Chapter 1
Why Study
Money, Banking,
and Financial
Markets?
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Why Study Money, Banking, and
Financial Markets
• To examine how financial markets such as bond and
stock markets work
• To examine how banks, other financial institutions and
financial regulation work
• To examine the role of monetary policy in the economy
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1-2
Financial Markets
• Markets in which funds are transferred from people
who have an excess of available funds to people who
have a shortage of funds
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1-3
The Bond Market and Interest
Rates
• A security (financial instrument) is a claim on the
issuer’s future income or assets
• A bond is a debt security that promises to make
payments periodically for a specified period of time
(that is, IOU)
• An interest rate is the cost of borrowing or the price
paid for the rental of funds
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1-4
FIGURE 1 Interest Rates on
Selected Bonds, 1950–2008
Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.
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1-5
The Stock Market
• Common stock represents a share of ownership in a
corporation (IOBU)
• A share of stock is a claim on the earnings and assets of
the corporation
• Common stock holders are residual claimants.
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1-6
FIGURE 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2008
Source: Dow Jones Indexes: http://finance.yahoo.com/?u.
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1-7
Financial Institutions and
Banking
• Financial Intermediaries: institutions that borrow funds
from people who have saved and make loans to other
people:
– Banks: accept deposits and make loans
– Other Financial Institutions: insurance companies, finance
companies, pension funds, mutual funds and investment
banks
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1-8
Financial Crises
• Financial crises are major disruptions in financial
markets that are characterized by sharp declines in asset
prices and the failures of many financial and
nonfinancial firms.
• Severe financial crises typically spill over into the real
economy.
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1-9
Function of Financial Markets
1. Allows transfers of funds
from person or business
without investment
opportunities to one who has
them
2.Improves economic efficiency
3.Transfer funds over life
horizon
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1-10
Direct and Indirect Finance
• Direct finance: lenders hold direct claims on
borrowers’ assets or future income.
• Indirect finance: Lenders hold claims on
financial intermediary, which in turn hold
claims on borrowers. (q)
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1-11
Classifications of Financial
Markets I
By Financial Instruments
1.
Debt Markets
Short-term (maturity < 1 year)
Long-term (maturity > 10 year)
2.
Equity Markets
Common stocks (owner a residual
claimant)
Securities are assets for holders, but
liabilities for issuers. (q)
The value of debt instruments was $20
trillion in 2002 while the value of equity
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1-12
Classifications of Financial
Markets II
• 1.
doors)
Primary Market
(often behind closed
New security issues sold to initial buyers
• 2.
Secondary Market
Securities previously issued are bought and
sold
• Investment Bank.
• Role of Brokers and Dealers. (q)
• Liquidity and Valuation Provided by the
Secondary Market.
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Classifications of Financial Markets
III
By Organization of Secondary Market
• 1. Exchanges
Trades conducted in central locations (NYSE,ASE)
• 2. Over-the-Counter (OTC) Markets
Dealers at different locations buy and sell
• U.S. Gov’t Bond Market Organized as an OTC
market with 40 or so dealers.
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1-14
Classifications of Financial Markets
IV
By Maturity
1. Money Market (< 1 year debt
instruments)
2. Capital Market (longer term debt and
equity)
.
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1-15
Chapter 4
Understanding
Interest Rates
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1-16
Present Value
Four Types of Credit Instruments
1. Simple loan
2. Fixed-payment loan
3. Coupon bond
4. Discount (zero coupon) bond
Concept of Present Value
Simple loan of $1 at 10% interest
Year
1
2
3
$1.10
$1.21
$1.33
PV of future $1 =
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reserved
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n
$1x(1 + i)n
$1
(1 + i)n
1-17
4-17
Yield to Maturity: Loans
Yield to maturity = interest rate that equates today’s value with
present value of all future payments
1. Simple Loan (i = 10%)
$100 = $110/(1 + i) 
i=
$110 – $100
$100
=
$10
$100
= 0.10 = 10%
2. Fixed Payment Loan (i = 12%)
$1000 =
LV =
$126
(1+i)
FP
(1+i)
+
+
$126
(1+i)2
FP
(1+i)2
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reserved
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+
+
$126
(1+i)3
FP
(1+i)3
+ ... +
+ ... +
$126
(1+i)25
FP
(1+i)n
1-18
4-18
Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
P=
$100
$100
+
+
(1+i)
(1+i)2
$100
$100
$1000
+
...
+
+
(1+i)3
(1+i)10
(1+i)10
P=
C
(1+i)
C
C
+
...
+
+
(1+i)3
(1+i)n
+
C
+
(1+i)2
F
(1+i)n
Consol: Fixed coupon payments of $C forever
C
C
i =
i
P
4. Discount Bond (P = $900, F = $1000), one year
P=
$900 =
i=
$1000
(1+i)
$1000 – $900
$900

= 0.111 = 11.1%
F–P
P
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i=
reserved
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1-19
4-19
Relationship Between Price
and Yield to Maturity
Three Interesting Facts in Table 1
1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par value
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reserved
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1-20
4-20
Distinction Between Interest
Rates and Returns
Rate of Return
RET =
C + Pt+1 – Pt
Pt
where: ic =
g=
C
Pt
Pt+1 – Pt
Pt
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reserved
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= ic + g
= current yield
= capital gain
1-21
4-21
Key Facts about Relationship
Between Interest Rates and
Returns
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reserved
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1-22
4-22
Maturity and the Volatility
of Bond Returns
Key Findings from Table 2
1. Only bond whose return = yield is one with maturity =
holding period
2. For bonds with maturity > holding period, i  P implying
capital loss
3. Longer is maturity, greater is % price change associated with
interest rate change
4. Longer is maturity, more return changes with change in
interest rate
5. Bond with high initial interest rate can still have negative
return if i 
Conclusion from Table 2 Analysis
1. Prices and returns more volatile for long-term bonds because
have higher interest-rate risk
2. ©No
interest-rate risk for any bond whose maturity equals
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1-23
holding period
reserved
4-23
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Chapter 5 The Behavior of Interest Rates
The Behavior of Interest Rates
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Determinants of Asset Demand
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1-25
Supply and
Demand
Analysis of
the Bond
Market
Market Equilibrium
d
s
1. Occurs when B = B , at P* =
$850, i* = 17.6%
s
2. When P = $950, i = 5.3%, B >
d
B (excess supply): P  to P*, i
to i*
d
3. When P = $750, i = 33.0, B >
s
B (excess demand): P  to P*,
i  to i*
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1-26
Shifts in the Bond Demand Curve
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1-27
Factors that Shift the Bond Demand
Curve
1. Wealth
A. Economy grows, wealth , Bd , Bd shifts out to
right
2. Expected Return
A. i  in future, Re for long-term bonds , Bd shifts out
to right
B. e , Relative Re , Bd shifts out to right
C. Expected return relative to other assests , Bd , Bd
shifts out to right
3. Risk
A. Risk of bonds , Bd , Bd shifts out to right
B. Risk of other assets , Bd , Bd shifts out to right
4. Liquidity
A. Liquidity of Bonds , Bd , Bd shifts out to right
d , Bd shifts out to
B.
Liquidity
of
other
assets
,
B
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1-28
Factors
that Shift
Demand
Curve for
Bonds
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1-29
Shifts in the Bond Supply Curve
1.Profitability of
Investment
Opportunities
Business cycle
expansion,
investment
opportunities
, Bs , Bs
shifts out to
right
2.Expected
Inflation
e , Bs , Bs
shifts out to
right
3.Government
Activities
Deficits , Bs
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, Bs shifts out
1-30
Factors
that Shift
Supply
Curve for
Bonds
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1-31
Changes in e: the Fisher Effect
If e 
1. Relative
RETe , Bd
shifts in to
left
2. Bs , Bs
shifts out to
right
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1-32
Evidence on the Fisher Effect
in the United States
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1-33
Business Cycle Expansion
1. Wealth , Bd
, Bd shifts
out to right
2. Investment
, Bs , Bs
shifts out to
right
3. If Bs shifts
more than
Bd then P ,
i
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1-34
Evidence on Business Cycles
and Interest Rates
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1-35
Relation of Liquidity Preference
Framework to Loanable Funds
Keynes’s Major Assumption
Two Categories of Assets in Wealth
Money
Bonds
1. Thus:
Ms + Bs = Wealth
2. Budget Constraint:
Bd + Md = Wealth
3. Therefore:
Ms + Bs = Bd + Md
4. Subtracting Md and Bs from both sides:
Ms – Md = Bd – Bs
Money Market Equilibrium
5. Occurs when Md = Ms
6. Then Md – Ms = 0 which implies that Bd – Bs = 0, so that Bd =
Bs and bond market is also in equilibrium
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1. Equating supply and demand for
bonds as in loanable funds
framework is equivalent to
equating supply and demand for
money as in liquidity preference
framework
2. Two frameworks are closely
linked, but differ in practice
because liquidity preference
assumes only two assets, money
and bonds, and ignores effects on
interest rates from changes in
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1-37
Liquidity Preference Analysis
Derivation of Demand Curve
1. Keynes assumed money has i = 0
2. As i , relative RETe on money  (equivalently,
opportunity cost of money )  Md 
3. Demand curve for money has usual downward
slope
Derivation of Supply curve
1. Assume that central bank controls Ms and it is a
fixed amount
2. Ms curve is vertical line
Market Equilibrium
1. Occurs when Md = Ms, at i* = 15%
2. If i = 25%, Ms > Md (excess supply): Price of
bonds , i  to i* = 15%
3. If i =5%, Md > Ms (excess demand): Price of bonds
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Money
Market
Equilibriu
m
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Rise in Income or the Price Level
1. Income , Md ,
Md shifts out to
right
2. Ms unchanged
3. i* rises from i1
to i2
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1-40
Rise in Money Supply
1. Ms , Ms shifts out to
right
d
2. M unchanged
3. i* falls from i1 to i2
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1-41
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1-42
Money and Interest Rates
Effects of money on interest rates
1. Liquidity Effect
Ms , Ms shifts right, i 
2. Income Effect
Ms , Income , Md , Md shifts right, i 
3. Price Level Effect
Ms , Price level , Md , Md shifts right, i 
4. Expected Inflation Effect
Ms , e , Bd , Bs , Fisher effect, i 
Effect of higher rate of money growth on interest
rates is ambiguous
1. Because income, price level and expected inflation
effects work in opposite direction of liquidity effect
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1-43
Does
Higher
Money
Growth
Lower
Interest
Rates?
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Evidence on Money Growth
and Interest Rates
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1-45
Chapter 6
The Risk and
Term Structure
of Interest Rates
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FIGURE 1 Long-Term Bond Yields,
1919–2008
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970;
Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.
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1-47
Risk Structure of Interest
Rates
• Bonds with the same maturity have
different interest rates due to:
– Default risk
– Liquidity
– Tax considerations
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1-48
Risk Structure of Interest
Rates
• Default risk: probability that the issuer of
the bond is unable or unwilling to make
interest payments or pay off the face value
– U.S. Treasury bonds are considered default free
(government can raise taxes).
– Risk premium: the spread between the interest
rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds
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1-49
FIGURE 2 Response to an Increase
in Default Risk on Corporate Bonds
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1-50
Table 1 Bond Ratings by Moody’s,
Standard and Poor’s, and Fitch
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1-51
Risk Structure of Interest
Rates
• Liquidity: the relative ease with which an
asset can be converted into cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
• Income tax considerations
– Interest payments on municipal bonds are
exempt from federal income taxes.
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1-52
FIGURE 3 Interest Rates on
Municipal and Treasury Bonds
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1-53
Term Structure of Interest
Rates
• Bonds with identical risk, liquidity, and tax
characteristics may have different interest
rates because the time remaining to
maturity is different
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1-54
Term Structure of Interest
Rates
• Yield curve: a plot of the yield on bonds
with differing terms to maturity but the
same risk, liquidity and tax considerations
– Upward-sloping: long-term rates are above
short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term
rates
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Facts Theory of the Term Structure of
Interest Rates Must Explain
1. Interest rates on bonds of different
maturities move together over time
2. When short-term interest rates are low,
yield curves are more likely to have an
upward slope; when short-term rates are
high, yield curves are more likely to slope
downward and be inverted
3. Yield curves almost always slope upward
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1-56
Three Theories to Explain the
Three Facts
1. Expectations theory explains the first two
facts but not the third
2. Segmented markets theory explains fact
three but not the first two
3. Liquidity premium theory combines the
two theories to explain all three facts
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1-57
FIGURE 4 Movements over Time of Interest
Rates on U.S. Government Bonds with Different
Maturities
Sources: Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.
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1-58
Expectations Theory
• The interest rate on a long-term bond will
equal an average of the short-term interest
rates that people expect to occur over the
life of the long-term bond
• Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a
different maturity
• Bond holders consider bonds with different
maturities to be perfect substitutes
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1-59
Expectations Theory:
Example
• Let the current rate on one-year bond be
6%.
• You expect the interest rate on a one-year
bond to be 8% next year.
• Then the expected return for buying two
one-year bonds averages (6% + 8%)/2 =
7%.
• The interest rate on a two-year bond must
be 7% for you to be willing to purchase it.
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1-60
Expectations Theory
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
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1-61
Expectations Theory (cont’d)
Expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
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1-62
Expectations Theory (cont’d)
If two one-period bonds are bought with the $1 investment
(1  it )(1  i )  1
e
t 1
1  it  i  it (i )  1
e
t 1
e
t 1
it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1
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1-63
Expectations Theory (cont’d)
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
int 
it  ite1  ite 2  ...  ite ( n 1)
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
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1-64
Expectations Theory
• Explains why the term structure of interest rates
changes at different times
• Explains why interest rates on bonds with different
maturities move together over time (fact 1)
• Explains why yield curves tend to slope up when
short-term rates are low and slope down when
short-term rates are high (fact 2)
• Cannot explain why yield curves usually slope
upward (fact 3)
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1-65
Segmented Markets Theory
• Bonds of different maturities are not substitutes at
all
• The interest rate for each bond with a different
maturity is determined by the demand for and
supply of that bond
• Investors have preferences for bonds of one
maturity over another
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then
this explains why yield curves usually slope
upward (fact 3)
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1-66
Liquidity Premium &
Preferred Habitat Theories
• The interest rate on a long-term bond will
equal an average of short-term interest
rates expected to occur over the life of the
long-term bond plus a liquidity premium
that responds to supply and demand
conditions for that bond
• Bonds of different maturities are partial (not
perfect) substitutes
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1-67
Liquidity Premium Theory
int 
e
e
e
it  it1
 it2
 ... it(
n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
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1-68
Preferred Habitat Theory
• Investors have a preference for bonds of
one maturity over another
• They will be willing to buy bonds of different
maturities only if they earn a somewhat
higher expected return
• Investors are likely to prefer short-term
bonds over longer-term bonds
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1-69
FIGURE 5 The Relationship Between the
Liquidity Premium (Preferred Habitat) and
Expectations Theory
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1-70
Liquidity Premium and
Preferred Habitat Theories
• Interest rates on different maturity bonds move
together over time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term
rates are low and to be inverted when short-term
rates are high; explained by the liquidity premium
term in the first case and by a low expected
average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
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1-71
FIGURE 6 Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates According to the Liquidity
Premium (Preferred Habitat) Theory
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1-72
FIGURE 7 Yield Curves for U.S.
Government Bonds
Sources: Federal Reserve Bank of St. Louis; U.S. Financial Data, various issues; Wall Street Journal, various
dates.
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1-73
Application: The Subprime Collapse
and the Baa-Treasury Spread
Corporate Bond Risk Premium and Flight to
Quality
10
8
6
4
2
Ju
l-0
7
Se
p07
N
ov
-0
7
Ja
n08
M
ar
-0
8
M
ay
-0
8
Ju
l-0
8
Se
p08
N
ov
-0
8
Ja
n09
-0
7
M
ay
-0
7
M
ar
Ja
n-
07
0
Corporate bonds, monthly data Aaa-Rate
Corporate bonds, monthly data Baa-Rate
10-year maturity Treasury bonds, monthly data
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1-74
Chapter 7
The Stock Market, The Theory of
Rational Expectations,
and the Efficient Market
Hypothesis
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Computing the Price of Common
Stock
• Basic Principle of Finance
Value of Investment = Present Value of Future Cash Flows
• One-Period Valuation Model
Div1
P1
P0 

(1  ke ) (1  ke )
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(1)
1-76
Generalized Dividend Valuation
Model
D1
D2
P0 


1
2
(1  ke ) (1  ke )
Dn
Pn


n
(1  ke ) (1  ke ) n
(2)
• Since last term of the equation is small,
Equation 2 can be written as

Dt
P0  
t
(1

k
)
t 1
e
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(3)
1-77
Gordon Growth Model
• Assuming dividend growth is constant,
Equation 3 can be written as
D0  (1  g )1 D0  (1  g ) 2
P0 


1
2
(1  ke )
(1  ke )
D0  (1  g ) 
(4)


(1  ke )
• Assuming the growth rate is less than the
required return on equity, Equation 4 can be
written as
D0  (1  g )
D1
(5)
P0 

( ke  g )
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( ke  g )
1-78
How the Market Sets Prices
• The price is set by the buyer willing to pay
the highest price
• The market price will be set by the buyer
who can take best advantage of the asset
• Superior information about an asset can
increase its value by reducing its perceived
risk
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1-79
How the Market Sets Prices
• Information is important for individuals to
value each asset.
• When new information is released about a
firm, expectations and prices change.
• Market participants constantly receive
information and revise their expectations,
so stock prices change frequently.
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1-80
Adaptive Expectations
• Expectations are formed from past
experience only.
• Changes in expectations will occur slowly
over time as data changes.
• However, people use more than just past
data to form their expectations and
sometimes change their expectations
quickly.
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1-81
Theory of Rational
Expectations
• Expectations will be identical to optimal forecasts
using all available information
• Even though a rational expectation equals the
optimal forecast using all available information, a
prediction based on it may not always be perfectly
accurate
– It takes too much effort to make the expectation the best
guess possible
– Best guess will not be accurate because predictor is
unaware of some relevant information
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1-82
Implications
• If there is a change in the way a variable
moves, the way in which expectations of the
variable are formed will change as well
– Changes in the conduct of monetary policy (e.g.
target the federal funds rate)
• The forecast errors of expectations will, on
average, be zero and cannot be predicted
ahead of time.
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1-83
Efficient Markets
• Current prices in a financial market will be
set so that the optimal forecast of a
security’s return using all available
information equals the security’s equilibrium
return
• In an efficient market, a security’s price
fully reflects all available information
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1-84
Evidence on Efficient Markets
Hypothesis
Favorable Evidence
1. Stock prices reflect publicly available information: anticipated
announcements don’t affect stock price
2. Stock prices and exchange rates close to random walk
If predictions of P big, Rof > R*  predictions of P small
Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. New information is not always immediately incorporated into
stock prices
Overview
Reasonable starting point but not whole story
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1-85
Application Investing in the
Stock Market
• Recommendations from investment advisors
cannot help us outperform the market
• A hot tip is probably information already
contained in the price of the stock
• Stock prices respond to announcements
only when the information is new and
unexpected
• A “buy and hold” strategy is the most
sensible strategy for the small investor
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1-86
Behavioral Finance
• The lack of short selling (causing
over-priced stocks) may be explained by
loss aversion
• The large trading volume may be explained
by investor overconfidence
• Stock market bubbles may be explained by
overconfidence and social contagion
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1-87
Chapter 8
An Economic Analysis of Financial Structure
An Economic Analysis of Financial
Structure
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1-88
Main Street - Wall Street
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1-89
What this chapter is about
• Facts about financial structure
• Function of financial intermediaries
• Asymmetric information
– Adverse Selection
– Moral Hazard
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1-90
Sources of External Finance for
Nonfinancial Business
•
•
•
•
Bank loans: 18%
Nonbank loans: 38%
Bonds: 32%
Stock: 11%
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1-91
Facts of Financial Structure
1.
2.
3.
4.
5.
Issuing marketable securities not primary
funding source for businesses, banks are.
Only large, well established firms have
access to securities markets
Collateral is prevalent feature of debt
contracts
Debt contracts are typically extremely
complicated legal documents with
restrictive covenants
Financial system is among most heavily
regulated sectors of economy
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1-92
Transaction Costs and Financial
Structure
Transaction costs hinder flow of funds to
people with productive investment
opportunities
Financial intermediaries make profits by
reducing transaction costs
1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs
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1-93
Adverse Selection
and Moral Hazard: Definitions
Adverse Selection:
1.
Before transaction occurs
2.
Potential borrowers most likely to
produce adverse outcomes are ones most
likely to seek loans and be selected
Moral Hazard:
1.
After transaction occurs
2.
Hazard that borrower has incentives to
engage in undesirable (immoral) activities
making it more likely that won’t pay loan
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1-94
Adverse Selection
and Financial Structure
Lemons Problem in Securities Markets
1. If investors can’t distinguish between good and bad
securities, they are only willing to pay only average
of good and bad securities’ values.
2. Result: Good securities undervalued and firms
won’t issue them; bad securities overvalued, so too
many issued.
3. Investors won’t want to buy bad securities, so
market won’t function well.
Explains Less asymmetric information for well
known firms, so smaller lemons problem
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1-95
Tools to Help Solve Adverse
Selection (Lemons) Problem
1.Private Production and Sale of Information
Free-rider problem interferes with this solution
2.Government Regulation to Increase
Information
Explains Fact 5
3.Financial Intermediation
A. Analogy to solution to lemons problem provided
by used-car dealers
B. Avoid free-rider problem by making private
loans
Explains dominance of banks
4.Collateral and Net Worth
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1-96
Moral Hazard: Debt versus
Equity
Moral Hazard in Equity:
Principal-Agent Problem
1. Result of separation of ownership by stockholders
(principals) from control by managers (agents)
2. Managers act in own rather than stockholders’
interest
Tools to Help Solve the Principal-Agent Problem
1. Monitoring: production of information
2. Government regulation to increase information
3. Financial intermediation
4. Debt contracts
1-97
Explains Why debt used more than equity
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Moral Hazard and Debt Markets
Moral hazard: borrower wants to take on too
much risk
Tools to Help Solve Moral Hazard
1. Net worth
2. Monitoring and enforcement of restrictive
covenants
3. Financial intermediation
Banks and other intermediaries have special
advantages in monitoring
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1-98
Conflicts of Interest
• Underwriting and Research in Investment Banking
• Auditing and Consulting in Accounting Firms
• Credit Assessment and Consulting in Credit-Rating
Agencies
• Political Beneficiary and Representing Public Interest in
Government Agencies
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1-99
Chapter 10
Banking and the Management of
Financial Institutions
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Table 1 Balance Sheet of All Commercial
Banks (items as a percentage of the total,
December 2008)
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1101
Bank Operation
T-account Analysis:
Deposit of $100 cash into First National Bank
Assets
Liabilities
Vault Cash + $100
(=Reserves)
Checkable Deposits + $100
Deposit of $100 check into First National Bank
Assets
Liabilities
Cash items in process
of collection + $100
First National Bank
Assets
Liabilities
Checkable Deposits + $100
Second National Bank
Assets
Liabilities
Checkable
Checkable
Reserves
Deposits
Reserves
Deposits
+ $100
+ $100
– $100
– $100
Conclusion: When bank receives deposits, reserves  by equal
amount; when bank loses deposits, reserves  by equal amount
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1102
Principles of Bank Management
1. Liquidity Management
2. Asset Management
Managing Credit Risk
Managing Interest-rate Risk
3. Liability Management
4. Capital Adequacy Management
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1103
Principles of Bank Management
Liquidity Management
Reserve requirement = 10%, Excess reserves = $10
million
Assets
Liabilities
Reserves $20 million
Deposits
$100 million
Loans
$80 million
Bank Capital $ 10 million
Securities
$10 million
Deposit outflow of $10 million
Assets
Liabilities
Reserves $10 million
Deposits
$ 90 million
Loans
$80 million
Bank Capital $ 10 million
Securities
$10 million
With 10% reserve requirement, bank still has excess
reserves of $1 million: no changes needed in balance
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1104
Liquidity Management
No excess reserves
Assets
Liabilities
Reserves $10 million Deposits
$100 million
Loans
$90 million Bank Capital $ 10 million
Securities $10 million
Deposit outflow of $
Assets
Reserves $ 0 million
Loans
$90 million
Securities $10 million
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10 million
Liabilities
Deposits
$ 90 million
Bank Capital $ 10 million
1105
Liquidity Management
1. Borrow from other banks or corporations
Assets
Liabilities
Reserves $ 9 million
Deposits
$ 90 million
Loans
$90 million Borrowings
$ 9 million
Securities $10 million Bank Capital $ 10 million
2. Sell Securities
Assets
Reserves $ 9 million
Loans
$90 million
Securities $ 1 million
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Liabilities
Deposits
Bank Capital
$ 90 million
$ 10 million
1106
Liquidity Management
3. Borrow from Fed
Assets
Securities $10 million
Reserves $ 9 million
Loans
$90 million
Liabilities
Bank Capital
$ 10 million
Deposits
$ 90 million
Discount Loans $ 9 million
4. Call in or sell off loans
Assets
Liabilities
Reserves $ 9 million
Deposits
Loans
$81 million Bank Capital
Securities $10 million
$ 90 million
$ 10 million
Conclusion: excess reserves are insurance against
above 4 costs from deposit outflows
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1107
Asset and Liability Management
Asset Management
1. Get borrowers with low default risk, paying high
interest rates
2. Buy securities with high return, low risk
3. Diversify
4. Manage liquidity
Liability Management
1. Important since 1960s
2. Banks no longer primarily depend on deposits
3. When see loan opportunities, borrow or issue CDs
to acquire funds
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1108
Capital Adequacy Management
1. Bank capital is a cushion that helps prevent bank
failure
2. Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets
ROE = Net Profits/Equity Capital
EM = Assets/Equity Capital
ROE = ROA  EM
Capital , EM , ROE 
3. Tradeoff between safety (high capital) and ROE
4. Banks also hold capital to meet capital
requirements
5. Managing Capital:
A. Sell or retire stock
B. Change dividends to change retained earnings
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1109
Application: How a Capital Crunch
Caused a Credit Crunch in 2008
• Shortfalls of bank capital led to slower credit
growth
– Huge losses for banks from their holdings of
securities backed by residential mortgages.
– Losses reduced bank capital
• Banks could not raise much capital on a
weak economy, and had to tighten their
lending standards and reduce lending.
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1110
Managing Credit Risk
Solving Asymmetric Information
Problems
1.
Screening
2.
Monitoring and Enforcement of
Restrictive Covenants
3.
Specialize in Lending
4.
Establish Long-Term Customer
Relationships
5.
Loan Commitment Arrangements
6.
Collateral and Compensating Balances
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1111
Managing Interest Rate Risk
First National Bank
Assets
Rate-sensitive assets
liabilities
$50 m
Variable-rate loans
Short-term securities
Fixed-rate assets
$80 m
Reserves
Long-term bonds
Long-term securities
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Liabilities
$20 m
Rate-sensitive
Variable-rate CDs
MMDAs
Fixed-rate liabilities $50 m
Checkable deposits
Savings deposits
Long-term CDs
Equity capital
1112
Managing Interest-Rate Risk
Gap Analysis
GAP = rate-sensitive assets – rate-sensitive
liabilities
= $20 – $50 = –$30 million
When i  5%:
1. Income on assets = + $1 million
(= 5%  $20m)
2. Costs of liabilities = +$2.5 million
(= 5%  $50m)
3. Profits = $1m – $2.5m = –$1.5m
= 5%  ($20m – $50m) = 5%  (GAP)
Profits = i  GAP
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1113
Duration Analysis
Duration Analysis
% value  –(% pointi)  (DUR)
Example: i  5%, duration of bank assets = 3
years, duration of liabilities = 2 years;
% assets = –5%  3 = –15%
% liabilities = –5%  2 = –10%
If total assets = $100 million and total liabilities
= $90 million, then assets  $15 million,
liabilities$9 million, and bank’s net worth by
$6 million
Strategies to Manage Interest-rate Risk
1. Rearrange balance-sheet
2. Interest-rate swap
3. Hedge with financial futures
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1114
Off-Balance-Sheet Activities
1.
Loan sales
2.
Fee income from
A. Foreign exchange trades for
customers
B. Servicing mortgage-backed
securities
C. Guarantees of debt
D. Backup lines of credit
3.
Trading Activities
A. Financial futures
B. Financial options
C. Foreign exchange
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1115
Off-Balance-Sheet Activities
• Loan sales (secondary loan participation)
• Generation of fee income. Examples:
– Servicing mortgage-backed securities.
– Creating SIVs (structured investment vehicles)
which can potentially expose banks to risk, as it
happened in the subprime financial crisis of
2007-2008.
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1116
Off-Balance-Sheet Activities
• Trading activities and risk management
techniques
– Financial futures, options for debt instruments,
interest rate swaps, transactions in the foreign
exchange market and speculation.
– Principal-agent problem arises
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1117
Off-Balance-Sheet Activities
• Internal controls to reduce the principalagent problem
– Separation of trading activities and bookkeeping
– Limits on exposure
– Value-at-risk
– Stress testing
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1118
Chapters 11 & 12
Banking Industry: Structure,
Competition and Regulation
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Financial Innovation
Innovation is result of search for profits
Response to Changes in Demand
Major change is huge increase in interest-rate risk
starting in 1960s
Example: Adjustable-rate mortgages
Financial Derivatives
Response to Change in Supply
Major change is improvement in computer technology
1. Increases ability to collect information
2. Lowers transaction costs
Examples:
1. Bank credit and debit cards
2. Electronic banking facilities
3. Junk bonds
4. Commercial paper market
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5. Securitization
1120
Avoidance of Existing
Regulations
Regulations Behind Financial Innovation
1.
Reserve requirements
Tax on deposits = i  r
2.
Deposit-rate ceilings (Reg Q till 1980)
As i , loophole mine to escape reserve
requirement tax and deposit-rate ceilings
Examples
1. Money market mutual funds (Bruce Bent)
2. Sweep accounts
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1121
The Decline in Banks
as a Source of Finance
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1122
Decline in Traditional Banking
Loss of Cost Advantages in Acquiring
Funds (Liabilities)
  i  then disintermediation because
1. Deposit rate ceilings and regulation Q
2. Money market mutual funds
3. Foreign banks have cheaper source of
funds: Japanese banks can tap large savings
pool
Loss of Income Advantages on Uses
of Funds (Assets)
1. Easier to use securities markets to raise
funds: commercial paper, junk bonds,
securitization
2. Finance companies more important
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1123
Banks’ Response
Loss of cost advantages in raising funds
and income advantages in making loans
causes reduction in profitability in
traditional banking
1. Expand lending into riskier areas: e.g., real
estate
2. Expand into off-balance sheet activities
3. Creates problems for U.S. regulatory
system
Similar problems for banking industry in
other countries
1-
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124
Structure of the Commercial Banking
Industry
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1125
Table 1 Size Distribution of Insured
Commercial Banks, September 30, 2008
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1126
Ten Largest U.S. Banks
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1127
Branching Regulations
Branching Restrictions: McFadden Act
and Douglas Amendment
Very anticompetitive
Response to Branching Restrictions
1. Bank Holding Companies
A. Allowed purchases of banks outside state
B.
BHCs allowed wider scope of activities by
Fed
C.
BHCs dominant form of corporate
structure for banks
2. Automated Teller Machines
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1128
Bank Consolidation and Number
of Banks
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1129
Bank Consolidation and
Nationwide Banking
• The number of banks has declined over
the last 25 years
– Bank failures and consolidation.
– Deregulation: Riegle-Neal Interstate Banking
and Branching Efficiency Act f 1994.
– Economies of scale and scope from
information technology.
• Results may be not only a smaller
number of banks but a shift in assets to
much larger banks.
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1130
Benefits and Costs of Bank
Consolidation
• Benefits
– Increased competition, driving inefficient banks
out
of business
– Increased efficiency also from economies of
scale and scope
– Lower probability of bank failure from more
diversified portfolios
• Costs
– Elimination of community banks may lead to less
lending to small business
– Banks expanding into new areas may take
1increased risks and fail
131
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Separation of Banking and
Other Financial Service
Industries
Erosion of Glass-Steagall
Fed, OCC, FDIC, allow banks to engage in
underwriting activities
Gramm-Leach-Bliley Financial Modernisation
Services Act of 1999: Repeal of GlassSteagall
1. Allows securities firms and insurance companies to
purchase banks
2. Banks allowed to underwrite insurance and engage in
real estate activities
3. OCC regulates bank subsidiaries engaged in
securities underwriting
4. Fed oversee bank holding companies under which all
real estate, insurance and large securities operations
are housed
Implications: Banking institutions become larger and
more complex
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1132
How Asymmetric Information
Explains Banking Regulation
1. Government Safety Net and Deposit
Insurance
A. Prevents bank runs due to asymmetric
information: depositors can’t tell good from
bad banks
B. Creates moral hazard incentives for banks to
take on too much risk
C. Creates adverse selection problem of crooks
and risk-takers wanting to control banks
D. Too-Big-to-Fail increases moral hazard
incentives for big banks
2. Restrictions on Asset Holdings
A. Reduces moral hazard of too much risk taking
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1133
How Asymmetric Information
Explains Banking Regulation
3. Bank Capital Requirements
A. Reduces moral hazard: banks have more to lose
when have higher capital
B. Higher capital means more collateral for FDIC
4. Bank Supervision: Chartering and Examination
A. Reduces adverse selection problem of risk takers or
crooks owning banks
B. Reduces moral hazard by preventing risky activities
5. New Trend: Assessment of Risk Management
6. Disclosure Requirements
A. Better information reduces asymmetric information
problem
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1134
How Asymmetric Information
Explains Banking Regulation
7. Consumer Protection
A. Standardized interest rates (APR)
B. Prevent discrimination: e.g., CRA
8. Restrictions on Competition to Reduce Risk-Taking
A. Branching restrictions
B. Separation of banking and securities industries in
the past: Glass-Steagall
International Banking Regulation
1. Bank regulation abroad similar to ours
2. Particular problem of regulating international
banking
e.g., BCCI scandal
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1135
Chapter 14
Multiple Deposit Creation and the
Money Supply Process
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Meaning and Function of Money
Economist’s Meaning of Money
1. Anything that is generally accepted in payment for goods
and services
2. Not the same as wealth or income
Functions of Money
1. Medium of exchange
2. Unit of account
3. Store of value
Evolution of Payments System
1. Precious metals like gold and silver
2. Paper currency (fiat money)
3. Checks
4. Electronic means of payment
5. Electronic money: Debit cards, Stored-value cards, Smart
cards, E-cash
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1137
Four Players
in the Money Supply Process
1.
Central bank: the Fed
2.
Banks
3.
Depositors
4.
Borrowers from banks
Federal Reserve System
1.
Conducts monetary policy
2.
Clears checks
3.
Regulates banks
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1138
The Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Monetary Base, MB = C + R
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1139
Control of the Monetary Base
Open Market Purchase from Bank
The Banking System
Assets
Liabilities
Assets
The Fed
Liabilities
Securities – $100
Securities + $100 Reserves +
$100
Reserves + $100
Open Market Purchase from Public
Public
The Fed
Assets
Liabilities
Assets
Liabilities
Securities – $100
$100
Deposits + $100
Banking System
Assets
Liabilities
Securities + $100
Reserves
Checkable Deposits
+ $100
+ $100
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Reserves +
1140
If Person Cashes Check
Fed
Assets
Public
Liabilities
The
Assets
Securities – $100
Currency + $100
Currency + $100
Result: R unchanged, MB  $100
Effect on MB certain, on R uncertain
Liabilities
Securities + $100
Shifts From Deposits into Currency
Fed
Assets
Public
Liabilities
Deposits – $100
$100
Currency + $100
$100
Banking System
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The
Assets
Liabilities
Currency +
Reserves –
1141
Discount Loans
Banking System
The Fed
Assets
Liabilities
Assets
Reserves
Discount
Discount
+ $100
loan + $100
+ $100
Liabilities
Reserves
loan + $100
Result: R  $100, MB  $100
Conclusion: Fed has better ability to control MB than
R
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1142
Deposit Creation: Single Bank
Assets
Securities
Reserves
Assets
Securities
Reserves
Loans
Assets
Securities
Loans
First National Bank
Liabilities
– $100
+ $100
First National Bank
Liabilities
– $100
+ $100
+ $100
Deposits
+ $100
First National Bank
Liabilities
– $100
+ $100
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Deposits
+ $100
1143
Deposit Creation: Banking
System
Assets
Reserves
Assets
Reserves
Loans
Assets
Reserves
Assets
Reserves
Loans
+ $100
+ $10
+ $90
+ $90
+$9
+ $81
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Bank A
Liabilities
Deposits
+ $100
Bank A
Liabilities
Deposits
+ $100
Bank B
Liabilities
Deposits
+ $90
Bank B
Liabilities
Deposits
+ $90
1144
Deposit Creation
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1145
Deposit Creation
If Bank A buys securities with $90 check
Bank A
Assets
Liabilities
Reserves + $10
Deposits
+ $100
Securities + $90
Seller deposits $90 at Bank B and process is same
Whether bank makes loans or buys securities,
get same deposit expansion
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1146
Deposit Multiplier
Simple Deposit Multiplier
1
D =
 R
r
Deriving the formula
R = RR = r  D
D=
1
r
R
D =
1
r
 R
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1147
Deposit Creation:
Banking System as a Whole
Banking System
Assets
Liabilities
Securities– $100
Deposits + $1000
Reserves+ $100
Loans + $1000
Critique of Simple Model
Deposit creation stops if:
1. Proceeds from loan kept in cash
2. Bank holds excess reserves
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1148
Money Multiplier
M = m  MB
Deriving Money Multiplier
R = RR + ER
RR = r  D
R = (r  D) + ER
Adding C to both sides
R + C = MB = (r  D) + ER + C
1. Tells us amount of MB needed support D,
ER and C
2. $1 of MB in ER, not support D or C
MB = (r  D) + (e  D) + (c D)
= (r + e + c)  D
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1149
D=
1
r+e+c
 MB
M = D + (c D ) = (1 + c) D
M=
1+c
r+e+c
m =
1+c
r+e+c
 MB
m < 1/r because no multiple expansion for currency
and because as D  ER 
Full Model
M = m  (MBn + DL)
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1150
Excess Reserves Ratio
Determinants of e
1. i , relative Re on ER  (opportunity cost ), e

2. Expected deposit outflows, ER insurance
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1151
Factors Determining Money
Supply
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1152
Deposits at Failed Banks: 1929–
33
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1153
e, c: 1929–33
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1154
Money Supply and Monetary Base: 1929–33
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