1 Frank & Bernanke 4 th edition, 2009 Ch. 9: The Financial System, Money, and Prices

2 Outline Savings Savings Bonds Bonds Stocks Stocks Money Money Banks Banks Fed Fed Inflation Inflation

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

4 Savings Lack of options for households may force them to keep their wealth in money form. 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. A relatively high inflation would wipe out most of their wealth. In many poor countries, households keep their wealth in gold. In many poor countries, households keep their wealth in gold. In , gold prices reached $800/oz.. On Feb. 24, 2004, gold was $ per ounce; on Feb. 15, 2010: $ In , gold prices reached $800/oz.. On Feb. 24, 2004, gold was $ per ounce; on Feb. 15, 2010: $ A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country. A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country.

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

6 Financial System A well-developed financial system provides many alternatives for savers. A well-developed financial system provides many alternatives for savers. Different risk levels; different size levels; different maturities; different liquidity levels. 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 provides scarce and costly information for lenders, thus reducing the overall risk. A well-developed financial system channels savings to most productive use. A well-developed financial system channels savings to most productive use.

7 Financial Institutions Asymmetric information creates a need for specialized institutions to evaluate risk. Asymmetric information creates a need for specialized institutions to evaluate risk. Comparative advantage leads to specialization. Comparative advantage leads to specialization. Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost. Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost.

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

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

10 Bonds Joe buys a 5-year government bond (Treasury note) issued on Jan. 1, 2010 with a face-value of $1,000 and a coupon rate of 4%. Joe buys a 5-year government bond (Treasury note) issued on Jan. 1, 2010 with a face-value of $1,000 and a coupon rate of 4%. Who is the lender and who is the borrower? Who is the lender and who is the borrower? On Jan. 1, 2011 and on Jan. 1, 2015 how much will the government pay to the holder of this bond? On Jan. 1, 2011 and on Jan. 1, 2015 how much will the government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2012, what price does he expect to get for his bond if If Joe wants to sell his bond on Jan. 2, 2012, 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 4%? similar bonds pay an interest rate of 3%? similar bonds pay an interest rate of 3%? similar bonds pay an interest rate of 5%? similar bonds pay an interest rate of 5%?

11 Bond Prices and Interest Rates When interest rates rise, bond prices fall. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. When interest rates fall, bond prices rise. If Joe expects to see higher interest rates in the future, should he buy or sell bonds today? (Hint: think about capital gains and losses). If Joe expects to see higher interest rates in the future, should he buy or sell bonds today? (Hint: think about capital gains and losses).

12 Stocks Stocks are shares in the ownership of a public company. Stocks are shares in the ownership of a public company. Stockholders are paid dividends from the profits of the 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. 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.

13 Stocks When a company issues stock it receives the funds to use for expansion, investment. 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. 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. Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also reduces the stock prices.

14 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. 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? 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? 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 (1.08) = $105 P = $105/1.08 = $97.22 P = $105/1.08 = $97.22

15 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? 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 P = $105/1.1 = $95.45 What if you expected IBM price to be $110? What if you expected IBM price to be $110? What if you expected dividends to be $10? What if you expected dividends to be $10?

16 Newly Issued Stocks and Bonds In order to raise funds (to borrow) businesses can go to the banks or issue new stocks or 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. 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.

17 What Is Money? Does Bill Gates have a lot of money? Does Bill Gates have a lot of money? Does LeBron James make a lot of money? Does LeBron James make a lot of money? Anything accepted by a community in exchange of goods and services and for settlements of debts. Anything accepted by a community in exchange of goods and services and for settlements of debts.

18 Functions of Money Unit of account Unit of account Increase in variety of goods requires a common unit to quote and compare prices. Increase in variety of goods requires a common unit to quote and compare prices. 3 goods: 2 prices 3 goods: 2 prices 4 goods: 6 prices 4 goods: 6 prices 5 goods: 24 prices 5 goods: 24 prices N goods: Prices N goods: N!/2(N-2)! Prices Money had to be invented. Money had to be invented.

A Proposed Unit of Account We could [have] labels providing a product or service’s “daily energy calories.” Along with physical labels, imagine a smartphone app — we’ll call it “Decal” for short — that would scan a product’s bar code and report how much energy it took to produce that item. We could [have] labels providing a product or service’s “daily energy calories.” Along with physical labels, imagine a smartphone app — we’ll call it “Decal” for short — that would scan a product’s bar code and report how much energy it took to produce that item. Like the nutritional data on the backs of food products, Decal would give consumers a user-friendly, universal measure that they could use to compare products or count their daily energy intake. Like the nutritional data on the backs of food products, Decal would give consumers a user-friendly, universal measure that they could use to compare products or count their daily energy intake. 19

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

21 Functions of Money Store of Value Store of Value Postponing consumption by storing wealth in an asset for future use. Postponing consumption by storing wealth in an asset for future use. Today we have many different assets for wealth storage. Today we have many different assets for wealth storage. Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.” Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.”

22 Financial Assets Savers Can Hold Currency Currency Checking account Checking account Savings account Savings account Certificate of Deposit Certificate of Deposit Foreign currency Foreign currency Bonds Bonds Stocks Stocks Options on stocks, bonds, foreign currency Options on stocks, bonds, foreign currency Futures on commodities, foreign currency Futures on commodities, foreign currency

23 Assets According to Liquidity Currency Currency Checking Account Checking Account Savings Account Savings Account Money Market Mutual Fund Money Market Mutual Fund Bonds Bonds

24 Measuring Money In billions of dollars

25 Measuring Money

26 Components of M1 and M2, July 2002 (billions of dollars) M1 Currency Demand deposits Other checkable deposits Travelers’ checks M2 M1 Savings deposits Small-denomination time deposits Money market mutual funds 1, , , ,

27 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. 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. Both the depositor and the borrower have funds to spend. Money has been created. Money has been created.

28 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. 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. Deposits into checking accounts are liabilities of a bank. Cash is an asset. Cash is an asset. Assets = Liabilities for a Balance Sheet to be in balance. Assets = Liabilities for a Balance Sheet to be in balance.

29 Creation of Money Ally deposits $1000 into her checking account with First National. Ally deposits $1000 into her checking account with First National. First National holds only 10% as reserves and loans the rest to Billy. First National holds only 10% as reserves and loans the rest to Billy. Billy buys a snow blower for $900 from Carl. Billy buys a snow blower for $900 from Carl. Carl deposits $900 with Second National. Carl deposits $900 with Second National. Second National loans how much to Deyna if it also holds 10% as reserves? Second National loans how much to Deyna if it also holds 10% as reserves?

30 Creation of Money If this process goes on for thirty rounds, how much checking deposits will be in the banking system? If this process goes on for thirty rounds, how much checking deposits will be in the banking system? (.9) (.9)(.9)+…+1000(.9)^ (.9) (.9)(.9)+…+1000(.9)^ … … [1/(1-.9)] = 1000 [1/.1] = 1000 [10] 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

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

32 Narrow Money, M1 M1 is defined as currency outside of the banks plus bank deposits. M1 is defined as currency outside of the banks plus bank deposits. Monetary Base is defined as Currency + Reserves. Monetary Base is defined as Currency + Reserves.

33 Measuring Money

34 What was the amount of currency in January 2010, January 2011? What was the amount of bank deposits in January 2010, January 2011? What was the reserve ratio in January 2010, January 2011? Measuring Money

35 Banks and the Creation of Money Summary Summary Bank reserves/bank deposits = desired reserve-deposit ratio Bank reserves/bank deposits = desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio

36 Banks and the Creation of Money The Money Supply with Both Currency and Deposits The Money Supply with Both Currency and Deposits CB provides 1 million in cash to residents CB provides 1 million in cash to residents Residents choose to hold 500,000 as currency Residents choose to hold 500,000 as currency Deposit 500,000 in the banks Deposit 500,000 in the banks Reserve-deposit ratio = 10% Reserve-deposit ratio = 10% Bank deposits = 500,000/.10 = 5,000,000 Bank deposits = 500,000/.10 = 5,000,000

37 Banks and the Creation of Money The Money Supply with Both Currency and Deposits The Money Supply with Both Currency and Deposits Money supply = currency + bank deposits 5,500,000 = 500, ,000,000 Money supply = currency + bank deposits 5,500,000 = 500, ,000,000 Money is increased by 4,500,000 when the residents hold 500,000 in bank deposits Money is increased by 4,500,000 when the residents hold 500,000 in bank deposits

38 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas Currency = 500 Currency = 500 Bank reserves = 500 Bank reserves = 500 Reserve-deposit ratio = 0.20 Reserve-deposit ratio = 0.20 Money supply = /.20 = ,500 = 3,000 Money supply = /.20 = ,500 = 3,000

39 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas If Xmas shoppers withdraw 100 If Xmas shoppers withdraw 100 Money supply = /.20 = ,000 = 2,600 Money supply = /.20 = ,000 = 2,600

40 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas Observation Observation When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.

41 The Federal Reserve System The Central Bank of the United States. The Central Bank of the United States. The Fed is responsible for monetary policy. The Fed is responsible for monetary policy. Amount of money supplied to the system. Amount of money supplied to the system. Affects interest rates, inflation, unemployment and exchange rates. Affects interest rates, inflation, unemployment and exchange rates. The Fed oversees and regulates the financial markets. The Fed oversees and regulates the financial markets.

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

43 Monetary Policy Federal Open Market Committee (FOMC) is the group that sets the 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. 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. FOMC meets eight times a year.

44 Controlling the Money Supply Open-Market Operations: buying and selling of financial assets. Open-Market Operations: buying and selling of financial assets. Buying government bonds from the public increases bank reserves, hence money supply. Buying government bonds from the public increases bank reserves, hence money supply. Selling bonds decreases money supply. Selling bonds decreases money supply. Discount window lending: Lending to banks increases bank reserves. Discount window lending: Lending to banks increases bank reserves. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. New Tools: New Tools:

45 Open-Market Operation Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. What is the money supply? What is the money supply? If the Central Bank purchased $5 worth of bonds, what will be 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? If the CB sold $10 worth of bonds, what will be the money supply?

46 The Federal Reserve System Example Example Currency = 1,000 Currency = 1,000 Reserves = 200 Reserves = 200 Reserve-deposit ratio = 0.2 Reserve-deposit ratio = 0.2 What is M1? What is M1? Money supply = 1, /0.2 = 2,000

47 The Federal Reserve System Example Example Increasing the money supply by open- market operations Increasing the money supply by open- market operations Open market purchase = 100 Open market purchase = 100 Reserves increase to 300 Reserves increase to 300 Money supply = 1, /0.2 = 2,500 Money supply = 1, /0.2 = 2,500

48 The Federal Reserve System Controlling the Money Supply: Discount Window Lending Controlling the Money Supply: Discount Window Lending The discount rate The discount rate The interest rate charged on these loans The interest rate charged on these loans Discount lending will increase reserves and the money supply. Discount lending will increase reserves and the money supply.

49 The Federal Reserve System Controlling the Money Supply: Changing Reserve Requirements Controlling the Money Supply: Changing Reserve Requirements The Fed sets the reserve-deposit ratio The Fed sets the reserve-deposit ratio Called the reserve requirement Called the reserve requirement A reduction in the reserve requirement would allow the money supply to increase. A reduction in the reserve requirement would allow the money supply to increase. An increase in the reserve requirement may reduce the money supply. An increase in the reserve requirement may reduce the money supply.

50

51 Primary Credit Rate

52 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Suppose: Depositors lose confidence in their bank. Depositors lose confidence in their bank. They attempt to withdraw their funds. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures. The bank fails and further erodes depositor confidence which triggers additional failures.

53 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: The Fed to the rescue: Instill confidence Instill confidence Discount lending Discount lending Open Market Operations Open Market Operations

54 Money and Price Level In the long run, prices adjust to pressures in the economy. In the long run, prices adjust to pressures in the economy. The “quantity theory of money” captures the long-run relationship. The “quantity theory of money” captures the long-run relationship. MV = PY

55 Quantity Theory M is money stock, like M1 or M2. M is money stock, like M1 or M2. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. P is price level, like 1.00 or 1.26 (price index) P is price level, like 1.00 or 1.26 (price index) Y is real GDP. Y is real GDP. PY is nominal GDP. PY is nominal GDP.

56 Long Run Inflation In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. Velocity is also thought predictable in the long-run. Velocity is also thought predictable in the long-run. Therefore, any growth in money supply will be reflected in inflation. Therefore, any growth in money supply will be reflected in inflation.

57 Money and Prices Velocity Velocity The speed at which money circulates The speed at which money circulates

58 Money and Prices Velocity in 2001 Velocity in 2001 M1 = $1,177.9 billion M1 = $1,177.9 billion M2 = $5,449.1 billion M2 = $5,449.1 billion Nominal GDP = $10,082.2 billion Nominal GDP = $10,082.2 billion

59 Money and Prices Money and Inflation in the Long Run Money and Inflation in the Long Run Quantity equation Quantity equation M x V = P x Y M x V = P x Y Assume V & Y are constant over the time period Assume V & Y are constant over the time period %Δ M + % Δ V = % Δ P + % Δ Y

60 Money and Prices Money and Inflation in the Long Run Money and Inflation in the Long Run If the Fed increases M by 10%, then prices must increase by 10%. If the Fed increases M by 10%, then prices must increase by 10%. High rates of money growth are associated with high rates of inflation (too much money chasing too few goods). High rates of money growth are associated with high rates of inflation (too much money chasing too few goods). %Δ M + % Δ V = % Δ P + % Δ Y

61 Inflation and Money Growth in Latin America,