1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 0 Financial Markets, Money, and the Federal Reserve

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 1 Financial System  High rates of saving and investment  Are crucial for economic growth and increased productivity  Are not sufficient  Successful economies save and use saving wisely  Free markets allow saving to be allocated by a decentralized, financial system

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 2 Improving Allocation of Savings  Market-oriented financial systems improve the allocation of savings  Provide information  To savers about which ways to use the funds are the most productive  Help savers share the risks  Of individual investment projects

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 3 The Banking System  Consists of financial intermediaries  Extend credit to borrowers using funds raised from savers  Commercial banks  Savings-and-loans  Bring together savers and investors  Gather important information necessary for profitable lending  Provide credit

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 4 Bonds  Bonds  A legal promise to repay a debt, usually including both the principal amount and regular interest payments  Principal amount  The amount originally lent  Coupon rate  The interest rate promised when a bond is issued  Coupon payments  Regular interest payments made to the bondholder

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 5 Bonds  Firms and governments often raise funds by issuing bonds and selling them to savers  Suppose  The principal amount of a bond is $1,000,000  Coupon rate is 5%  Annual coupon payment is $50,000  $50,000 = (0.05)($1,000,000)

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 6 Bonds  The coupon rate on new bond issues depends upon  The bond’s term  The longer the length, the higher the interest required  Its credit risk  A higher risk requires a higher interest rate  “junk bonds” are high yield because of their greater risk  Its tax treatment  Interest paid on local government bonds are exempt from federal taxes, although municipal bonds have a lower yield

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 7 Bond Market  People holding bonds do not have to keep them until maturity  They can be sold in bond markets  An organized market run by professional bond traders  Price of a bond  The market value of a particular bond at any given point in time  An inverse relationship exists between the price of a bond and the interest rate

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 8 Bond Prices and Interest Rates  A new 2-year government bond  Principal = $1,000  Coupon rate = 5% annually  Coupon payment  Year one = $50 (5% of $1,000)  Year two = $1050

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 9 Bond Prices and Interest Rates  Suppose  The bondholder sells the bond after receiving the first coupon payment  The prevailing interest rate in the bond market for 1-year bonds is 6%  How much will it sell for?  The bondholder won’t get the full $1000  Currently, a new 1-year bond will pay $1060 in one year

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 10 Bond Prices and Interest Rates  Someone will buy the used bond for only a price that allows at least a 6% return  The prevailing market interest rate  The buyer of the used bond will receive $1050  The $1,000 plus $50 interest  The price for her bond that allows a 6% return must satisfy the equation:

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 11 Bond Prices and Interest Rates  What if the prevailing interest rate is 4%?  The price of the used bond must satisfy the bond price equation  Bond prices and interest rates are inversely related. Thus

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 12 Stocks  Stock (or Equity)  A claim to partial ownership of a firm  If a corporation has 1 million shares of stock outstanding, ownership of one share means ownership of one-millionth of the company  Stockholders receive returns on their financial investment in two forms  Capital gains  When the price of their stock increases  Annual dividends  Annual payments

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 13 Dividends  Dividend  A regular payment received by stockholders for each share that they own  Determined by the firm’s management and normally depend on recent profits  Today’s stock price is affected by this year’s dividend, next year’s dividend, and so on…  The ability to pay dividends depends upon the firm’s future earnings

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 14 Stock Price Determination  Prices of stocks are determined through trading on a stock exchange  New York Stock Exchange, NASDAQ  Stock prices rise and fall as demand for the stock changes  Demand for stocks depend on prospects of the company

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 15 Maximum Stock Price  Suppose  You know that you can get a $1.00 dividend from owning a share of stock that will be valued at $80 in one year  The riskiness of the stock is zero so that your expected rate of return is that of what is offered by government bonds, say 6%  The maximum price one is willing to pay for a share of stock

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 16 Stock Prices and Expected Dividends  Suppose  The dividend will be $5.00  Higher expected dividends in the future increases the value of the stock today

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 17 Stock Prices and Expected Dividends  Suppose  The expected future price of stock is $84 with a dividend will be $5.00  Higher expected future stock raises the price of the stock today

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 18 Stock Prices and Interest Rates  Suppose that the stock is risky  The expected future price of stock is $80 with a dividend will be $1.00  But, the rate of return you require increases to 10% (4% risk premium)  Increases in interest rates tend to depress stock prices as well as bond prices

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 19 Bond and Stock Markets  Provides a way of channeling funds  From savers to borrowers with productive investment opportunities  Corporations can  Borrow from banks  Issue new bonds  Sold in bond markets  Issue new shares in itself  Sold in stock markets  Proceeds can then be used to finance capital investment

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 20 Bond and Stock Markets and Allocation  Both markets  Provide information  About the most profitable financial investments  Share risks  Diversification  The practice of spreading one’s wealth over a variety of different financial investments to reduce overall risk  Via Mutual funds--a financial intermediary that sells shares in itself to the public, then uses the funds raised to buy a wide variety of financial assets

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 21 Money  Money: Any asset that can be used directly in making purchases  Currency and coin  Checking account balance  Principal uses  Medium of exchange  Unit of account  Store of value

23. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 22 Medium of Exchange  Medium of exchange  An asset used in purchasing goods and services  Reduces transaction costs  Barter  The direct trade of goods or services for other goods or services  Has very high transaction costs  Requires double coincidence of wants

24. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 23 Uses of Money  Unit of account  A basic measure of economic value  A yardstick for measuring value  Uses dollars in the U.S.  Store of value  An asset that serves as a means of holding wealth  Not a particular good way to hold wealth unless one wants to avoid the Internal Revenue System

25. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 24 Measuring Money  How much money?  M1  Sum of currency outstanding and balances held in checking accounts  Narrow definition  M2  All the assets in M1 plus some additional assets that are usable in making payments but at greater costs or inconvenience than currency or checks  Broader definition

26. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 25 Determining the Money Supply  The money supply consists of  Currency  Deposit balances held by commercial banks  The determination of the money supply depends in part on the behavior of commercial banks

27. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 26 Bank’s Balance Sheet  Assets  What banks own  Liabilities  What banks owe  Bank reserves  Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawls and payments  Not part of the money supply

28. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 27 Reserve Banking  100 percent reserve banking  A situation in which banks’ reserves equal 100 percent of their deposits  Banks realize they don’t need to keep 100 percent of their deposits  Most of the deposits sit there  Solution: Banks can keep 10% and loan up to 90%

29. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 28 Fractional-Reserve Banking  Reserve-deposit ratio  Bank reserves divided by deposits  Fractional-reserve banking system  A banking system in which bank reserves are less than deposits so that the reserve- deposit ratio is less than 100

30. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 29 Money Creation  When a bank lends out reserves it creates money  Process of expansion of loans and deposits ends when all excess reserves are loaned out  When the actual ratio of bank reserves to deposits equals the desired reserve-deposit ratio

31. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 30 Federal Reserve System  Federal Reserve System, “Fed”  The central bank of the U.S.  Two main responsibilities  Regulate monetary policy  Determines how much money circulates in the economy  Influence key macro variables  Regulate financial markets

32. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 31 History of the Fed  A government agency created by the 1913 Federal Reserve Act  Pursuing public goals of growth, low inflation, and smooth operation of financial markets  Oversees private commercial banks  Trying to make a profit

33. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 32 The Fed  Consists of 12 regional banks  Each represent a geographic area in national policymaking  Each provides services like check clearing  Headquarters is in Washington D.C.  Board of Governors  The leadership of the Fed, consisting of seven governors appointed by the president to staggered 14-year terms

34. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 33 FOMC  Federal Open Market Committee  The committee that makes decisions concerning monetary policy  Meets 8 times a year to determine monetary policy

35. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 34 Fed and the Money Supply  The Fed controls the money supply indirectly  Through changing the supply of reserves held by commercial banks  Open-market operations  Open-market purchase and open-market sales are the Fed’s most convenient and flexible tools

36. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 35 Open Market Operations  Open market purchase  Buying government bonds from the public  Increasing the supply of bank reserves and the money supply  Open market sale  Selling government bonds to the public  Reducing bank reserves and the money supply

37. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 36 Discount Window Lending  Discount window lending  The lending of reserves by the Fed to commercial banks when banks are short on reserves  The lending of reserves directly increase reserves in the banking system, thereby increasing the money supply  Discount rate  The interest rate the Fed charges commercial banks that borrow reserves

38. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 37 Reserve Requirements  Reserve requirements  Set by the Fed, the minimum values of the ratio of bank reserves to bank deposits that commercial banks are allowed to maintain  With an increase in reserve requirements  Banks lend out a smaller share of their deposits  The money supply falls

39. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 38 Banking Panic  Banking panic  An episode in which depositors, spurred by news or rumors of the imminent bankruptcy of one or more banks, rush to withdraw their deposits from the banking system  With fractional-reserve banking  Banks do not keep 100% of deposits  If everyone shows up and wants his or her deposits, a bank will run out of cash  1930-1933 saw the worst bank panics in the U.S.

40. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 11 - 39 Deposit Insurance  Deposit insurance  A system under which the government guarantees that depositors will not lose any money even if their bank goes bankrupt  In 1934 policymakers wanted to stop the banking panics  Incentives for banks change  Less concerned about the solvency of the loans made