The Financial System and the Economy
The Financial System and the Economy ECON 3210
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Chapter 1 Introducing Money and the Financial System Chapter 1 Introducing Money amp the Financial System I Key Terms and Concepts Asset Anything of value owned by a person or a rm Bond A nancial security issued by a corporation or a government that represents a promise to repay a xed amount of money Bubble An unsustainable increase in the price ofa class of assets Commercial bank A nancial rm that serves as a nancial intermediary by taking in deposits and using them to make loans Diversi cation Splitting wealth among many different assets to reduce risk Dividend A payment that a corporation makes to its shareholders Information Facts about borrowers and about expectations of returns on nancial assets Interest rate The cost of borrowing funds or the payment for lending funds usually expressed as a percentage of the amount borrowed Liquidity The ease with which an asset can be exchanged for money Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives Money Anything that is generally accepted in payment for goods and services or to pay off debts Money supply The total quantity of money in the economy Portfolio A collection of assets such as stocks and bonds Federal funds rate The interest rate that banks charge each other on shortterm loans Federal Reserve The central bank of the United States usually referred to as the Fed Financial asset An asset that represents a claim on someone else for a payment Financial intermediary A nancial rm such as a bank that borrows funds from savers and lends them to borrowers Financial liability A nancial claim owed by a person or a rm Financial market A place or channel for buying or selling stocks bonds and other securities Foreign exchange Units of foreign currency Primary market A nancial market in which stocks bonds and other securities are sold for the rst time Risk sharing A service the nancial system provides that allows savers and borrower to spread and transfer risk Secondary market A nancial market in which investors buy and sell existing securities Securitization The process of converting loans and other nancial assets that are not tradable into securities Security A nancial asset that can be bought and sold in a nancial market Stock Financial securities that represent partial ownership of a rm also called equities Chapter 1 Introducing Money and the Financial System I Brief Chapter Summary and Learning Objectives 11 Key Components of the Financial System pgs 2 14 0 Financial assets nancial institutions and government regulators are the key components of the nancial system 0 There are many different types of nancial assets with distinctive characteristics 0 Financial institutions are distinguished by how they transfer funds from savers or lenders to borrowers 0 There are different regulators that provide oversight to different aspects of the nancial system 12 The Financial Crisis of 2007 2009 pgs 14 17 0 Provides a unique opportunity to explore the role amp signi cance of the nancial system in the economy 13 Explain Key Issues and Questions from the Financial Crisis pgs 17 19 0 Many issues arise as a result of the nancial crisis most of which will be addressed in lture chapters l Chapter Outline Can the F ed Restore the FIOW of Money A nancial system can be compared to an irrigation system The nancial crisis of 200772009 showed what happens when credit does not ow Just as a lack of water keeps crops from growing lack of credit keeps the economy from growing Just like a severe drought can cause many crops to die an extreme scarcity of credit can kill of parts of the economy resulting in a severe recession Few people doubt the importance of the nancial system but the nancial crisis also exposed the complexity of the system Chapter 1 Introducing Money and the Financial System 11 Key Components of the Financial System pgs 2 14 A Financial Assets Can be divided among 5 categories money stocks bonds foreign exchange amp securitized loans Money is anything people are willing to accept in payment for goodsservices or to pay off debts Stocks also called equities are nancial securities that represent partial ownership of a rm When you buy a bond issued by a corporation or government you are lending the corporation or government a xed amount of money Foreign exchange refers to units of foreign currency Loans that banks could sell on nancial markets became securities so the process of converting loans into securities is known as securitization B Financial Institutions The nancial system is made up of 2 types of nancial institutions Banks amp other nancial intermediaries amp nancial markets Funds ow from lenders to borrowers indirectly through nancial intermediaries such as banks or directly through nancial markets Commercial banks are the most important nancial intermediaries Some nancial intermediaries such as savingsandloans savings banks amp credit unions are legally distinct from banks although these nonbanks operate in a similar way by taking in deposits amp making loans Other nancial intermediaries include insurance companies pension funds mutual funds hedge funds amp investment banks Financial markets are places or channels for buying selling stocks bonds and other securities C The Federal Reserve amp Other Financial Regulators The federal government of the United States has several agencies that are devoted to regulating the nancial system including the Securities amp Exchange Commission SEC which regulates nancial markets the Federal Deposit Insurance Corporation FDIC which insures deposits in banks the Of ce of the Comptroller of the Currency which regulates federally chartered banks amp the Federal Reserve System which is the central bank of the United States 2 of the major roles of the Fed are lserving as the lender of last resort and 2conducting monetary policy Monetary policy is the actions the Federal Reserve takes to manage the money supply amp interest rates to pursue macroeconomic policy objectives such as high levels of employment low rates of in ation high rates of growth amp stability of the nancial system Figure 12 on page 11 shows the location of the 12 districts of the Federal Reserve system D What Does the Financial System Do The nancial system provides 3 key nancial services risk sharing liquidity amp information Risk sharing gives savers amp borrowers ways to reduce the uncertainty to which they are exposed Liquidity is a measure of how easily an asset can be converted to cash The nancial system gathers amp communicates information about borrowers circumstances Teaching Tips Pages 13714 of the main text include a Solved Problem which shows students how to solve an economic problem by breaking it down step by step Encourage students to read the Solved Problems in each chapter because it can help them solve homework problems on their own and develop skills needed to complete exams An Inside LookatPolicyat the end of the chapter considers options Federal Reserve Chairman Ben Bemanke considered to further support the economy in late 2010 and his view of the large federal budget de cit Discussion of the article can help students gain an appreciation about the complexity involved in policymaking Chapter 1 Introducing Money and the Financial System 12 The Financial Crisis of 2007 2009 Overview pgs 14 17 A Origins of the Financial Crisis The origins of the nancial crisis lie in the housing bubble of 200072005 While overly optimistic expectations by home buyers and builders may have played some role in the housing bubble many economists believe that changes in the market for mortgages played a bigger role By the 2000s signi cant changes had taken place in the mortgage market First investment banks became signi cant participants in the secondary market for mortgages Second by the height of the housing bubble in 2005 and early 2006 lenders had greatly loosened the standards for obtaining a mortgage loan Unfortunately the decline in housing prices that began in 2006 led to rising defaults among subprime and AltA borrowers borrowers with adjustablerate mortgages and borrowers who had made only small down payments By mid2007 the decline in the value of mortgagebacked securities and the large losses suffered by commercial and investmentbanks began to cause turmoil in the financial system Many investors refused to buy mortgagebacked securities and some investors would only buy bonds issued by the US Treasury Banks began to restrict credit to all but the safest borrowers The ow of funds from savers to borrowers on which the economy depends began to be greatly reduced B The Deepening Crisis and the Response ofthe Fed and Treasury The fallout from the Lehman Brothers 39 39 l had 39 39 A 39 l 39 including a sharp decline in most types of lending In October 2008 Congress passed the Troubled Asset Reliemegmm TARP under which the Treasury provided funds to commercial banks in exchange for stock in those banks These actions by the Fed and the Treasury were meant to restore the ow of funds from savers to borrowers 13 Explain the Key Issues amp Questions from the Financial Crisis pgs17 19 Pages 17718 list the Issues and Questions that serve as a roadmap for the topics the book will explore in the remaining chapters l Answers to Thinking Criticaly Questions p921 1 Although the extension of unemployment bene ts increased incomes of 25 million unemployed people it also reduced the incentive for these people to search for new jobs Ben Bemanke referred to the risks of extending the period that people are unemployed People who are unemployed for a long period of time often see their skills atrophy or see their skills become irrelevant I think we need to be very seriously concerned about the implications of longterm unemploymen 2 a Increasing the interest rate paid on reserve balances will increase incentive banks have to hold onto excess reserves rather than use them to create new loans When banks make new loans the money supply increases which could cause additional in ationary pressure Although the Fed could increase its target for the federal funds rate to stem future in ation this could also signal to nancial markets that the Fed was moving to a more contractionary monetary policy This signal could risk slowing economic growth in an economy that in July 2010 was suffering from a 95 unemployment rate 57 11 Answers to Key Components ofthe Financial System Questions PG 22 12 Brie y Define each of the 5 Key Financial Assets 1 Money Anything that people are willing to accept in payment for goods and services or to pay off debts 2 Stocks Financial securities that represent partial ownership of a rm 3 Bonds Financial securities issued by corporationGovn t to borrow money in exchange for the rights to interest amp principal payments Chapter 1 Introducing Money and the Financial System 4 Foreign Exchange Units of foreign currency 5 Securitized Loans Loans that are tradableithat can be bought and sold in nancial markets Is every nancial asset also a nancial security No every nancial asset is not a nancial security Only nancial assets that can be boughtsold in a nancial market are nancial securities Is it possible that what a saver considers a financial asset a borrower considers a financial liability Yes what a saver considers a nancial asset a borrower would consider a nancial liability 13 What is the difference between Direct and Indirect Finance Direct nance is a direct transaction between two parties where one party lends directly to the other party Requires nancial markets Buying stock of a rm s IPO Initial Public Offering is direct nancing Indirect nancing involves 3 parties borrower lender amp the nancial intermediary who accepts the savings of party one amp independently lends those savings to party two A bank is an example of indirect nancing Indirect nancing involves nancial intermediaries 16 What is the Federal Reserve The Federal Reserve is the central bank of the United States amp serves as lender of last resort to banks The Federal Reserve is responsible for monetary policy Who appoints the members ofthe Federal Reserve s Board ofGovernors The members of the Board of Governors are appointed by the president with consent of the senate How do the Fed s current responsibilities compare with its responsibilities when it was first created by congress The Federal Reserve s initial responsibility was to act as a lender of last resort As the nancial system amp banking system have evolved the Fed s role has expanded to include the conduct of monetary policy to manage in ation unemployment amp the stability of the nancial system 17 Describe the 3 Key services the nancial system provides to savers i Risk sharing this allows investors to diversify their nancial assets ii Liquidity which is the ease with which an asset can be exchanged for money iiiCollectioncommunication of info about borrowers amp expectations of returns on nancial assets 18 Is an Insurance Company a Financial Intermediary Insurance companies specialize in contracts to protect their policy holders from risk of nancial loss These companies invest the insurance premiums they collect in stocks bonds amp mortgages Insurance companies channel funds from savers to borrowers which makes them a nancial intermediary 12 The Financial Crisis of 2007 2009 Questions pg 24 21 What do economist mean by bubble A bubble is an unsustainable increase in the price of a class of assets Why do they believe there was a Housing Bubble between 20002005 Many economists believe that there was a housing bubble in the United States between 2000 and 2005 because among other things housing prices rose nearly 90 from 2000 to July 2005 and then fell more than 30 from 2006 to 2009 Chapter 4 Determining Interest Rates 4 H 42 43 44 Closed economy An economy in which households rms and governments do not borrow or lend internationally Diversi cation Dividing wealth among many different assets to reduce risk Expected return The return expected on an asset during a future period also known as expected rate of return Brief Chapter Summary and Learning Objectives How to Build an Investment Portfolio pages 88 94 Discuss the most important factors in building an investment portfolio The determinants of portfolio choice include wealth the expected rate of return compared to other investments degree of risk compared to alternatives liquidity compared to other assets and the cost of acquiring information about the investment relative to other investments 0 To compensate for the inability to find a perfect asset investors typically hold various types of assets such as shares of stock issued by different companies Market Interest Rates and the Demand and Supply for Bonds pages 94 102 Use a model of demand and supply to determine market interest rates for bonds The demand and supply of bonds determines bond prices and thus their interest rates Changes in the following factors will cause the demand curve for bonds to shift wealth expected returns on bonds risk liquidity and costs of information Changes in the following factors will cause supply curve for bonds to shift the expected pro tability of physical capital investment business taxes expected in ation and government borrowing The Bond Market Model and Changes in Interest Rates pages 102 107 Use the bond market model to explain changes in interest rates 0 Any factor that affects the demand or supply of bonds affects bond prices and thus interest rates The Loanable Funds Model and the International Capital Market pages 107 115 Use the loanable funds model to analyze the international capital market 0 Virtually all economies interact with the rest of the world and are open economies o In a small open economy the domestic real interest rate is determined by the international capital market since the domestic supply and demand for funds is too small to affect the world real interest rate 0 A large open economy is an economy that is large enough to affect the world real interest rate Key Terms and Concepts Fisher effect The assertion by Irving Fisher that the nominal interest rises or falls pointforpoint with changes in the expected in ation rate Idiosyncratic or unsystematic risk Risk that pertains to a particular asset rather than to the market as a whole as when the price of a particular rm s stock uctuates because of the success or failure of a new product 2012 Pearson Education Inc Publishing as Prentice Hall 32 Hubbard amp O Brien Money Banking and the Financial system First Edition La 8 open 9an An ecfmomy in WhiCh Open economy An economy in which households shifts in domestic savrng and investment are large firms and governments borrow and lend enough to affect the world real interest rate internationally Market or SYStematic riSk RjSk that is Risk The degree of uncertainty in the return on common to all assets of a certain type such as the an asset increases and decreases in stocks resulting from the business cycle Small open economy An economy in which total saving is too small to affect the world real interest rate I Chapter Outline Ifianation increases are bonds a good investment Some investment advisors in late 2009 advised clients to not to buy bonds because of anticipated in ation in upcoming years 41 How to Build an Investment Portfolio pages 88 94 Learning Objective Discuss the most important factors in building an investment portfolio A The Determinants of Portfolio Choice The determinants of portfolio choice include wealth the expected rate of return compared to other investments degree of risk compared to alternatives liquidity compared to other assets and the cost of acquiring information about the investment relative to other investments An increase in wealth tends to increase the demand for most nancial assets Demand for some assets such as CDs stocks and bonds are likely to increase more while other assets such as checking accounts increase less People choose to acquire assets with higher expected rates of return Investors need to consider possible returns and the probability of those returns occurring when estimating expected returns Risk is the degree of uncertainty in the return of an asset Most investors are risk averse and will choose to invest in a risky asset only if they are compensated by receiving a higher return As a result we tend to view a tradeoff between risk and return The greater an asset s liquidity the more desirable the asset is to investors Thus an investor will be willing to receive a lower return on a liquid asset compared to an asset that is less liquid Investors nd assets more desirable if they do not have to spend time or money acquiring information about them All else equal investors will accept a lower return on an asset that has lower costs of acquiring information 03 Diversi cation To compensate for the inability to nd a perfect asset investors typically hold various types of assets such as shares of stock issued by different companies Diversi cation reduces idiosyncratic risk the risk associated with a particular asset Much of the remaining risk is market or systematic risk risk that is common to all assets of a certain type Teaching tips In Mla39ng the Connection Fear the Bla ck Swan on pages 90791 the authors introduce the concept of a Black Swan event that was developed by Nassim Taleb professional investor and professor at New York University The basic idea of a black swan is that occasionally there are unique events that take place more often than people think that have a signi cantly adverse effect on returns In an article titled Preparing for the Next Black Swan in the Wall Street Journal August 21 2010 points out that diversi cation may not be suf cient in reducing risk when there are Black Swan events For example during the nancial crisis in late 2008 virtually all asset classes declined in value at the same time Instead of relying on only diversi cation 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 33 investors may instead want to make use of various forms of derivatives to prepare for Black Swans However there is no free lunch since there are costs involved in purchasing derivatives while they may only be exercised on rare occasions This topic will be explored further in Chapter 7 42 Market Interest Rates and the Demand and Supply for Bonds pages 94 102 Learning Objective Use a model of demand and supply to determine market interest rates for bonds A A Demand and Supply Graph of the Bond Market 2012 Pearson Education Inc Publishing as Prentice Hall 34 Hubbard amp O Brien Money Banking and the Financial system First Edition The demand curve for bonds represents the relationship between the price of bonds and the quantity of bonds demanded by investors holding constant all other factors As the price of bonds increases their interest rates fall and they become less desirable to investors so the quantity demanded will decline resulting in a downwardsloping demand curve The supply curve represents the relationship between the supply of bonds and quantity of bonds supplied byinvestors W110 own existing bonds and b y rms that are considering issuingnew bonds As the price of bonds increases their interest rates will fall and holders of existing bonds will be more inclined to sell them resulting in an upwardsloping supply curve An excess supply of bonds leads to a lower bond price and therefore a higher interest rate whereas an excess demand for bonds leads to a higher bond price and a lower interest rate B Explaining Changes in Equilibrium Interest Rates The demand and supply curves for bonds held constant everything that could affect the willingness of investors to buy bonds or rms and investors to sell bonds except for the price of bonds If any other relevant variableisuch as wealth or the expected rate of inflationichanges then the demand or supply curve shifts and we have a change in demand or supply C Factors that Shift the Demand Curve for Bonds An increase in wealth increases the demand for bonds If the expected return on bonds rises relative to expected returns on other assets then investors will increase their demand for bonds and the demand curve for bonds will shift to the right If expected inflation increases the expected real interest rate will decline reducing the demand for bonds An increase in the risk of bonds relative to the risk ness of other assets decreases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the left If the liquidity of bonds increases investors demand more bonds at any given price and the demand curve for bonds shifts to the right Lower information costs for bonds causes the demand curve for bonds to shift to the right Teachings Tips In the spring of 2010 there was considerable concern about a possible sovereign debt crisis in Europe with particular attention paid to Greece Portugal and Spain Have students discuss the response of global investors to this crisis Be sure to indicate how global investors ed to the safety of US Treasury bonds resulting in a decline in interest rates on U S government bonds D Factors That Shift the Supply Curve for Bonds An increase in rms expectations of the pro tability of investments in physical capital will holding all other factors constant shift the supply curve for bonds to the right as firms seek to nance new investment When business taxes are raised the pro ts firms earn on new investments in physical capital decline and rms issue fewer bonds causing the supply of bonds to shift to the left An increase in the expected inflation rate results in a decline in the real interest rates causing the supply curve of bonds to shift to the right Ifthe government runs a larger budget de cit it will need to issue more bonds causing the supply of bonds to shift to the right Ifthe government runs a deficit households may save more in anticipation of higher future tax payments causing the demand for bonds to shift to the right However studies indicate that households do not increase their saving by the full amount of the budget de cit thus all else equal bond prices are likely to decline and interest rates increase Teachings Tips Encourage students to spend some time reviewing the following tables Table 42 Factors that Shift the Demand Curve for Bonds on page 99 Table 43 Factors that Shift the Supply Curve for Bonds on page 103 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 35 43 The Bond Market Model and Changes in Interest Rates pages 102 107 Learning Objective Use the bond market model to explain changes in interest rates 44 A 03 Why Do Interest Rates Fall During Recessions During recessions wealth declines as does the expected pro tability of investments The decline in wealth shifts the demand for bonds to the left putting downward pressure on bond prices while the decline in the expected pro tability of investment causes the supply of bonds to shift to the left putting upward pressure on prices Evidence from US data shows that interest rates decline during recessions indicating that supply declines more than demand resulting in higher bond prices How Do Changes in Expected In ation Affect Interest Rates The Fisher Effect Higher expectations of in ation reduce the expected real interest rate leading to an increase in the supply of bonds and a decrease in the demand for bonds As a result the bond price declines and the interest rate increases This supports the Fisher Effect which states that the nominal interest rate increases oneforone with changes in expected in ation Economists have found that various real world frictions result in nominal interest rates not always increasing or decreasing by exactly the amount of a change in expected in ation The Loanable Funds Model and the International Capital Market pages 107 115 Learning Objective Use the loanable funds model to analyze the international capital market A P3 Q U The Demand and Supply for Loanable Funds The demand curve for loanable funds which shows the relationship between the quantity demanded for loanable funds and the interest rate is equal to the supply of bonds The supply curve for loanable funds which relates the quantity of loanable funds supplied to the interest rate is equal to the demand for bonds Equilibrium in the Bond Market from the Loanable Funds Perspective Any of the factors that that cause the demand curve for bonds to shift will cause the supply curve for loanable funds to shift Similarly any of the factors that cause the supply curve for bonds to shift will cause the demand curve for loanable funds to shift Interest rates will adjust to ensure that the quantity demanded for loanable funds equals the quantity supplied of loanable funds The International Capital Market and the Interest Rate Nearly all economies are open economies where nancial capital or loanable funds is mobile internationally Borrowing and lending takes place in the international capital market which is the capital market in which households firms and governments borrow and lend across national borders The world real interest rate is the interest rate that is determined in the international capital market A closed economy is an economy that has no interaction in terms of trade or nance with other countries which is extremely rare in today s world Small Open Economy In the case of a small open economy the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate So a small open economy s domestic real interest rate equals the world real interest rate as determined in the international capital market Ifthe quantity of loanable funds supplied domestically exceeds the quantity of funds demanded domestically at that interest rate the country invests some of its loanable funds abroad If the quantity of loanable funds demanded domestically exceeds the quantity of funds supplied domestically at that interest rate the country finances some of its domestic borrowing needs with funds from abroad 2012 Pearson Education Inc Publishing as Prentice Hall 36 Hubbard amp O Brien Money Banking and the Miranda system First Edition E Large Open Economy A large open economy is an economy that is large enough to affect the world real interest rate The interest rate will adjust until the excess supply demand of loanable funds from the large open economy equals the excess demand supply for loanable funds in the rest of the world resulting in the domestic real interest rate equaling the world real interest rate Factors that cause the demand and supply of funds to shift in a large open economy will affect not just the interest rate in that economy but the world real interest rate as well Teaching Tips For years the United States has experienced huge net capital in ows Some people are concerned about borrowing from abroad Have students discuss what would happen to real interest rates in the United States if we restricted borrowing from overseas ie if the United States became a more closed economy 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 37 Solutions to the Endof Chapter Questions and Problems Answers to Thinking Critically Questions 1 41 The Fisher effect states that the nominal interest rate rises pointforpoint with the expected rate of in ation The Fisher effect implies that changes in expected in ation can lead to changes in nominal interest rates before a change in in ation has occurred Bill Gross from the investment firm Pimco cited in ationary expectations as well as an increase in the supply of Treasury bonds as reasons for interest rate increases Besides the in ation fears set off by the strengthening economy Mr Gross said he was also wary of Treasury bonds because he feared the burgeoning supply of new debt issued to nance the government s huge budget de cits would overwhelm demand driving interest rates higher The US in ation rate in the late 1970s reached doubledigit levels which made in ation the nation s number one economic problem After Paul Volcker was named chairman of the Federal Reserve Board in August 1979 the Fed began to reduce the growth of the money supply The combination of high in ationary expectations and tight monetary policy drove interest rates to very high levels As a result the United States suffered from a recession that began in August 1981 and ended in November 1982 As the economy contracted in ationary expectations and interest rates declined How to Build an Investment Portfolio Learning objective Discuss the most important factors in building an investment portfolio Review Questions 11 12 A portfolio is a collection of investments held by an institution or private individual There are ve determinants 1 The amount of wealth a saver has 2 the expected rate of return compared to quot 3 the l quot degree of risk 4 the comparative degree of liquidity and 5 the comparative degree of the cost of acquiring information about the investment Expected return is the return expected on an asset during a future period Risk is the degree of uncertainty in the return on an asset Risk averse refers to investors who have an aversion to risk meaning that when choosing between two assets with the same expected returns riskaverse investors would choose the asset with the lower risk Most investors are risk averse The higher the risk that an asset has the lower the demand for the asset which raises the yield or return Lowrisk assets have a high demand which lowers their yield or return Market risk is the risk that is common to all assets of a certain type because of shared economic conditions Idiosyncratic risk is the risk that pertains to a particular asset such as an individual stock rather than to the market as a whole Diversi cation is the process by which individuals or firms allocate savings among many different assets Diversi cation reduces risk because individuals and firms have a variety of different asset classes so if one class say bonds performs poorly the rest of the portfolio may perform well 2012 Pearson Education Inc Publishing as Prentice Hall 38 Hubbard amp O Brien Money Banking and the Miranda system First Edition Problems and Applications 18 Google founders Page and Erin were reducing the amount of idiosyncratic risk in their portfolios by reducing their holdings of Google stock and purchasing other assets to increase diversi cation and liquidity 19 A black swan event is an event that happens very rarely that has a large impact on society Black swan events are hard to predict because the likelihood of them happening is statistically very low Some consider the financial crisis of 200772009 a black swan event 110 The primary tradeoff is between risk and reward Generally the more risk an asset has the higher the return it provides For instance a highyielding corporate bond probably has a high yield because of the risk of default However if the company stays solvent then the reward is very high A government bond has a very low risk of default but also has a relatively lower yield 111 Young people should allocate the majority of their portfolio to equities because of the greater rate of return over the long run As investors get older their portfolio should switch to less risky assets such as treasury bonds 42 Market Interest Rates and the Demand and Supply for Bonds Learning objective Use a model of demand and supply to determine market interest rates for bonds Review Questions 21 a The demand curve for bonds would shift to the left because wealth decreases expected returns on bonds relative to other assets decreases expected in ation increases 1 2 3 4 risk on bonds relative to other assets increases 5 liquidity decreases or 6 costs of information increases b The supply curve for bonds would shift to the right because 1 expected pro tability increases 2 corporate tax rates decrease 3 subsidies to business increase 4 expected in ation rises or 5 government borrowing increases 22 The bond demand curve slopes down because as the price of bonds decreases the interest rates on the bonds will rise and the bonds will become more desirable to investors so the quantity demanded will rise The bond supply curve slopes up because as the price of bonds decreases their interest rates will rise and holders of existing bonds will be less willing to sell them Also firms will find it more expensive to borrow at the higher interest rate and will issue fewer bonds For both of these reasons the quantity of bonds supplied will decrease 23 The excess supply of bonds causes the price of bonds to fall increasing quantity demanded and reducing quantity supplied There is no shift in the supply or demand curve 24 a False the quantity demanded of bonds falls b True The lower the price the higher the yield which increases the cost of borrowing True A shift to the right in the demand curve will push bond prices up and yields down 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 39 d False This would cause a shift to the left of the demand for US government bonds pushing price down and yield up 2012 Pearson Education Inc Publishing as Prentice Hall 40 Hubbard amp O Brien Mane Ballring andtllel l39nancial 53512111 First Edition Problems and Applications 25 a Demand curve shi s le supply ofbonds shi s right Supply curve shi s right Supply curve shi s le Demand curve shi s le Demand curve shi s le supply curve shi s le F 9 51 26 a The actual real rate of interest can become negative if the actual in ation rate suf ciently exceeds the expected in ation rate During the 19705 the in ation rate unexpectedly rose to double digits leading to negative actual real interest rates 9 27 a Supply curve shi s right reducing the price of bonds and increasing the equilibrium quantity of bonds Price of 51 S Bonds 2 3 P1 E 2 2 gt Q1 02 Quantity of Bonds b The demand curve shi s to the right increasing the price of bonds and increasing the equilibrium quantity of bonds Price of s Bonds 39 P E 2 P 1 E gt DI 0 Q2 Quantity of Bonds 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 41 c The supply of bonds shi s to the right and the demand for bonds shi s to the right This increases the equilibrium quantity of bonds but the change in the price of bonds is in determinant O 02 Quantityof Bonds 28 The supply curve would shi to the le mising bond prices and lowering bond yields 52 Price of 5 Bonds P2 f El Pl El Dl 4 Q2 01 Quantity of Bonds 29 The pro table business opportunities would increase the supply for bonds and the increase in stock prices would lower the comparative return on bonds decreasrng the demand for bonds As shown in the graph below the price of bonds would fall but the equilibrium quantity would be indeterminate Price of S Bonds I S gt 2 P1 5 P2 52 lt D D2 0 Quantity of Bonds 2012 Pearson Education Inc Publishing as Prentice Hall 42 Hubbard amp O Brien Mane Banking andtlleFinancial 53512111 First Edition 43 The Bond Market Model and Changes in Interest Rates Learning objective Use the bond market model to explain changes in interest rates Review Questions 31 Interest rates fall during recessions As the graph below shows the demand for bonds decreases since households experience declining wealth and the supply of bonds decreases since businesses have fewer pro table opportunities during a recession For interest mtes to fall the price of bonds must rise so the decrease in the supply for bonds must exceed in magnitude the decrease in the dem for bonds Price of Bonds 02 0 Quantity of Bonds According to the Fisher effect the nominal interest rate rises or falls point for point with changes in the expected in ation me As the graph below shows an increase in expected in ation decreases bond demand and increases bond supply decreasing bond prices and increasing bond yields interest mtes Price of 5 Bonds 52 P E1 P2 52 D1 DZ 01 Quantity of Bonds 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 43 Problems and Applications 33 a F o P 517 7 9 Demand will shi right and supply will shi le The price increases and but it is unclear What happens to the equilibrium quantity of bonds The demand for bonds shi s right With the increase in Weath from the expansion and the supply for bonds shi s right With the increase in pro table opportunities During economic expansions interest rates typically rise so the price of bonds must fall implying that the increase in the supply for bonds exceeds the increase in the demand for bonds The equilibrium quantity of bonds increases Supply of bonds shi s to right and the demand for bonds shi s le The price ofbonds falls but it is unclear What happens to the equilibrium quantity of bonds The supply of bonds increases shi ing the supply curve to the right forcing prices down and the It Was unclear Whether the Greek government Was going to be able to continue to nance its large budget de cits The demand for bonds was falling drastically because of the risk of Greece defaulting on its debt The large Greece budget de cits increasedbond supply and the increasing risk of default decreased bond demand decreasing bond prices and increasing yields Price of Bonds P1 P2 D2 Quantity of Bonds De ation is a fall in the aggregate price level When calculating the real interest rate de ation increases the yield on bonds An increase in expected in ation Would shi the demand for bonds to the le and the supply for bonds to the right pushing prices down and yields up Longerterm bonds Wouldbe more at risk because in ation is expected to increase over extended periods of time because of Fedeml Reserve policy during the nancial crisis for a given change in interest mtes longterm bond prices are more affected than shortterm bond prices Bond prices Will fall and interest rates Will rise Investors Who bought long term treasury bonds Will bene t because the price will not fall as anticipated meaning owners of these bonds will make a higher yield 2012 Pearson Education Inc Publishing as Prentice Hall 44 Hubbard amp O Brien Money Banking and the Miranda system First Edition 44 The Loanable Funds Approach and the International Capital Market Learning objective Use the loanable funds model to analyze the international capital market Review Questions 41 42 43 44 a b F 37 0 9 Bond lVIarket The good is the bond Loanable Funds The good is the use of funds Bond Market The buyer is the bond holder the saver investor Loanable Funds The buyer is the borrower Bond Market The seller is the borrower a government or a corporation Loanable Funds The seller supply curve is the saver Bond Market The price is the price of the bond Loanable Funds The price is the interest rate The demand curve is downward sloping because the higher the interest rate the less demand for borrowing because the cost is higher The supply curve is upward sloping because the higher the interest rate the more willing suppliers of loanable funds will be to lend money The bond market approach is most useful when considering how the factors affecting the demand and supply for bonds affect the interest rate The loanable fund approach is most useful when looking at the ow of funds between the US and foreign nancial markets A closed economy is an economy where households rms and governments do not borrow or lend internationally Small open economy An economy where the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate It is also assumed that nancial capital moves internationally A large open economy is an economy that is large enough to affect the world interest rate and assumes that capital moves internationally The world real interest rate is the interet rate that is determined in the international capital market that equates the world quantity demanded of loanable funds to the world quantity supplied of loanable funds Problems and Applications 45 a b As shown in the graph below the demand curve for loanable funds shifts right raising the world real interest rate The supply curve for loanable funds would also shift right The interest rate would fall from its previous point in part a to an undetermined point depending on how much households increased their saving See the graph below 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 45 World real interest rate rw Quantity of Loanable Funds World 46 As shown in the graph below the demand curve for loanable funds in the United States shi s to the le Which lowers somewhat the World real interest mte This Would cause an excess supply 0 loanable inds inthe US Which Would make the US a net international lender d real interest rate r w Quantity of Loanable Funds United States 47 a No change in World interest rate Since a small open economy has the same interest rate as the World interest rate there Would be no change in the domestic interest rate b No change in the interest rate c The supply of loanable inds Worldwide shi s to the right reducing interest mtes d No change in World interest rate 48 a Demand for loanable funds increases increasing interest mtes 9 Demand for loanable funds decreases decreasing interest rates 2012 Pearson Education Inc Publishing as Prentice Hall 46 Hubbard amp O Brien c 49 a b c 410 a b Money Banking and the Miranda system First Edition Supply of loanable funds increases decreasing interest rates Supply of loanable funds decreases increasing interest rates Net expected pro tability falls so the demand for loanable funds falls Expected pro tability rises so the demand for loanable funds rises The increase in the expected aftertax interest rate reduces the demand for loanable funds The treasury market is the market for US Treasury bonds If there were panic people would sell Treasury bonds pushing prices down and the yield up The author notes that yields have not risen which means there has not been a selloff of Treasury bonds 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 4 Determining Interest Rates 47 411 a In the graph below begin with the world real interest rate equal to 3 and the rest ofthe world as a n 39nternational lender and the US as a net international borrower An increase in saving in the rest of the world shi s the supply of loanable funds in the rest of the world to the right lowering the world real interest mte to 1 With the increased saving the rest of the world becomes more of an international lender and with the lower world real interest rate the U S becomes more of an international borrower World re I L s 3 interest rates rW L t o Y Rest of he 3 world lends abroad 1 1 n Hg US borrows from abroad Lu t39ty of Quantity of Quan I Loanable Funds Leanabte Funds La United States Rest of the World b There is a debate over whether the Fedeml Reserve was responsible for low interest rates or whether the global savings glut was responsible If the global savings glut was responsible we could argue that the Federal Reserve should take less blame for the arti cially low interest rates that helped facilitate the housing bubble Data Exercises D4l The peak yield over the 5 year period was 511 in May and June of 2006 The lowest yield was at 242 in December of 2008 Bond yields fell from peak to trough because ofinvestors ight to safety In a time ofpanic US Treasury bonds are the safest asset in the world The demand curve shi s to the right pushing prices up and yields down 10 231 Tveasuvy Band mm Yield 6 2 2005 was 20a7 20m 2009 20m 2012 Pearson Education Inc Publishing as Prentice Hall 48 Hubbard amp O Brien Mane Banking andtllel l39nancial 53512111 First Edition D42 Assuming the investor holds to maturity 1981 would have been the best year to buy a bond 10 8 3 6 E a 4 H 2 2 Egg 0 73 m 2 4 6 1973 1979 1985 1991 1997 2003 2009 Nominal interest rate percent 8 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 Pearson Education Inc Publishing as Prentice Hall Ch 2 Money amp the Payments System I Key Terms and Concepts Barter system of exchange in which individuals trade goodsservices directly for other goodsservices Checks promise to pay on demand money deposited with a bank or other nancial institution Commodity money a good used as money that has value independent of its use as money Legal tender government designation that currency is accepted as payment of taxes amp must be accepted by individuals amp rms in payment of debts M1 A narrower de nition of the money supply The sum of currency in circulation checking account deposits amp holdings of traveler s checks M2 A broader de nition of the money supply all the assets that are included in M1 as well as time deposits with a value ofless than 100000 savings accounts money market deposit accounts amp noninstitutional money market mutual fund shares Medium of exchange Something thats generally accepted as payment for goods services a function of money Monetary aggregates The measures of the quantity of money that are broader than currency M1 amp M2 Money Anything thats generally accepted as payment for goods services or in the settlement of debts Emoney Digital cash people use to buy goodsservices over the Internet short for electronic money Fiat money Money such as paper currency which has no value apart from its use as money Hyperin ation rate of in ation that exceeds 100 per year Quantity theory of money theory about the connection between money amp prices that assumes that the velocity of money is constant Specialization A system in which individuals produce the goodsservices for which they have relatively the best ability Standard of deferred payment The characteristic of money by which it facilitates exchange over time Store of value The accumulation of wealth by holding dollars or other assets that can be used to buy goodsservices in the future a function of money Transactions costs The costs in time or other resources that parties incur in the process of agreeing amp carrying out an exchange of goods services Unit of account way of measuring value in an economy in terms of money a function of money Wealth The sum of the value of a person s assets minus the value of the person s liabilities l Brief Chapter Summary and Learning Obiectives 21 Do We Need Money PG 26 28 Analyze the inef ciencies of a barter system 0 Money reduces the transactions costs of exchange as well as other inefficiencies of the barter system 22 Discuss the four key functions of money pages 28 31 0 Money serves four key functions in the economy It acts as a medium of exchange a unit of account and a store of value and it offers a standard of deferred payment 23 Explain the role of The Payments System pages 31 33 0 The efficiency of the payments system has increased over time as new instruments have reduced the cost of settling transactions 24 Explain how the U S money supply is measured pages 33 37 0 There are currently 2 measures of the money supply in the United States M1 amp M2 0 M1 includes liquid assets that can directly be used as a medium of exchange while M2 includes shortterm assets that are less liquid but can readily be converted to currency amp be used as a medium of exchange 25 Use the Quantity Theory of Money to analyze the relationship between money amp prices in the long run pages 37 43 0 The quantity theory of money helps to explain the longrun relationship between the growth of the money supply amp in ation l Chagter Outline 77w Federal Reserve F 1113 to Preserve Its Independence Most people assume money doesn t change over time However money continues to evolve even today for example consider PayPal an ecommerce business that allows people to make payments amp transfer money through the Internet A more efficient payments system leads to increased economic activity Given the important role of money in the economy it s important to understand what it means amp how it s measured When central banks lose control of the money supply or allow it to grow too much the result is higher in ation over time 21 Do We Need Money Analyze the inefficiencies of a barter system PG 26 28 es we need money because money allows for specialization higher productivity and higher incomes A Barter a system of exchange in which individuals trade goods services directly for other goodsservices There are 4 main sources of inef ciency in a barter economy 1 the time and effort spent looking for trading partners 2 Each good has many prices in terms of all other goods with which it can be exchanged 3 A lack of standardization of the products being traded 4 Difficulty in accumulating wealth people need to store various products The Invention of Money Money reduces transactions costs as well as other inefficiencies of barter Money allows for specialization a system in which individuals produce the goods services for which they have relatively the best ability 03 22 Money serves four key functions in the economy PG 28 31 1 Acts as a Medium of Exchange describes the role of money as a generally accepted payment for goods and services N It s a Unit of Account the function of money in which money can be used to measure value in an economy LA It s a Store of Value Money allows for the accumulation of wealth by holding onto dollars or other assets that can be used to buy goodsservices in the future 5 It offers a Standard of Deferred Payment Money facilitates exchange over time Example a furniture store may order 25 dining room tables from a furniture manufacturer by promising to make full payment in 60 days Distinguishing Among Money Income amp Wealth Money like other assets is a component of wealth which is the sum of the value of a person s assets minus the value of the person s liabilities However only if an asset serves as a medium of exchange can we call it money A person s income is equal to his or her earnings over a period of time So a person typically has considerably less money than income or wealth What Can Serve as Money An asset is suitable to use as a medium of exchange if it is Acceptable to that is usable by most people Standardized in terms of quality so that any two units are identical Durable so that it does not quickly become too worn out to be usable Valuable relative to its weight so that amounts large enough to be useful in trade can be transported Divisible because prices of goods and services vary US paper currencyiFederal Reserve Notesimeet all these criteria The Mystery of Fiat Money Money such as paper currency that has no value apart from its use as money is called at money The most important reason why paper currency circulates as a medium of exchange is the con dence of consumers and rms that if they accept paper currency they will be able to pass it along when they need to buy goodsservices 23 Explain the role of The Payments System PG 31 33 Payments system The mechanism for conducting transactions in the economy A The Transition from Commodity Money to Fiat Money Centuries ago people had dif culty transporting large numbers of gold coins to settle transactions amp also ran the risk of having their gold robbed To get around this problem beginning around the year AD 1500 in Europe governments amp private rmsiearly banksibegan to store gold coins in safe places amp issue paper certi cates In modern economies central banks issue at money B The Importance of Checks It can be expensive to transport paper money to settle large commercial or nancial transactions Checks are promises to pay on demand money deposited with a bank or other nancial institution The use of checks avoids the drawbacks of paper money but also requires more trust on the part of the seller c IDI N u u u r 1 the ef ciency 39 39 39 h b transferring i 1 House ACH transactions automated tellermachines ATMs amp emoney 24Fimlnin hawthrn s mr 2237 quotquot uppi 39 vea s A Measuring Monetlry Aggregate Travelnrsaneas saviuosueoosus 54 when s5 ionsauuau ML si mathiman smauluue deposits 5 I w amnion 7 Mumynauat Cutlancy muluailundshnres Saab Smillnn 5745 opinion I m s slcnu himan to M2 status uunnu m Supply July 2010 l l39 39 traveler s Ml checks and checking deposits M2 is abroader definition ofmoney that includes shortterm investments that can be easily converted to banks and non institutional money market shares B Does it Matter whid De nition ofthe Money Supply We Une M7 L V CDs M1 has been more Volatile soaring during the recession years of199071991 2001 and 200772009 as investors desired the safety of liquid assets The strengths amp weaknesses ofeach measure will be discussed in future chapters 25 Use the Quantity Theory of Money to anal e the relationship between money 6 W06 37 Irv39ng mild and the Equation ufExdunge The equnion ofexchlmgeMV 11x states that the quantity ofmoney M multiplied by the Velocity ormoney V equals the price level or GDP de ate11 multiplied by the level ofreal GDP y Note that Pquuall nominal GDP and that velocity PYIM 1rvingrisnei 1 39 39 quot 39 39 39 39 asserting that velocity is constant Quantity theory ofmoncyAtheory L 39 the velocity ofmoney is constant Thus ifthe money supply M increases more quickly than real GDP Y the di erence is in ation P L w The Quantity Theory Explanation of In ation We use the quantity equation expressed in percentage changes Change in M Change in V Change in P Change in Y Since the percentage change in the price level is in ation then In ation rate Change in M 7 Change in Y C How Accurate Are Forecasts of In ation Based on the Quantity Theory Because velocity can move erratically in the short run we would not expect the quantity equation to provide good forecasts of in ation in the short run Over the long run however there is a strong link between changes in the money supply and in ation Indeed most of the variation in in ation rates in the United States comes from variation in the rates of growth of the money supply When looking across countries it is also true that countries where the money supply grew rapidly tended to have high in ation rates Zimbabwe s in ation rate of 15 billion percent during 2008 is an example of 11 Werm ation D The Hazards of Hyperin ation A rate of in ation that exceeds 100 per year When there is hyperin ation prices rise so rapidly that a given amount of money can purchase fewer amp fewer goodsservices each day Households and firms may refuse to accept money at all in which case money no longer functions as a medium of exchange When economies do not use money the specialization necessary to maintain high rates of productivity breaks down E What Causes Hyperin ation The quantity theory indicates that hyperin ation is caused by the money supply increasing far more rapidly than real output of goods and services The ultimate cause of hyperin ation is usually governments spending more than they collect in taxes which results in government budget deficits If private investors are not willing to purchase the government bonds and the central bank is controlled by the government the government sells the bonds to the central bank In paying for the bonds the central bank increases the country s money supply This process is called monetI39ZI39ng the government s debt or more casually funding government spending by printing money The equation of exchange explains 110Whyperin ation occurs When both M and V increase more rapidly than Y the in ation rate must soar Mydoes it occur Because central banks are not always free to act independently of the rest of the government Deutsche Bank during the German Hyperin ation During a hyperin ation loans will be repaid in money that will have lost most of its value One of the most famous hyperin ations occurred in Germany during the early 1920s The total number of marksithe German currencyiin circulation rose from 115 million in January 1922 to 13 billion in January 1923 and then to 497 billion or 497000000000000000000 in December 1923 The German price index rose to 126160000000000 in December 1923 The German mark became worthless Deutsche Bank would make loans only to borrowers who would repay them in either foreign currencies or commodities F Should Central Banks Be Independent The more independent a central bank is of the rest of the government the more it can resist political pressures to increase the money supply and the lower the country s inflation rate is likely to be This result was proven in a study of 16 highincome countries Figure 24 Critics of the Fed in Congress argue that the F ed s independence violates democratic principles and that its actions exceed the authority granted under federal law But in 2010 the financial reform bill passed by Congress actually granted the Fed even more authority The Fed now regulates financial firms and was also charged with ensuring that there would not be another financial crisis of the magnitude of 200772009 At the beginning of this chapter we asked Should a central bank be independent of the rest of the government We have seen that policymakers disagree on the answer to this question The degree of independence that a country grants to its central bank is ultimately a political question We have also seen though that most economists believe that an independent central bank provides a check on inflation AN lNSlDE LOOK AT POUCV Its Independence Was Threatened but New Law Grants the Fed New Powers The two counmes wrtn greatest degree oflndependence German and Swllzerland had the Iawest average rates annnatmn uverthe 1973788 penod mm wt mtsz m l Answers to the EndofChapter Review Questions and Problems 11 What is Specialization How does it improve an economy s standard of living It s when economic agents engage in a small number of productive activities but consume a larger number of goods and services Specialization increases productivity What are the costs ofa barter system The costs of a barter system include the costs associated with transporting the form of payment Suppose a farm er is trading a cow for honey Transporting a cow is much more difficult and costly than transporting a checkbook There is also the transaction cost of finding someone who wants the product and has a product to offer that you will accept for trade double coincidence of wants What are transactions costs How does using money affect the level of transactions costs in an economy Transactions costs are the costs in time or other resources that parties incur in the process of agreeing and carrying out an exchange of goods and services The use of money reduces transactions costs significantly from barter by eliminating the problem of the double coincidence of wants 22 What are the four main functions of money The four main functions of money are to serve as a medium of exchange generally accepted means of payment unit of account all prices expressed in monetary terms store of value transferring purchasing power over time and standard of deferred payment unit of account for credit arrangements 5 N W 2 3 4 4 4 4 4 5 5 5 5 4 H 1 N 3 II 6 quotN 4 1 Is the store of value function unique to money Must money be a store of value to serve its function as a medium of exchange N0 the storeofvalue function is not unique to money Houses bonds amp stocks are also stores of value Money must be a store of value to function as a medium of exchange People will not accept the form of money unless it can be stored What is commodity money How does it differ from at money Commodity money has value beyond its use as currency at money has no intrinsic value What is a payments system A payments system is a 39 39 for J quot quot economy If there were a decrease in the ef ciency of the payments system what would be the cost to the economy Ifthe payments system became less efficient the costs to the economy would be fewer and more costly transactions causing the economy to achieve fewer gains from specialization Are the assets included in Mlmore or less liquid than the assets included in M2 The assets in M1 are more liquid M1 is the narrowest de nition of money and includes currency traveler s checks and checking account deposits all assets that are very liquid M2 is a broader measure of money and includes Ml time deposits with a value of less than 100000 savings accounts money market deposit accounts and noninstitutional money market mutual fund shares Since the 1960s which measure of the money supply has grown more rapidly M1 or M2 M2 has grown more rapidly Certi cates of deposit money market mutual fund shares and other assets have grown faster than currency or checking accounts The growth of M2 has been more stable than the growth of M1 Liquidity indicates the ease with which an asset can be converted to de nitive money Ranking from most to least liquid dollar bill checking account money market mutual fund savings account corporate stock gold bar house If you withdraw 1000 from your checking account and use the funds to buy a certi cate of deposit at your bank How will these actions affect M1 and M2 M1 will decrease and M2 will stay the same M2 includes both the checking account deposit since M2 includes M1 and the certi cate of deposit Why aren t Credit cards included in M1 or M2 Credit is not a form ofmoney since it is a debt that is owed to the issuer of the card What is the equation of exchange M V P Y Is the equation of exchange a theory it s an identity not a theory A theory is a statement about the world that might possibly be false What is the quantity theory of money it s a theory about the relationship between prices amp the money supply This theory is based on an identity known as the equation of exchange M V PY Increases in the money supply that exceed increases in real GDP lead to in ation What is Hyperin ation its tripledigit in ation per year What causes Hyperin ation Large increases in the money supply cause hyperin ation As prices rise the purchasing power of the currency falls increasing the velocity of money and further compounding the rapid increase in prices The large increases inthe money supply resulting in hyperin ation are ultimately caused by large government budget de cits ProsCons of a central bank being independent of the GoV39t Pros Independent from direct political action Congress has no direct control over monetary policy The trend is that in ation is lower under these circumstances Cons A central bank can have too much power without the checks and balances from democratic representatives in the Chapter 3 Interest Rates amp Rates of Return I Brief Chapter Summary ampLearning Objectives 31 The Interest Rate Present Value and Future Value pages 52 59 Explain how the interest rate links present value with future value 0 Funds in the future are worth less than funds in the present so future funds need to be discounted to determine their present value 32 Debt Instruments and Their Prices pages 59 62 Distinguish among different debt instruments and understand how their prices are determined 0 Debt instruments take different forms because lenders and borrowers have different needs There are four basic categories of debt instruments simple loans discount bonds coupon bonds and xedpayment loans 33 Bond Prices and Yield to Maturity pages 62 66 Explain the relationship between the yield to maturity on a bond and its price 0 The yield to maturity equates the present value of the payments from an asset with the asset s price today 34 The Invase Relationship between Bond Prices and Bond Yields pages 67 72 Understand the inverse relationship between bond prices and bond yields 0 The reasoning behind the inverse relationship between bond prices and yields to maturity is that if interest rates rise existing bonds issued when interest rates were lower become less desirable to investors and their prices fall 35 Interest Rates and Rates of Return pages 72 74 Explain the difference between interest rates and rates of return 0 The rate of return is the return on a security as a percentage of the initial price This includes capital gains as well as interest payments 36 Nominal Interest Rates Versus Real Interest Rates pages 74 77 Explain the difference between nominal interest rates and real interest rates 0 The real interest rate is the nominal interest rate adjusted for in ation 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 3 Interest Rates and Rates of Return 21 l Key Terms and Concepts Capital Gain increase in the market price of an asset Capital Loss decrease in the market price of an asset Debt instruments also known as credit market instruments or xed income assets Methods of nancing debt including simple loans discount bonds coupon bonds and xed payment loans De ation A sustained decline in the price level Discount bond debt instrument in which the borrower repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially Discounting process of finding the present value of funds that will be received in the future Equity A claim to part ownership of a rm common stock issued by a corporation Financial arbitrage process of buyingselling securities to pro t from price changes over a brief period of time Fixedp ayment loan debt instrument that requires the borrower to make regular periodic payments of principal and interest to the lender Future value value at some future time of an investment made today Interestrate risk risk that the price of a nancial asset will uctuate in response to changes in market interest rates Compounding process of earning interest on interest as savings accumulate over time Coupon bond debt instrument that requires multiple payments of interest on a regular basis such as semiannually or annually and a payment of the face value at maturity Nominal interest rate interest rate that is not adjusted for changes in purchasing power Present value The value today of funds that will be received in the future Rate of return R The return on a security as a percentage of the initial price for a bond the coupon payment plus the change in the price of a bond divided by the initial price Real interest rate interest rate that is adjusted for changes in the purchasing power Return total earnings from a security for a bond the coupon payment plus the change in the price of the bond Simple loan debt instrument which borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a speci c date when the loan matures Time value of money The way the value of a payment changes depending on when payment is received Yield to maturity interest rate that makes the present value of the payments from an asset equal to the asset s price today 2012 Pearson Education Inc Publishing as Prentice Hall 22 Hubbard amp O Brien Money Banking and the Miranda system First Edition l Chapter Outline 31 The Interest Rate Present Value and Future Value pages 52 59 Explain how the interest rate links present value with future value A Why Do Lenders Charge Interest on Loans Interest on loans compensates for in ation default risk and the opportunity cost of waiting to spend money B Most Financial Transactions Involve Payments in the Future Most loans involve future payments to pay off the loan Interest rates are an important factor in comparing different nancial transactions C Compounding and Discounting Economists refer to the process of eaming interest on interest as savings accumulate over time as compounding Funds in the future are worth less than funds in the present so funds in the future have to be reduced or discounted to nd their present value Funds in the future are worth less than funds in the present since 1 Dollars in the future will usually buy less than dollars can today 2 Dollars that are promised to be paid in the future may not actually be received and 3 There is an opportunity cost in waiting to receive a payment because you cannot get the bene ts of the goods and services you could have bought if you had the money today D Discounting and the Prices of Financial Assets By adding up the present values of all the payments we have the dollar amount that a buyer will pay for the asset in other words we have determined the asset s price 32 Debt Instruments and Their Prices pages 59 62 Distinguish among different debt instruments amp understand how their prices are determined A Loans Bonds and the Timing of Payments Debt instruments include loans granted by banks and bonds issued by corporations and governments Debt instruments take different forms because lenders and borrowers have different needs There are four basic categories of debt instruments simple loans discount bonds coupon bonds and xedpayment loans With a simple loan the borrower receives from the lender an amount of funds called the principal and agrees to repay the lender the principal plus interest on a speci c date when the loan matures With a discount bond the borrower pays the lender an amount called the face value at maturity but receives less than the face value initially The interest paid on the loan is the difference between the amount repaid and the amount borrowed Borrowers issuing coupon bonds make interest payments in the form of coupons at regular intervals typically semiannually or annually and repay the face value at maturity With a xedpayment loan the borrower makes periodic payments to the lender The payments are of equal amounts and include both interest and principal 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 3 Interest Rates and Rates of Return 23 33 Bond Prices and Yield to Maturity pages 62 66 Explain the relationship between the yield to maturity on a bond amp its price A Bond Prices The price of a coupon bond is the present value of all future payments including coupons and its face value B Yield to Maturity The yield to maturity equates the present value of the payments from an asset with the asset s price today Calculating yields to maturity for alternative investments allows savers to compare any types of debt instrument 0 Yields to Maturity on Other Debt Instruments For both simple loans and discount bonds the yield to maturity is the interest rate that makes the lender indifferent between having the amount of the loan today or the nal payment at maturity Calculating the yield to maturity for a xedpayment loan is similar to calculating the yield to maturity for a coupon bond The yieldtomaturity is the interest rate that ensures that the amount of the loan today equals the present value of the loan payments 34 The Inverse Relationship between Bond Prices and Bond Yields pages 67 72 Understand the inverse relationship between bond prices and bond yields A What Happens to Bond Prices When Interest Rates Change Since the coupon is xed once a bond is issued a change in market interest rates affects the present value of future payments and thus affects the price of a bond Higher market interest rates reduce the price of existing bonds while a lower market interest rate increases the price of existing bonds B Bond Prices and Yields to Maturity Move in Opposite Directions If the yield to maturity increases then the present values of the coupon payments and the face value payment must decline causing the price of the bond to decline The economic reasoning behind the inverse relationship between bond prices and yields to maturity is that if interest rates rise existing bonds issued when interest rates were lower become less desirable to investors and their prices fall Secondary Markets Arbitrage and the Law of One Price 0 If yields to maturity on comparable securities differ traders on secondary markets will engage in nancial arbitrage the process of buying and selling securities to pro t from price changes over a brief period of time Prices of securities adjust very rapidlyioften within secondsito eliminate arbitrage pro ts because of the very large number of traders participating in nancial markets and the speed of electronic trading This description of how prices of nancial securities adjust is an example of a general economic principle called the law of one price which states that identical products should sell for the same price everywhere 35 Interest Rates and Rates of Return pages 72 74 Explain the difference between interest rates and rates of return A A General Equation for the Rate of Return The rate of return is the return on a security as a percentage of the initial price for a bond the coupon payment plus the change in the price of a bond divided by the initial price In general the rate of return is the current yield coupon divided by the initial price plus the rate of capital gain B InterestRate Risk and Maturity 2012 Pearson Education Inc Publishing as Prentice Hall 24 Hubbard amp O Brien Money Banking and the Financial system First Edition Economists refer to the risk that the price of a nancial asset will uctuate in response to changes in market interest rates as interestrate risk Bonds with fewer years to maturity will be less affected by a change in market interest rates than would bonds with more years to maturity 36 Nominal Interest Rates versus Real Interest Rates pages 74 77 Explain the difference between nominal interest rates and real interest rates A nominal interest rate is an interest rate that is unadjusted for changes in purchasing power The real interest rate is the interest rate adjusted for changes in the price level Because lenders and borrowers don t know what the actual real interest rate will be during the period of a loan they must make saving or investing decisions on the basis of what they expectthe real interest rate to be The expected real interest rate is the nominal interest rate minus expected in ation l Solutions to the Endof Chapter Questions and Problems Answers to Thinking Criticaly Questions 1 The interest charged on loans is compensation for in ation default risk and the opportunity cost to the lender for waiting to spend his money Interest rates on bonds declined from 2008 to 2009 because of a reduction in default risk 2 The interest rate is equal to wxloo87 92 31 The Interest Rate Present Value and Future Value Learning objective Explain how the interest rate links present value with future value Review Questions 11 Interest provides the pro t incentive to supply credit It also encompasses the compensation for in ation compensation for default risk and the compensation for the opportunity cost of spending your money 12 A corporate bond promises payments in the future 13 1000 x 1 1032 106090 14 PV 12001 010 109091 15 a Time value of money The way that the value of a payment changes depending on when the payment is received b Present value Value today of funds that will be received in the future 0 Discounting The process of nding the present value of funds that will be received in the future Reversal of the compounding process 16 The price of a nancial asset is related to the payments to be received through the present value formula Problems and Applications 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 3 Interest Rates and Rates of Return 25 Money does not produce anything by itself It is a representation of value but does not have use value itself Aristotle argues that you can only charge interest on productive goods like farms or houses Aristotle failed to understand the role of creditithat money loaned to another person provides future goods and services such as funds for investment projects CD 1 1000 x 1 0053 115763 CD 2 1000 x 1 008 x 1 005 x 1 003 116802 You should choose CD 2 1000 x 1 001 x 1 001 x 1 010 112211 The first CD has the higher future value so you should still choose the first CD 1000 x 1 103 x 1 103 x 1 107 113516 This CD is better than the other two Money has a time value PV SSS110 3415 million PV 252441 0052278491 0053 304531 0054 72008 million using an interest rate of 5 Using an interest rate of 10 the present value of the contract extension equals 6259 million The reporters were not correct because they did not take into account the time value of money 32 Debt Instruments and Their Prices Learning objective Distinguish among different debt instruments and understand how their prices are determined Review Questions 2 1 22 a b c d e 23 a b c d Debt instruments include loans granted by banks or bonds issued by government Equities imply the ownership of a firm Face value is the amount to be repaid by the bond issuer at maturity Coupon is the annual or semiannual xed dollar amount of interest paid by the issuer of the bond to the buyer Coupon rate is the value of the coupon expressed as a percentage of the face value Current yield is the value of the coupon expressed as a percentage of the current price of the bond Maturity is the length of time before the bond expires Fixed payment loan Coupon bond Discount bond Fixed payment loan Problems and Applications 24 Fixed payment loans are popular with households because as long as the household makes all the payments the loan will be completely paid off There will be no large final payment to worry about like with a simple loan This applies to both cars and loans 2012 Pearson Education Inc Publishing as Prentice Hall 26 Hubbard amp O Brien Money Banking and the Miranda system First Edition 25 A STRIP is a bond that has its interest payments separated and sold individually STRIPS were created to allow investors to customize their cash ows to meet their individual needs This allows individuals to effectively obtain longterm discount bonds from the government as well as the regular Treasury coupon bonds thereby increasing their options for investment 26 Coupon bonds with the face value due at maturity allow the investment project time to pay off 33 Bond Prices and Yield to Maturity Learning objective Explain the relationship between the yield to maturity on a bond and its price Review Questions 31 The yield to maturity is the interest rate that equates the present value of future payments of a debt instrument with its current price The yield to maturity is a better measure of the interest rate than the coupon rate because the coupon rate does not take into account that the purchase price of a bond may differ from the face value of the bond C C C C F V 32 77777 1 1 1 02 1 O3 1 1quot 1 1quot 33 139 Required loan payment 7 principleprinciple 34 139 E P 3 5 Loan value P FP FP F 11 112 11n39 Problems and Applications 36 85 dollars in two years would bring the best return at 7025 The answer would change at an interest rate of 020 because the present value of money becomes more valuable At 020 the 75 in one year provides the best return 37 The present value of two oneyear subscriptions is 60 60 110 11455 The present value of a two year subscription is 115 So you prefer the oneyear subscription today There is a complication however The price next year is unknown 38 721 39 350000 475000115 720 1000115 950 8011 80112 80113 8011quot 80115 80116 1000116 4000 275113 27511 2751122 9957 310 450 6251i11 6251i12 6251i13 6251i3 10001i3 311 In effect the payments to George were like those of a perpetuity or consol Therefore the relevant interest rate would be 1351125 12 2012 Pearson Education Inc Publishing as Prentice Hall Chapter 3 Interest Rates and Rates of Return 27 312 a 100000 100001i 100001i2 Sl 100001i20 b The interest rate should be higher since David received the 10000 annual payment for a longer period of time 34 The Inverse Relationship Between Bond Prices and Bond Yields Learning objective Understand the inverse relationship between bond prices and bond yields Review Questions 41If a bond is purchased directly from the company issuing the bond it was purchased in the primary market If the bondholder decides to sell the bond to another investor that transaction would take place on the secondary market 42Capital gain is an increase in the price of an asset If market interest rates increase bond prices fall so you will experience a capital loss 43The equation for bond prices shows that the higher the purchase price of the bond the lower the rate of return Buying a bond at a high price means that the difference made between the purchase price and face value can be small and even negative The higher the price the lower the overall rate of return 44Investors hold a stockbond for a long period of time and collect the dividend from a corporation or the coupon payment from the bond A trader buys and sells securities and bonds hoping to take advantage of price arbitrage in a short time horizon 45Financial arbitrage is the process of buying and selling securities to profit from price changes over a brief period of time Problems and Applications 46The answer depends on the purchase price of the bond If the price increases past the purchase price then capital gains can be made Also with the time value of money money received today is more valuable than money received in the futureiat the maturity of the bond 47 a 5050 109620 46 b The price is higher than the face value which lowers the yield to maturity 48Conditions in the bond market changed with longterm market interest rates rising 49Bad assets refer primarily to mortgagebacked securities that fell in value Because of an increase in default risk investors required higher yields to invest which required prices to fall Ample lending is necessary because bank lending is necessary for business expansion and an increase in economic activity 410Bond A has a low coupon rate but a lower price Bond B has a higher coupon rate and a higher price Because of the bond price formula if coupon rates fall the yield will fall which requires prices to fall to keep the yield the same If both bonds have the same risk pro le the law of one price brings bond yields to the same level 411The analysis is partially correct There is an inverse relationship between bond prices and bond yields and the rate of return on the coupon payment is higher if the purchase price is lower However the analysis does not take into account the present value equation of calculating a bond yield The analysis incorrectly uses the current yield the value of the coupon expressed as a percentage of the current price as the yield to maturity 2012 Pearson Education Inc Publishing as Prentice Hall 28 Hubbard amp O Brien Money Banking and the Miranda system First Edition 35 Interest Rates and Rates of Return Learning objective Explain the difference between interest rates and rates of return Review Questions 51 Yield to maturity is the return on a bond assuming the bondholder holds the bond for the full maturity Rate of return is the return over a specific holding period that takes into account not just the coupon rate but the price change Interestrate risk is the risk of interest rate changes affecting the value of a bond A given change in interest rates has a larger effect on the present value and therefore the price of a longterm bond than a shortterm bond Problems and Applications 53 54 57 36 R 40 200950 2526 With active secondary markets these bonds could be sold before maturity so investors other than young people would have an interest in them Being longterm 40year bonds these bonds would be a particularly bad investment if market interest rates rose The coupon payment would be 8375 and with the current yield of 75 the initial price of the bond was 111667 The total return for the year is 8375 850 7 111667111667 x 100 7 1638 The fall in the market interest rate one year later to 4 raises the price of the bond to 105550 The total return for the year is 60 7 105550 7 10001000 x 100 1155 37 Price is 1000 and current yield is 6 Price rises to 103546 and current yield falls to 60103546 x 100 579 Investors would be willing to pay 102723 Your total return on the bond would be 60 2723 1000 x 100 872 The total return of the other investor who bought the bond for 103546 would be 60 7 102723 7103546103546 x 100 5 Investors would be willing to pay 93058 for the bond The current yield would rise to 6093058 x 100 644 The rate ofretum would be 60 7 93058 7 102723102723 x 100 7357 ST 0 9 Nominal Interest Rates Versus Real Interest Rates Learning objective Explain the difference between nominal interest rates and real interest rates Review Questions 61 62 Nominal interest rates do not adjust for in ation Real interest rates adjust for in ation The expected real interest rate equals the nominal interest rate minus expected in ation The actual real interest rate equals the nominal interest rate minus actual in ation 2012 Pearson Education Inc Publishing as Prentice Hall X Staple business cards here Name Section 321001 Student M Row Seat FIELD RESEARCH PAPER Econ 32100 1 Summer 2012 Professor William F Ford I Instructions You are to complete the following eld research assignment it is due in Diane Cothem s of ce BAS Room N330 by 400 pm on Friday May 25 2012 You can add up to 5 points to your nal grade in the course by completing this assignment The points assigned will be based on the grade you earn A 5 pts B 4 pts C 3 pts less than C 0 pts II The Assignment SHOPPING FOR BANKING SERVICES This assignment involves comparing the prices charged by three local nancial institutions FIs for checking saving credit card and other services The rst step is to select m local FIs near where you live and or work Include at least one commercial bank CB and one SampL g Credit Union CU in your sample Make a list in the space below of each of the three FIs you visited Be sure to ll in Q the blanks as no credit will be given if this information is either missing or incomplete person you spoke with person s Lumber Next ll in the attached form showing what each of the three FIs charges for each of the services listed ALSO STAPLE THE BUSINESS CARDS OR STATIONERY OF THE THREE PEOPLE YOU INTERVIEWED TO THE UPPER LEFT CORNER OF THIS PAGE No credit will be given without this III A COMPARISON OF RETAIL BANKING SERVICE CHARGES Fl 1 Fl 2 Fl 3 LIST OF SERVICES name name name I Checking accounts amp ATMs Yes No Yes No Yes No A Does this FI offer completely free checking accounts ie no minimum balance no monthly fees or charges circle one circle one circle one B If it does not offer free checking What is the monthly service charge on accounts with a low minimum balance eg under 500 C How much do they charge to process a returned item ie a bounced check or overdrawn debit card tran action D How much do they charge for each ATM Withdrawal when you use their machines E How much for an ATM Withdrawal on another bank s machine F How much do they charge for the first supply of checks you buy assuming you purchase the plainest design available II Traveler s Checks What is their fee for selling you traveler s checks Note that they might charge a flat fee or a of face value of the checks you buy or Ill Credit Cards A What is their annual fee in dollars for a normal VISA or MASTERCHARGE CARD the gold or platinum card B What rate of interest do they charge if you do not pay your credit card bill in full Within the grace period If variable show the range of rates C Does the rate they charge depend on your FICO or your ADVANTAGE credit score Yes No circle one Yes No circle one Yes No circle one IV Savings Accounts A What rate do they pay on a normal passbook or statem enttype savings account with a balance under 1000 B What is their rate on a 1 year CD with 1000 or more invested C On a 3 year 5000 CD
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