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Financial System and Allocation of Saving
A successful economy uses its savings for investments that are likely to be the most productive
The interest on deposits is one important reason people put savings in banks
The financial system improves the allocation of saving
Difference between Money and Income.
1) Income—A flow of earning per unit of time. $500.00 of income per week.
2) Money—a stock at a certain point in time. $50.00 of cash in your pocket.
3 Functions of Money
1) Medium of Exchange—money is an asset used in purchasing goods and services.
This is the most important function of money.
3 Functions of Money
2) Unit of Account—money is a basic measure of economic value. Money is used to “keep score.”
Example
We begin with an economy with N commodities. These commodities are C1, C2, C3, - - - Cn. Ci is commodity i.
Barter Economy
In a barter economy, each good exchanges for every other good. Barter is the direct trade of goods and services for other goods and services.
In a barter economy, each and every good serves as money.
That is, each and every good is an asset that can be used in making purchases.
Barter Economy
Monetary Economy
In a monetary economy, at least one good, but not all goods, serve as money.
That is, at least one good, but not all goods, is an asset that can be used in making purchases.
Some goods don’t trade for other goods because of exchange costs.
Exchange costs exist in both barter economies and monetary economies, but they are higher in barter economies.
Exchange costs
1) Opportunity cost of time spent in exchange.
2) Resource costs—transportation costs and the wastage of goods in the exchange process.
3) Waiting costs—The costs of delaying consumption.
4) Trading costs—The cost of not making the best possible trade.
Exchange costs are higher in a barter economy because barter requires a double coincidence of wants.
U.S. Money Supply Measures: M1 and M2
M1 – a measure of funds that are available for immediate spending.
M1 = currency outstanding + checkable deposits
Checkable Deposits
1) Demand deposits2) NOW accounts and super NOW accounts3) ATS accounts4) Travelers’ checks
M2 – a measure of funds available for immediate spending + funds that can be converted quickly into funds that can be spent immediately.
Small denominated time deposits—savings accounts with a fixed term to maturity (interest penalty for early withdrawal). Small < $100,000.
Example: Certificate of Deposit
Money Market Mutual Funds—organizations that sell shares, use the proceeds to buy safe assets, and often allow check-writing privileges.
Banking System
Financial intermediaries are firms that extend credit to borrowers using funds raised from savers
Banks have lower cost of evaluating opportunities than an individual would
Banks pool the savings of many individuals to make large loans
Two types of intermediaries Traditional & Market-based (recent
development)
Banking System
Banks gather and evaluate potential investments to direct savings to higher-return, more productive investments Service provided to depositors
Banks provide access to credit for small businesses and homeowners May be the only source of credit for some
investmentsWhen banks make loans, they earn interest which, in turn, is paid to the bank's depositors
The Banking System
Having bank deposits makes payments easier Checks ATMs Debit card
Checks and debit cards are safer than cash
Banks provide a record of your transactions
Bonds
A bond is a legal promise to repay a debt Each bond specifies
Principal amount, the amount originally lent Maturation date, the date when the principal
amount will be repaid The term of a bond is the length of time from
issue to maturation Coupon payments, the periodic interest
payments to the bondholder Coupon rate, the interest rate that is applied to
the principal to determine the coupon payments
Bonds
Corporations and governments issue bonds The coupon rate depends on
The bond's term 30 days to 30 years; longer term, higher coupon rate
The issuer's credit risk Probability the issuer will default on repayment Higher risk, higher coupon rate
Tax treatment for the coupon payments Municipal bonds are free from federal taxes Lower taxes, lower coupon rates
Bond Market
Bonds can be sold before their maturation date Market value at any time is the price of the bond Price depends on the relationship between the
coupon rate and the interest rate in financial markets
A two-year government bond with principal $1,000 is sold for $1,000, 1/1/09 Coupon rate is 5% $50 will be paid 1/1/10 $1,050 will be paid 1/1/11
Bond's price on 1/1/10 depends on the prevailing interest rate
Selling a Bond
Offer for sale: one government bond with payment of $1,050 due in one year
The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% Pays $1,060 in one year
Year-old bond with 5% coupon rate is less valuable than the new bond Price of the used bond will be less than $1,000
(Bond price) (1.06) = $1,050Bond price = $991
Bond prices and interest rates are inversely related
Stocks
A share of stock is a claim to partial ownership of a firm Receive dividends, a periodic payment
determined by management Receive capital gains if the price of the stock
increasesPrices are determined in the stock market
Reflect supply and demand
FortuneCookie.com Example New company with estimated dividend of $1 in 1 year
Selling price of stock will be $80 in 1 year Interest rate on safe asset (government bond) is 6%
Value of the new stock is $81 in 1 year
(Stock price) (1.06) = $81
Stock price = $76.42 Value would be higher if
Dividend were higher Price of stock in one year were higher Interest rate were lower
Risk Premium
Risk premium is the rate of return investors require of risky asset minus the rate of return on a safe asset
Suppose interest on a safe investment is 6% FortuneCookie.com is risky, so 10% return is
required Stock will sell for $80 in 1 year; dividend will be $1
(Stock price) (1.10) = $81Stock price = $73.64
Risk aversion increases the return required of a risky stock and lowers the selling price
Bond Markets and Stock Markets Channel funds from savers to borrowers with
productive investment opportunities Sale of new bonds or new stock can finance
capital investment Like banks, bond and stock markets allocate savings
Provision of information on investment projects and their risks
Provide risk sharing and diversification across projects Diversification is spreading one's wealth over a
variety of investments to reduce risk
Benefits of Diversification
Vikram has $200 to invest in stocks, each $100
Buy 2 shares of either stock 50% chance of $20
gain and 50% chance of $0
Diversify and buy 1 share of each One stock will be
worth $100 and the other will be worth $110 Return is $10 with no
risk
Increase in Stock Price per Share
Actual Weathe
r
Smith Umbrella
Jones Suntan Lotion
Rainy (50%)
+$10 $0
Sunny (50%)
$0 +$10
Stock and Bond Markets
Savers can put savings into a variety of financial assets Diversification makes risky but potentially valuable projects possible
No individual saver bears the whole risk Society is better off
Rise and Fall of the US Stock MarketStandard & Poor's 500 index rose 60% between 1990 and 1995 More than doubled 1995 – 2000 Lost 40% of its value Jan 2001 – Jan 2003 Returned to Jan 2000 level by Jan 2008 And then…..
Increase in stock prices can be due to Increased optimism about future value A fall in required return
Rise and Fall of the US Stock Market In the 1990s, optimism was high
Strong dividends Promise of new technologies
Risk premium declined Increased diversification through mutual funds Investors may have underestimated risk
Optimism and risk premium trends reversed in 2000 Many high-tech firms less profitable than expected Corporate accounting scandals of 2002 Terrorist attack in US
Other Financial Products
A Mutual fund is a variety of financial assets sold to the public as shares in a single financial intermediary Diversified asset for the saver Less costly than buying many stocks and bonds directly
Closed-End funds Structured similar to a mutual fund, however is traded
on the exchange like a stock and has a fixed number of shares outstanding (thus can trade at a premium or discount to market value)
Exchange-Traded Funds Similar to a closed-end fund, however the amount of
shares outstanding is allowed to fluctuate (trades close to its market value)