Economics 350: Money and Banking. Lecture Notes

University at Albany State University of New York Economics 350: Money and Banking Lecture Notes Fall 2015 John Bailey Jones

Sources 1. Abel, Andrew B., and Ben S. Bernanke, 1998, Macroeconomics, 4th ed., Reading, MA: Addison-Wesley. 2. Aliber, Robert Z., James S. Duesenberry and Thomas Mayer, 1984, Money, Banking and the Economy, 2nd ed., New York: W.W. Norton & Company. 3. Baumol, William A., and Alan S. Blinder, 1997, Macroeconomics: Principles and Policy, 7th ed., Orlando: Harcourt Brace & Company. 4. Board of Governors of the Federal Reserve System, 1994, The Federal Reserve System: Purposes and Functions, Washington, D.C.: Board of Governors of the Federal Reserve System. 5. Chicago Board of Trade, 1994, CBOT Financial Instruments Guide. 6. Financial Crisis Inquiry Commission, 2010, Staff Reports (http://www.fcic.gov/reports/). 7. Dornbusch, Rudiger Stanley Fischer and Richard Startz, 1998, Macroeconomics, 7th ed., Boston: Irwin/McGraw-Hill. 8. Federal Reserve Bank of Chicago, 1994, Modern Money Mechanics. 9. Hester, Donald, 1997, lecture notes for Economics 330, University of Wisconsin- Madison, fall semester. (Compiled by Meredith Crowley.) 10. Mankiw, N. Gregory, 1998, Principles of Macroeconomics, Orlando, FL: The Dryden Press. 11. Mishkin, Frederic S., 1998, The Economics of Money, Banking and Financial Markets, 5th ed., Reading, MA: Addison-Wesley. 12. Mishkin, Frederic S., 2007 & 2013, The Economics of Money, Banking and Financial Markets, Business School Edition, Reading, MA: Addison-Wesley. 13. Ritter, Lawrence S., William L. Silber and Gregory F. Udell, 2000, Principles of Money, Banking and Financial Markets, 10th ed., Reading, MA: Addison-Wesley. 14. Stern, Gary H., 2000, Using Market Data to Manage Risk, The Region (Federal Reserve Bank of Minneapolis), 14 (March). 2

Topic 0: Overview of Course 1. Introduction: Topics 1-2 A. Money: what it is and what it does B. Financial markets: what is traded, why it is traded, and who trades it 2. Principles of Finance: Topics 3-7 A. Interest rates/bond prices and how to calculate them B. How bond prices/interest rates are set in the marketplace C. Financial derivatives: how they work and what they do 3. Financial Institutions: Topics 8-11 A. Basic principles of bank management B. The evolution of commercial banks, their regulation, and their non-bank competitors 4. Monetary Policy and Central Banking: Topics 12-16 A. How the money supply is set, and how central banks control it B. The Federal Reserve s goals and tactics C. Financial crises and central banks 5. Monetary Theory: Topics 17-18 A. How the money supply affects aggregate output and prices B. Whether the Federal Reserve can (or should) intervene in the economy 3

Topic 1: Introduction to Money Mishkin, Chapter 3 1. Money and its Functions A. Money: any asset widely accepted as payment for goods and services or in the repayment of debt B. 3 Functions of Money i. Medium of exchange: facilitates trade ii. Unit of account iii. Store of value (wealth): extremely liquid, but subject to inflation risk C. Evolution of the payments system i. Autarky ii. Barter iii. Commodity money iv. Paper currency: full-bodied and fiat v. Checks vi. Electronic money vii. Monetary Collapse 2. Measuring Money: The Federal Reserve s Monetary Aggregates A. M1 and M2: M2 is more general B. M1 = Total: 7/2015 ($billions) Currency 1,299.9 + Travelers checks 2.7 + Demand deposits ( classic no-interest checking accts) 1,226.7 + Other checkable deposits 506.4 Total 3,035.6 C. M2 = M1 3,035.6 + Small denomination (< $100,000) time deposits 466.2 (Certificates of Deposit or CDs) + Money market mutual fund shares (retail owners) 618.8 + Savings deposits and money market deposit accounts (MMMFs offered by banks) 7,938.5 Total 12,059.2 D. Comment: the different measures move together, but far from exactly. 4

Topic 2: Overview of Financial Markets Mishkin, Chapter 2 1. Main Function A. Transfer funds from lenders to borrowers: improves allocation of resources B. Direct finance: borrowers sell securities to lenders C. Indirect finance: funds go through a financial intermediary 2. Four Ways of Characterizing Financial Markets A. Debt vs. equity i. Debt: a security with a specified payment schedule ii. Equity: a claim to a share of a firm s income (net of debt payments) and net worth B. Primary vs. secondary i. Primary: new securities ii. Secondary: resale of existing securities C. Exchange vs. over-the-counter i. Exchange: trade in a central location ii. Over-the-counter: dealers in many locations D. Money vs. capital markets i. Money markets: maturity of one year or less ii. Capital markets: maturity of more than one year 3. Financial Intermediaries A. Financial intermediary: an institution that borrows funds from one group of people in order to lend them to another B. Function: utilize economies of scale in: i. Contracting ii. Diversification iii. Creating liquidity iv. Handling asymmetric information 5

C. Adverse selection: i. When the people most undesirable to the other party are the ones mostly likely to seek to transact with him/her ii. Problem with asymmetric information before transaction is made iii. Handled with screening D. Moral hazard: i. Risk that one party in a transaction will engage in an action harmful to the other party ii. Problem with asymmetric information after transaction is made iii. Handled with monitoring E. Types of financial intermediaries i. Depository: includes commercial banks, S&Ls, credit unions ii. Contractual savings: includes insurance companies and pension plans iii. Investment: includes mutual funds and finance companies 4. Regulation A. Goals i. Transparent and efficient operation ii. Preventing financial panics B. Regulating direct markets i. Disclosure ii. Insider trading prohibited iii. Other screening and monitoring C. Regulating financial intermediaries i. Screening: chartering ii. Monitoring: reporting and management restrictions iii. Deposit insurance iv. Limiting competition v. Reserve requirements 6

Topic 3: Understanding Interest Rates Mishkin, Chapter 4 1. Present Value A. One-period loan i. i = interest rate ii. Future Payment = (1 + i) [Present Value of Loan]: FP = (1 + i)pv iii. Discounting: PV = FP/(1 + i); compensation for foregone interest B. More generally: if FP is received n periods ahead (with constant rate i): PV = FP/(1 + i) n 2. Yield to Maturity A. Interest rate that equates the present value of a series of payments to a security s market price. Most common definition of interest rate. B. Suppose security pays FP 1 one period later, FP 2 2 periods later, etc. Then i. PV(d) = FP 1 /(1 + d) + FP 2 /(1 + d) 2 + FP 3 /(1 + d) 3 + + FP n /(1 + d) n ii. For d > -1, PV(d) in d iii. i = Y-T-M = value of d that sets PV(d) = P = market price. Present Value ($) Market Price = P PV(d) i = Y-T-M Discount Rate (d) iv. Negative relationship between a security s price and its Y-T-M 3. Pricing/Yield Formulae A. Simple Loan: Y-T-M = interest rate B. Fixed Payments Loan i. Pay FP after each of n periods ii. LV = FP/(1 + i) + FP/(1 + i) 2 + FP/(1 + i) 3 + + FP/(1 + i) n 7

iii. Given LV, FP and n, i found with table or calculator. Given i, FP and n, LV found similarly. C. Coupon Bond i. F = face value = amount repaid at end of final period ii. c = coupon rate iii. cf = C = coupon payment = interest payment made at end of each period iv. P B = cf/(1 + i) + cf/(1 + i) 2 + cf/(1 + i) 3 + + cf/(1 + i) n + F/(1 + i) n v. Given P B, c, F and n, use table to find i. Given i, c, F and n, find P B. vi. When F = P B, i = c D. Consol i. Coupon bond with no maturity date ii. P C = C/i i = C/P C. iii. C = cf = coupon payment E. Discount Bond i. No interest payments: repay F at the end of n periods ii. P D = F/(1 + i) n i = (F/P D ) 1/n 1 4. Rate of Return A. 1-period rate of return = ret = C/P 1 + [P 2 - P 1 ] /P 1 = i c + g i. i c = current yield: C = total payments of any sort over upcoming periods ii. g is the rate of capital gain iii. Negative relationship between current price (P 1 ) and ret B. Lifetime ret = Y-T-M if one holds the security until it matures i. g irrelevant once security matures C. Interest rate risk: the uncertainty in an security s total return induced by changes in the market Y-T-M i. As market i changes, so does a security s price capital gains or losses ii. Long-term securities have more interest rate risk iii. Avoid risk by matching holding period and maturity 5. Nominal vs. Real Interest Rates (and Rates of Return) A. Nominal interest rates: calculated with money (nominal) quantities B. Real interest rates: calculated with purchasing power (real) quantities C. Real interest rates usually more relevant 8

D. Fisher equation: i r + π e, where i is the nominal rate, r is the real rate, and π e is expected inflation. E. Same logic applies for rates of return F. Indexed bonds i. Nominal payments adjusted for inflation: i = r + π ii. Direct indicator of real interest rates iii. No inflation risk 9

Monthly Payment Necessary To Amortize a $1,000 Loan* 10 Annual ----------------------------------------------------Term (Years)----------------------------------------------------- Interest 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Rate (%) ** 8.00 $9.56 $9.25 $8.98 $8.75 $8.55 $8.36 $8.20 $8.06 $7.93 $7.82 $7.72 $7.63 $7.54 $7.47 $7.40 $7.34 8.50 9.85 9.54 9.28 9.05 8.85 8.68 8.52 8.38 8.26 8.15 8.05 7.96 7.88 7.81 7.75 7.69 9.00 10.14 9.85 9.59 9.36 9.17 9.00 8.85 8.71 8.59 8.49 8.39 8.31 8.23 8.16 8.10 8.05 9.50 10.44 10.15 9.90 9.68 9.49 9.32 9.17 9.04 8.93 8.83 8.74 8.66 8.58 8.52 8.46 8.41 10.00 10.75 10.46 10.21 10.00 9.81 9.65 9.51 9.38 9.27 9.17 9.09 9.01 8.94 8.88 8.82 8.78 10.50 11.05 10.77 10.53 10.32 10.14 9.98 9.85 9.73 9.62 9.52 9.44 9.37 9.30 9.25 9.19 9.15 11.00 11.37 11.09 10.85 10.65 10.47 10.32 10.19 10.07 9.97 9.88 9.80 9.73 9.67 9.61 9.57 9.52 11.50 11.68 11.41 11.18 10.98 10.81 10.66 10.54 10.42 10.33 10.24 10.16 10.10 10.04 9.99 9.94 9.90 12.00 12.00 11.74 11.51 11.32 11.15 11.01 10.89 10.78 10.69 10.60 10.53 10.47 10.41 10.37 10.32 10.29 For example, for a 20-year loan with a 10 percent interest rate, the monthly payment would be $9.65 a * month. ** Interest rate expressed as 12x monthly rate; for example, an "annual" rate of 12.00% reflects a monthly rate of 1.00%. The payments tabulated above thus satisfy LV = FPx(1/i)x[1-1/(1+i) N ], where LV is the loan's value ($1,000), FP is the monthly payment, i is the monthly interest rate and N is the number of months.

11 10.00 Bond Values per $1,000 of Face Value for a 10% Coupon Bond* ---------------------------------------------------------------Years to Maturity---------------------------------------------------------------- Annual 1 2 3 4 5 6 7 8 9 10 15 20 30 Yield (%) ** 10.00 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 10.25 997.7 995.6 993.7 992.0 990.4 989.0 987.7 986.6 985.5 984.6 981.1 978.9 976.8 10.50 995.4 991.2 987.4 984.0 980.9 978.2 975.6 973.4 971.3 969.5 962.6 958.5 954.6 10.75 993.1 986.8 981.2 976.1 971.6 967.5 963.8 960.4 957.4 954.7 944.7 938.8 933.2 11.00 990.8 982.5 975.0 968.3 962.3 956.9 952.1 947.7 943.8 940.2 927.3 919.8 912.8 11.25 988.5 978.2 968.9 960.6 953.2 946.5 940.5 935.2 930.4 926.1 910.4 901.3 893.1 11.50 986.2 973.9 962.8 953.0 944.1 936.3 929.2 922.9 917.2 912.2 893.9 883.5 874.1 11.75 983.9 969.6 956.8 945.4 935.2 926.1 918.0 910.8 904.4 898.6 877.9 866.2 855.9 12.00 981.7 965.3 950.8 937.9 926.4 916.2 907.1 898.9 891.7 885.3 862.4 849.5 838.4 12.25 979.4 961.1 944.9 930.5 917.7 906.3 896.2 887.3 879.3 872.3 847.2 833.4 821.5 12.50 977.2 956.9 939.0 923.1 909.1 896.6 885.6 875.8 867.2 859.5 832.4 817.7 805.3 12.75 974.9 952.8 933.2 915.9 900.6 887.1 875.1 864.6 855.2 847.0 818.1 802.5 789.6 * For example, a 20-year bond with a yield of 12 percent has a market value of $849.5. Interest rate expressed as 2x biannual rate; for example, an "annual" rate of 12.00% reflects a biannual rate of ** 6.00%. The bond values tabulated above thus satisfy PB = [c/i + (1-c/i)/(1+i) N ]xfv, where PB is the bond's market value, FV is the bond's face value ($1,000), c is the half-year coupon rate (5%), i is the half-year interest rate and N is the number of half-years.

In-Class Problems 1 Interest Rate and Return Formulae 1. Use the table in your lecture notes to answer the following questions. A. Suppose you have borrowed $1,700. If you repay this loan in a series of constant monthly payments over 23 years, what will be the monthly payment that gives your lender an (approximate) annual yield of 12 percent? B. Suppose that you have won $1,000,000 in the lottery. You have 3 payment choices: (1) the $1,000,000 today; (2) $10,900 at the end of each month for the next 20 years; (3) $10,600 at the end of each month for the next 25 years. If your (approximate) annual discount rate is 12 percent, which option has the highest present value? 2. When necessary, use the table in your lecture notes to answer the following questions. A. Find the (approximate) annual yield to maturity on the following 10-percent coupon bonds: (1) a bond maturing in 8 years, with a face value of $100 and a market value of $93.52; (2) a bond maturing in 6 years, with a face value of $500 and a market value of $453.15. B. What is the yield to maturity on a coupon bond, maturing in 17 years, with an annual coupon rate of 8.75 percent, a face value of $250,000 and a market value of $250,000? C. Find the market value of the following 10-percent coupon bonds: (1) a bond maturing in 5 years, with a face value of $100 and an (approximate) annual yield of 12.25 percent; (2) a bond maturing in 9 years, with a face value of $750 and an (approximate) annual yield of 10.75 percent. D. Which 10-percent coupon bond would generate the highest annual yield: (1) a bond maturing in 8 years, with a face value of $100 and a market value of 96.04; (2) a bond maturing in 6 years, with a face value of $100 and a market value of $97; (3) a bond maturing in 10 years, with a face value of $100 and a market value of $95. 12

3. Use the formulae in your notes to answer the following questions. A. Suppose you own an apartment that produces a perpetual rent of $12,000 every year. (Pretend the rents are year-end.) If you bought this apartment for $300,000, what will be its annual yield to maturity? B. What is the annual yield to maturity of a discount bond, maturing in three years, with a face value of $1,000 and a market value of $804.96? C. What is the market value of a discount bond, maturing in 4 years, with a face value of $5,000 and an annual yield of 5 percent? 4. Consider a consol with a coupon rate of 5 percent and a face value of $1,000. A. Suppose that at the beginning of year 1, when the market s yield to maturity for consols is 6.25 percent per year, you buy the consol at price P 1. What will P 1 be? B. Now suppose that at the beginning of year 2 the market yield to maturity is 4.0 percent per year. What will the new price, P 2, be? C. What is the annual rate of return that you would earn by holding the consol from the beginning of year 1 to the beginning of year 2? (Assume that the coupon payment is made at the end of year 1/beginning of year 2.) 5. Consider a discount bond with a face value of $1000 and a maturity date of January 1, 2000. A. Suppose that on January 1, 1990, when the market s yield to maturity on this bond is 5 percent per year, you purchase the bond at price P 1. What will P 1 be? B. Now suppose that on January 1, 1991, the market s yield to maturity on this bond is 4 percent per year. What will the new price, P 2, be? (Warning: what is the bond s maturity now?) C. What is the annual rate of return that you would earn by holding this discount bond from January 1, 1990 through January 1, 1991? D. Suppose that on January 1, 1991, the market s yield to maturity on this bond is 6 percent instead. Without redoing your calculations, explain whether your rate of return is higher or lower than in part (C). E. Suppose that on January 1, 1990, you want to buy a discount bond that had no interest rate risk over the upcoming year. What would be the maturity of the bond that you would buy? 13