Money and Financial
Institutions
Mike & Ryan
Bonds
• Bonds: certificate that promises to pay some money in the future
• Future money can be paid in two ways
• Maturity Value (Par Value, Face Value)
• Coupon (most coupon bonds pay semi-annually)
• Yield or yield to maturity=interest rate paid on a bond
• $90.91 matures to $100 equivalent to earning 10%
• Inverse relationship with prices and yields
• i.e. high price, low yield
• Seesaw
Government Bonds
• 3 Types
• T-Bills
• Zero coupon bond
• Maturity = 1-12 months
• T-Notes
• Semi-annual coupons
• 2-10 years
• T-Bonds
• Semi-annual coupons
• 20-30 years
Income Risk
• Income risk is the risk that changing interest rates will reduce the
income from portfolio
• Income Risk higher for short term assets
• CUs face income risk when rates change
• Because CUs have longer term assets and shorter term liabilities,
income risk occurs when interest rates rise.
Capital Risk
• Higher for longer term assets
• Higher interest rates reduce the market value of assets and reduce
the market value of equity capital
M1
• Defined as cash outside of banks plus checking deposits, plus
travelers checks
• Cash outside of banks=cash not in vault, not in federal reserve, not in banking
system
Structure of Federal Reserve system
• 12 District banks each with president
• Board of Governors with chair and 6 other governors
• Combine = FOMC (Federal Open Market Committee)
• FOMC= All 7 governors plus 5 district bank presidents
• Chair serves 4 year term NOT synchronous with president term, CAN
be reappointed
• Governors serve 14 year terms
• FOMC meets every 6 weeks, 1951 Fed Treasury accord made Fed
independent
Loanable funds Model
• Supply meets Demand = Equilibrium
• “market clearing rate”
• Rise in loan demand will push interest rates UP
• Rise in loan supply will push interest rates DOWN
Money Multiplier
• Real world multiplier is around 2 or 3 due to leakages
• Leakage = currency in system, required reserves, excess reserves
• Reserve Requirements
• Has an inverse relationship with money supply
• Lower reserves = higher money supply
• Discount Rate
• Lower discount rate=more discount loans=more bank reserves=more bank
deposits=money supply raises
• Higher discount rate=less discount loans=less reserves=less bank
deposits=money supply decreases
• Discount rate typically non-factor as volume of loans is low
FOMC Open Market Operations
• Open market purchase = money supply increases, loans rise
• Open market sale=money supply decreases, loans fall
• Fed target rate=Federal Funds rate
• Uses open market operations to maintain Fed Target Rate
• Short term rates move together because short term assets are close
substitutes.
• If Fed funds rate goes above target, Fed will buy bonds until rate
lowers. Opposite if rate is below target.
• Expectations theory
• Long term rates=expected average short term rates over the life of the bond
• 3yr bond yield is 8%, people expect 1yr bonds to average 8% of the next 3 years
• When market expects short term rates to be high in the long run,
then long term rates will be high. Opposite for low short term rates
• Adjusted conclusions to theory
• When long term rates is higher than normal relative to short term rates,
people expect short term rates to rise. Opposite for when lower than normal.
• When there is a normal gap between short term and long term rates, then
people expect rates to stay the same.
• Income we earn is spread between short term and long term rates
• Larger spread tends to push up CU income
• Can Fed control long term rates?
• Can influence but NOT control
• Fed established dual mandate
• Maximum employment, stabile prices (inflation)
• Taylor Rule
• Fed Funds rate is a positive function of inflation minus unemployment
• When inflation is high relative to unemployment, Fed increases short term
rates
• When unemployment is higher, Fed sets short term rates low