Money, Prices, and the

Financial System
Chapter 9

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
1. Describe the role of financial intermediaries
2. Differentiate between bonds and stocks and show
why their prices are inversely related to interest
rates
3. Explain how the financial system improves the
allocation of saving to productive uses
4. Discuss the three functions of money and how the
money supply is measured
5. Analyze how the lending behavior of commercial
banks affects the money supply
6. Explain how the central bank controls the money
supply and its relation to inflation in the long run
9-2
 Money in Economics
• The term "money" in economics has a specific
meaning different from every day use
• To an economist:
– Your paycheck is income
– The income you don't spend is saving
– The increase in the value of your stock is a capital
gain
– When your house appreciates, your wealth
increases

9-3
 The Allocation of Saving
• A successful economy allocates its saving to the
most productive investments
• The interest on deposits is one important reason
people put their saving 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
9-4
 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 a lower cost of evaluating opportunities
than an individual would
• Banks pool the saving of many individuals to make
large loans
9-5
 Banking System
• Banks gather information about potential
investments
– Evaluate the options
– Direct saving
– Service provided to depositors
• Banks provide access to credit for small
businesses and homeowners
– May be the only source of credit for some
investments
• When banks make loans, they earn interest
which, in turn, is paid to the bank's depositors
9-6
 The Banking System
• Having bank deposits makes payments easier
– Checks
– ATMs
– Debit card
• Checks and debit cards are safer than cash
• Banks provide a record of your transactions

9-7
Japanese Banking Crisis, 1990s
• Japanese banks fell into severe trouble
– Property values decreased and some loans on real
estate went into default
– Banks held stocks and the stock values decreased
• Japan had relied on banks to allocate its saving
– Thin financial markets
– Borrowers had difficulty obtaining credit
– Small- and medium-sized businesses suffered
– Credit shortages prolonged the recession as
businesses struggled to fund new projects

9-8
 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
9-9
 Bonds
• Corporations and governments issue bonds
• The coupon rate depends on
– The bond's term
• 30 days to 30 years; longer term, higher coupon rate
– The issuer's credit risk
• Probability the issuer will default on repayment
• Higher risk, higher coupon rate
– Tax treatment for the coupon payments
• Municipal bonds are free from federal taxes
• Lower taxes, lower coupon rates

9-10
 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, 1/1/12
– Coupon rate is 5%
– $50 will be paid 1/1/13
– $1,050 will be paid 1/1/14
• Bond's price on 1/1/10 depends on the prevailing
interest rate
9-11
 Selling a Bond
• Offer for sale: one government bond with payment
of $1,050 due in one year
• The competition: a new one-year bond with
principal of $1,000 and coupon rate of 6%
– Pays $1,060 in one year
• Year-old bond with 5% coupon rate is less valuable
than the new bond
– Price of the used bond will be less than $1,000
(Bond price) (1.06) = $1,050
Bond price = $991
• Bond prices and interest rates are inversely related
9-12
 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

9-13
 FortuneCookie.com
• New company with estimated dividend of $1 in 1
year
– Estimated selling price of stock will be $80 in 1 year
– Interest rate is 6%
• Value of the new stock is $81 in 1 year
(Stock price) (1.06) = $81
Stock price = $76.42
– Value would be higher if:
• Dividend were higher
• Price of stock in one year were higher
• Interest rate were lower
9-14
 Risk Premium
• Risk premium is the rate of return investors
require to hold risky assets minus 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
9-15
 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
saving
– 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

9-16
 Benefits of Diversification
• Vikram has $200 to invest in stocks, each $100
Increase in Stock Price per Share
Actual Weather Smith Umbrella Jones Suntan Lotion
Rainy (50%) +$10 $0
Sunny (50%) $0 +$10

• Buy 2 shares of either stock

– 50% chance of $20 gain and 50% chance of $0
• Diversify and buy 1 share of each
– One stock will be worth $100 and the other will be
worth $110
• Return is $10 with no risk
9-17
 Stock and Bond Markets
• Savers can put saving 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 financial intermediary that sells
shares in itself to the public, then uses the funds
raised to buy a wide variety of financial assets.
– Diversified asset for the saver
– Less costly than buying many stocks and bonds
directly
9-18
 Rise and Fall of the US Stock
Market
• Standard & Poor's 500 index rose 60% between
1990 and 1995
– More than doubled 1995 – 2000
– Lost 40% of its value Jan 2001 – Jan 2003
– Returned to Jan 2000 level by Jan 2008
• Increase in stock prices can be due to
– Increased optimism about future value
– A fall in required return

9-19
 Rise and Fall of the US Stock
Market
• In the 1990s, optimism was high
– Strong dividends
– Promise of new technologies
• Risk premium declined
– Increased diversification through mutual funds
– Investors may have underestimated risk
• Optimism and risk premium trends reversed in
2000
– Many high-tech firms less profitable than expected
– Corporate accounting scandals of 2002
– Terrorist attack in US
9-20
 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
1.Medium of exchange
2.Unit of account
3.Store of value
• Money makes barter unnecessary
– Barter is trading goods directly
9-21
 Private Money
• Money is usually issued and controlled by the
government
• Private money can develop in certain circumstances
• An Ithaca Hour is worth $10, the average hourly
wage of workers
– 1,600 individuals have earned and spent this currency
• Encourages local shopping
• LETS (Local Electronic Trading System) is
electronic money from buying and selling goods and
services
– Used in UK, Australia, and New Zealand
9-22
 Measuring Money March 2010
• Definitions of money range from narrow to broad
M1 ($B) $1,712.3
Currency $871.7
Demand deposits 445.5
Other checkable deposits 390.0
Traveler's checks 5.1

M2 ($B) $8,512.5
M1 $1,712.3
Savings deposits 4,935.4
Small-denomination time notes 1,105.0
Money market mutual funds 759.8
9-23
 Commercial Banks Create
Money
• Republic of Gorgonzola begins with no banking
system
– Government issues 1 million guilders
– Banks are created to store cash
• Payments are made by withdrawing cash or writing
checks
– Checks tell bankers of change in ownership of the
specified number of guilders
– Without interest, banks earn profits by charging
depositors fees

9-24
 Consolidated Bank Balance
Sheet – Part 1
• All guilders (g) are deposited
Assets Liabilities
Currency 1,000,000 g Deposits 1,000,000 g
• Bank reserves are cash or similar assets held
by banks
– Used to meet depositors' withdrawals and
payments
– Gorgonzola's banks have 100% reserves
• 100% reserve banking is when banks' reserves
equal 100% of their deposits
9-25
 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
9-26
 Consolidated Bank Balance
Sheet – Part 2
• Currency held in the vault is the bank reserves
Assets Liabilities
Currency 100,000 g Deposits 1,000,000 g
Loans 900,000 g
• The reserve – deposit ratio is bank reserves
divided by total deposits
• Fractional reserve banking system holds less
bank reserves than deposits
– The reserve – deposit ratio is less than 100%

9-27
 Consolidated Bank Balance
Sheet – Part 3
• Farmers borrow 900,000 guilders to buy supplies
– Farmers spend the 900,000 guilders which are then
deposited in the banks
Assets Liabilities
Currency 1,000,000 g Deposits 1,900,000 g
Loans 900,000 g
• Bank deposits are the entire money supply
– Loan of 900,000 guilders increased the money supply
by 900,000 guilders
• Banks are again holding excess reserves on
deposits of 1,900,000 guilders
9-28
 Consolidated Bank Balance
Sheet – Part 4
• With deposits of 1,900,000 guilders and a
reserve – deposit ratio of 10%, banks want only
190,000 guilders in reserves
– Currently holding 1,000,000 guilders
– Loan 810,000 guilders
Assets Liabilities
Currency 1,000,000 g Deposits 2,710,000 g
Loans 1,710,000 g
– Loan are spent and re-deposited
• Excess reserves are created and re-loaned

9-29
 Consolidated Bank Balance
Sheet – The End
• Expansion of loans and deposits stops when
reserves are 10% of deposits
– 1,000,000 guilders available as reserves
– Deposits stabilize at 10,000,000 guilders
Assets Liabilities
Currency 1,000,000 g Deposits 10,000,000 g
Loans 9,000,000 g

• Beginning with 1,000,000 guilders in cash, the

money supply is now 10,000,000 guilders

9-30
 Money Creation
• With 10% reserves, each guilder supports 10
guilders in deposits
• Deposits in the banking system satisfy this
relationship
Bank reserves
= Desired reserve – deposit ratio
Bank deposits

• Solving for bank deposits we get

Bank reserves
Bank deposits =
Desired reserve – deposit ratio

9-31
 Money Supply with Currency
and Deposits
• Gorgonzola residents hold 500,000 guilders as
currency
– Deposit 500,000 guilders in the banks
– Reserve-deposit ratio = 10%
– Bank deposits = 500,000 / 0.10 = 5,000,000
guilders
– Money supply = 500,000 cash + 5,000,000 deposits
= 5,500,000 guilders
Money supply = Currency held by public +
Bank reserves
Desired reserve – deposit ratio
9-32
 Money Supply at Christmas
• Suppose banks hold $500 billion in reserves and
the public holds $500 billion in cash
– Reserve-deposit ratio = 0.20
– Money supply = $500 + (500 / 0.20) = $3,000
• As Christmas approaches, consumers reduce
bank deposits by $100 billion
– Banks have $400 billion in reserves; public holds
$600 billion cash
– Money supply = $600 + ($400 / 0.20) = $2,600
• Reducing bank deposits reduces the money
supply
9-33
 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
9-34
 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

9-35
 Increasing the Money Supply
• An economy has 1,000 shekels in currency and
bank reserves of 200 shekels
– Reserve-deposit ratio = 0.2
– Money supply = 1,000 + (200 / 0.2) = 2,000 shekels
• Central bank pays 100 shekels for a bond held
by the public
– Assume that all 100 shekels are deposited
– Money supply = 1,000 + (300/ 0.2) = 2,500 shekels
– 100 shekel increase in reserves leads to a 500
shekel increase in the money supply

9-36
 Money and Prices
• In the long run, the amount of money circulating
and the level of prices are closely linked
– Sustained high inflation rates occur with a comparably
high growth rate of the money supply

9-37
 Velocity of Money (V)
• Velocity is a measure of the speed money
changes hands in transactions for final goods
and services
Nominal GDP
Velocity =
Money stock

• Nominal GDP is the price level (P) times real

GDP (Y)
Px Y
• M is the money stock V =
M

9-38
 Velocity in the US, 2009
• M1 = $1,693.3 billion
• M2 = $8,524.3 billion
• Nominal GDP = $14,258.7 billion
• Using M1, velocity is 8.42
$14,258.7
V= = 8.42
1,693.3
• Using M2, velocity is 1.67
$14,258.7
V= = 1.67
8,524.3
• Velocity is determined by a number of factors
including technology such as ATMs and debit cards
9-39
Money and Inflation in the Long
Run
• The quantity equation states that money times velocity
equals nominal GDP, M x V = P x Y
– Restatement of the velocity definition
• Shows a relationship between money and price level
– Suppose velocity and real GDP are constant
V and Y, respectively
• The quantity equation becomes
MxV=PxY
– An increase in the money supply by a given percentage
would increase the price level by the same percentage

9-40
 Money, Prices, and the Financial
System
Financial Quantity Equation
System
Open Market
Money
Stocks Operations
Diversification

Bonds
Reserves Federal
Banks Reserve
System

9-41