Frank & Bernanke Ch. 11: Financial Markets, Money, and the Federal Reserve
Savings and Investments National savings done by governments, households and businesses will not be channeled into investments if there is no intermediary to bring the two sides together. Even if there were intermediaries, investments may not be productive and resources may be wasted, condemning the future generations to poverty.
Savings Lack of options for households may force them to keep their wealth in money form. – A relatively high inflation would wipe out most of their wealth. In many poor countries, households keep their wealth in gold. – In 1980-81, gold prices reached $800/oz.. On Feb. 24, 2004, gold was $403.45 per ounce. A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country.
Investments Those that need funds to bring new products or to expand operations (entrepreneurs and managers) are taking risks. They do not know what the future will hold but given their present day knowledge they are betting on a positive outcome. If all investments are done through a central office, an unfortunate turn of events can render the investment worthless and savings wasted. Concentration of risk, political decision-making, limited knowledge can waste scarce resources and render investments unproductive.
Financial System A well-developed financial system provides many alternatives for savers. – Different risk levels; different size levels; different maturities; different liquidity levels. A well-developed financial system provides scarce and costly information for lenders, thus reducing the overall risk. A well-developed financial system channels savings to most productive use.
Financial Assets Savers Can Hold Currency Checking account Savings account Certificate of Deposit Foreign currency Bonds Stocks Options on stocks, bonds, foreign currency Futures on commodities, foreign currency
Financial Institutions What if someone comes and gives a brilliant talk on how she can make you a millionaire if you only gave her $100,000? Can someone with savings of $1000 have the means to investigate the validity of high rate of returns promised? What if special skills and knowledge is required to evaluate claims (Enron, notwithstanding).
Financial Institutions Asymmetric information creates a need for specialized institutions to evaluate risk. Comparative advantage leads to specialization. Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost.
Assets According to Liquidity Assets According to Liquidity Currency Checking Account Savings Account Money Market Mutual Fund Bonds Stocks
Three Classes of Assets Bonds Stocks Money They all respond to interest rates. The higher the interest rates, the lower is the quantity of money demanded. The higher the interest rate, the lower is the quantity of bonds and stocks supplied.
Bonds A bond is an IOU that indicates the principal to be paid at maturity (face value), the rate of interest to be earned per year on the principal (coupon rate), and the date the bond will mature (date the principal will be paid). Bonds are issued by borrowers and bought by lenders. During the life of the bond, the holders may decide to sell the bond to someone else.
Bonds Bonds issued by different entities carry different coupon rates. Credit risk is the most important reason that determines the variations in coupon rates in same maturity bonds. Municipal bonds usually have lower coupon rates because they are exempt from federal taxation.
Bonds Joe buys a 2-year government bond (Treasury note) issued on Jan. 1, 2002 with a face-value of $1,000 and a coupon rate of 4%. Who is the lender and who is the borrower? On Jan. 1, 2003 and on Jan. 1, 2004 how much will the government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2003, what price does he expect to get for his bond if – similar bonds pay an interest rate of 4%? – similar bonds pay an interest rate of 3%? – similar bonds pay an interest rate of 5%?
Bond Prices and Interest Rates When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. If Lydia expects to see higher interest rates in the future, should she buy or sell bonds today? (Hint: think about capital gains and losses).
Stocks Stocks are shares in the ownership of a public company. Stockholders are paid dividends from the profits of the company. If future profits are expected to increase, dividends are expected to increase, creating an extra demand for the stock and pushing the price of the stock up today.
Stocks When a company issues stock it receives the funds to use for expansion, investment. When existing stocks are bought and sold in the stock market, the company gets nothing except a signal that if it wants to raise funds would it be cheaper or more expensive. Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also reduces the stock prices.
Stock Prices Suppose you expect the stock price of IBM to be $100 a year from now and also you expect dividends per share to be $5, then. Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, what price are you willing to pay for this stock? Hint: If you were to sell the stock a year from now, how much would you get and what is the present value today that will yield 8% to bring this amount? P (1.08) = $105 P = $105/1.08 = $97.22
Stock Prices If in general, interest rates have risen because of inflation, so that you expect 10% return rather than 8%, how much would you pay for the same IBM stock? P = $105/1.1 = $95.45 What if you expected IBM price to be $110? What if you expected dividends to be $10?
Newly Issued Stocks and Bonds In order to raise funds (to borrow) businesses can go to the banks or issue new stocks or bonds. If the future of the business is considered risky, the bonds will carry a high interest rate and the stocks will sell at a low price.
Diversification For lenders, to put all their eggs in the basket of one borrower is very risky. Diversification, that is holding assets that behave differently under similar economic conditions, would reduce the risk. Look at Problem #4 on p. 302.
Answers to Problem #4 4a. DonkeyInc pays 10% with a 40% probability, zero otherwise. The expected average return is 40% times 10%, or 4%. ElephantInc pays 8% with 60% probability, zero otherwise, an expected average return of 4.8%. To maximize expected return, invest all your funds in ElephantInc. b. If Democrats win your dollar return is $50 (10% of the $500 invested in DonkeyInc). If Republicans win your dollar return is $40 (8% of the $500 invested in ElephantInc). Since the Democrats win with probability of 40% and the Republicans win with a probability of 60%, your expected dollar return is (40%)($50) + (60%)($40) = $44, or a 4.4% expected return on your $1000 initial investment.
Answers to Problem #4 c. The strategy in part b gives a lower expected return than the strategy in part a. However the strategy in part a is riskier, since you receive nothing if the Democrats win. The advantage of the strategy in part b is that you receive a reasonable return no matter which party wins (that is, it is less risky, which compensates for the lower expected return). d. To achieve a guaranteed 4.4% return, you need a strategy that guarantees you at least $44 no matter who wins the election. $44 = x(0.1)(.4) + (1000- x)(.08)(.6). 44 =.04x + 48 -.048x x=$500. e. Let D be the number of dollars you bet on the Democrats and $1000 – D be the number of dollars you bet on the Republicans. If the Democrats win you receive a dollar return of 10% x D. If the Republicans win you receive a dollar return of 8%($1000 – D). You want these two returns to be equal. Setting 10% x D = 8%($1000 – D) and solving for D we find D = $80/0.18 = $444.44. So invest $444.44 in DonkeyInc and $555.56 in ElephantInc to guarantee a return of 4.44% no matter who wins.
Money: A Special Financial Asset If bonds and stocks provide a return for holders why would anyone hold money? Liquidity. Money has three uses. – Unit of account – Medium of exchange – Store of value
Banks and the Creation of Money When depositors put money in the bank, the bank turns around and loans part of the money to others. Both the depositor and the borrower have funds to spend. Money has been created.
Banks and the Creation of Money We will show the changes in assets and liabilities of a bank in response to deposit and loan activities. Deposits into checking accounts are liabilities of a bank. Cash is an asset. Assets = Liabilities for a Balance Sheet to be in balance.
Creation of Money Ally deposits $1000 into her checking account with First National. First National holds only 10% as reserves and loans the rest to Billy. Billy buys a snow blower for $900 from Carl. Carl deposits $900 with Second National. Second National loans how much to Deyna if it also holds 10% as reserves?
Creation of Money If this process goes on for thirty rounds, how much checking deposits will be in the banking system? 1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^ 30 1000 + 900 + 810 + … + 0.04 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 
Creation of Money The banking system used the initial deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create checking deposits for the economy. What would be the deposits created by the same $1000 deposit, if the banks kept 5% as the reserve ratio?
Narrow Money, M1 M1 is defined as currency outside of the banks plus bank deposits. Monetary Base is defined as Currency + Reserves. What was the amount of currency in January 2003? What was the amount of bank deposits in January 2003? What was the reserve ratio in January 2003?
Problem #8, p. 303 8a. Deposits equal bank reserves/(desired reserve/deposit ratio) = 100/0.25 = 400. The money supply equals currency held by the public + deposits = 200 + 400 = 600. b. Let X = currency held by the public = bank reserves. Then the money supply equals X + X/(reserve/deposit ratio), or 500 = X + X/0.25 = 5X X = 100 So currency and bank reserves both equal 100. c. As the money supply is 1250 and the public holds 250 in currency, bank deposits must equal 1000. If bank reserves are 100, the desired reserve/deposit ratio equals 100/1000 = 0.10.
The Federal Reserve System The Central Bank of the United States. The Fed is responsible for monetary policy. – Amount of money supplied to the system. – Affects interest rates, inflation, unemployment and exchange rates. The Fed oversees and regulates the financial markets.
The Fed Fed was established in 1913 in the hopes of eliminating banking panics of the 19th century by providing credit to the financial markets. In order to disperse power 12 regional Federal Reserve Banks were formed. The seven members of the Board of Governors are appointed by the President for 14-year terms every other year.
Monetary Policy Federal Open Market Committee (FOMC) is the group that sets the monetary policy. Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC. FOMC meets eight times a year.
Controlling the Money Supply Open-Market Operations: buying and selling of financial assets. – Buying government bonds from the public increases bank reserves, hence money supply. – Selling bonds decreases money supply. Discount window lending: Lending to banks that increases bank reserves. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply.
Open-Market Operation Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. What is the money supply? If the Central Bank purchased $5 worth of bonds, what will be the money supply? If the CB sold $10 worth of bonds, what will be the money supply?
The Great Depression The Fed did not prevent the Great Depression. Both currency held by the public and reserve- deposit ratio rose, reducing money supply. The Fed increased the reserves but not enough. Lack of enough reserves forced bank bankruptcies.
Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, (McGraw-Hill, 2001), p. 299.