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Financial Markets, Money, and the Federal Reserve PowerPoint Presentation
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Financial Markets, Money, and the Federal Reserve

Financial Markets, Money, and the Federal Reserve

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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