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Financial Markets, Money, and the Federal Reserve

Financial Markets, Money, and the Federal Reserve. 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

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Financial Markets, Money, and the Federal Reserve

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  1. Financial Markets, Money, and the Federal Reserve

  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. FOMC • Federal Open Market Committee • The committee that makes decisions concerning monetary policy • Meets 8 times a year to determine monetary policy

  35. 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. 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. 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. 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. 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. 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

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