank prevent a bank failure? A bank holds excess reserves and short-term,

highly liquid securities to prevent a bank failure. In this next example, your bank fails. Your bank has the following balance sheet below.

Your Bank

Assets Liabilities



A rumor is circulating that the bank president lost millions in the derivatives market and

disappeared to the Bahamas. As a result, you and the depositors are afraid that your bank will fail, so you and the depositors withdraw $20 million from your bank. Your bank sells $10 million in securities and uses $10 million in required reserves to meet depositors’ demand.

Your Bank

Assets Liabilities



Now your bank needs $8 million in required reserves. Your bank could sell loans, but the

bank would have to sell the loans for a value less than the book value of the loans. The other banks do not know your bank’s borrowers, so these banks will only buy the loans for a small fraction of the loan’s value. This could be a substantial loss. Your bank could ask other banks for a loan, but other banks may fear that your bank will fail and they will not get their money back. Your bank could ask the Federal Reserve for a loan, but the Fed may not grant the loan. Your bank decides to sell $40 million of loans, but the other banks will only pay $25 million for them. Now your bank is insolvent, because total liabilities > total assets. Your bank is on the verge of failing. When a bank becomes insolvent, the U.S. federal government can legally take over the bank. This bank failure could have been prevented, if the bank had more reserves or more highly-liquid securities. Your insolvent bank’s balance sheet is listed below.

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Required reserves $25 million Loans $50 million


As you can see from the previous example, a bank can fail if too many loans go bad. A

bank is very concerned about credit risk. Credit risk is the risk that borrowers will default on their loans. One method banks use to lower credit risk is by diversify their loan portfolios. Banks spread out their loans among different industries, different regions, and different loan types. For example, a bank may grant loans for credit cards, mortgages where the homes are spread out in the state, and different types of commercial loans such as a loans for hotels, restaurants, retail stores, and factories. If a factory bankrupts and defaults on its commercial loan, the bank is not harmed. The bank is earning income on the other loans.

Adverse selection is a problem for banks. Some borrowers will apply for loans at banks, when the borrowers know they will have a high chance of defaulting. The banks implement five procedures to prevent adverse selection. The five procedures are:

1. Banks perform credit-risk analysis. The bank collects information about the borrowers’

employment, income, and net worth. From this information the bank assesses the borrowers’ ability to repay the loan.

2. The bank prevents adverse selection by requiring collateral. Borrowers pledge assets to the bank. If a borrower defaults on the loan, then the bank will seize the asset. For example, the collateral for a mortgage is the house. If the homeowner defaults on the mortgage, then the bank takes the house.

3. The bank minimizes adverse selection by credit rationing. Banks establish a maximum amount of loan for a borrower. For example, credit cards for college students usually have a maximum credit of $1,000. If the credit limit was $10,000, then some students may use the credit card too much and not be able to pay the credit card balance.

4. The banks use restrictive covenants to minimize adverse selection. Restrictive covenants are conditions specified in the loan agreement. These conditions prevent the borrowers from engaging in certain activities. For example, a person applies for a home improvement loan, but wants to use the loan to speculate in the derivatives market. The bank puts a restrictive covenant in the loan agreement. The borrower can only use the loan for home improvement.

5. Banks minimize adverse selection by having a long-term relationship with the borrowers. When banks know the customers well, they can accurately assess the customers’ risk of default.

11.3. Interest Rate Risk

With increased volatility of interest rates in the 1980s, banks became more concerned with interest rate risk. Banks experience interest rate risks, when changes in the interest rates cause the banks’ profit to fluctuate. Look at the bank’s balance sheet below:

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Your Bank

Assets Liabilities Interest-rate sensitive assets: $20 million

• Variable-rate loans

• Short-term securities

Fixed-rate assets: $80 million

• Long-term bonds

• Long-term securities

Interest-rate sensitive liabilities: $50 million

• Certificates of deposit

• Money market deposit accounts

Fixed-rate liabilities: $50 million

• Checkable deposits

• Savings accounts

Interest-rate sensitive items are short-term securities, variable interest-rate loans, and

short-term deposits. When the interest rate changes, these items change almost immediately. The fixed-rate assets and liabilities are not sensitive to interest rate changes. These loans and securities are locked into one interest rate for a very long time. Checking and savings accounts are considered fixed-rate liabilities, because these accounts pay little or no interest.

If interest rates increase from 10% to 15%, (a 5% interest increase, the income on interest-rate sensitive assets increases by $1 million (0.05 x $20 million = $1 million). The cost of funds increases by $2.5 million (0.05 x $50 million = $2.5 million). The bank’s profits now decrease by $1.5 million ($1 M - $2.5 M = -$1.5 M). Changes in the interest rates can have a very big impact on a bank’s profits. Three conditions can occur when interest rate changes:

1. If interest-rate sensitive liabilities > interest-rate sensitive assets, then an increase in the

interest rates cause bank profits to decrease, while a decrease in interest rates cause bank profits to increase.

2. If interest-rate sensitive liabilities < interest-rate sensitive assets, then an increase in the interest rates cause bank profits to increase, while a decrease in interest rates cause bank profits to decrease.

3. If interest-rate sensitive liabilities = interest-rate sensitive assets, then changes in interest rates does not change bank profits.

For example, if the bank manager knows that interest-rate sensitive liabilities > interest-

rate sensitive assets and he believes interest rates will fall, then he will do nothing. The bank manager expects the bank’s profit to increase. If the bank manager thinks interest rates will increase, then he will try to increase interest-rate sensitive assets and decrease interest-rate sensitive liabilities by manipulating the items on the balance sheet.

Over the last 20 years, three factors changed how a bank manages its balance sheet. First, the U.S. federal government deregulated the financial markets, giving banks more flexibility in acquiring assets and liabilities. Second, financial innovation created new financial instruments that are more liquid, such as repurchase agreements, federal funds market, and securitization. Banks use securitization to transform bank loans into liquid securities. Finally, the high volatility of interest rates during the 1980s contributed to the creation of new financial

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instrument. One innovation was floating-rate debt. Some banks started granting loans to borrowers that have variable interest rates. If interest rates increase, the banks can increase the interest rate on the loans. Therefore, interest rate changes do not harm banks. The derivatives market also expanded during the 1980s. Banks could buy futures and options to protect themselves from changing interest rates.

11.4. Securitization

Securitization is very similar concept to the mutual funds. Securitization is the process of transforming otherwise illiquid financial assets into marketable securities. The banks take similar loans, such as mortgages, pool them together into one fund, and issue securities that are based on this fund to investors. On average, the pool of funds has a predictable cash flow and as people pay their loans, investors receive this money as investment. Securitization is possible, because of computers, which makes the record keeping process simple. Banks have turned the following loans into marketable securities:

• Mortgages

• Car loans

• Third world debt

• Credit cards

Securitization has been blamed for the 2007 real estate crisis in the United States. Some

claim banks were too lenient in granting mortgages. Banks granted mortgages to people with poor credit or poor work history. Then banks used securitization to “cash” out of the mortgages and “push” the risk onto the investors. Cashing out of the mortgages gave banks funds to grant new mortgages, and continue the process. This credit flow started the rapid appreciation of the housing prices in the United States during 2000 and 2006. Even if a borrower defaulted on the mortgage, homes were appreciating over time, so foreclosures did not harm banks and the investors.

Everything ended in 2007. The demand for mortgages and new homes slowed down. Housing prices started to fall in many markets. Further, many of these mortgages were variable interest rate loans. As interest rates increased and the economy slowed down during 2007, people started to default on the mortgages. Now banks and investors were stuck with properties that are losing value.


1. Know how to do all the T-account transaction in this chapter.

2. What are all the bank’s assets, liabilities, and capital?

3. What does bank net worth mean?

4. What is liquidity risk?

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5. How does a bank become insolvent?

6. How do banks reduce adverse selection?

7. How can a bank protect itself from interest rate risk?

8. What is securitization?

9. What is floating rate-debt?

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12. The Banking Industry


• The difference between national and state banks.

• The government agencies that regulates the banking sector.

• Why the government heavily regulates the banking sector.

• How banks circumvented government regulations.

12.1. The United States Banking System

The United States banking system is different when compared to other industrial countries. The United States has more banks per capita and the banks tend to have smaller assets. U.S. government regulations caused this difference. Early in the United States history, the public feared big banks, so state and federal governments passed regulations that caused banks to be small and encouraged a large number of banks to be formed.

The United States has a dual banking system. A bank may choose a charter from a state government or from the U.S. federal government. The charter is a document that legally establishes a corporation and allows a financial institution to participate in banking activities. When a bank receives a charter from the federal government, the bank is called a national bank. If a bank receives a charter from a state government, then it is called a state bank.

If a bank receives a charter from the federal government, then that bank is subject to three regulatory agencies. The regulatory agencies are:

1. Comptroller of the Currency: This is an office in the U.S. Treasury Department and

regulates national banks. This is the office that grants charters from the U.S. federal government and also requires national banks to be members of the Federal Reserve and FDIC.

2. Federal Deposit Insurance Corporation (FDIC): This agency insures deposits at banks. If this agency insures, then it also regulates.

3. Federal Reserve System (Fed): The central bank of the United States. The Fed is a lender of the last resort. When a bank is having financial difficulties and cannot receive a loan from another financial institution, then the Fed is the last institution to ask for a loan. The Fed also regulates banks.

A state-chartered bank has fewer regulations. A state government agency regulates state banks, and state banks have the option of joining the Fed and/or FDIC. Therefore, a state bank could have one regulatory agency to deal with or up to a maximum of three regulatory agencies.

Savings institutions and credit unions also have their own regulatory agencies. These institutions either have a charter from the federal government or a state government. The Federal

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Home Loan Bank System (FHLBS) is the U.S. government agency that is equivalent to the Federal Reserve. The FHLBS regulates the savings institutions. Also, the FDIC insures deposits at savings institutions. Most credit unions have charters from the federal government and the agency is called the National Credit Union Administration. This agency also insures the deposits at credit unions. FDIC does not insure credit unions.

The government regulates the banking system for five reasons. The reasons are:

1. First, the United States government wants to ensure a stable financial system. A wave of bank failures could cause the economy to enter a recession. Banks help create a nation’s money supply. A wave of bank failures can cause a large contraction in the money supply, causing the economy to contract.

2. Regulating banks helps the central bank achieve national economic goals by controlling the money supply, such as low inflation and low unemployment.

3. The U. S. government wants to promote efficiency in the financial intermediation process.

4. The U.S. government wants to provide low-cost financing for home buyers.

5. Finally, the U.S. government wants to protect consumers. The financial system, such as a bank can be an extremely complicated. Many depositors may not understand the financial instruments and therefore are not able to determine the soundness of the institution or make rational decisions. In a competitive market like TVs, VCRs, and computers, the consumers can easily evaluate and compare different products.

12.2. Federal Deposit Insurance Corporation (FDIC)

The United States government passed the Glass-Steagall Banking Act of 1933. This law created the Federal Deposit Insurance Corporation (FDIC). FDIC is a U.S. federal government agency that insures the deposits of each depositor in commercial banks up to $100,000. For example, if you have $60,000 in your checking account and $60,000 in certificates of deposits, FDIC only insures up to $100,000. If your bank fails, you are guaranteed that your will get at least $100,000 from FDIC, potentially losing $20,000. In some cases, the FDIC insured all deposits for amounts exceeding $100,000. It depends how FDIC handles the bank failure.

Insurance premiums fund the FDIC. Each commercial bank that is a member of FDIC has to pay $2,000 per year. The FDIC has been very successful. Between 1934 and 1981, bank failures average 10 per year. Before the U.S. government created the FDIC, bank failures averaged 2,000 per year during the Great Depression.

The U.S. government established the FDIC to lower the rate of bank failures by preventing bank runs. A bank run is depositors find out their bank is having financial trouble. Everyone runs to the bank to withdraw their deposits. A bank holds only a fraction of the total deposits, so the bank will close its doors after all the cash is gone from the vault. If the bank is holding many illiquid loans, then the bank has to sell these loans at a discount in order to raise more reserves. Selling the illiquid loans at a discount can cause the bank to become insolvent. Total bank liabilities become greater than total assets. The bank is on the verge of failing and many depositors will not be able to get their money back. A bank can be financial healthy, but a

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rumor that the bank is having trouble can still cause a bank run, eventually causing the bank to fail.

A bank run on one bank can lead to bank runs on other banks. This is known as a contagion. As depositors line up at one bank to withdraw their accounts, not all depositors will get their money back. The depositors will tell friends and family, and they will begin to question the health of their banks. For many people, it is hard to gauge the financial health of banks. The friends and family start going to their banks to withdraw their accounts, causing more bank runs. As the contagion spreads, it can cause a wave of severe bank runs called financial panics. Financial panics can cause the economy to enter into a recession.

The insurance premium is the same for all depository institutions. Each institution has different costs, different levels of risk of its asset portfolios, and different probabilities of failure. The FDIC does not adjust its premium to reflect differences among banks. The flaws with FDIC can cause some banks to invest in riskier loans and securities, because the banks know if they get into financial trouble, the FDIC protects the depositors.

The FDIC uses two methods for bank failures. For the first method, the FDIC closes the bank and seizes the bank’s assets. FDIC sells all the bank’s assets and returns the money to the depositors. If FDIC does not receive enough money to pay all depositors from selling the bank’s asset, then FDIC pays the difference from its own pocket. The FDIC does not use the first method often. The second method, the FDIC purchases and assumes control of the failed bank. The FDIC keeps the bank open and looks for another bank that is interested in buying the failed bank. If the FDIC cannot find a buyer, then FDIC will give extra incentives, such as low-interest rate loans from the FDIC or the FDIC buys the problem loans from the failed bank’s portfolio. The FDIC even allows a bank located in another state to buy a failed bank. (Federal law prohibited banks from crossing state lines and opening banks in another state).

The Glass-Steagall Banking Act of 1933 divided the functions of investment banking and commercial banking. An investment banker is really a marketing agent for selling new stocks and bonds. Politicians and the public thought that commercial banks should not underwrite new stock and bonds for corporations. They believed banks were underwriting “risky” securities and banks had enormous power to create monopolies. In practice, the Glass-Steagall Banking Act insulated investment banking from competition. Consequently, borrowers pay more for issuing new securities than they would if commercial banks could underwrite new securities.

Another federal law, the McFadden Act, prohibits any type of commercial bank from opening a branch in another state. This law was to put national and state banks on equal footing and foster competition. However, this law allowed small inefficient banks to remain in business and caused the U.S. to have the largest number of banks in the world (14,217 banks as of 1986).

Some states restricted banks to one geographic location, which is called unit banking. Unit banking is a system that permits each bank to have a single geographical location, such as in one city, and the bank cannot have any branches. Currently, no states enforce unit banking. The other form is called branch banking. The state government allows a bank to have two or more banking offices owned by a single banking corporation within a geographical area. The geographic area can be a city, county, or statewide. Currently, 45 states allow statewide branch banking.

12.3. Innovations in the Banking Industry

Regulations caused banks to invent new financial institutions, thus circumventing the law. The first innovation was the development of bank holding companies. A bank holding company

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is one corporation obtains ownership or control of two or more independent banks. A bank holding company can do three things.

1. The bank holding company can branch within states or across state lines. For example, a

corporation buys enough common stock of two banks to be the majority shareholder. Usually majority shareholders elect the Board of Directors and vote on corporate policy. Therefore, the holding company can control several banks.

2. Bank holding companies can buy other non-bank companies and enter into other spheres of economic activity, such as data processing, investment advice, and insurance. Allowing banks to participate in nonfinancial activities is called universal banking.

3. The bank holding company can easily raise nondeposit funds. For example, a bank holding company controls one bank, and this bank needs funds. The holding company issues commercial paper on itself and diverts these raised funds to the bank, getting around interest rate restrictions on bank deposits. Therefore, bank holding companies circumvent laws on restrictive banking.

The second innovation that allowed banks to circumvent federal and state regulations was the creation of a nonbank bank: The legal definition of a bank is an institution that accepts deposits and makes loans. What if a bank stops taking deposits? Legally it is no longer a bank, so the bank is not subjected to the extensive bank regulations.

The third innovation was the creation of money market mutual funds (MMMF), which are pools of liquid money-market assets managed by investment companies. The investment companies sell shares to the public in small denominations. MMMF were very successful. In 1977, MMMF was $3.3 billion and it grew to $186.9 billion in 1981. The MMMFs hurt the banks, as people started to withdraw money from the banks and invest it into MMMFs. MMMFs tend to pay a higher interest rate and allowed check writing privileges. This put pressure on banks, which put pressure on the regulatory agencies, which put pressure on Congress (and the President) to change the laws. Since 1982, banks have been offering money market deposit accounts (MMDA). MMDA are exactly the same as MMMF. The only difference is the MMDA is consider a bank account and is insured by the FDIC. MMDAs have no reserve requirements and have grown rapidly as people started to invest in them. In 1995, MMDAs had balances of $685 billion.

The last innovation that allowed banks to circumvent regulations was the invention of the automated teller machine (ATM). Modern computer technology allows bank customers to receive banking services through computer terminals located at banks, stores, and shopping malls. Customers can make deposits, withdrawals, and credit card transactions. Technically, ATMs are not bank branches, and are not subjected to branch banking restrictions. Therefore, ATMs can be located some distance away from the main bank. Many banks created networks, so customers have access to their accounts from any place within the United States. One of the largest networks is CIRRUS.

The political climate is changing in the United States. Innovation, rising interest rates, and deregulation has eroded the regulatory structure set up in the 1930s. Banks are allowed to cross state lines, open branches in other states, offer investment advice and brokerage services. The banking industry will have two trends. First, banks will start acquiring other banks, causing the number of banks in the United States to decrease. Second, as banks merge, they become

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bigger and the size of their assets will increase. U.S. banks will approach the size of Japanese and German banks.


1. What is the difference between a state bank and a national bank?

2. Which government agencies regulate the banks?

3. Why does the government regulate the banking sector?

4. What is the Federal Deposits Insurance Corporation (FDIC)?

5. What are the two methods the FDIC uses in a bank failure?

6. What are bank runs, contagion, and financial panics?

7. How does a bank holding company circumvent government regulations?

8. How does a nonbank bank and automated teller machines circumvent bank regulations?

9. What is the difference between a money market mutual fund and a money market deposit account?

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13. Banking in the International Economy


• Why banks enter the international markets.

• How U.S. banks enter into foreign markets.

• How foreign banks enter the United States banking market.

• How banks circumvent government regulations by using international financial instruments.

• The problems of regulating international banks.

13.1. Functions of International Banks

International banks are similar to domestic banks. International banks help people and businesses who engage in international trade, finance, and foreign currency exchange rates. For example, Compaq enters into a contract with a firm in Hong Kong to buy memory chips. Compaq goes to an international bank, where the bank gives a short-term loan for the memory chip purchase. The bank helps Compaq pay for the memory chips and can also help Compaq with the currency exchange rates.

International banks have three benefits. First, international banks accept deposits from savers and lend to borrowers. The savers and borrowers do not have to be located in the same country. Second, international banks can lower transaction costs by lowering information costs, lowering the risk of investments, and increasing the liquidity of financial markets. Liquidity is the ease of converting assets to currency. Third, international banks stimulate financial innovation by creating new financial instruments.

International banks link savers and borrowers from different countries around the world, crossing international borders. International banks tend to be concentrated in countries that are financial centers in the world, such as New York City, Tokyo, and London. Consequently, a government in one country has problems regulating its bank’s business in other countries. For example, Citibank has branches and subsidiaries in many countries around the world. The U.S. government and Federal Reserve System have trouble regulating and monitoring all the bank’s activities.

International banks are also located in places that have offshore markets. An offshore market has little regulations, low tax rates, and strict banker-customer confidentiality laws. The leading offshore markets are the Bahamas, Hong Kong, and Singapore. If the regulatory agency believes a bank is participating in risky investments, the regulatory agency has difficulty getting access to bank records for subsidiaries located in offshore markets.

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13.2. Becoming an International Bank

Banks in the United States have four methods to become an international bank. The four methods are:

1. The U.S. bank opens a bank branch in a foreign country. These branches accept deposits

and make loans. U.S. banks tend to open branches in financial centers around the world, or where U.S. firms and corporations engage in business. The bank branches help the bank transfer money around the world.

2. The U.S. bank becomes a holding company. The U.S. bank buys and becomes majority shareholder of a foreign bank. The Federal Reserve System restricts U.S. banks to foreign firms that are “closely related to banking.”

3. The U.S. bank becomes an Edge Act corporation. The U.S. bank sets up a subsidiary. The subsidiary can accept deposits only from U.S. residents and foreigners, but can only grants loans for international business activity. These international banks assist with international trade and foreign currency exchange. The subsidiary is exempt from some U.S. banking regulations and the Federal Reserve System has to approve the Edge Act corporation.

4. The U.S. bank creates an international banking facility (IBF). An international banking facility is similar to an Edge Act corporation and the IBFs accepts deposits from foreigners and make loans to foreigners. The IBFs cannot conduct any type of business within the United States except with its parent company or with other IBFs. The IBFs are exempt from many government regulations and are also exempt from local and state taxes. The Fed encourages U.S. banks to use this method for engaging in the international markets.

Foreign banks can enter the banking market in the United States. A foreign bank has three methods.

1. The foreign bank opens an agency office. The agency office cannot accept deposits from

U.S. residents, but it can make loans to them. Moreover, the agency office is not subjected to U.S. banking laws and does not have to carry FDIC deposit insurance. The agency office receives it funding from foreign depositors and investors. The agency office is similar to a nonbank bank. A nonbank bank circumvents the numerous U.S. banking regulations, because the legal definition of a bank is an institution that accepts deposits and grants loans. If the institution stops one of the functions, like accepting deposits, then legally the institution is not a bank.

2. A foreign bank does business in the U.S. through a foreign bank branch. This is a full fledge bank that accepts deposits and makes loans. The foreign bank branch is subjected to the U.S. banking regulations.

3. A foreign bank enters the U.S. market through a subsidiary U.S. bank. The foreign bank buys stock of a U.S. bank and becomes the majority shareholder. The foreign bank

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controls the U.S. bank and the U.S. bank becomes a subsidiary. Many foreign banks use subsidiaries to enter the U.S. banking market.

13.3. Exchange Rate Risk

Exchange rates are a ratio of one currency to another currency. Exchange rates are usually written as Equation 2.1. Thus, one U.S. dollar is equivalent to 1.5 Euros.

$1 = 1.5 Euros (2.1)

If you are holding 1,500 Euros, then how much U.S. dollars is this equivalent to? The

trick with exchange rates is to retain the currency units in the calculation. If the calculation is correct, then only one currency unit remains after the calculation. We can form two ratios with the currency by dividing both sides of the equation by one of the currency unit. The two ratios are:

15.1

1$=

Euros or

1$

5.11

Euros= (2.2)

Now multiply the ratios by 1,500 Euros. The first ratio is correct in Equation 2.3,

because one currency unit remains after the calculation. The ratio for Equation 2.4 is not correct, because the Euro currency units are squared.

000,1$5.1

1$500,1 =

EurosEuros (2.3)

( )1$

25.2

1$

5.1500,1

2EurosEuros

Euros = (2.4)

Exchange rates can change over time. If the exchange rate changes to Equation 2.5, the

U.S. dollar buys more Euros. Thus, the U.S. dollar appreciates. If the U.S dollar appreciated, then automatically the Euro depreciated. Always look at the currency that has a one. When you know what happens to that currency, then you automatically know what happens to the other currency.

$1 = 2 Euros (2.5)

The exchange rate can also go in the other direction. If the exchange rate changes to

Equation 2.6, then the U.S. dollar buys less Euros. Thus, the U.S. dollar depreciated, while the Euro appreciated.

$1 = 1 Euro (2.6)

Be careful about mixing terms. Financial analysts use the terms strong and weak to refer

to a currency. For instance, if the U.S. dollar is weak, the dollar is being compared to a “basket”

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of currencies. Overall, the dollar went down in value relative to this basket. The basket of currencies tends to be other industrialized countries, like Canada, Europe, and Japan.

Changing exchange rates leads to the exchange rate risk, which can financially harm international banks. The international bank has to keep track of the trends in exchange rates, when accepting deposits and granting loans. For example, an international bank accepts $1 million from depositors in the United States and the bank grants a loan to a business in Russia for $1 million. Many countries have laws, where business activity is denominated in that country’s currency. Thus, the bank converts the U.S. dollars into Russian rubles, because the ruble is the legal currency in Russia. If the exchange rate is $1 for 25 rubles, then the bank’s loan is valued at 25 million rubles. The calculation is Equation 2.7.

rublesmillionrubles

LoanBank 251$

25000,000,1$ =⋅= (2.7)

What happens if the exchange rate changes? Then the international bank could gain or

lose from exchange rate changes. If the currency exchange rate changes to $1 for 50 rubles, the U.S. dollar appreciated while the Russian ruble depreciated. When the Russian business pays back its 25 billion-ruble loan, the bank gets only $0.5 million. The calculation is Equation 2.8. Therefore, the bank experienced a major loss.

000,500$50

1$000,000,25 =⋅=

rublesrublesLoanBank (2.8)

If the exchange rate changes from $1 to 10 rubles, then the Russian ruble appreciated

while the U.S. depreciated. When the Russian business repays the loan, the amount of the loan is $2.5 million dollars. The calculation is Equation 2.9. Consequently for this case, the international bank benefits.

000,500,2$10

1$000,000,25 =⋅=

rublesrublesLoanBank (2.9)

13.4. International Financial Securities

International banks created several financial securities to hedge against foreign exchange rate risk. Furthermore, some financial securities allow international banks to circumvent government regulations, and to facilitate international trade.

Currency swaps reduce exchange rate risk and lowers transaction costs. A currency swap is the exchange of debt instruments denominated in different currencies. For example, Intel wants to build a factory in Germany, while Volkswagen wants to build a new factory in the United States. Intel needs German deutschmarks, while Volkswagen needs U.S. dollars for these investments. These companies are known well within their own countries and can borrow on more favorable terms with their banks. Intel takes a loan from a U.S. bank, while Volkswagen takes a loan from a German bank. Now Intel and Volkswagen can exchange their loans. Intel has deutschmarks to build a factory in Germany, while Volkswagen has U.S. dollars to build a factory in the United States.

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Eurodollars are a financial innovation that can also reduce the foreign exchange risk. Banks create Eurodollars when a bank customer transfers a deposit from the United States to a foreign bank. The bank does not convert the account to the local currency, but keeps the account denominated in U.S. dollars. Many other financial instruments were created from Eurodollars, which are Euroloans and Eurobonds. The principal and interest payments are denominated in U.S. dollars. For example, Europe can grant a loan to Russia, using a Euroloan. All terms of the loan are in dollars and Russia has to pay the loan back in dollars. The bank is protected from changes in the ruble-dollar exchange rate. The exchange rate risk is completely passed onto the Russian business. However, Euroloans and Eurobonds are not completely free from the exchange rate risk. If the Russian business earns profits from sales denominated in rubles, then a severe ruble depreciation can cause the Russian business to default and/or bankrupt.

Euroloans can often be in billions of dollars. Therefore, several international banks may cooperate to grant a large loan. This cooperation is referred to as loan syndication. The syndicate spreads a large loan among several banks and one bank manages the loan and earns a management fee.

Most international banking business is conducted through the Euromarkets. These markets are essentially unregulated and include all financial markets that are denominated in U.S. dollars and are located outside of the United States. Eurodollars allow banks to circumvent laws and regulations. In the United States, banks originally could not pay interest on checking accounts. In Britain, banks originally could not grant loans outside of Britain. Eurodollars allowed these banks to circumvent these laws. U.S. banks could borrow Eurodollars instead relying on deposits while British banks could lend outside of Britain by using Eurodollars. Eurodollars were so successful that many governments repealed regulations. The U.S. dollar still dominants the Eurodollar market.

Eurodollars are not limited to only Europe. During the 1970s, Organization of Petroleum Exporting Countries (OPEC) was successful in reducing the production of petroleum, causing the price of oil to increase. The high oil prices caused a large inflow of U.S. dollars into the OPEC nations and OPEC became the largest source of Eurodollars. Currently, Japan and South Korea also have large deposits in U.S. dollars.

The last financial instrument is a banker’s acceptance and this instrument facilitates international trade. If a U.S. store wants to import coffee from Costa Rica, the exporter in Costa Rica has no information about the U.S. store’s credit worthiness. If the exchange of coffee for money occurs in the future, the U.S. store does not know what the future exchange rate will be. This is an information problem and an international bank can use a banker’s acceptance. The U.S. store deposits money at its international bank. The bank guarantees payment by issuing a banker’s acceptance and sends a letter of credit to the exporter in Costa Rica. If the U.S. store bankrupts, the exporter in Costa Rica still gets his money. If the firm does not deposit money at the bank and the bank guarantees payment, then the bank still has to pay the exporter in Costa Rica. When the exporter in Costa Rica exports the coffee to the U.S., the exporter deposits his letter of credit at his bank. The exporter’s bank will contact the U.S. store’s bank and make payment arrangements. Banker’s acceptances are liquid assets, because banks can sell or buy them on secondary markets.

13.5. International Transaction Currency and Regulatory Oversight

After World War II, the U.S. dollar became the international transaction currency. An international transaction currency is the preferred currency used in negotiating transactions in the

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international financial markets. For example, all transactions in the petroleum market are priced entirely in U.S. dollars.

During the 1980s, several developing countries threaten to default on their Euroloans. The loan default could cause a global banking crisis in the industrialized countries. This threat prompted twelve countries including the United State to meet in Basel to discuss capital requirements. The Basel committee and Basel agreement are named after the city, Basel. These countries wanted to reduce risky international banking activities by ensuring banks had enough capital. If an international bank suffered losses, having enough capital would help the bank to survive. Countries have difficulty in implementing the Basel agreement, because each country has different regulations and different accounting standards. The Basal agreement set common capital standards for banks engaged in currency swaps, financial futures, and options.

The 1980s debt crisis also prompted central banks to meet and discuss their roles of being the lenders of last resort during a banking crisis. The central banks concluded they should concentrate on the financial stability of their own domestic banks. However, many banks are linked internationally to other banks abroad. If there is an international banking crisis, one central bank is not likely to prevent an international financial crisis.

Leaders of central banks and government finance ministries continue to push for coordination and restrictions on deposit insurance. For instance, deposit insurance in the United States insures up to $100,000 for each individual. In other countries, the deposit insurance is not as generous. Currently, U.S. banks pay modest premiums only on domestic deposits. If the Federal Deposit Insurance Corporation (FDIC) requires U.S. banks to pay deposit insurance on all accounts including foreign accounts, then their premiums will increase. Coordination of international deposit insurance is also difficult. First, many regulatory agencies in other countries lack the monitoring power of the FDIC. Second, only three countries in Europe, Netherlands, Spain, and United Kingdom, have laws requiring the government to step in and fund the deposit insurance if the insurance premiums cannot cover all accounts during a bank fails.

Government regulations and regulatory differences among countries are likely to diminish in the future. Bank holding companies and financial innovation allow banks to circumvent regulations and enter spheres of new business activity. In the future, bank holding companies will offer a broad range of financial services. The type of services a bank holding company can offer will depend on the legal tradition of the country where the bank holding company wants to do business. Banks are more likely be subjected to more restrictions in the United States, while regulations are less stringent in Europe and Japan.

Chapter 13 Questions

1. What are the benefits of being an international bank?

2. What is an offshore market?

3. What are the four methods for a U.S. bank to become an international bank?

4. What are the three methods for a foreign bank to enter the United State banking sector?

5. What is an exchange rate risk?

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6. What is the purpose of currency swaps and banker’s acceptances?

7. What are Eurodollars, Euroloans, and Eurobonds? Why are these financial instruments so popular?

8. What are the problems that governments experience when regulating international banks?

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14. The Money Supply Process

After reading this chapter, you should understand the following: How the public, banks, and the Fed influence the money supply through multiple deposit

creation and multiple deposit contraction.

• How the monetary base and money supply are related.

• An introduction to the Federal Reserve’s balance sheet.

• Why the Fed cannot precisely control the money supply.

14.1. The Fed’s Balance Sheet

The money supply has a large impact on interest rates, exchange rates, inflation, and a country’s production of goods and services. Money supply fluctuations affect the financial markets, the prices of goods and services, and general economic well being of society. The Fed cannot completely control the money supply. The behavior of the public and banks can influence the money supply. For this chapter, you are using the narrowest definition of money, which is the M1 definition. The model only examines currency and checkable deposits.

The monetary base is the total of all currency in circulation and reserves held by banks. The Fed can directly influence the monetary base and the monetary base influences the money supply. To understand how the money supply process works, the Fed’s balance sheet is introduced. The Fed’s liabilities are the currency in circulation and bank reserves. The currency in circulation is the Federal Reserve Notes the public is holding, i.e. U.S. money. This does not include vault cash at banks, because vault cash is already counted as bank reserves.

Keeping this example simple, let the required reserve ratio, which is the percentage of total reserves that banks must hold at the Fed or as vault cash, to be 10%. If you open a bank account by depositing $100, then the bank is required to hold 10% of your deposit, which amounts to $10. The $10 is called the required reserves. The bank may elect to hold more than $10 and this excess amount is called excess reserves. The bank holds reserves to meet depositors’ withdrawal. You could go back to your bank and withdraw your $100 deposit and the bank pays your money back from reserves. The bank may either hold $10 in its vault or deposit the $10 with the Fed. The important thing to notice is bank reserves are assets to the bank, but liabilities to the Fed. The money the public is holding is an asset to them, but a liability to the Fed.

The two major assets the Fed has are government securities and discount loans. When the Fed increases its assets, the monetary base increases. When the Fed decreases its assets, the monetary base decreases. The first and direct method to change the monetary base is through open market operations. Open market operations are the Fed buying and selling financial securities. Usually the Fed buys and sells U.S. government securities. When the Fed buys U.S. government securities, it is called an open market purchase. The Fed’s assets increase, causing the monetary base to increase. The Fed could also sell U.S. government securities, which is called an open market sale. The Fed’s assets decrease, causing the monetary base to decrease.

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For example, the Fed buys a $10,000 T-bill from your bank. The transaction is listed below in the T-accounts:

Your Bank

Assets Liabilities

-$10,000 T-bill +$10,000 Deposit at the Fed

The Fed

Assets Liabilities

+$10,000 T-bill +$10,000 Bank reserves The Fed buys the T-bill by using a Fed check. When the bank sends the check to the Fed,

the Fed increases the reserves at your bank. There is no money behind the Fed check; its more like adding more numbers in a bank’s accounting books. The bank’s reserves increase and your bank will make a loan to someone, so the bank can earn interest. The Fed’s assets increase, the monetary base increases, and the money supply increases.

The second example, the Fed buys one T-bill from you for $10,000, using a Fed check. You deposit the Fed check at your bank.

You Assets Liabilities

-$10,000 Treasury Bill +$10,000 Demand Deposit (Checking)

Your Bank

Assets Liabilities

+$10,000 Fed Reserve Deposit +$10,000 Demand Deposit

The Fed Assets Liabilities

+$10,000 T-bill +$10,000 Bank reserves The money supply increased, because you traded the T-bill for a demand deposit. It

makes no difference if the Fed buys U.S. securities from the public or a bank. The Fed’s assets increase, causing the monetary base to increase. Your bank’s reserves increase and your bank can make loans to earn interest. Then the money supply increases. If the Fed sells U.S. government securities, the opposite occurs.

The Fed’s second asset is loans. The Fed can extend loans to banks, which helps the banks survive liquidity problems. The Fed loans are called discount loans. The interest rate the Fed charges for these loans is called the discount rate. The Fed does not use loans to influence the monetary base. Instead, the Fed relies on open market operations, because the Fed has complete control over how much securities it wants to buy and sell. With discount loans, the banks determine if they want to borrow from the Fed or not. The Fed cannot force a bank to accept a loan. However, if the Fed makes more discount loans, the Fed’s assets increase, causing the monetary base and money supply to increase. For example, a bank asks the Fed for a loan of $1 million.

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The Bank

Assets Liabilities

Reserves at Fed +$1 million Loan from Fed +$1 million


Loan to institution +$1 million Bank reserves +$1 million The bank’s reserves increased by $1 million, and now the bank can make more loans,

which will increase the money supply. When the bank repays the Fed loan, the Fed’s assets decrease, the monetary base decreases, and the money supply decreases. The transaction is listed below:

The Bank

Assets Liabilities

Reserves at Fed -$1 million Loan from Fed -$1 million


Loan to institution -$1 million Bank deposit at Fed -$1 million

14.2. Multiple Deposit Expansion and Contraction

The financial system creates the money supply through multiple deposit expansion. This means when the Fed increases the monetary base by $1, then the amount of checkable deposits will increase by more than $1. Checkable deposits are one component of the M1 definition of money, so the money supply increases by more than $1. The Fed wants to increase the money supply, so the Fed buys a $10,000 U.S. T-bill from you. You take the Fed check and deposit it at your bank.

Your Bank

Assets Liabilities

Required Reserves $1,000 Excess Reserves $9,000

Deposits $10,000

The money supply immediately increases by $10,000. The bank is required to hold 10%

of its deposits as required reserves. The bank holds $1,000 for your account either as a deposit at the Fed or as vault cash. However, the bank has $9,000 in excess reserves. These reserves earn no interest, so the bank loans them out. Let your bank make a $9,000 car loan to your friend. The transaction is listed below:

Your Bank

Assets Liabilities

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Required Reserves $1,000 Excess Reserves $0

Loans $9,000

Deposits $10,000

The bank will write a check to your friend for $9,000. Your friend takes this check to a

car dealership and buys a car. The car dealer deposits this check at his bank. The transaction is listed below:

Car Dealer’s Bank

Assets Liabilities

Required Reserves $900 Excess Reserves $8,100

Loans $0

Deposits $9,000

The first thing to notice is the change in the money supply. The money supply has

increased by $19,000. The $10,000 is sitting in your account and the $9,000 is in the car dealer’s account. The car dealer’s bank is required to hold 10% of the deposit, which is $900. The remaining funds, $8,100, earn no interest, so the car dealer’s bank can loan this out. The car dealer’s bank grants a $8,100 business loan. The transaction is below:

Car Dealer’s Bank

Assets Liabilities

Required Reserves $900 Excess Reserves $0

Loans $8,100

Deposits $9,000

The small business contracts with a construction company to renovate the business. The

construction company receives a check for $8,100 and deposits this check in its bank. The transaction is listed below:

Construction Company’s Bank

Assets Liabilities

Required Reserves $810 Excess Reserves $7,290

Loans $0

Deposits $8,100

The construction company’s bank is required to hold 10% of this deposit, which is $810.

The remaining reserves, $7,290, earn no interest, so this bank will grant a loan. The important thing to notice is the change in the money supply. The money supply increases to $27,100, which includes $10,000 in your account, $9,000 in the car dealer’s account, and $8,100 in the construction company’s account. When the construction company’s bank grants a loan, then the money supply will increase again and this multiple deposit expansion will occur indefinitely.

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A formula can be derived that shows the maximum change in the money supply when the monetary base changes. First, we start with the formula for total reserves. Total bank reserves are:

Total Reserves = Required Reserves + Excess Reserves

In this case, excess reserves equal zero, because banks earn no interest. The banks use this to make loans. The second equation is required reserves. When a bank accepts a new checking account, the bank is required to hold a percent of the deposit. The formula is:

)(r Ratio Reserve Required Deposits Reserves Required r×=

Substitute this equation into the total reserves equation. Remember, the excess reserves

equal zero.

rr Deposits Reserves Total ×=

The important thing is how the money supply changes when bank reserves change. The

formula is modified below. The ∆ symbol means change and we are taking the difference between two time periods. The first time period is t and the second is t+1.

Change in reserves is: t1t Reserves TotalReserves Total Reserves −=∆ +

Change in deposits is: t1t DepositsDeposits Deposits −=∆ +

Changing the reserves formula yields:

rrDeposits Reserves ×∆=∆

Rearranging the equation yields how the money supply changes when bank reserves

change.

rr

1Reserves Deposits ×∆=∆

If the Fed increases the money base by buying $10,000 of T-bills, then bank reserves

increase by $10,000. If the required reserve ratio is 10%, then substitute this into the equation. The total change in checkable deposits will be $100,000. This formula is called the simple deposit multiplier, which equals ( 1 / rr ). The simple deposit multiplier shows the maximum increase of the money supply for a change in bank reserves. The money multiplier will be smaller in the real world because of leakages. Some people withdraw cash, when they deposits checks at the bank and some banks may hold onto their excess reserves as a safety measure.

The Fed can decrease the monetary base by selling its assets, causing bank reserves to decrease and the money supply to contract. The result of the Fed’s sell of securities is called the multiple deposit contraction. The transaction is very similar to multiple deposit expansion, except all the numbers are negative.

As you can see, the Fed can control the monetary base very easily, but has less control over the money supply. For instance, a change in the public’s behavior can have an impact on

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bank reserves. For example, you went to your bank to withdraw $200. The transaction is listed below:

Your Bank

Assets Liabilities

Required Reserves $1,000 - $200 Excess Reserves $0

Loan $9,000

Deposits $10,000 -$200

The bank pays you $200 out of required reserves. The bank does not have any excess

reserves, because it loaned the excess reserves out. Your deposit is now $9,800 and the bank is required to hold $980 in required reserves. However, it only has $800, so the bank is short $180. The bank has to call in loans. When the bank calls in loans, this causes other banks to lose deposits, so the money supply decreases by:

0.10

1$180- $1,800- ×=

Your $200 is not included, because you converted $200 from a checkable deposit into

currency. Remember the M1 definition of money, which is listed below: The starting point is the $180.

M1 = checkable deposits + currency

14.3. Money Supply Multipliers

People desiring to hold more currency and fewer deposits can cause bank reserves to decrease, contracting the money supply. Thus, the public determines how much currency to hold relative to bank deposits. Economists examine the proportion of cash (C) to checkable deposits (D) as the currency-deposit ratio (C/D). This ratio changes over time and four factors affect this ratio:

1. Higher wealth causes the currency-deposit ratio to decrease. When a country becomes

wealthier, people have higher income. Holding large amounts of currency is risky, so people tend to deposit their money into banks.

2. Higher interest rates cause the currency-deposit ratio to decrease. Bank deposits pay interest rates, while currency does not. When interest rates increase, people will tend to deposit more money into banks to earn the higher interest rate.

3. Risk causes the currency-deposit ratio to increase. During a bank panic, people convert their deposits into currency. This has a detrimental effect on an economy. When depositors convert deposits into currency, bank reserves decrease, causing the money supply to decrease. A contracting money supply can cause a recession.

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4. Underground activities cause the currency-deposit ratio to increase. People participating in these activities do not want the government to know about it, so they tend to deal exclusively with currency. Bank accounts leave transaction records. The currency-deposit ratio will increase, if people avoid paying taxes or participate in other illegal activities.

What if the Fed bought a T-bill from you for $10,000 and you took the Fed check to a bank and wanted the money in cash. In this case, total bank reserves do not change, but currency in circulation increases by $10,000 and the monetary base still increases by $10,000. The effect of an open-market purchase on the monetary base is always the same, whether the proceeds from the sale are kept in deposits or currency. When the Fed sells U.S. government securities, it decreases the monetary base by the amount of government securities sold. The Fed can effectively control the monetary base.

The money multiplier is the ratio that relates the change in the money supply to a given change in the monetary base. The notation is:

• M1 is the money supply definition 1

• m is the money multiplier

• B is the monetary base

The money supply is: BmM ×=1

The M1 definition of the money supply and the monetary are:

M1 = C + D and B = C + R,

where C is currency, D is deposits, and R is bank reserves.

Here is a clever substitution. Start with the equation below. As you can see, the monetary base cancels out and M1 = M1.

BB

MM ×

=1

1

Now substitute M1 = C + D and B = C + R into the equation. Only substitute these

equations into the variables that are in the brackets.

BRC

DCM ×

++

=1

The term in brackets is the money multiplier. Divide both the numerator and

denominator of this fraction by D. The result is:

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B

DR

DC

DC

M ×

+

+=

11

The currency-deposit ratio and reserve-deposit ratio are fixed. The notation is:

• D

C is the currency-deposit ratio

• D

R is total reserves-deposits ratio

If the currency in circulation equals $240 billion, checkable deposits equal $600 billion, and total bank reserves equal $60 billion, then substitute these numbers into the currency-deposit ratio and total reserves-deposit ratio, yielding:

40.0600$

240$ ==B

BD

C

10.0600$

60$ ==B

BD

R

Substitute the currency-deposit and reserve-deposit ratios into the money supply equation,

yielding:

BM

BM

8.21

1.04.0

0.14.01

=

×

++

=

The money multiplier equals 2.8. If the Fed buys $100,000 in T-bills, the monetary base

increases by $100,000 and the M1 money supply increases by $280,000. This multiplier assumes that banks lend out their excess reserves.

The banks can weaken the ratio between the monetary base and money supply. For example, if the Fed increased the monetary base by buying $100,000 in T-bills and the banks end up holding this change in excess reserves, then the money supply increases only by $100,000. The banks do not lend out any reserves, therefore money supply multiplier is one. This is easy to prove, because R = D if banks do not lend out excess reserves. The bank reserve to deposit ratio is one, causing the money multiplier to be one.

The money supply multiplier for M2 is derived in a similar manner. The M2 definition includes time deposits, which is denoted by T. The M2 definition and monetary base are:

M2 = C + D + T and B = C + R

Start with the following:

BB

MM ×

=2

2

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Substitute the M2 and monetary base definitions into the variables in the brackets,

yielding:

BRC

TDCM ×

+++

=2

Divide the numerator and denominator by D, yielding:

B

DR

DC

DT

DC

M ×

+

++=

12

The only new variable is the time deposit to checkable deposit ratio. The public

determines this ratio by choosing how to spread their funds among time deposits, checkable deposits, and currency.

If the currency in circulation equals $240 billion, checkable deposits equal $600 billion, total bank reserves equal $60 billion, and total time deposits equal $800 billion, then substitute these numbers into the currency-deposit ratio, reserves-deposit ratio, and time-checkable-deposit ratio, yielding:

40.0600$

240$ ==B

BD

C

10.0600$

60$ ==B

BD

R

333.1600$

800$ ==B

BD

T

Substituting this information into the M2 definition yields:

BM

BM

47.52

1.04.0

0.1333.14.02

=

×

+

++=

As you can see, the money multiplier is larger. The money multipliers for M3 and L can

be derived in a similar fashion. Of course, these multipliers would be larger. Economists can tell how sophisticated a country financial system by the money definitions and their money multipliers. If a country has all money multipliers very close together, then this country does not have sophisticated financial markets. If these multipliers diverge greatly, then this country has more sophisticated financial markets.

If the money multipliers are unstable, the Fed can have problems implementing monetary policy. The Fed can control the monetary base precisely (B), but it can only influence the money supply. The Fed can set the required reserve ratio, but the public determines the currency-

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deposit ratio and the banks determine how much excess reserves to hold. The main conclusion is the Fed cannot precisely control the money supply.


1. Know the T-account transactions in this chapter.

2. Know how to use the equations in this lesson and be able to calculate the change in the money supply when the monetary base changes.

3. What are the items on the Fed’s balance sheet? Are they assets or liabilities?

4. Using T-accounts and equations, how does the money supply change when the Fed changes its balance sheet? What is multiple deposit expansion and contraction?

5. What is the money multiplier? Who influences the money multiplier?

6. What is the currency-deposit ratio and why does it change over time?

7. Why can excess reserves be a problem for the Fed?

8. Why does the Fed have trouble controlling the money supply?

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15. Changes in the Monetary Base


• The major items on the Fed’s balance sheet.

• How the Fed clears a check between two banks.

• All the factors that influence the Fed’s balance sheet, which influence the monetary base and money supply.

• How the actions of the U.S. Treasury affect the Fed’s monetary policy.

15.1. The Fed’s Balance Sheet

Like any corporation or business, the Federal Reserve has a balance sheet. The Fed has assets, which are anything of value that is owned by the Fed. The Fed also has liabilities, which are obligations and debt the Fed owes to another party. When the Fed’s total assets are subtracted from total liabilities, then the remainder is the Fed’s net worth.

The Fed’s balance sheet information is available to the public and published in the Federal Reserve Bulletin. The Federal Reserve Bulletin is a monthly publication of the Board of Governors and also includes money supply numbers, interest rates, and other economic data. The Fed’s assets are listed below:

The Fed’s Assets:

1. Securities: The largest amount of the Fed’s assets and consists of U.S. government

securities: T-bills, T-notes, and T-bonds. When the Fed uses open market operations, it is buying and selling securities. The Fed also buys banker’s acceptances.

2. Discount Loans: The Fed loans funds to banks, helping the bank overcome short-term liquidity problems. The Fed controls the interest rate on these loans, which influence the amount of loans that banks need. The interest rate is called the discount rate.

3. Items in the Process of Collection (CIPC): These are assets that arise from the check clearing process by the Fed. More is said about this topic later.

4. Gold Certificates: When the U.S. Treasury buys gold, it issues certificates that are claims to this gold. The Fed buys these certificates and credits the U.S. Treasury account at the Fed.

5. Special Drawing Rights (SDRs): The International Monetary Fund (IMF) issues SDRs. The IMF allocates SDRs to various countries around the world. More information on SDRs are available in Chapter 19.

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6. Coins: This is U.S. Treasury currency held by the Fed.

7. Other assets: This includes assets such as foreign-exchange reserves, deposits and bonds denominated in foreign currencies, and buildings and equipment owned by the Fed.

The Fed’s Liabilities and Capital Accounts:

1. Currency Outstanding: Currency issued by the Fed in the form of Federal Reserve Notes,

i.e. U.S. money.

2. Deposits by Depository Institutions: Banks must hold required reserves in the form of vault cash and deposits at the Fed. These deposits are assets to the depository institutions, but liabilities to the Fed.

3. U.S. Treasury Deposits: When the U.S. Treasury receives tax payments, collects fees, and sells U.S. government securities, the money is deposited at commercial banks. When the U.S. Treasury pays expenditures, it transfers funds from its commercial bank accounts to its accounts at the Fed. Then the Treasury Department writes checks on its Fed account.

4. Foreign and Other Deposits: The Fed holds deposits from foreign governments, IMF, World Bank, United Nations, and U.S. government agencies such as FDIC.

5. Deferred Availability Cash Items (DACI): These are liabilities that arise from the Fed’s role in the check-clearing process. More is said about this topic later.

6. Other Federal Reserve Liabilities and Capital Accounts: This category contains whatever is left over when total assets are subtracted from total liabilities. This category is substantial and is approximately $15 billion a year. If this were a corporation, then profits and the value of outstanding stock would be around $15 billion. However, the Fed is a nonprofit organization. The Fed’s capital includes stock of the Fed, which was sold to member commercial banks. The Fed pays commercial banks 6% annual dividend on their Fed stock.

15.2. Check Clearing Process

The Fed has the authority to clear checks. The check clearing process can cause bank reserves to fluctuate through the Federal Reserve float. The Federal Reserve float is the difference between cash items in the process of collection (CIPC) and deferred availability cash items (DACI). The float is always positive and when the float changes, bank reserves change, causing the money supply to change. For example, you sent a $1,000 check to a firm in New York City to buy a computer. The computer firm will deposit the check in his bank account. His bank will present the check to the Fed so the Fed can clear the check with your bank. The Fed gives the computer firm’s bank a $1,000 asset called the DACI and the Fed must collect $1,000 from your bank, which is called the CIPC. Below is the computer firm’s bank and Fed’s T-accounts:

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The Computer Firm’s Bank Assets Liabilities

+$1,000 DACI +$1,000 Deposits


+$1,000 CIPC +$1,000 DACI

The computer firm’s bank cannot touch the asset, DACI. This asset is simply an

acknowledge that the Fed is collecting money for the computer firm’s bank. After two days, the Fed converts the DACI into bank reserves. Now the bank can loan out the reserves.

The Fed

Assets Liabilities

- $1,000 DACI +$1,000 Reserves for computer firm’s bank

The Computer Firm’s Bank Assets Liabilities

- $1,000 DACI + $1,000 Reserves at the Fed

If the Fed still has not collected $1,000 from your bank with two days, the Fed is

extending credit to the computer firm’s bank. The total reserves of the banking system increases, because no other bank has lost reserves. That $1,000 check you wrote now exists as a $1,000 in your bank account and the computer firm’s bank account. The float from your check is $1,000.

Float = CIPC - DACI = $1,000 - 0 = $1,000

The Fed collects the $1,000 from your bank. Now the float now goes to zero, and your

checking account decreases by $1,000. Your check for $1,000 no longer exists in two places. The reason why check clearing is a long-drawn out process is because if you write a check for $100 and have only $10 in your checking account, this check will not clear! That is why the Fed gets permission to lower the bank’s reserves to clear the check; instead of automatically doing it. The transaction is listed below:

The Fed

Assets Liabilities

- $1,000 CIPC - $1,000 Reserves at your bank


-$1,000 Reserves at the Fed - $1,000 Your checking account

Usually the float changes predictably at the midmonth (when people pay their bills). The

float also changes in December, because people are writing checks to buy Christmas presents or

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in April when people pay their taxes. Bad weather and transportation strikes can cause the float to increase significantly as the Fed is delayed in check collections. Changes in the float causes bank reserves to change. The Fed must off-set the float by selling or buying U.S. government securities.

15.3. Changes in the Monetary Base

When the Fed’s balance sheet changes, the monetary base also changes, causing the money supply to change. First, list the Fed’s assets, liabilities, and capital.

Total Assets: U.S. gov. securities + discount loans + gold certificates + SDRs + CIPC

Total Liabilities + capital: Currency outstanding + deposits by depository institutions + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital

Substitute the monetary base formula into liabilities, because monetary base is deposits

by depository institutions plus currency in circulation.

Total Liabilities + capital: Monetary base + U.S. Treasury deposits + Foreign and other deposits + DACI + Capital

Use the accounting identity below to relate assets, liabilities, and capital:

Total Assets = Total Liabilities + Capital Substitute total assets and total liabilities plus capital into the accounting equation. Then

solve for the monetary base. Monetary base = U.S. gov. securities + discount loans + gold certificates + SDRs + CIPC - DACI - U.S. Treasury deposits - Foreign and other deposits - Capital The equation shows how changes in the Fed’s balance sheet affects the monetary base.

When the Fed purchases an asset, the monetary base increases, causing bank reserves to increase. When banks have more reserves, they grant more loans, potentially causing the money supply to increase. The opposite can occur. If the Fed sells an asset, the monetary base, bank reserves, and money supply all decrease. When the Fed acquires a liability listed in the equation above, the monetary base decreases, bank reserves decrease, and the money supply potentially decreases. If the Fed pays off a liability, the monetary base increases, bank reserves increase, and the money supply potentially increases.

As you can see, many things can alter the Fed’s balance sheet and the Fed cannot control most of them. For example, the Fed has no control over the Treasury deposits, the float (CIPC - DACI), gold certificates, SDRs, and foreign government deposits. These items can change and the Fed has to do a balancing act to keep the monetary base stable.

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15.4. Does U.S. Treasury Affect the Monetary Base?

Over the last 30 years, the federal government has been running budget deficits. The U.S. government spends more than what it collects in taxes. The U.S. government can finance the budget deficit in three ways. First, the U.S. government can decrease its spending. Second, the U.S. government can raise taxes. Finally, the U.S. can sell U.S. government securities. Can the U.S. federal government affect the monetary base?

For example, the U.S. government increases taxes, so now you are paying a total of $2,000. You send the U.S. government a check for $2,000. Below are the T-accounts for you, your bank, the Fed, and U.S. Treasury Department.

You

Assets Liabilities

- $2,000 Deposit - $2,000 Taxes due


- $2,000 Reserves - $2,000 Deposits


- $2,000 Reserves +$2,000 U.S. Treasury deposits

The U.S. Treasury Department

Assets Liabilities

- $2,000 Taxes due + $2,000 Deposits at the Fed

Now the U.S. Treasury spends your $2,000 to buy more paper for a government agency.

The $2,000 goes to a company and the company deposits the funds into the company’s bank account. Even though you paid higher taxes, your money is returned to the economy. When the government raises taxes, there is no impact on the monetary base and money supply.

For this next example, let the U.S. Treasury finance a budget deficit by selling T-bills. You decided to buy a $20,000 T-bill. Below are the T-accounts for you, your bank, the Fed, and U.S. Treasury.

You

Assets Liabilities

- $20,000 Deposit + $20,000 T - bill

Your Bank

Assets Liabilities

- $20,000 Reserves - $20,000 Deposits

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- $20,000 Reserves +$20,000 U.S. Treasury deposits

The U.S. Treasury Department

Assets Liabilities

+ $20,000 Deposits at the Fed + $20,000 U.S. T-bill

Now the U.S. Treasury has your $20,000 and will buy something with it. When the

Treasury pays a bill, the $20,000 is paid to a company and the company will deposit the $20,000 into its bank account. The $20,000 is returned to the economy and the change in bank reserves will be zero. When the U.S. Treasury issues new securities, the new securities have no affect on the monetary base and money supply.

If the U.S. Treasury sold government securities directly to the Fed, then the Fed is financing budget deficits, which is called monetizing the debt. The media calls this strategy “printing money.” The Fed is not required to buy U.S. government securities and is not required to help the U.S. Treasury finance budget deficits. The Fed and U.S. Treasury are independent. However, the Fed can finance budget deficits indirectly. If the Fed wants to stabilize interest rates, then the Fed may end up monetizing the debt. For example, when the U.S. Treasury issues new securities, the market price of the securities decrease, causing the interest rate to increase. If the Fed wants the original interest rate, the Fed has to buy U.S. government securities to decrease the interest rates.

In many developing countries, the central banks and finance ministries are not independent. The central bank is required to help finance budget deficits. When central banks monetize the debt, it always leads to inflation. Many developing countries have high inflation rates.


1. What are the Fed’s assets, liabilities, and capital?

2. How does the Fed clear a check between two banks?

3. What are the factors that influence the reserve float?

4. When the Fed acquires new assets or new liabilities, how does this affect the monetary base and money supply?

5. What are the assets and liabilities that the Fed has no control over?

6. If the U.S. Treasury changes the taxes or changes its borrowing behavior, how does this affect the monetary base and money supply?

7. How can the Fed monetize the U.S. debt, when the Fed and the U.S. Treasury Department are independent?

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16. Organization of Central Banks


• How the Federal Reserve System is organized.

• The Board of Governors.

• The Federal Open Market Committee.

• Why it is important for a central bank to be independent of its government.

16.1. Why the U.S. Government Created Federal Reserve System

The United States was a late comer to the world in the creation of its cental bank. The U.S. government permanently established a central bank in 1913 and named it the Federal Reserve System. Most European countries started central banks in the 17, 18, and 19th centuries. Congress, government officials, and the public did not want to create a powerful financial institution, so the U.S. government created the Federal Reserve System to have many checks and balances.

The Federal Reserve System is composed of 12 Federal Reserve banks. The United States is broken down into 12 regions and each region has a Federal Reserve Bank. The reason is that each section of the country is economically different. For example, Michigan originally manufactured all U.S. cars, while Texas and Oklahoma supplied oil and natural gas. Therefore, a Federal Reserve Bank can provide services to its unique region. Originally, each Federal Reserve Bank was to provide the following functions:

• Perform check clearing.

• Regulate member commercial banks.

• Manage currency.

• Prevent financial panics by being a source of liquidity (i.e. loans) for banks during financial crises.

• Collect and publish data for the public.

One of the most important reasons for the creation of the Federal Reserve System is to prevent financial panics. A Federal Reserve Bank is a “lender of the last resort.” A bank having financial trouble can temporarily borrow from the Fed. For example, a bank needs money, so the bank gives a $10,000 T-bill to the Fed as collateral. The Fed increases the bank’s reserves by $9,000 (i.e. the loan). The difference is called the discount, which reflects the interest rate that

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the Fed charges for the loan. This interest rate is called the discount rate. The government did not create the Fed to alter the money supply, manipulate interest and currency exchange rates, or manipulate the financial markets to achieve economic goals. The Fed learned to do this during the 1920s.

16.2. Structure of the Federal Reserve System

The unique feature of a Federal Reserve Bank is each bank is a federally chartered corporation. Each bank has stockholders, directors, and a president. Every national commercial bank has to purchase stock of the Federal Reserve Bank in its district, which is equal to 6% of the commercial bank’s net equity (capital). The national commercial banks are banks that have a carter from the U.S. government. These national banks are also called member banks and the banks earn dividends on their shares of stock of the Fed bank.

Each Federal Reserve Bank has 9 directors. The member commercial banks elect 6 directors, which 3 directors are bankers and the other 3 are from business. The Board of Governors, which holds most of the power at the Fed, appoints the last 3 directors. In turn, the 9 directors elect the president of the Fed district bank. Of course, this is not a free election. The Board of Governors has to approve the bank president.

Even though the Fed district banks are privately owned, the commercial banks have no control over the Fed banks. A Fed bank is not like a corporation where the stockholders can freely elect the board of directors and vote on major corporate policies. The reason the Fed has this odd structure was that Congress did not want the Fed to be part of government or controlled by the banks, but somewhere in between. Currently, the Fed is a part of government or quasi-government.

The Board of Governors is the entity that controls the Federal Reserve System. The Board of Governors determines monetary policy, reserve requirements, and discount policy. Originally, the Fed was decentralized and the power was dispersed among the 12 Fed banks. The board consists of 7 members, who serve a 14-year term. A U.S. president appoints the members. A U.S. President also appoints the chairperson and vice-chairperson of the board. The Comptroller of the Currency and Secretary of the Treasury cannot be members of the board, because if the government is running up a massive debt and the Treasury is unable to increase taxes or borrow, you do not want the Treasury to “print money” to cover deficits. “Printing money” leads to inflation.

The Board of Governors is independent of the U.S. federal government in three ways. First, the Board of Governors gets its revenue from the 12 district banks. The Fed does not have to go to Congress for money. (Whoever controls the money is directly or indirectly in charge). Second, the terms of the governors are staggered. Every two years, the U.S. President appoints one director to the Board of Governors (7 - members, 14 years). This prevents a President coming into office and appointing all members at once, so the members would be loyal to the President. Third, the government cannot completely audit the Fed. (The less government knows, the less it can tamper with things.) Please do not think the Fed is completely independent! If the Federal Reserve angers Congress too much, Congress can rewrite the laws that created the Fed.

The Federal Open Market Committee (FOMC) makes decisions concerning open-market operations. After a decision is made, a directive is sent to the manager at the New York City Federal Reserve bank to actually buy and sell U.S. government securities. The FOMC consists of the Board of Governors, plus 5 Fed district bank presidents. The chairperson of the Board of Governors is also chairperson of the FOMC. This person is a powerful man. This

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person can advise the President, informs Congress of the Fed’s actions, and spokesperson of the whole Federal Reserve System. When he speaks, the financial markets listen. Currently the chairperson is Ben Bernanke and he is considered the second most power man in the United States right next to the U.S. president.

The president of the Federal Reserve Bank of New York City is a permanent member of the FOMC and always the FOMC vice-chairperson. The reason is New York City is the financial center of the U.S. and the Fed buys and sells government securities through the New York Fed Bank. The four other positions for the FOMC are rotated among the other 11 Fed district bank presidents. Moreover, the Fed buys securities from the secondary markets. It buys existing U.S. government securities. If the Fed bought securities directly from the primary market, then it would be too close to the Treasury. The Treasury issues new securities in the primary market.

16.3. Is the Federal Reserve Independent of the U.S. Government?

Does the Fed serve the public interest or does it act by its own self interest? The first view is called the public interest view. The public interest view states the Fed serves the public interest by implementing monetary policy that causes stable prices, low unemployment, and economic growth. Many economists argue that the Fed does not serve the public interest, because it has not emphasized price stability and growth.

The second view is called the principal-agent view. This view is that government bureaucracies do not serve the purpose that they were created for. They are only concerned about maximizing their power, influence, and prestige. For example, a new computer corporation is created. If the new corporation creates new computers for a low price that consumers want, then the corporation earns profits. However, if the corporation builds computers that nobody wants, then the corporation will eventually bankrupt. The role of profits ensures businesses to produce goods and services that consumers want. Government agencies are not governed by profits. No mechanism keeps a government agency in check. Every year, government agencies receive more funding, regardless of the agencies’ performance. Over time, bureaucrats become more concerned with funding, job security, and prestige, instead of following its original function. That is why the public poorly rates government agencies customer satisfaction.

The Fed is independent of the U.S. Treasury Office, even though many Presidents have tried to influence it. However, a government budget deficit can lead to money creation. If the Fed want to keep interest rates stable and the U.S. government has a budget deficit, the U.S. Treasury department can finance the deficit by issuing T-bills. However, the increase of supply of T-bills causes the market price of T-bills to decrease, which causes interest rates to increase. If the Fed wants the original interest rate, it has to buy the T-bills that the Treasury issued. This causes bank reserves to increase, and the money supply increases too. Then, increases in the money supply leads to inflation.

Foreign countries differ in how independent their central banks are. For example, Germany and Switzerland have the most independent central banks in the worlds. These countries also have some of the lowest inflation rates in the world. Central banks in New Zealand, Italy, and Spain have less independent central banks and these countries experienced significantly higher inflation rates.


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1. What is the structure of the Federal Reserve System? How many Fed district banks are

there, and who owns the Fed stock?

2. What is the Board of Governors? Who appoints a person to this board?

3. What are the factors that cause the Fed to be independent from the U.S. federal government?

4. What is the Federal Open Market Committee? Who appoints a person to this board?

5. Why is the chairman of the Board of Directors such a powerful person?

6. What is the difference between the public interest view and principal-agent view?

7. Why is the degree of independence between the central bank and its government so important?

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17. Monetary Policy Tools


• The benefits in using open market operations as a monetary policy tool.

• The costs and benefits in using discount policy as a monetary policy tool.

• The costs and benefits in using reserve requirements as a monetary policy tool.

• Why the Fed can only concentrate on either the money supply or short-term interest rates, but not both at the same time.

• Why financial analysts and the public scrutinize the federal funds market.

This chapter introduces the Federal Reserve’s three most important tools for conducting

monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements. Many people especially in the financial markets scrutinize the Fed’s actions in order to determine monetary policy. The people are trying to determine how interest rates will change, which in turn affect the prices in the financial markets. The process of watching the Fed in order to determine monetary policy is called Fed watching.

17.1. Expanding and Contracting the Money Supply

The most important tool of the Fed is the Open Market Operations, which is the Fed’s purchase and sale of U.S. government securities. Open market operations have the same effect if the Fed purchased any short-term, highly liquid securities. However, the Fed usually buys and sells highly liquid U.S. government securities. Open market operations have an impact on the money supply and interest rates.

The Fed can use two monetary policies. The first is called expansionary monetary policy, where this policy increases the money supply and lowers short-term interest rates. The second policy is called contractionary monetary policy, where this policy reduces the money supply and increases short-term interest rates.

The Fed wants to increase the money supply, which is expansionary monetary policy. The Fed buys T-bills. The T-bill market is shown in Figure 17.1. The original market price and quantity for T-bills are P* and Q*. The Fed purchases T-bills, causing the demand for T-bills to increase and shift right. Both the market price and quantity of T-bills increases. Using the present value formula, the market interest rate for T-bills decreases. The Fed pays for a T-bills with its check. When the check is deposited into banking system, bank reserves increase. When bank reserves increase, the money supply increases.

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T-bill Market

Figure 17.1. Fed increases money supply by purchasing T-bills

The important thing to notice is open market operations affect the interest rate. The T-

bill is a short-term credit instrument. When the Fed conducts open-market operations for T-bills, the T-bill price increases and T-bill interest rate decreases. This causes changes in other short-term interest rates, such as the federal funds rate and the interest rates on commercial paper and banker’s acceptances. Therefore, short-term interest rates of all short-term credit instruments will rise and fall together.

The contractionary monetary policy works the same way as expansionary monetary policy. The T-bill market is shown in Figure 17.2 The market price and quantity for T-bills are P* and Q*. The Fed sells T-bills, causing the supply of T-bills to increase. The supply curve for T-bills shifts right. The market price of T-bills decreases and the market interest rate for T-bills increases, when using the present value formula. All other short-term interest rates increase, such as the federal funds rate. Bank reserves decrease, causing the money supply to decrease.

T-bill Market

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Figure 17.2. Fed decreases the money supply by selling T-bills

The Fed can only control the growth rate of the money supply or short-term interest rates.

The Fed cannot control both at the same time. For example, the Fed wants to increase the M1 money supply by 3%. The Fed keeps buying T-bills until the M1 money supply increases by 3%. However, short-term interest rates become lower. The Fed cannot prevent the lower interest rates, because it is focusing on the money supply. What if the Fed wants to influence short-term interest rates? Currently the interest rate is 4%, but the Fed wants a 6% short-term interest rate. In this case, the Fed sells T-bills, causing the market price of T-bills to decrease and interest rates to increase. The Fed keeps selling T-bills until the interest rate is 6%. However, this transaction causes bank reserves and the money supply to decrease. The Fed has no control over the money supply, because it is focusing on the interest rates. Thus, the Fed can control short-term interest rates or the money supply, but not both at the same time.

17.2. Federal Open Market Committee

The Federal Open Market Committee meets eight times per year and issues a general directive. A general directive states the objective for the monetary aggregates and interest rates. The Federal Reserve Bank of New York has the responsibility to carry out the general directive. The Fed Bank of New York deals with about 40 dealers who specialize in U.S. government securities (i.e. secondary market). The New York Fed is electronically connected to the dealers. When the Fed is ready to buy or sell government securities, the Fed will ask these dealers to make an offer. The Fed buys or sells to the dealers with the best offer. The department at the Fed that buys and sells government securities is referred to as the Open Market Trading Desk.

The Fed uses two types of methods to buy and sell U.S. government securities. The first method is outright purchases and sales. When the Fed sells or buys a security, the transaction is permanent. The dealer who bought the security has no obligation in the future to sell the security back to the Fed or vice-versa. The second method is the Federal Reserve repurchase agreement (REPO). The Fed buys securities from a dealer and the dealer agrees to repurchase the securities for a specific price and on a specific date in the future. This is very similar to a bank repurchase agreement. Usually, the dealer buys the government security back within 15 days. The REPO provides temporary reserves in the banking system. For example, at Christmas time, there are enormous currency drains from the financial institutions as people withdraw money to buy presents. The Fed then uses a REPO to inject reserves in the banking system to offset the currency drain. When Christmas is over and the currency returns to the financial institutions, the REPO expires, and the temporary reserves are removed from the banking system, when the dealer buys back REPO.

The Fed can also do the opposite of a REPO, which is called the Reverse REPO (matched sale-purchase transactions). The Fed sells securities to the dealers and the dealers sells them back to the Fed for a specific price and on a specific data in the future. The reserve REPO temporarily lowers excess reserves in the banking system.

When the trading desk at the Fed conducts monetary action, the trading desk uses two types of transactions. The first is called dynamic transactions. This type of transaction is intended to carry out monetary policy as specified in the general directive. The second type of transaction is a defensive transaction. The Fed uses open market operations to offset fluctuations in bank reserves. Defensive transactions are used more than dynamic transactions.

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For example, bank reserves decrease when people withdraw money from their accounts to buy presents at Christmas or when people pay their taxes in April. Further, natural disasters and employee strikes can delay the delivery of the mail. Thus, a mail delay slows down the Fed’s check clearing process. The float increases, causing bank reserves to increase. The Fed uses defensive transaction to offset temporary fluctuations in bank reserves.

The open market operations are the most popular tool the Fed uses. First, the Fed can completely control how many securities that it wants to buy or sell. Second, open market operations are very flexible. The Fed can influence bank reserves by a little amount by buying a small amount of U.S. government securities, or by a large amount by buying lots of securities. Third, if the FED made a mistake by buying too many U.S. government securities, then it can turn around and sell them to counteract this. Finally, open market operations can be implemented quickly.

Many people who watch the Fed read the directives issued to the open market trading desk. However, these directives are vague and are not precise. The reason is the principal-agent problem. If the directives are vague, then the outcome does not matter. The Fed can deem any outcome as a success, making the Fed unaccountable for errors. Many European central banks including the European Central Bank use open market operations very similar to the United States. Some countries have a small market for government securities, such as Japan. The Japanese central bank relies on interest rate controls to control the money supply.

17.3. Discount Policy

The second monetary tool the Fed uses is discount policy. The Fed can make loans to financial institutions. For example, a bank is experiencing financial problems and needs reserves. The bank sells a $10,000 T-bill to the Fed. The Fed increases bank’s reserves by $9,000. The difference is called the discount. The T-bill acts as the collateral of the loan. Eventually the bank buys the T-bill back from the Fed for $10,000. The $1,000 difference reflects the interest rate the Fed charges for the loan, called the discount rate. Traditionally, the Fed only lends money to banks that were members of the Federal Reserve System. Now days, any bank in the U.S. can borrow from the Fed and the Fed may not require any collateral for the loan.

Each Fed district bank provides loans, known as the “discount window.” The Fed can use discount policy to influence the money supply and interest rates. The Federal Funds Market is shown in Figure 17.3. The demand function is the banks’ demand for federal funds. These banks borrow funds to ensure they are holding enough reserves to meet depositors’ withdrawals or satisfy the Fed’s reserve requirements. The demand curve is downward sloping, because banks borrow more funds, if the interest rate decreases (i.e. the loans are cheaper). The supply function is the banks’ supply of federal funds to the market, because these banks are holding excess reserves. These banks temporarily lend out excess reserves, so they can earn interest income. The supply function is upward sloping, because banks lend more funds, if the interest rate is higher (i.e. they earn higher profits). The point where the demand and supply curves intersect is the equilibrium interest rate ( i* ) and amount of reserves ( R* ). The reserves are banks lending among themselves.

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Federal Funds Market

Figure 17.3. Fed uses the discount rate to increase money supply

The Fed decides to use expansionary monetary policy by using the discount rate. The

Fed decreases the discount rate. Banks can borrow more cheaply from the Fed, causing the amount of discount loans to increase. The discount loans are injecting more reserves into the banking system. Banks have more reserves, so the supply function in the federal funds market shifts to the right and increases. The interest rate for federal funds decreases and both the monetary base and money supply increase.

The contractionary monetary policy works the same way as expansionary monetary policy. The Federal Funds Market is shown in Figure 17.4. The market interest rate is i* and the reserves are R*. The Fed raises the discount rate. Banks borrow less from the Fed, because loans have higher interest rates. Thus, banks have fewer reserves and reserves are removed from the banking system. The supply decreases in the federal funds market and shifts left, causing the interest rate to increase and the monetary base and money supply to decrease.

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Federal Funds Rate

Figure 17.4. Fed uses discount rate to decrease money supply

The Fed makes three types of loans. The first is an adjustment credit. These are short-

term loans to help banks that are having short-term liquidity problems. The second type is called seasonal credit. These loans help small banks that are located in areas where agriculture or tourism is important. The Fed will make extended loans called extended credit. A large bank is on the verge of bankruptcy and has severe liquidity problems. The Fed loans to this bank, preventing a bank failure. The Fed along with FDIC will help restore the financial health of the bank. For example, Continental Illinois Bank failed during the 1970s. This bank was the 8th largest bank and failed because of too many bad loans. The FDIC purchased 80% of the bank’s stock and elected new management. In essence, the U.S. government nationalized the bank, because the bank was too big to fail. The Fed provided loans around $3.5 billion to FDIC

The discount window has potential for abuse. For example, a bank could borrow funds from the Fed at 5% and loan these funds out at 6%, earning 1% interest on these loans. The Fed counters this problem by investigating and auditing the bank more, making sure the bank is complying with regulations. The Fed can also impose fines or publicly criticize the bank. A bank borrowing from the Fed may indicate financial weakness. Finally, the Fed may stop lending to the bank, because borrowing from the Fed is a privilege and not a right! Many economists argue that the Fed should set the discount rate higher than short-term interest rates. That way, borrowing from the Fed is always a penalty, because a bank borrows with a higher interest rate than the market.

The use of discount policy has many benefits. The first is the Fed is the “Lender of the last resort.” If a bank has trouble with liquidity or needs reserves, the Fed is the last place to go (if the bank could not find another lender). The second benefit is the announcement effect. When the Fed unexpectedly changes the discount rate, this change provides information to the financial markets, because monetary policy is conducted secretly. For example, the Fed causes the discount rate to rise. The press, politicians, and financial analyst think the Fed is following a tight monetary policy, i.e. contracting the money supply. The third benefit is moral suasion. The Fed uses its power to persuade depository institutions to do what the Fed wants. Remember, to borrow from the Fed is a privilege, and not a right. If a bank needs a loan from the Fed and the bank did not do what the Fed wanted, then the bank might not get the loan! The last benefit of

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discount policy is preventing financial crisis. The Fed lends to large banks, preventing them from bankrupting and even extended credit to financial institutions during the stock market crash in 1987.

Discount policy is not a good tool to control the money supply. If the Fed wants to increase the money supply, the Fed has to grant more discount loans to banks. What if the banks do not want these loans? In this case, discount policy fails to increase the money supply.

The public and financial analysts scrutinize the federal funds market to predict monetary policy. Banks electronically transfer deposits through the Fedwire. When the Fed implements monetary policy, it has an immediate impact on the federal funds rate. When the public and financial analysts see the federal funds interest rate decrease, they infer that the Fed is using expansionary policy. If the federal funds rate increases, the public believes the Fed is using contractionary monetary policy. As you know from this chapter, the Fed cannot control the federal funds rate, but can only influence it.

17.4. Reserve Requirements

The last monetary tool the Fed uses is reserve requirements. Reserve requirements are the ratio of reserves to deposits that banks must hold to satisfy depositors’ withdrawals. The reserves could be vault cash or deposits at the Fed. The Fed has the power to set reserve requirements for banks within the limits set by Congress. The Fed rarely changes the reserve requirements, because changes in the reserve requirements have a significant and disruptive impact on the banking system. Currently, the reserve requirement for checking accounts is 3% for the first $47.8 million and 10% for checking accounts exceeding $47.8 million. Eurodollar accounts and nonpersonal time deposits have no reserve requirements.

The Fed can use reserve requirements to alter the money supply. If the Fed believes banks are holding too much excess reserves, then this may cause too much inflation in the future. When banks start lending their excess reserves out as loans, these loans come back as deposits, which increases the money supply and you have the multiple deposit expansion. The Fed can increase the reserve requirement ratio, which causes some excess reserves to be switched to required reserves.

The money multiplier (1 / rr ) changes, when the Fed changes the reserve requirement. For example, let the required reserve ratio be 10%. If the Fed buys a $10,000 T-bill using a Fed check, the money supply can potentially increase by $100,000 ( = $10,000 / 0.10). What if the Fed lowered the required reserve ratio to 5%? If the Fed buys a $10,000 T-bill, the money supply can potentially increase to $200,000 ( = $10,000 / 0.05). Therefore, the Fed rarely changes the reserve requirement ratios, because this tool is too powerful! Small changes in the reserve requirement could have enormous impact on the banking system and the money supply.

Economists and policymakers believe reserve requirements are not an effective monetary policy tool. The reasons are:

1. Changing reserve requirements may be too powerful. Small changes in reserve

requirements have a large impact on the money supply.

2. Required reserves impose a cost to the banks. Banks are not able to lend these reserves to borrowers, and therefore, do not earn interest income on required reserves. Instead, the reserves sit in a vault as cash or as deposits at the Fed.

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3. The purpose of reserve requirements is to make deposits safer and have a more stable banking system. However, if the majority of the depositors came to their bank to withdraw their deposits, the bank would still fail. The bank is holding less than 10% of the deposits as vault cash and/or deposits at the Fed. Thus, reserve requirements will not prevent bank runs and will not stabilize the banking system. Only deposit insurance prevents bank runs.

4. The reserve requirement ratios are components of the money multiplier. The money multiplier and reserve requirements need to be stable for the Fed to effective control the money supply. No empirical evidence indicates that reserve requirements improve the stability of the money multiplier. Also, banks would still hold reserves in order to meet depositors’ withdrawals, if a central bank did not impose reserve requirements.

Milton Friedman, a Nobel laureate, suggested that banks should have a 100% reserve requirement. The banks would hold all deposits as deposits at the Fed and/or vault cash. The banking system would not have multiple deposit expansion and the money multiplier would be one. For example, if the Fed bought a $10,000 T-bill, the monetary base and the money supply would both increase by exactly $10,000.

A 100% reserve requirement would give the Fed better control of the money supply. Banks would hold all deposits as reserves, so they could meet depositor’s withdrawals. Moreover, the U.S. government could eliminated federal deposit insurance and substantially reduce bank regulations. However, this idea has one problem. Banks could not grant loans under this system, causing the financial intermediation process to break down. Banks link savers to the investors. Thus, the whole economy would need restructuring.


1. How do open market operations affect the short-term interest rates, bond prices, bank reserves, and money supply?

2. Why can the Fed only concentrate either the growth rate of the money supply or short-term interest rates, but not both?

3. What are REPOS and reverse REPOS? What is their purpose?

4. What is the difference between dynamic and defensive transactions?

5. Why is open market operations such a good monetary tool?

6. When the Fed changes the discount rate, how does this affect the short-term interest rates, bank reserves, and the money supply?

7. What are the three types of credit-loans that banks can receive from the Fed?

8. How does the Fed prevent banks from abusing their privilege in receiving Fed loans?

9. What is the problem in using discount policy as a monetary tool?

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10. Why are reserve requirements such a powerful monetary tool?

11. What are the costs and benefits by having a 100% reserve requirement for banks.

12. Why do the financial analysts and the public scrutinize the federal funds market?

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18. The Conduct of Monetary Policy


• The Fed’s six monetary policy goals.

• How time lags complicate monetary policy.

• How the Fed chooses targets in order to reduce the problem with time lags.

• How the Fed’s monetary policy may cause the economy to become more unstable.

18.1. Monetary Policy Goals

The goal of monetary policy is to increase the well-being of society. The well-being is measured in terms of the quantity and quality of goods and services that people consume. The Fed has six monetary policy goals: Price stability, high employment, economic growth, financial market & institution stability, interest rate stability, and foreign-exchange rate stability.

The first monetary policy goal is price stability. Product prices are very important, because they communicate information to households and businesses. Households determine how much goods to buy, while businesses determine how much goods to produce. Inflation is a persistent increase in prices of goods and services and inflation erodes the value of money. The higher the inflation rate becomes, the more variable it becomes. This variability causes uncertainty for businesses, consumers, workers, which can lead to adverse effects on decisions and lead to lower economic activity. If the inflation rate becomes too high, then money’s functions of a “store of value” and “medium of exchange” breaks down.

The second monetary policy goal is high employment. The Fed and Federal government try to lower unemployment as much as possible, because high unemployment causes human misery. Workers are idle, and factory space and equipment are underutilized. When a society does not use all its resources, then the economy’s GDP will grow at a slow rate or even decrease. The government cannot lower the unemployment rate to zero. Unemployment results from workers who quit their jobs and look for new ones and students who graduate and enter the labor market. The Fed tries to lower the unemployment rate to the natural rate of unemployment. Currently, economists estimate the natural rate of unemployment to be approximately 6% for the United States. If the Fed strives for an unemployment rate less than 6%, then the Fed’s policy results in inflation.

The third monetary policy goal is economic growth. When the economy is growing, real GDP is increasing, indicating that society is producing more goods and services. A high real GDP growth rate causes the unemployment rate to decrease and businesses earn profits. Moreover, businesses increase investment, causing more goods and services to be produce. Another important benefit when real GDP is strongly growing is income increases for businesses and households. When businesses and households have higher incomes, the local, state, and federal governments collect more tax revenue. The Fed uses its monetary policy to encourage strong economic growth.

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The fourth monetary policy goal is financial market and institution stability. Financial panics, bank runs, stock market crashes, or a large financial institution bankrupts can cause a chain reaction that causes other financial institutions to bankrupt. A financial panic severs the link between savers and investors. Businesses will not receive loans they need to invest and customers will not receive loans to buy homes, cars, and other assets. If the financial market and institutions break down, then the economy could enter into a recession, causing high unemployment and slow or negative GDP growth rates. The Fed stabilizes the financial system by being a “lender of the last resort” to prevent financial panics.

The fifth monetary policy goal is interest rate stability. The Fed stabilizes the interest rates, because fluctuations in interest rates can create uncertainty in the economy and makes it more difficult to plan for the future. Businesses will be uncertain about investing in new buildings, machines, and equipment. Consumers will be uncertain about long-term investments, such as buying a house or car. Interest rate stability relates to the stability of the financial markets. Large swings in interest rates can cause large capital gains and losses in the financial markets. Some investors will earn profits, while others earn losses.

The last monetary policy goal is foreign-exchange market stability. The Fed tries to stabilize the value of the U.S. dollar to other major currencies, such as the Japanese Yen and German Deutsche Mark. A strong U.S. dollar causes products made in the United States to be more expensive to foreigners while foreign made products become cheaper to U.S. citizens. Consumers will buy the cheaper foreign products, causing imports to rise, while U.S. businesses sell less products abroad, causing exports to decrease. If the U.S. dollar becomes weaker, you get the exact opposite effect. The products made in the U.S. become cheaper to foreigners, while foreign made goods become more expensive. U.S. exports increase while import decrease.

Some of these goals conflict with each other. For example, if the FED pursues monetary policy that expands the money supply to cause national output to increase and unemployment to decrease. This monetary policy can cause higher inflation and the nominal interest rates increase,

because of the higher expectations of inflation (i = r + πe).

18.2. Time Lags

The Fed cannot influence the monetary policy goals directly. The Fed uses its tools, open market operations, discount rates, and reserve requirements, to influence indirectly the monetary policy goals. However, two time lags occur, which makes implementing monetary policy very difficult. The first time lag is the information lag. For the Fed or government to do anything, it needs data and information. It needs fast data, but some data like the unemployment rate and GDP data takes months to collect. The economy could be in a recession, but the recession does not show up in the statistics for several months. The second time lag is the impact lag. Impact lag is a time delay when the Fed implements policy and has an impact on the economy.

These time lags can cause problems. For example, if the information lag is 6 months and the impact lag is 1 year, then the Fed’s policy takes 1½ years to influence the economy. What happens if the economy entered a recession, the recession lasted only 1 year, and then the economy naturally returns to the full employment level? If the Fed’s tried to counteract this recession, then the Fed’s intervention may make the economy more unstable. The economy is at the full employment level and the Fed’s policy “kicks in,” potentially creating inflation.

The Fed uses two targets to reduce the problems with time lags. The first target is intermediate targets. The intermediate targets are the M1, M2, and M3 definitions of the money supply and short-term interest rates. The Fed uses its tools to influence the intermediate targets.

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These intermediate targets directly affect the price level, unemployment rate, economic growth rate, etc. The Fed has more control over the intermediate targets and the time lags are shorter. The second target is operating targets. The Fed has even more control over operating targets than intermediate targets. Operating targets are the federal funds rate and nonborrowed reserves. The federal funds rate is the interest rate that banks charge for lending their excess reserves to other banks. When the Fed uses open markets operations, change discount policy, or change reserve requirement, then the Fed’s monetary policy has an immediate impact on the federal funds rate and nonborrowed reserves. When the Fed implements monetary policy, such as a higher GDP growth rate, the Fed’s policy immediately affects the operating targets. The operating targets in turn influence the intermediate targets, and the intermediate targets influence the policy goals, such as higher GDP growth rate. The Fed monitors changes in the intermediate and operating targets and determine if the monetary policy is having the correct affect.

The Fed has three criteria for selecting intermediate targets. The first criterion is measurability. The Fed must easily measure the intermediate target in order to overcome information lags. The second criterion is controllability. The Fed has to sufficiently control the intermediate target to overcome the impact lag. For example, the Fed can influence the money supply, but not the GDP growth rate. Many factors influence the GDP growth rate and the Fed cannot influence all of them. Thus, Fed would never select GDP as an intermediate target. The last criterion is predictability. The Fed needs to have intermediate targets that have a predictable impact on the policy goals. For example, if the Fed influences the M1 definition of the money supply, M1 sometimes influence the unemployment rate and other times do not, then M1 would not be a good intermediate target.

Before the 1990s, the Fed switched back and forth between interest rate and money supply targets. This strategy was not successful, because the Fed’s monetary policy caused more instability in the economy. Economists refer this to procyclical monetary policy. Procyclical monetary policy is a Fed policy causes either a rapidly growing economy to grow faster and create inflation or a recession to be worse. For example, the Fed selects interest rates as its intermediate target. When an economy is growing rapidly, interest rates tend to increase. For the Fed to lower the interest rates, the Fed has to buy more U.S. government securities. The price of the securities increases, causing interest rates to decrease. However, bank reserves increase, the money supply increases, and a larger money supply can cause the economy to grow faster. If the economy entered into a recession, the interest rates tend to decrease. For the Fed to increase the interest rates, the Fed has to sell U.S. government securities. The price of the securities decreases, causing the interest rate to increase. However, bank reserves decrease, the money supply decreases, and decreasing the money supply can cause the recession to become worse. Since the 1990s, the Fed has emphasized a goal of low inflation and has been successful. Europe and Japan also emphasize price stability and low inflation rates.

Economists have suggested that the Fed use other intermediate targets. Other intermediate targets are:

1. The first is nominal GDP. If an economy produces more goods and services, then real

and nominal GDP increase. If inflation causes higher prices, then the higher prices increase nominal GDP, but have no impact on real GDP. Some economists believe the Fed cannot influence real GDP. However, the Fed can influence the inflation rate, which in turn influences the nominal GDP. If the Fed selected nominal GDP as an intermediate target, then the Fed would be focusing on price stability.

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2. Some economists suggested the Fed use the yield curve as an intermediate target. However, the Fed examines the yield curve, but the shape of the yield curve depends on expectations of inflation and real interest rates.

3. Other intermediate targets that have been suggested is commodity prices. However, commodity prices do not accurately predict inflation well.

4. The fed could use foreign-exchange rate of the U.S. dollar as an intermediate target. Exchange rates to some degree predict inflation and real GDP growth rate, but the exchange rate may be responding to changes in the interest rate. International investors invest in countries with high real interest rates.


1. What are the Fed’s six monetary policy goals? Why is each goal important?

2. What are the time lags? Why are they such a problem?

3. Why does the Fed use targets?

4. What is the difference between an operating target and an intermediate target?

5. What are the criteria for selecting intermediate targets?

6. Why is procyclical monetary policy? Why does it occur?

7. What other intermediate targets have economists suggested?

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19. The International Financial System and Monetary Policy


• Why governments intervene in the foreign-exchange markets

• The components of the balance-of-payment account for the United States.

• The three exchange rate regimes: The gold standard, Bretton Woods System, and flexible exchange rates.

• The International Monetary Fund and World Bank.

19.1. How a Central Bank Intervenes in its Currency Exchange Rate

The United States financial system is linked to the international financial markets. Investors, savers, households, businesses, and governments in foreign countries can influence the financial markets in the United States. Likewise, U.S. financial markets affect foreign financial markets. Consequently, governments intervene into the international markets as an attempt to influence their financial markets.

The Federal Reserve tries to manage the value of the U.S. dollar in the international markets. However, governments and central banks have difficulties in influencing exchange rate of their currency, because over $1 trillion in transactions occur daily in the foreign-exchange market. When a central bank tries to control the foreign-exchange rate of its currency, economists call this foreign-exchange market intervention.

The Federal Reserve and U.S. Treasury Department intervene in the foreign-exchange markets, because they want to change the exchange rate value of the U.S. dollar. Usually the Federal Reserve and Treasury coordinate their policies together. For example, the Federal Reserve holds foreign currencies, such as British pounds, German deutschmarks, and Japanese yen. The foreign currencies are an asset to the Federal Reserves and are called international reserves. The Federal Reserve can sell or purchase U.S. dollars on the international markets, which impacts the U.S. exchange rates and U.S. money supply. Table 19.1 contains the impact of a strong or weak U.S. dollar on the U.S. economy.

Figure 19.1. Impact of a Strong or Weak Dollar on the U.S. Economy

Strong U.S. Dollar Weak U.S. Dollar

Foreign-produced goods are cheaper. U.S. customers benefit. U.S. produced goods are more expensive. U.S. export businesses are hurt in foreign markets. The trade deficit worsens.

Foreign-produced goods are more expensive. U.S. customers are hurt. U.S. produced goods are cheaper in foreign markets. U.S. export businesses benefit in international markets. The trade deficit becomes smaller.

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The Fed believes the dollar is too weak and wants the dollar to be stronger (appreciate). The Fed will sell foreign currency and buy U.S. dollars. The Fed sells $10,000 in foreign currency and the transaction is recorded below:

The Fed

Assets Liabilities

- $10,000 Foreign currencies -$10,000 Currency in circulation This transaction removed $10,000 of U.S. currency out of the economy. (The Fed is

holding the U.S. dollars). The monetary base decreases by $10,000 and the money supply will also decrease. This transaction causes the money supply to contract. The Fed’s international reserves also decrease by $10,000. The Fed does not have to buy U.S. currency. Instead, the Fed could have accepted a check for the foreign currency sales. When the Fed cashes a check, the Fed would be decreasing bank reserves. The transaction is listed below:

The Fed

Assets Liabilities

-$10,000 Foreign currencies -$10,000 Bank reserves

In this case, the monetary base still decreases by $10,000 and the money supply still decreases. It makes no difference if the Fed accepts a check or cash denominated in dollars. Both these transactions have the same impact on the monetary base. If the Fed believes that the U.S. dollar is too strong, then the Fed can weaken (depreciate) the dollar by selling U.S. currency and buying foreign currencies. The Fed buys $30,000 of foreign currency and this transaction is listed below:

The Fed

Assets Liabilities

+$30,000 Foreign currencies +$30,000 Currency in circulation

The Fed’s assets increase by $30,000, causing the monetary base to increase by $30,000 and the money supply also increases. The world’s economy has $30,000 more U.S. dollars in circulation. If the Fed allows these foreign exchange transactions to change the monetary base, then this is called unsterilized foreign-exchange intervention.

The Fed can prevent the monetary base from changing, when influencing the U.S. dollar exchange rates. This is called sterilized foreign-exchange intervention. For example, the Fed believes the dollar is too strong and wants to weaken it. The Fed buys $30,000 in foreign currencies and sells $30,000 in U.S. currency. This transaction causes the monetary base to increase. However, the Fed can do an open market sell by selling $30,000 in T-bills for cash. These two transactions cause the change in the monetary base to be zero. The change in the Fed’s assets and liabilities is zero. The transaction is listed below:

The Fed

Assets Liabilities

+$30,000 Foreign currencies -$30,000 T-bills

+$30,000 Currency in circulation -$30,000 Currency in circulation

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19.2. Balance of Payments

A balance-of-payments account is a record of all transactions among the households, businesses, and government of one country to the rest of the world. Economists use balance-of-payments accounts to compare the total flow of money between one country and the rest of the world. The balance of payments is examined for the United States.

A payment by U.S. residents or government to another country is a deficit item. The number is negative, because money is leaving the United States. For example, U.S. residents are buying imported goods, sending money to relatives in foreign countries, or traveling abroad. A transaction that leads to a receipt by country’s residents or government is a surplus item. The number is positive, because money is entering the United States. For example, U.S. businesses export goods to other countries, U.S. residents receive money from foreigners, or foreigners travel in the United States.

The first account is the current account. This account summarizes the purchases and sales of goods and services between the United States and the rest of the world. The current account is the summation of the following three items:

1. Trade balance = Exports – Import

Trade surplus: Trade balance > 0 Trade deficit: Trade balance < 0

2. Expenditures on sales of services from other nations, such as shipping, brokerage, and insurance

3. Unilateral transfers between nations, including foreign aid and private gifts

For the United States, the current account balance equaled -$811.5 billion in 2006. The current account is negative and means that $811.5 billion left the United States. This is called a current account deficit. For the United States to finance this deficit, it has to borrow from abroad. The current account deficit is large, because the United States imported more goods than what was exported. The trade balance was -$758.5 billion in 2006.

The second account is the financial account and equaled $804.4 billion in 2006. The financial account records all transactions in assets, such as stocks, bonds, and real estate between the United States and the rest of the world. If the financial account is positive, money is flowing into the United States, which is called a capital inflow. Foreigners are buying more assets in the United States than the amount of foreign assets bought by domestic residents. If the financial account is negative, then money is flowing out of the United States, which is called a capital outflow. The value of foreign assets bought by U.S. residents is greater than the amount of assets bought in the United States by foreigners.

If a country has a current account deficit, than the deficit is financed by a financial surplus. For example, the United States experienced current account deficits for the last 35 years. The United State imports more goods and services than what it exports. This causes an outflow of U.S. dollars into the foreign exchange markets. International investors obtain U.S. dollars and use it to buy assets in the United States (i.e. a financial account surplus). Foreigners are buying

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government securities, stocks, bonds, and real estate in the United States. An equation below relates the current and financial accounts.

current account + financial account = 0

If the United States had a positive current account balance (called current account

surplus), then more money flows into the United States than money that is leaving. The net inflow of money into the U.S. would allow American to lend to foreign countries and purchase foreign assets.

The United States is having a current account deficit and U.S. dollars are flowing into the foreign-exchange markets. Foreign countries are collecting U.S. dollars and investing them back in the United States. If foreign investors do not want to invest in the United States, then market forces will cause the U.S. dollar to weaken (depreciate). A weaker dollar results from a surplus of U.S. dollars on the international markets. A weaker U.S. dollar will cause the current account to become smaller.

The Federal Reserve can temporarily finance balance-of-payment deficits. If foreign central banks do not want to hold too many U.S. dollars, then the Federal Reserve buys U.S. dollars by using official reserve assets. The Federal Reserve can do one or more of the following:

• Sell gold to buy U.S. dollars

• Sell foreign currencies and buy U.S. dollars

• Borrow from foreign central banks

• Use reserves at the IMF

• Use Special Drawing Rights (SDRs)

Official reserve assets are recorded under the account called the official settlements balance. In 2006, the official settlements balance was $2.4 billion and this balance is already included in the financial account. The Federal Reserve collected $2.4 billion in U.S. dollars by selling official reserve assets to foreign countries.

The last account is statistical discrepancy. The current and financial accounts do not equal zero, and this non-zero amount is a statistical discrepancy. The statistical discrepancy was -$17.8 billion in 2006. The discrepancy results from measurement errors and some financial activities are not reported, such as revenue from illegal businesses and tax evasion.

19.3. Gold Standard

Nations agree to a particular exchange rate system and the mechanisms to settle international payments from international trade and finance. The system that nations adopt is called the exchange rate regime.

Before World War I, countries used the gold standard. The central banks set an exchange rate of their currency to gold. Central banks agreed to convert their currency to gold on demand. Using the U.S., Japan, and Britain as an example, the following exchange rate is defined below:

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400 U.S. dollars = 1 ounce of gold 1,000 Japanese yen = 1 ounce of gold 800 British pounds = 1 ounce of gold

If the central bank in the U.S. wants a money supply of $4 million, the central bank has to

buy and hold 10,000 ounces of gold ($4 million / $400 per ounce). The gold standard causes the exchange rates to be fixed. Economists call this a fixed

exchange rate system. One U.S. dollar will equal 2.5 yen or 2 pounds. The exchange rates are calculated below by dividing all numbers by 400:

1 ounce of gold = $400 = 1,000 yen = 800 pounds

poundsyen

poundsyen

25.21$

400

800

400

000,1

400

400$

==

==

The U.S. has a payments deficit with Japan (current account + financial account < 0).

U.S. dollars are flowing out of the United States and into Japan. Japan has surplus of U.S. dollars, so U.S. central bank exchanges gold for dollars. This causes gold to flow out of the United States and into Japan. The U.S. central bank has less gold, so it has to decrease the money supply. Remember, the money supply is a ratio to the amount of gold the government is holding. When the money supply decreases, prices in the economy will decrease. This is called deflation (i.e. negative inflation).

U.S. products become cheaper relative to other countries, so U.S. businesses export more goods abroad. However, the lower U.S. prices cause foreign products to become more expensive, so U.S. consumers buy less imported goods. Exports became larger and imports smaller, so the current account increases until it equals zero and gold stop flowing out of the United State. The exact opposite will occur in Japan.

The gold standard has three benefits:

1. High inflation rates were rare under the gold standard, because central banks have little control over the money supply. If a central bank wants to increase the money supply, the central bank has to buy gold. For example, the inflation rate average less than 1% in U.S. under the gold standard.

2. International investors have lower risk, because exchange rates do not fluctuate. If a country’s currency is depreciating from rapid expansion of its money supply, then other countries can keep exchange rates stable by also rapidly expanding their money supplies (Gold Standard, p. xii).

3. Central banks have little power to influence the money supply, and hence, use the money supply to influence the economy. The gold standard limits a government’s power. Thus, gold goes in hand to hand with free markets, strong property rights, and limited government (This point depends on the reader’s views; this could be a problem or benefit). (Gold Standard, pp. viii-ix).

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4. The gold standard restricts commercial banks and government. If banks create too much credit, the credit expands the money supply, leading to inflation in the long run. People would convert their currency into gold, restricting credit expansion and inflation. Moreover, government could ‘print money” to finance budget deficits. Again, this leads to inflation and the public counteracts by converting money into gold (Gold Standard, p. xi).

The gold standard has a problem. If one country experiences a recession, then the recession is exported to other countries under the gold standard. Nations left the gold standard during World War I.

19.4. Bretton Woods System

After World War II, 44 countries implemented a new financial international system, known as the Bretton Woods System. (Bretton Woods is a vacation resort in New Hampshire). The Bretton Woods System was an attempt to establish fixed exchange rates and lasted from 1945 until 1971. All countries except the United States fixed their exchange rates to the U.S. dollar. The United States promised to convert U.S. dollars into gold by the official exchange rate of $35 for 1 ounce of gold. The U.S. dollar became the international reserve currency and the United States held much of the world’s supply of gold. (The gold-dollar exchange rate was only for foreign governments and did not apply to the public) The Bretton Woods system was more flexible than the gold standard, because countries could adjust their exchanges rates relative to the U.S. dollar. Consequently, countries had something resembling a gold standard, but governments could intervene in their exchange rates.

The Bretton Woods system created two institutions: International Monetary Fund (IMF) and International Bank of Reconstruction and Development, otherwise known as World Bank. Countries created the International Monetary Fund to be the lender of the last resort. The IMF granted loans to countries that were experiencing balance-of-payment problems. The World Bank grants long-term loans to developing countries. The loans are for economic development and help to build a country’s infrastructure, such as highways, bridges, power plants, and water supply systems. World Bank sells bonds in the international markets in order to raise funds for its projects. Countries abandoned the Bretton Woods system in 1971, but the World Bank and IMF still live on

19.5. Current Exchange Rate Regime

Since the demise of the Bretton Woods system, many industrial countries have followed a flexible exchange rate system. The governments allow the supply and demand in the foreign-exchange markets to determine the currency exchange rates. Occasionally, a government intervenes in the foreign-exchange market in order to achieve its policy goals. The U.S. dollar is still the international reserve currency. However, the Euro may evolve into the new reserve currency.

Some countries like the United Arab Emirates, Bahamas, and Barbados peg their currencies to the U.S. dollar. Pegging currencies is a fixed exchange rate system and it has been successful for small countries. For example, the government of the United Arab Emirates fixed the currency exchange rate as $1 = 3 Dirhams.

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19.6. International Monetary Fund (IMF).

Countries created the International Monetary Fund to enhance stability in international payments and promote international trade. The IMF also collects and standardizes international economic data. The IMF has 181 members and membership is open to independent nations.

A country wants to join the IMF. This country has to contribute capital based upon a formula. One-fourth of the capital has to be gold and the three-fourths has to be the country’s own currency. This gives the IMF financial capital, because the IMF has gold and a pool of foreign currencies. The IMF can help countries that are experiencing payment deficits.

For example, Britain has a payments deficit and borrows from the IMF. The British needs U.S. dollars, so the British give pounds and receive dollars from the IMF to finance its payments deficit. U.S. dollars decrease and pounds increase in the IMF’s currency pool. When Britain pays back the loan (with interest), it needs a currency acceptable to IMF and Britain gets its pounds back.

The IMF created Special Drawing Rights (SDRs), because of the belief of gold and reserve assets shortage. Each member country of IMF gets a proportion of newly created SDRs. Between 1968 and 1971, IMF created $10 billion worth of SDRs. When a country has a payments deficit, it can use its SDRs as money to obtain foreign currencies from the IMF.

The U.S. Treasury receives newly created SDRs, then it issues certificates that are claims to the SDRs, and sells these certificates to the Federal Reserve. These SDR certificates are an asset to the Federal Reserve.

Chapter 19 Review Questions .

1. Know the T-account transactions.

2. Why do central banks and governments intervene in the foreign-exchange markets/

3. What does a “weak” dollar and “strong” dollar mean? How does the strength of the dollar affect the U.S. economy?

4. What is the difference between unsterilized and sterilized foreign-exchange intervention?

5. What is the purpose of the balance-of-payments accounts?

6. What do the following terms mean: Current account, trade balance, capital account, and official settlement balance?

7. Why does a statistical discrepancy occur in the balance-of-payments accounts?

8. What are three exchange rate regimes? How do these difference regimes work?

9. How does the gold standard cause current account deficits to decrease to zero?

10. What are the functions of World Bank and IMF?

References

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Bureau of Economic Analysis. September 14, 2007. “New Release: U.S. International Transactions.” Available at www.bea.gov (access date: 10/21/2007).

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20. Economic Analysis of the Gold Standard


20.1. Problems with the Gold Standard

Gold standard has problems The money has a fixed exchange rate with gold Market price of gold fluctuates with supply and demand (Gold Standard, p. 64). Quantity theory of money (Gold Standard, p. 69). The variables are: MS is the quantity of money in circulation P is the price level in the economy Y is the real GDP v is the velocity of money. The velocity means on average, how many transactions a $1 bill has in the economy each year.

PYvM S ⋅=⋅

Government issues too much money, creates inflation. People start to hoard gold (Gold Standard, p. 70). Productivity increases causes higher output and lower prices (Gold Standard, p. 73).

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