Transcript Frank & Bernanke - Hiram Reads! — Where Hiram College

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
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Currency
Checking account
Savings account
Certificate of Deposit
Foreign currency
Bonds
Stocks
Options on stocks, bonds, foreign currency
Futures on commodities, foreign currency
Financial Assets

Varied risk levels.
 Varied maturity levels.
 Varied liquidity levels.
 Varied returns.
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.
Financial Institutions
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
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
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) + (1000x)(.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
http://research.stlouisfed.org/publications/mt/page16.pdf
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 [10]
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 reservedeposit ratio rose, reducing money supply.
 The Fed increased the reserves but not
enough.
 Lack of enough reserves forced bank
bankruptcies.
MONETARY STATISTICS DURING GREAT DEPRESSION
Currency
rr
Reserves
M1
Dec-29
3.85
0.075
3.15
45.9
Dec-30
3.79
0.082
3.31
44.1
Dec-31
4.59
0.095
3.11
37.3
Dec-32
4.82
0.109
3.18
34.0
Dec-33
4.85
0.133
3.45
30.8
Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics,
(McGraw-Hill, 2001), p. 299.