Chapter 17
Financial Economics
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Financial Investment
• Economic investment
• New additions or replacements to the
capital stock
• Financial investment
• Broader than economic investment
• Buying or building an asset for financial
gain
• New or old asset
• Financial or real asset
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-2
Compound Interest
• Compound interest
• Earn interest on the interest
• X dollars today = (1 + i)tX dollars in t years
• $100 today at 8% is worth:
• $108 in one year
• $116.64 in two years
• $125.97 in three years
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-3
Present Value Model
• Present Value of a future amount of
money
• Calculate what you should pay for an asset
today
• Asset yields future payments
• Asset’s price should equal total present
value of future payments
• The formula:
X
(1+
i)t
dollars today = X dollars in t years
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-4
Applications
• Take the money and run
• Lottery jackpot paid over a number of
years
• Calculating the lump sum value
• Salary caps and deferred compensation
• Calculating the value of deferred salary
payments
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-5
Popular Investments
• Wide variety available to investors
• Three features
• Must pay to acquire
• Chance to receive future payment
• Some risk in future payments
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-6
Stocks
• Represents ownership in a company
• Bankruptcy possible
• Limited liability rule
• Capital gains
• Dividends
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-7
Bonds
• Debt contracts issued by government and
corporations
• Possibility of default
• Investor receives interest
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-8
Mutual Funds
• Company that maintains a portfolio of
either stocks or bonds
• Currently more than 8,000 mutual funds
• Index funds
• Actively managed funds
• Passively managed funds
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-9
Mutual Funds Continued
The 10 Largest Mutual Funds, April 2016
* The letter A indicates funds that have sales commissions and are generally purchased by individuals
through their financial advisors.
Source: Lipper Performance Report, March 31, 2016
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-10
Calculating Investment
Returns
• Gain or loss stated as percentage rate of
return
• Difference between selling price and
purchase price divided by purchase price
• Future series of payments also considered
into return
• Rate of return inversely related to price
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-11
Arbitrage
• Buying and selling process to equalize
average expected returns
• Sell asset with low return and buy asset
with higher return at same time
• Both assets will eventually have same rate
of return
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-12
Risk
• Future payments are uncertain
• Diversification
• Diversifiable risk
• Specific to a given investment
• Nondiversifiable risk
• Business cycle effects
• Comparing risky investments
• Average expected rate of return
• Beta
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-13
Risk Continued
• Risk and average expected rates of return
• Positively related
• The risk-free rate of return
• Short-term U.S. government bonds
• Greater than zero
• Time preference
• Risk-free interest rate
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-14
Investment Risks
LO7
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-15
The Security Market Line
Compensate investors for:
• Time preference
• Nondiversifiable risk
Average
expected
rate of return
=
Average
expected
rate of return
=
Rate that
compensates
for time
preference
if
+
+
Rate that
compensates
for risk
risk premium
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-16
Average expected rate of return
The Security Market Line
Graph
Market
Portfolio
Security Market
Line
A Risk-free Asset
(i.e., a short-term U.S.
Government bond)
Risk Premium for
The Market Portfolio’s
Risk Level of beta = 1.0
if
Compensation
For Time Preference
Equals if
0
1.0
Risk Level (beta)
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-17
The Security Market Line Cont’d
Average expected rate of return
Risk levels determine average expected
rates of return
Security Market
Line
Y
Risk Premium for
This Asset’s Risk
Level of beta = X
if
Compensation
For Time-Preference
Equals if
0
LO8
X
Risk Level (beta)
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-18
Average expected rate of return
Arbitrage and The Security
Market Line
A
Y
B
f
C
0
LO8
Security Market
Line
X
Risk Level (beta)
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-19
The Security Market Line
Concluded
Average expected rate of return
An increase in the risk-free rate
SML 2
SML 1
Y2
A After Increase
Y2
f2
Y1
A Before Increase
Y1
f1
0
X
Risk Level (beta)
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-20
SML: Applications
• Fed’s expansionary monetary policy led to
lower interest rates
• SML shifted downward
• Slope of SML increased due to increased
investor risk-aversion
• Stocks fell
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
37-21
Index Funds versus Actively
Managed Funds
• Choice of actively or passively managed
mutual funds
• After costs, index funds outperform
actively managed by 1% per year
• Role of arbitrage
• Management costs are significant
• Index funds are boring — no chance to
exceed average rates of return
37-22
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 16
Interest Rates and Monetary
Policy
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Interest Rates
• The price paid for the use of money
• Many different interest rates
• Speak as if only one interest rate
• Determined by the money supply and
money demand
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-2
Demand for Money
• Why hold money?
• Transactions demand, Dt
• Determined by nominal GDP
• Independent of the interest rate
• Asset demand, Da
• Money as a store of value
• Varies inversely with the interest rate
• Total money demand, Dm
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-3
Rate of interest, i percent
Demand for Money Continued
(a)
Transactions
demand for
money, Dt
(c)
Total
demand for
money, Dm
and supply
(b)
Asset
demand for
money, Da
10
Sm
7.5
=5
+
5
2.5
Dt
0
50
100
Da
150
200
Amount of money
demanded
(billions of dollars)
50
100
150
200
Amount of money
demanded
(billions of dollars)
Dm
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-4
Interest Rates Continued
• Equilibrium interest rate
• Changes with shifts in money supply and
money demand
• Interest rates and bond prices
• Inversely related
• Bond pays fixed annual interest payment
• Lower bond price will raise the interest
rate
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-5
Federal Reserve Balance Sheet
• Assets
• Securities
• Loans to commercial banks
• Liabilities
• Reserves of commercial banks
• Treasury deposits
• Federal Reserve Notes outstanding
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-6
Federal Reserve Balance Sheet
Example
April 6, 2016 (in Millions)
Assets
Liabilities and Net Worth
Securities
Loans to Commercial
Banks
All Other Assets
$4,243,689
Total
$4,484,069
37
240,343
Reserves of Commercial
$2,467,091
Banks
263,537
Treasury Deposits
1,400,041
Federal Reserve Notes
(Outstanding)
353,400
All Other Liabilities and
Net Worth
$4,484,069
Total
Source: Federal Reserve Statistical Release, H.4.1, April 6,2016, www.federalreserve.gov
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-7
Central Banks
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-8
Four Tools of Monetary Policy
1.
2.
3.
4.
Open Market Operations
The Reserve Ratio
The Discount Rate
Interest on Reserves
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-9
Tool #1: Open-Market
Operations
• Open-market operations
• Buying and selling of government
securities (or bonds)
• Commercial banks and the general
public
• Used to influence the money supply
• When the Fed sells securities, commercial
bank reserves are reduced
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-10
Open-Market Operations: Fed Buys
Bonds from Commercial Banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
+ Securities
+ Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
Liabilities and Net Worth
-Securities (a)
+Reserves (b)
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-11
Open Market Operations: Fed Buys Bonds
from Commercial Banks Continued
•Fed buys $1,000 bond from a commercial bank
New Reserves
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-12
Open Market Operations: Fed Buys
Bonds from the Public
• Fed buys $1,000 bond from the public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-13
Open Market Operations: Fed Sells
Bonds to Commercial Banks
• Fed sells bonds to commercial banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
- Securities
- Reserves of Commercial
Banks
(a) Securities
Assets
(b) Reserves
Commercial Banks
Liabilities and Net Worth
+ Securities (a)
- Reserves (b)
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-14
Open Market Operations: Fed Sells
Bonds to the Public
• Same effect as selling bonds to commercial
banks
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-15
Repos and Reverse Repos
• Collateralized loans
• Repo transaction — loan of money in
exchange for government bonds used as
collateral
• Reverse repo — repo in reverse
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-16
Tool #2: The Reserve Ratio
• Changes the money multiplier
• The discount rate
• The Fed as lender of last resort
• Short term loans
• Term auction facility
• Introduced December 2007
• Banks bid for the right to borrow
reserves
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-17
The Reserve Ratio Continued
Effects of Changes in the Reserve Ratio
(6)
Money-Creating
Potential of
Single Bank, =
(5)
(7)
Money-Creating
Potential of
Banking System
(1)
Reserve
Ratio, %
(2)
Checkable
Deposits
(3)
Actual
Reserves
(4)
Required
Reserves
(5)
Excess
Reserves,
(3) - (4)
(1) 10
$20,000
$5000
$2000
$3000
$3000
$30,000
(2) 20
20,000
5000
4000
1000
1000
5000
(3) 25
20,000
5000
5000
0
0
0
(4) 30
20,000
5000
6000
-1000
-1000
-3333
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-18
Tool #3: The Discount Rate
• The discount rate
• The Fed as lender of last resort
• Short term loans
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-19
Tool #4: Interest on Reserves
• Law changed in 2008
• Allows banks to pay interest on excess
reserves
• Can encourage or discourage banks to
keep reserves
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-20
Tools of Monetary Policy
Summary
• Open market operations are the most
important
• Reserve ratio last changed in 1992
• Discount rate was a passive tool
• Interest on reserves
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-21
The Federal Funds Rate
• Rate charged by banks on overnight loans
• Targeted by the Federal Reserve
• FOMC conducts open market operations
to achieve the target
• Demand curve for Federal funds
• Supply curve for Federal funds
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-22
Expansionary Monetary Policy
• Economy faces a recession
• Lower target for Federal funds rate
• Fed buys securities
• Expanded money supply
• Downward pressure on other interest
rates
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-23
Restrictive Monetary Policy
• Periods of rising inflation
• Increases Federal funds rate
• Decreases money supply
• Increases other interest rates
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-24
Prime Interest
RatePolicy
and
Monetary
Federal Funds Rate
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-25
Taylor Rule
• Rule of thumb for tracking actual
monetary policy
• Fed has 2% target inflation rate
• If real GDP = potential GDP and inflation is
2%, then targeted Federal funds rate is 4%
• Target varies as inflation and real GDP vary
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-26
Monetary Policy, Real GDP,
Price Level
• Affect on real GDP and price level
• Cause-effect chain
• Market for money
• Investment and the interest rate
• Investment and aggregate demand
• Real GDP and prices
• Expansionary monetary policy
• Restrictive monetary policy
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-27
(a)
The market
for money
Sm1
Sm2
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Sm3
AS
10
P3
Price Level
Rate of Interest, i (Percent)
Monetary Policy and
Equilibrium GDP
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-28
Monetary Policy and
Equilibrium GDP Continued
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
c
P3
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
a
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
Price Level
Price Level
P3
b
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-29
Expansionary Monetary Policy Effects
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or lowers interest on reserves
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
LO5
Real GDP rises
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-30
Restrictive Monetary Policy Effects
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed sells bonds, increases reserve ratio, increases
the discount rate, or raises interest on reserves
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
LO5
Inflation declines
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-31
Evaluation and Issues
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy is more subtle than
fiscal policy
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-32
Recent U.S. Monetary Policy
• Highly active in recent decades
• Responded with quick and innovative
actions during the recent financial crisis
and the severe recession
• Critics contend the Fed contributed to the
crisis by keeping the Federal funds rate too
low for too long
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-33
After the Great Recession
• Slow recovery especially in terms of
employment
• Zero interest rate policy
• Zero lower bound problem
• Quantitative easing
• Forward commitment
• Operation Twist
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-34
Problems and Complications
• Lags
• Recognition and operational
• Cyclical asymmetry
• Liquidity trap
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-35
The Big Picture
Input
Resources
With Prices
Productivity
Sources
LegalInstitutional
Environment
Consumption
(Ca)
Aggregate
Supply
Levels of
Output,
Employment,
Income, and
Prices
Aggregate
Demand
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
36-36
Less than Zero
• European Central Bank set negative
interest rates
• Idea is to make banks lend more
• Existence of a negative lower bound
36-37
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 15
Money Creation
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Fractional Reserve System
• The Goldsmiths
• Stored gold and gave a receipt
• Receipts used as money by public
• Made loans by issuing receipts
• Characteristics:
• Banks create money through lending
• Banks are subject to “panics”
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-2
Balance Sheet for a Bank
• Balance sheet
• Assets = Liabilities + Net Worth
• Both sides balance
• Necessary transactions
• Create a bank
• Accept deposits
• Lend excess reserves
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-3
A Single Commercial Bank:
Transaction 1
Vault cash: cash held by the bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets
Cash
Liabilities and Net Worth
$250,000 Stock Shares
$250,000
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-4
A Single Commercial Bank:
Transaction 2
Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$10,000 Stock Shares
240,000
$250,000
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-5
A Single Commercial Bank:
Transaction 3
Commercial bank functions
• Accepting deposits
• Making loans
Accepting Deposits
Balance Sheet 3: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
Checkable
$110,000
Deposits
$100,000
240,000
Stock Shares
250,000
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-6
Required Reserves
Depositing reserves in a Federal Reserve
bank
• Required reserves
• Reserve ratio
Reserve
ratio
=
Commercial bank’s
required reserves
Commercial bank’s
checkable-deposit liabilities
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-7
Reserve Requirements
Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$15.2 Million
$15.2 - $110.2 Million
Over $110.2 Million
Noncheckable nonpersonal
savings and time deposits
0%
3
10
3%
3
8-14
0
0-9
• The Fed can establish and vary the reserve
ratio within limits set by Congress
• Required reserves help the Fed control
lending abilities of commercial banks
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-8
A Single Commercial Bank:
Transaction 4
Assume the bank deposits all cash on
reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
110,000
Deposits
Property
240,000 Stock Shares
$100,000
250,000
35-9
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Excess Reserves
• Excess reserves
• Actual reserves - required reserves
• Required reserves
• Checkable deposits × reserve ratio
• Example:
• Checkable deposits $100,000
• Reserve ratio 20%
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-10
A Single Commercial Bank:
Transaction 5
Clearing a check
• $50,000 check reduces reserves and
checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets
Reserves
Property
LO2
Liabilities and Net Worth
Checkable
$60,000
Deposits
240,000 Stock Shares
$50,000
250,000
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-11
Money Creating Transactions:
Transaction 6a
Granting a loan
• $50,000 loan made to a customer is deposited
to the customer’s checking account
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
$100,000
250,000
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-12
Money Creating Transactions:
Transaction 6b
Using the loan
• $50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$10,000 Checkable
Deposits
50,000
$50,000
240,000 Stock Shares
250,000
A single bank can only lend an amount
equal to its preloan excess reserves
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-13
Money Creating Transactions:
Transaction 7
Bank buys government securities
from a dealer
• Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Assets
Reserves
Securities
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
$100,000
250,000
• New money is created
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-14
Profits, Liquidity, and the
Federal Funds Market
• Conflicting goals
• Earn profit
• Make loans to earn interest
• Buy securities to earn interest
• Maintain liquidity
• Alternative?
• Overnight bank loans
• Federal funds rate
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-15
The Banking System
• Multiple-deposit expansion
• Assumptions:
• 20% required reserves
• All banks “loaned up”
• Banks lend all of their excess reserves
• A $100 bill is found and deposited
• Multiple deposits can be created
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-16
The Banking System
Multiple Bank Expansion
(3)
Excess
Reserves
(1) - (2)
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
Bank A
$100
$20
$80
$80
Bank B
$80
$16
$64
$64
Bank C
$64
$12.80
$51.20
$51.20
Bank D
$51.20
$10.24
$40.96
$40.96
Bank
(4)
Amount Bank Can
Lend; New Money
Created = (3)
The process will continue…
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-17
Multiple Bank Expansion
Illustration
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
Bank H
Bank I
Bank J
Bank K
Bank L
Bank M
Bank N
Other Banks
LO4
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1) - (2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-18
The Monetary Multiplier
Monetary
multiplier
=
1
required reserve ratio
=
1
R
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
35-19
The Monetary Multiplier
Continued
• Maximum amount of new money created
by a single dollar of excess reserves
• Higher R, lower m
• Reversibility
• Making loans creates money
• Loan repayment destroys money
35-20
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Banking, Leverage, and
Financial Instability
• Leverage is the use of borrowed money to
magnify profits and losses
• Modern banks use lots of leverage
• Thus small losses can drive banks into
insolvency
35-21
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 14
Money, Banking, and Financial
Institutions
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Functions of Money
• Medium of exchange
• Used to buy and sell goods
• Unit of account
• Goods valued in dollars
• Store of value
• Hold some wealth in money form
• Money is liquid
LO1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-2
Money Definition M1
• M1
• Currency
• Checkable deposits
• Institutions offering checkable deposits
• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-3
Money Definition M2
• M2
• M1 plus near-monies
• Savings deposits including money market
deposit accounts (MMDA)
• Small-denominated time deposits
• Money market mutual funds (MMMF)
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-4
Money Definitions
LO2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-5
What “Backs” the Money
Supply?
• Guaranteed by government’s ability to
keep value stable
• Money as debt
• Why is money valuable?
• Acceptability
• Legal tender
• Relative scarcity
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-6
What “Backs” the Money
Supply? Continued
• Prices affect purchasing power of money
• Hyperinflation renders money
unacceptable
• Stabilizing money’s purchasing power
• Intelligent management of the money
supply — monetary policy
• Appropriate fiscal policy
LO3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-7
Federal Reserve — Banking
System
• Historical background
• Board of Governors
• 12 Federal Reserve Banks
• Serve as the central bank
• Quasi-public banks
• Banker’s bank
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-8
Federal Reserve — Banking
System Continued
Board of Governors
Federal Open Market Committee
12 Federal Reserve Banks
Commercial Banks
Thrift Institutions
(Savings and Loan Associations,
Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-9
Federal Reserve Banks
The 12 Federal Reserve Banks
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-10
Federal Reserve — Banking
System Concluded
• Federal Open Market Committee
• Aids Board of Governors in setting
monetary policy
• Conducts open market operations
• Commercial banks and thrifts
• 6,000 commercial banks
• 8,500 thrifts
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-11
Financial Institutions
LO4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-12
Federal Reserve Functions
• Issue currency
• Set reserve requirements
• Lend money to banks
• Collect checks
• Act as a fiscal agent for U.S. government
• Supervise banks
• Control the money supply
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-13
Federal Reserve Independence
• Established by Congress as an
independent agency
• Protects the Fed from political pressures
• Enables the Fed to take actions to increase
interest rates in order to stem inflation as
needed
LO5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-14
The Financial Crisis of 2007
and 2008
• Mortgage Default Crisis
• Many causes
• Government programs that encouraged
home ownership
• Declining real estate values
• Bad incentives provided by mortgagebacked bonds
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-15
The Financial Crisis of 2007
and 2008 Continued
• Securitization — the process of slicing up
and bundling groups of loans into new
securities
• As loans defaulted, the system collapsed
• “Underwater” homeowners abandoned
homes and mortgages
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-16
The Financial Crisis of 2007
and 2008 — Failures
• Failures and near-failures of financial firms
• Countrywide: second largest lender
• Washington Mutual: largest lender
• Wachovia
• Other firms came close
LO6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-17
The Financial Crisis of 2007
and 2008 — Fiscal Response
• Troubled Asset Relief Program (TARP)
• Allocated $700 billion to make
emergency loans
• Saved several institutions from failure
LO7
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-18
Post-Crisis U.S. Financial Services
• Major categories of financial institutions
• Commercial banks
• Thrifts
• Insurance companies
• Mutual fund companies
• Pension funds
• Securities firms
• Investment banks
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-19
Major Categories of Financial
Institutions
LO8
Institution
Description
Examples
Commercial
Banks
State and national banks that provide checking and savings
accounts and make loans
JP Morgan Chase, Bank
of America, Citibank,
Wells Fargo
Thrifts
Savings and loan associations, mutual savings banks, credit
unions that offer checking and savings accounts and make
loans
Charter One, New York
Community Bank
Insurance
Companies
Firms that offer policies through which individuals pay
premiums to insure against lose
Prudential, New York
Life, Northwestern
Mutual, Hartford
Mutual Fund
Companies
Firms that pool customer deposits to purchase stocks or
bonds
Fidelity, Vanguard,
Putnam, Janus, T Rowe
Price
Pension Funds
Institutions that collect savings from workers throughout their
working years and then invest the funds to pay retirement
benefits
TIAA-CREF, Teamsters’
Union, CalPERs
Securities Firms
Firms that offer security advice and buy and sell stocks and
bonds for clients
Merrill Lynch, TD
Ameritrade, Charles
Schwab
Investment Banks
Firms that help corporations and governments raise money
by selling stocks and bonds
Goldman Sachs,
Morgan Stanley,
Deutsche Bank, Credit
Suisse
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-20
Post-Crisis U.S. Financial
Services Continued
• Wall Street Reform and Consumer
Protection Act
• Passed to help prevent many of the
practices that led to the crisis
• Critics say it adds heavy regulatory costs
LO8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
34-21
Extend and Pretend
• Fed had to act as lender of last resort for
both solvent and insolvent firms
• Increased moral hazard
34-22
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Purchase answer to see full
attachment