Lecture Principles of economics (Asia Global Edition) - Chapter 20

Money, Prices, and the
Financial System
Chapter 20

McGraw­Hill/Irwin

Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved.
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Learning Objectives
1.

2.

3.

4.

5.

6.

Describe the role of financial intermediaries such as
commercial banks in the financial system
Differentiate between bonds and stocks and show why
their prices are inversely related to interest rates
Explain how the financial system improves the
allocation of saving to productive uses
Discuss the three functions of money and how the
money supply is measured

Analyze how the lending behavior of commercial
banks affects the money supply
Explain how a central bank controls the money supply
and how control of the money supply is related to
inflation in the long run
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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

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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
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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
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Banking System
•

Banks gather information about potential
investments
–

–
–

•

Banks provide access to credit for small
businesses and homeowners
–

•

Evaluate the options
Direct saving
Service provided to depositors

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
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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

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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
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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
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Bonds
•
•

Corporations and governments issue bonds
The coupon rate depends on
–

The bond's term
•

–

The issuer's credit risk
•
•

–

30 days to 30 years; longer term, higher coupon rate
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
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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
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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
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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

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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
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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
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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
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