Chapter 21: The Financial System, Money, and Prices

1. Chapter 21: The Financial System, Money, and Prices Learning Objectives: Describe the role of financial intermediaries Differentiate between bonds and stocks Explain how their prices relate to interest rates Explain how the financial system improves the allocation of savings to productive uses Discuss the three functions of money and how money is measured Analyze how the lending behavior of commercial banks affects the money supply Understand the central bank control of the money supply and its relation to inflation in the long run

2. Financial System and Allocation of Saving A successful economy uses its savings for investments that are likely to be the most productive The interest on deposits is one important reason people put savings in banks The financial system improves the allocation of saving Provides information to savers about the possible uses of their funds Help savers share the risks of individual investment projects Risk sharing makes funding possible for projects that are risky but potentially very productive

3. Banking System Financial intermediaries are firms that extend credit to borrowers using funds raised from savers Thousands of commercial banks accept deposits from individuals and businesses and make loans Banks and other intermediaries specialize in evaluating the quality of borrowers Principle of Comparative Advantage Banks have lower cost of evaluating opportunities than an individual would Banks pool the savings of many individuals to make large loans

4. Bonds A bond is a legal promise to repay a debt Each bond specifies Principal amount, the amount originally lent Maturation date, the date when the principal amount will be repaid The term of a bond is the length of time from issue to maturation Coupon payments, the periodic interest payments to the bondholder Coupon rate, the interest rate that is applied to the principal to determine the coupon payments

5. Bond Market Bonds can be sold before their maturation date Market value at any time is the price of the bond Price depends on the relationship between the coupon rate and the interest rate in financial markets A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 Coupon rate is 5% $50 will be paid 1/1/10 $1,050 will be paid 1/1/11 Bond's price on 1/1/10 depends on the prevailing interest rate

6. Stocks A share of stock is a claim to partial ownership of a firm Receive dividends, a periodic payment determined by management Receive capital gains if the price of the stock increases Prices are determined in the stock market Reflect supply and demand

7. Risk Premium Risk premium is the difference between the required rate of return to hold risky assets and the rate of return on safe assets Suppose interest on a safe investment is 6% FortuneCookie.com is risky, so 10% return is required Stock will sell for $80 in 1 year; dividend will be $1 (Stock price) (1.10) = $81 Stock price = $73.64 Risk aversion increases the return required of a risky stock and lowers the selling price

8. Bond Markets and Stock Markets Channel funds from savers to borrowers with productive investment opportunities Sale of new bonds or new stock can finance capital investment Like banks, bond and stock markets allocate savings Provision of information on investment projects and their risks Provide risk sharing and diversification across projects Diversification is spreading one's wealth over a variety of investments to reduce risk

9. Stock and Bond Markets Savers can put savings into a variety of financial assets Diversification makes risky but potentially valuable projects possible No individual saver bears the whole risk Society is better off A mutual fund is a variety of financial assets sold to the public as shares in a single financial intermediary Diversified asset for the saver Less costly than buying many stocks and bonds directly

10. Money Money is any asset that can be used in making purchases Examples include coins and currency, checking account balances, and traveler's checks Shares of stock are not money Money has three principal uses Medium of exchange Unit of account Store of value Money makes barter unnecessary Barter is trading goods directly

11. Bank Reserves Cash in a bank's vault is not part of the money supply Unavailable for payments Bank deposits available for use in transactions are part of the money supply Depositing a $100 bill in your checking account does not change the money supply Bankers realize that inflows and outflows from vaults leave some guilders unused Only 10% of deposits are needed for transactions 90% can be lent to borrowers for a fee -- interest

12. The Federal Reserve System The Fed is the central bank of the US Responsible for monetary policy and the oversight and regulation of financial markets Monetary policy is deciding and managing the size of the nation's money supply Money supply is controlled indirectly Open-market purchase of government bonds from the pubic by the Fed increases bank reserves and the money supply Open-market sale of government bonds by the Fed to the public decreases reserves and money supply

13. Open Market Operations When the Fed purchases a bond from the public Fed pays bond holder with new money Receipts are deposited and this leads to a multiple expansion of the money supply When the Fed sells a bond to the public Bondholder pays with checking funds Bank reserves decrease and this leads to a multiple contraction of the money supply

14. Velocity of Money (V) Velocity is the speed money changes hands in transaction for final goods and services Nominal GDP is the price level (P) times real GDP (Y) M is the money supply

15. Money and Inflation in the Long Run Quantity equation states (M) (V) = (P) (Y) Restatement of the velocity definition The quantity equation relates the money supply to price levels Suppose velocity and real GDP are constant The quantity equation becomes An increase in the money supply by a given percentage would increase prices by the same percentage