Money, Banking, and Financial Markets: PDF

Chapter 1: Why study Money, Banking and Financial Markets? Money & Banking  Ch01 - Why study Money, Banking and Financial Markets ? Objectives By the end of this chapter the student is expected to be able to: Recognize the importance of financial...

Chapter 1: Why study Money, Banking and Financial Markets? Money & Banking  Ch01 - Why study Money, Banking and Financial Markets ? Objectives By the end of this chapter the student is expected to be able to: Recognize the importance of financial markets in the economy. Describe how financial intermediation and financial innovation affect banking and the economy. Identify the basic links among monetary policy, the business cycle, and economic variables. Explain the importance of exchange rates in a global economy. 3  Ch01 - Why study Money, Banking and Financial Markets ? Financial Markets Why Study Financial Markets? Financial markets: are markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who need funds. Financial markets are important to promoting greater economic efficiency by channeling funds from people who don’t have productive use for them to those who have. Well-functioning financial markets are a key factor in producing high economic growth and poorly performing financial markets are a key factor that remain desperately poor. 1. The Bond Market and Interest Rates The Bond Markets and Interest Rates are Important to economic activity because: 1. The Bond Market enables corporations and governments to borrow to finance their activity. 2. Interest rates are the cost of borrowing, determined in the bond market. 4  Ch01 - Why study Money, Banking and Financial Markets ? A security (also called a financial instrument) is a claim on the issuer's future income or assets. It can be any Financial Assets that can be Credited. A bond is a debt security that promises to make payments periodically for a specified time. An interest rate is the cost of borrowing, or the price paid for the rental of funds. Example: A company needs Capital, so they Issue a security. In this case, they are the issuer and then the investors will be buyers and buy the security. Securities might be a better option for the company to have funds than a Bank loan. Securities can be bonds, stocks, or any other financial instrument. 2. The Stock Market Issuing stock and selling it to the public is a way for corporations to raise Funds to Finance their activities. The Stock Market is an important Factor in Business Investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. Most widely followed financial market. A stock represents a share of ownership in a corporation. 5  Ch01 - Why study Money, Banking and Financial Markets ? Financial Institutions and Banking Why Study Financial Institutions and Banking? Financial intermediaries: institutions that borrow funds from people who have saved and in turn make loans to other people who need Funds (people who have productive opportunities). – Banks & Other Financial Institutions: accept deposits and make loans. – Other financial institutions: finance companies, pension funds, mutual funds and investment companies Financial innovation: The development of new financial products and services – Can be an important force for good by making the financial system more efficient. Financial crises: major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. The crises produced the worst economic downturn in the economy. 6  Ch01 - Why study Money, Banking and Financial Markets ? Money and Monetary Policy Why Study Money and Monetary Policy? Money and Business cycle - Evidence suggests that money plays an important role in generating business cycles the upward and downward movement of aggregate output in the economy. - Recessions (unemployment) and expansions affect all of us. - Monetary theory ties changes in the money supply to changes in aggregate economic activity and the price level. Example: When Output is rising, it’s easier for us to find a good job, and When it’s falling, finding a good job might be difficult. Money & Inflation The aggregate price level is the average price of goods and services in an Economy. - A continual rise in the price level (inflation) affects all economic players. - Data shows a connection between the money supply and the price level. (a continuing increase in the money supply is an important factor in causing the continuing increase in the price level that we call inflation) Example: inflation happens when the amount of money increases whether by loans or Central Bank. In this case, 7  Ch01 - Why study Money, Banking and Financial Markets ? prices will increase, money will be worth less than before and the value of money will decrease. Money and Interest Rates - Interest rates: are the price of money. - Before 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely tied. - Since then, the relationship has been less clear but the rate of money growth is still an important determinant of interest rates. - To analyze the relationship between money growth and interest rates, we have to examine the behavior of interest rates. Figure1 : Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950-20141 1 Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2 8  Ch01 - Why study Money, Banking and Financial Markets ? Fiscal Policy and Monetary Policy - Monetary policy is the management of the money supply and interest rates conducted by the country's central bank. - Central Bank: the organization responsible for the conduct of a nation’s monetary policy. o Monetary Policy Conducted in the KSA by the Saudi Central Bank(SAMA). - Fiscal policy deals with government spending and taxation. o A budget deficit is the excess of expenditures over revenues for a particular year. o A Budget surplus: is the excess of revenues over expenditures for a particular year. o Government deficit must be financed by borrowing. International Finance Why Study International Finance? 1. The Foreign Exchange Market : - The foreign exchange market: where funds are converted from one currency into another. The foreign exchange rate is the price of one currency in terms of another currency. - The foreign exchange market determines the foreign exchange rate. 9  Ch01 - Why study Money, Banking and Financial Markets ? 2. The international financial system: - Financial markets have become increasingly integrated throughout the world. - The international financial system has a tremendous impact on domestic economies. Example: A country X pegging its currency to the US Dollar. Therefore, when the USA increases the interest rate, money demand will increase in US dollars so the demand for dollars will increase(the exchange rate will change by the market forces and the value of the currency for Country X will drop. So, by controlling the inflow and outflow of money to avoid changes in Country X exchange value. 10 Chapter 2 : An Overview of the Financial System Money & Banking  Ch02 - An Overview of the Financial System Objectives By the end of this chapter the student is expected to be able to: Compare and contrast direct and indirect finance. Identify the structure and components of financial markets. List and describe the different types of financial market instruments. Recognize the international dimensions of financial markets. 3  Ch02 - An Overview of the Financial System Function of Financial Markets Performs the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds. Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities. Indirect finance: borrowers borrow funds indirectly through financial intermediaries such as Banks (savers deposit their money into these intermediaries, which then lend it out to borrowers, enabling the allocation of funds from those who have surplus funds to those who need them). Promotes economic efficiency by producing an efficient allocation of capital, which increases production. Well-functioning of financial markets will improve the well-being of consumers by allowing them to time purchases better and provide young people to buy what they need without forcing them to wait until they have saved up the entire purchase price. 4  Ch02 - An Overview of the Financial System The Economy as A circular Flow Figure 1: Flows of Funds Through the Financial System 5  Ch02 - An Overview of the Financial System The arrows show that funds flow from lenders (Savers) to borrowers (Spenders) via two routes : 1. Direct Finance: In which borrowers borrow funds directly from financial markets by selling securities 2. Indirect Finance: In which financial intermediaries borrow funds from lenders (Savers) and then use these funds to make loans to borrowers (Spenders) Securities are assets for the person who buys them but liabilities for the individual or firm that sells them. Structure of Financial Markets After understanding the basic function of financial markets, let’s look at their structure. A. Debt and Equity Markets (Product Types) A firm or individual can obtain funds in a financial market in two ways: 1. Debt: Debt instruments (maturity) Issuance of debt instruments such as bonds or mortgages with a commitment from the borrower to pay to the lender a fixed amount at maturity: Short Term debt instrument: if the maturity term is less than a year. Long-Term debt instrument: if the maturity term is ten years or longer. 6  Ch02 - An Overview of the Financial System Intermediate Term instrument: if the maturity is between one to ten years. 2. Equities(dividends) Issuance of equities such as common stocks which are claims to share in the net income. Equities often make periodic payments (dividends) to their holders. B. Primary and Secondary Markets (Market Types) B. Primary Market: is a financial market in which new issues of securities are sold to initial buyers. 1. Investment banks underwrite securities in primary markets. C. Secondary Market: is a financial market in which securities that have been issued can be resold. Such as the exchange Market. D. Brokers and dealers work in secondary markets. E. Brokers: are agents of investors who match buyers with sellers of securities. F. Dealers: link buyers and sellers by buying and selling securities at stated price. (Such as Al Rajhi Capital ) C. Exchanges and Over-the-Counter (OTC) Markets (place to buy or organize): 1. Exchanges: Secondary Markets can be organized through exchanges where buyers and sellers of securities meet in one central location to conduct trades such as NYSE. 7  Ch02 - An Overview of the Financial System Exchanges are official and Organized Markets. 2. OTC markets: in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices, so the OTC market is very competitive such as foreign exchange, Federal funds. Mainly depends on the demand and supply of securities. D. Money and Capital Markets (maturity): 1. Money markets deal in short-term debt instruments such as deposit certificates. Debt instruments only traded. Least price fluctuations. Least risky investment (because of the short-term maturity) Least profit (Because of the Positive Relation between risk and revenue => more risk = more revenue) 2. Capital markets deal in longer-term debt and equity instruments such as stocks and long-term bonds Debt and equity instruments traded. Wide price fluctuations Fairly risky investment More revenue (profits) 8  Ch02 - An Overview of the Financial System Financial Market Instruments A. Money Market Instruments: The debt instruments traded in the money market undergo the least price fluctuation and so are the least risky investment because of their short-term maturity, such as : Treasury Bills: short term debt instruments of the government are issued in one, three-, and six-month maturities to finance the government. Negotiable bank certificate of deposit (CD): is a short-term debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. Commercial paper: is a short-term debt instrument issued by large banks and well-known corporations such as Microsoft. Repurchase agreements are effectively short-term loans (usually with a maturity term of less than two weeks. 9  Ch02 - An Overview of the Financial System Table1 : Principal Money Market Instruments B. Capital Market Instruments: Are debt and equity instruments with maturities of greater than one year. They have wider price fluctuations than money market instruments and are considered to be fairly risky investments. Such as: Stocks: Are equity claims on the net income and assets of a corporation. Mortgage: Mortgages (debt instruments) are loans to households or firms to purchase land, housing, or other real structures. Corporate Bonds: are (debt instrument) long-term bonds are issued by corporations with very strong credit ratings which send the holder an interest payment twice a year and pay off the face value when the bond matures. Government Securities: are long-term debt instruments issued by the treasury to finance the deficit of the government. 10  Ch02 - An Overview of the Financial System Government Agency Securities: long-term bonds are issued by various government agencies to finance such items as farm loans or power-generating equipment. State and Local Government Bonds: are long-term debt instruments (also called municipal bonds) issued by state and local governments to finance expenditures on schools, roads, and other large programs. Consumer and Bank Commercial loans: these loans to consumers and businesses are made principally by banks. Table 2 : Principal Capital Market Instruments 11  Ch02 - An Overview of the Financial System Internationalization of Financial Markets The internationalization of financial markets is having profound effects on the economies. Foreigner investors are not only providing funds to corporations in the Financial Markets but also financing the government if needed. The internationalization of financial markets is also leading the way to a more integrated world economy in which flows of goods and technology between countries are more commonplace. 1. International Bond Market, Eurobonds, and Eurocurrencies Foreign Bonds: sold in a foreign country and denominated in that country’s currency. Eurobond: bond denominated in a currency other than that of the country in which it is sold. Eurocurrencies: foreign currencies deposited in banks outside the home country – Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. 2. World Stock Markets: Also help finance government 12  Ch02 - An Overview of the Financial System Function of Financial Intermediaries: Indirect Finance The Main function is to meet borrowers and lenders in one place handled by intermediaries and help transfer funds by borrowing from lenders and using them to make loans to borrowers. The primary route for moving funds from lenders to borrowers is called financial intermediaries. Functions are: 1. Transaction Cost Lower transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. (time and money spent in carrying out financial transactions) Economies of scale: the reduction in transaction costs per (SR) of transactions as the size (scale) of transaction increases. Liquidity services: because financial intermediaries can reduce transaction costs substantially, they make it possible for borrowers to provide funds for them indirectly. 2. Risk Sharing Financial intermediaries can help Reduce the exposure of investors to risk: – Risk Sharing: low transaction costs allow financial intermediaries to share risk at low cost. This process of risk sharing is also sometimes referred to as asset transformation 13  Ch02 - An Overview of the Financial System because in a sense risky assets are turned into safer assets for investors. – Diversification: financial intermediaries also promote risk sharing by helping individuals to diversify and thereby lower the amount of risk to which they are exposed. 3. Asymmetric Information: Adverse Selection and Moral Hazard : In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. Deal with asymmetric information problems: - Adverse Selection is the problem created by asymmetric information before the transaction occurs: try to avoid selecting the risky borrower by gathering information about them. - Moral Hazard is the problem created by asymmetric information after the transaction occurs: ensure the borrower will not engage in activities that will prevent him/her from repaying the loan. 4. Conflict of interest: a type of moral hazard problem that arises when a person or institution has multiple objectives(interests), some of which conflict with each other. 14  Ch02 - An Overview of the Financial System Conclusion: – Financial intermediaries allow “small” savers and borrowers to benefit from the existence of financial markets. Types Of Financial Intermediaries: Indirect Finance 1. Depository Institutions 2. Contractual Saving Institutions 3. Investment Intermediaries 4. Money and Capital Markets Table 3 : Primary Assets and Liabilities of Financial Intermediaries 15  Ch02 - An Overview of the Financial System Table 4 : Primary Financial Intermediairies and Value of Their Assets 16 Chapter 3: What is Money ? Money & Banking  Ch03 - What is Money ? Objectives By the end of this chapter the student is expected to be able to: Describe what money is List the functions of money Identify different types of payment systems Compare and contrast the M1 and M2 money supplies 3  Ch03 - What is Money ? Meaning of Money Money has taken different forms at different times, but it has always been important to people and the economy. To understand the effect of money on the economy, we must understand exactly what money is. As used in everyday conversation, the word money can mean many things but to economists, it has a very specific meaning. Referred to as the money supply: Money is anything that is generally accepted as payment for goods or services or in the repayment of debts and is distinct from income and wealth. When most people talk about money, they're talking about currency (paper money and coins). A rather broad definition of money is needed because checks are also accepted as payment for purchase, current account deposits are considered money as well. Money is different from – Wealth: is the total collection of pieces of property that serve to store value. Wealth includes not only money but also other assets such as bonds, stocks, houses, cars, and furniture. – Income: is the flow of earnings per unit of time (a flow concept). So, income is a certain amount at a given point in time such as monthly, per day, or year. 4  Ch03 - What is Money ? Functions of Money 1- Medium of Exchange: - By facilitating transactions between buyers and sellers allowing goods and services to be traded (it`s used to pay for goods and services). - Promotes economic efficiency by minimizing the time spent exchanging goods and services. - Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs). - Promotes specialization. When money is A medium of exchange, it must: be easily standardized. be widely accepted. be divisible. be easy to carry. not deteriorate quickly. 2- Unit of Account: – Money is used to measure the value of goods, services, assets, and debts in the economy. – Reduces transaction costs in the economy by reducing the number of prices that need to be considered. 5  Ch03 - What is Money ? 3- Store of Value: – Money Used to save purchasing power over time (from the time income is received until the time it is spent). – Other assets such as stocks, houses, or jewelry also serve this function (store wealth). – Money is the most liquid of all assets (because it doesn’t have to be converted to money and can be easily and quickly converted into goods, services, or other assets). – Money loses value during inflation (when the price level is increasing rapidly, money loses value rapidly) Evolution of the Payments System The payment system is the method of conducting transactions in the economy. It has been evolving over centuries. 1-Barter System: A barter system is an old method of exchange. This system was used for centuries and long before money was invented. People exchanged services and goods for other services and goods in return. (Example: Mohamed needs to buy clothes and he owns only an apple; he goes to the shop and pays the apple to buy the clothes). - The problem with this payment system was that the worth of the goods and services used in trading was not equal. 6  Ch03 - What is Money ? 2- Commodity Money: money made up of precious metals Such as gold and silver or another valuable commodity. - The problem with this payment system was that metals were very heavy and hard to transport from one place to another. 3- Fiat Money: paper currency decreed by governments as legal tender (meaning that it must be accepted as legal payment for debts). - This money is issued by the government. - Accepted by everyone. - Accepted as payment for debt. - Not convertible into precious metal. - Much lighter than commodity money (easy to transfer from buyer to seller). 4 - Checks: instructions from your bank to transfer money from your account to someone else`s account when she deposits the check. - The use of checks thus reduces the transaction costs associated with the payment system. - They can be written for any amount up to the balance in the account. 5- Electronic Payment: electronic payment systems provided by banks (e.g., online bill payments, sadad payment in KSA). - payments of bills can be automatically deducted from your bank account. 7  Ch03 - What is Money ? 6- Electronic Money (e-money): Money that exists only in electronic form. – Debit card. – smart card: Stored-value card – E-cash is used on the Internet to purchase goods or services. When a consumer gets e-cash, she can buy things by only clicking one button and the fund will transfer from her bank account to the seller`s bank account before the goods are shipped. Measuring Money How do we measure money? Which assets can be called “money”? Construct monetary aggregates using the concept of liquidity: M1: The narrowest definition of the money supply. The sum of currency in circulation M1 = checking account deposits in banks + traveler’s checks + demand deposits M1 includes: 1. Currency, which is all the paper money and coins that are in circulation, where “in circulation” means not held by banks or the government. 2. The value of all checking account deposits at banks. 3. The value of traveler’s checks. 8  Ch03 - What is Money ? M2: A Broader Definition of Money. (adds to M1 other assets that are not so liquid) M2 = M1 + small-denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares. 9 Chapter 4, Part 1 : Quantity Theory, Inflation, and the Demand for Money Money & Banking  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money Objectives By the end of this chapter the student is expected to be able to: Understand the framework of the quantity theory of Money. Assess the relationship between money growth and other Variables in the short run, as implied by the Equation of Exchange. Calculate the Velocity of Money. 3  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money Quantity Theory of Money Monetary Theory: The study of the effects of money and monetary policy on the economy. Quantity Theory of Money: 1. Developed by the classical economists in the nineteenth and early twentieth centuries. 2. Explains how the nominal value of aggregate income is determined. 3. Is a theory of the demand for money because it tells us how much money is held for a given amount of aggregate income. 4. It suggests that interest rates do not affect the demand for money. Velocity of Money and The Equation of Exchange: The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher. Fisher wanted to examine the link between the total quantity of money (M: The Money Supply) and the total amount of spending on final goods and services produced in the economy (nominal GDP : P x Y) The concept that provides the link between M and Nominal GDP is called the Velocity of Money. Velocity of Money is the number of times per year the dollar is spent in buying the total amount of goods and services produced in the economy. 4  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money Equation of Exchange: M= the money supply P= price level Y= aggregate output (income) P x y = aggregate nominal income (nominal GDP) V= velocity of money (average number of times per year that a dollar is spent) V= P x Y / M Equation of Exchange MxV=PxY Example: If nominal GDP ( P x Y ) in a year is 10 trillion $ and the quantity of money (M) is 2 trillion $, we can calculate the velocity of money as follows :  Answer: by using the equation of exchange, we can calculate the velocity of money: V=PxY/M V = 10 / 2 = 5 5  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money The value of 5 for velocity means that the average dollar bill is spent five times in purchasing final goods and services in the economy. Determinants of velocity : 1. To convert the equation of exchange into a theory of how nominal income (nominal GDP : P x Y ) is determined we must first understand the factors that determine velocity. 2. Less money is required to conduct the transactions generated by nominal income (nominal GDP) When people use charge accounts and credit cards to conduct their transactions as they often do today and consequently use money less often when making purchases ( M falls so velocity increases ) 3. Conversely, if it's more convenient for purchases to be paid with cash, checks, or debit cards, more money is used to conduct the transactions (M rises so Velocity will fall ) 4. Fisher took the view that the institutional and technological features of the economy would affect velocity only slowly over time , so velocity would normally be reasonably constant in the short run. Demand for Money: To interpret Fisher’s quantity theory in terms of the demand for money, Divide both sides by V M= 1/V x PY K=1/Y When the money market is in equilibrium Ms = Md 6  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money Let Md = K x PY Because K is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md that people will demand. The demand for money is not affected by interest rates. Its theory of the demand for money because it tells us how much money is held for a given amount of nominal spending. From the equation of exchange to the quantity theory of money: Fisher’s view that velocity is fairly constant in the short run, transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money (M). P  Y = M V Example: Assume that velocity is 5, nominal income GDP(P x Y is initially 10 trillion $, and the money supply (M) is 2 trillion $. If the money supply (M) doubles to 4 trillion $, what will happen to the nominal income?  Answer: 7  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money M x V = P x Y 🡺 2 X 5 = 10 🡺 SO, 10 = 10 when M doubles and refers to the quantity theory of money, suggests that nominal income will double: M x V = P x Y 🡺 4 x 5 = 10 x 2 🡺 SO, 20 = 20 Quantity Theory of Money and the Price Level : Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level. Y could be treated in the equation as a constant in the short run and thus could be assigned a fixed value in the equation. Dividing both sides by Y, we can then write the price level as follows: M V P= Y Example: Assume that aggregate output is 10 trillion $, velocity is 5, and the money supply is 2 trillion $. How much the price level will equal?  Answer: 🡺 P = 2 x 5 / 10 🡺 So, p = 1 8  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money When the money supply doubles to 4 trillion, P will be P= 4 x 5 / 10 🡺 So, P = 2 (price level double to 2 ) Changes in the quantity of money lead to proportional changes in the price level. Quantity Theory of Money and Inflation : We now transform the quantity theory of money into a theory of inflation. Percentage Change in (x ✕ y) = (Percentage Change in x) + (Percentage change in y) Using this mathematical fact, we can rewrite the equation of exchange as follows: %M + %V = %P + %Y Subtracting from both sides of the preceding equation, and recognizing that the inflation rate is the growth rate of the price level,  = %P = %M + %V − %Y Since we assume velocity is constant, its growth rate is zero, so the quantity theory of money is also a theory of inflation:  = %M − %Y 9  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money we call this an equation of inflation The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output. Example: if the aggregate output is growing at 3% per year and the growth rate of money is 5%. Calculate the inflation rate.  Answer: inflation rate = 5% - 3% = 2 % if the central bank increases the money growth rate to 10%, the inflation rate referred to the quantity theory of inflation will equal : inflation rate = 10% - 3% = 7% so the inflation rate rises to 7% 10  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money The quantity theory of money in the Long Run Figure1 : Relationship Between Inflation and Money Growth 1870s-2000s Figure2 : Relationship Between Inflation and Money Growth 2003-20131 1 Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975; Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/ For panel (b), International Financial Statistics. International Monetary Fund, http://www.imfstatistics.org/imf/. 11  Ch04, P1 - Quantity Theory, Inflation, and the Demand for Money The quantity theory of money in the Short Run Figure3 : Annual U.S. Inflation and Money Growth Rates, 1965–20152 2 Sources: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/. 12 Chapter 4, Part 2 : Quantity Theory, Inflation, and the Demand for Money Money & Banking  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money Objectives By the end of this chapter the student is expected to be able to: Summarize the three motives underlying the liquidity preference theory of money demand. Identify the factors underlying the portfolio choice theory of money demand. Identify the circumstances under which budget deficits can lead to inflationary monetary policy. 3  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money Keynesian Theories of Money Demand John Maynard Keynes abandoned the quantity theory view that velocity is a constant and developed a theory of money demand that emphasized the importance of interest rates. Keynes’s liquidity preference theory presented three motives behind the demand for money. Why do individuals hold money? Three motives: – Transactions motive – Precautionary motive – Speculative motive Distinguishes between real and nominal quantities of money Demand for money Motives based on Keynesian liquidity preference theory: 1) Transactions Motive : Individuals are assumed to hold money because it's a medium of exchange that can be used to carry out everyday transactions. Keynes initially accepted the quantity theory view that the transactions component is proportional to income (positive relation between income and the demand for money motivated by transactions) Later, he and other economists recognized that new payment methods, referred to as payment technology, could also affect the demand for money. 4  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money In Keynes's view as payment technology advanced, the demand for money would be likely to decline relative to income. 2) Precautionary Motive : Keynes also recognized that people hold money as a cushion against unexpected wants. Unexpected wants such as a profitable deal or emergency. Keynes argued that the precautionary money balances people want to hold would also be proportional to income (positive relation between income and the demand for money motivated by precautions) Precautionary demand: o Similar to transaction demand (Money serves as a medium of exchange) o As interest rates rise, the opportunity cost of holding precautionary balances rises o The precautionary demand for money is negatively related to interest rates. 3) Speculative Motive : Keynes also believed people choose to hold money as a store of wealth, which he called the speculative motive. What is the function of money in this motive? Store of value In Keynes's analysis money includes currency (which earns no interest) and checking account deposits (which typically earn little interest) 5  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money Putting the three motives together: Velocity is not constant: – The procyclical movement of interest rates should induce procyclical movement in velocity. – Velocity will change as expectations about future normal levels of interest rates change. Where the demand for real money balances is negatively related to the interest rates and positively related to real income. Portfolio Theories of Money Demand Related to Keynes's analysis of the demand for money are so-called portfolio theories of money demand, in which people decide how much of an asset such as money they want to hold as part of their overall portfolio of assets. Theory of portfolio choice and Keynesian liquidity preference The theory of portfolio choice can justify the conclusion from the Keynesian liquidity preference function that the demand for real money balances is positively related to income and negatively related to the nominal interest rate. Because income and wealth tend to move together, when income is higher, wealth is likely to be as well. Hence, higher income means greater wealth, and the theory of portfolio choice then indicates that the demand for money assets will rise and the demand for real money balances will be higher. 6  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money As interest rates rise, the expected return on money does not change. However, the return on bonds, an alternative asset, goes up. Thus, although the expected absolute return on money did not change, money's expected return relative to bonds went down. In other words, as the theory of portfolio choice indicates, higher interest rates make money less desirable, and the demand for real money balances falls. Factors that Determine (affect) the demand for money: Our analysis of the demand for money using Keynesian and portfolio theories indicates that seven factors affect the demand for money: Interest rates – Income – Payment technology - Wealth – Riskiness of other assets - Inflation Risk - Liquidity of other assets. Table 1 indicates the response of money demand to changes in each of these factors and gives a brief of the reasoning behind each response. Table 1 : Factors That Determine the Demand for Money 7  Ch04, P2 - Quantity Theory, Inflation, and the Demand for Money Budget Deficits and Inflation Budget deficits can be an important source of inflationary monetary policy. We need to look at how a government finances its budget deficits. Government Budget Constraint : The methods used to finance government spending are described by an expression called the government Budget Constraint. There are two ways the government can pay for spending: raise revenue or borrow - Raise revenue: by levying taxes or going into debt by issuing government bonds. - The government can also create money and use it to pay for the goods and services it buys. Hyperinflation Hyperinflations are periods of extremely high inflation of more than 50% per month. Many economies—both poor and developed—have experienced hyperinflation over the last century. One of the most extreme examples of hyperinflation 1 throughout world history occurred recently in Zimbabwe in the 2000s. 1 The Art of Being Human. (2023, March 6). Zimbabwe's Economic Crisis Explanation [Video]. YouTube. https://www.youtube.com/watch?v=cppZDEpSrro 8 Chapter 5: The Meaning and Behavior of Interest Rates Money & Banking  Ch05- The meaning and behavior of Interest Rates Objectives By the end of this chapter the student is expected to be able to: Calculate the present value of future cash flows and the yield to maturity. Interpret the distinction between real and nominal interest rates. Identify the factors that affect the demand for assets. Draw the demand and supply curves for the bond market and the equilibrium interest rate. Describe the factors that affect the equilibrium interest rate in the bond market. 3  Ch05- The meaning and behavior of Interest Rates Interest Rates Interest rates are the price of money. The movement of interest rates affects our everyday lives and has important consequences for the health of the economy. The concept known as the yield to maturity is the most accurate measure of interest rates. The yield to maturity is what economists mean when they use the term interest rate (will find out how it is measured). Different debt instruments have very different streams of cash payments (known as Cash flows) to the holder, with very different timing. Measuring Interest Rates 1. Present value: The concept of present value(or present discounted value )is based on the commonsense notion that : a dollar paid to you one year from now is less valuable than a dollar paid to you today -Why: a dollar deposited today can earn interest and become $1 x (1+i) one year from today. Example Let 𝑖 =.10 In one year: $100 X (1+0.10) = $110 In two years: $110 X (1+0.10) = $121 4  Ch05- The meaning and behavior of Interest Rates Or $100 X (1 + 0.10)2 In three years: $121 X (1+0.10) = $133 Or $100 X (1 + 0.10)3 n=years so, $100 x (1 + 𝑖)𝑛 The example shows us that by having 100$ today as you will be having : 110 $ a year from now 121$ two years from now or 133$ three years from now. 2. Simple Present Value PV= today`s (present) value CF = future cash flow ( payment ) 𝑖 = the interest rate 𝐶𝐹 PV = (1+𝑖)𝑛 1. The timeline indicates that we can also work backward from future amounts to the present. 2. Cannot directly compare payments scheduled at different points in the timeline 5  Ch05- The meaning and behavior of Interest Rates $1 $10 $10 $10 00 0 0 0 Year 0 1 2 n PV 10 100/(1 100/(1 100/(1 0 +i) +i)2 +i)n Figure 1 : Timeline of Simple Present Value Example What is the simple present value of 250 $ to be paid in two years if the interest rate is 15%?  Solution By using the equation: PV= CF/ (1 + 𝑖)𝑛 Where CF = cash flow in two years = 250 i = annual interest rate =.15 n = numbers of years = 2 Thus PV = 250$ / (1 + 0.15)2 = 189.04 $ 6  Ch05- The meaning and behavior of Interest Rates Four Types of Credit Market Instruments 1. Simple Loan: when the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with an additional payment for the interest (example: commercial loans to business ). 2. Fixed Payment Loan: also called ( a fully amortized loan ) in which the lender provides the borrower with an amount of funds that the borrower must repay by making the same payment, consisting of part of the principal and interest every period (such as a month) for a set number of years (example: auto loans). 3. Coupon Bond: pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount ( face value or par value ) is repaid. A coupon bond is identified by four pieces of information: First is the bond`s face value; second is the corporation or government agency that issues the bond; third is the maturity date of the bond; and fourth is the bond`s coupon rate, which is the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond (example: treasury bills and corporate bonds) 4. Discount Bond: also called a zero-coupon bond is bought at a price below its face value (at a discount ), and the face value is repaid at maturity. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off face value. These four types of instruments make payments at different times : 7  Ch05- The meaning and behavior of Interest Rates simple loans and discount bonds  make payments only at their maturity dates Fixed-payment loans and coupon bonds  make payments periodically until maturity How can you decide which of these instruments will provide you with the most income? They all seem different because they make payments at different times.so we can use the concept of present value explained earlier to provide us with a procedure for measuring interest rates on these different types of instruments. The bond markets are important because they are : A) The markets where interest rates are determined. B) The markets where the borrowers get their funds. C) The markets where foreign exchange rates are determined. 3. Yield to Maturity Of the several common ways of calculating interest rates, the most important is the yield to maturity. Yield to maturity: the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today. Because the concept behind the calculation of the yield to maturity makes good economic sense, economists consider it the most accurate measure of interest rates. 8  Ch05- The meaning and behavior of Interest Rates We will calculate it for some of the types of credit market instruments. The key to understanding the calculation of the yield to maturity is realizing that we are equating today`s value of the debt instrument with the present value of all of its future cash flow payments. Yield to Maturity on a Simple Loan using the concept of present value. PV = amount borrowed = $100 CF = cash flow in one year = $110 N = number of years = 1 $110 $100 = (1+𝑖)1 (1 + 𝑖)⬚ $100 = $ 110 (1 + 𝑖) = $110 /$100 𝑖 = 0.10 = 10% For simple loans, the simple interest rate equals the yield to maturity. Yield to Maturity on a Simple Loan, timeline : Figure 2 : Timeline of Yield to Maturity on a Simple Loan 9  Ch05- The meaning and behavior of Interest Rates The timeline indicates that a simple (simple loan) interest rate equals the yield to maturity. Yield to Maturity and bond price for a Coupon Bond : When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. When the coupon bond is priced below its face value , the yield to maturity is greater than the coupon rate. The price of a coupon bond and the yield to maturity are negatively related. The Distinction Between Real and Nominal Interest Rates Nominal interest rate: the interest rate before taking inflation into account (makes no allowance for inflation). For instance, imagine that you borrowed $100 from your bank one year ago at 8% interest on your loan. When you repay the loan, you must repay the $100 you borrowed + $8 in interest, a total of $108(it is unadjusted for inflation). Real interest rate: the interest rate that takes inflation into account. This means it adjusts for inflation and gives the real rate of a bond or loan (adjusted for changes in price level). so it more accurately reflects the cost of borrowing and measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. For instance, In our earlier example, if the inflation rate is 5%, the lender earned 8% or $8 on the $100 loan. 10  Ch05- The meaning and behavior of Interest Rates However, because inflation was 5% over the same period, the lender earned only 3% in real purchasing power or $3 on the $100 loan. By using Fisher Equation, we can calculate Nominal and real interest rates : 𝑖 = 𝑖𝑟 + 𝜋 𝑒 𝑖 = nominal interest rate 𝑖𝑟 = real interest rate 𝜋 𝑒 = expected inflation rate When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. The real interest rate is a better indicator of the incentives to borrow and lend. Calculating interest rates 11  Ch05- The meaning and behavior of Interest Rates Interest Rates, Government Securities, and Treasury Bills for Saudi Arabia: https://research.stlouisfed.org/fred2/series/INTGSTSAM193N Determinants of Asset Demand 1. Wealth: the total resources owned by the individual, including all assets holding everything else constant, an increase in wealth raises the quantity demand of an asset. 2. Expected Return: the return expected over the next period on one asset relative to alternative assets an increase in an asset`s expected return relative to that of an alternative asset, holding everything else unchanged raises the quantity demand for the asset. 3. Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets holding everything else constant, if an asset`s risk rises relative to that of alternative assets, its quantity demanded will fall. 4. Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is and the greater the quantity demanded will be. 12  Ch05- The meaning and behavior of Interest Rates Theory of Portfolio Choice Tells us how much of an asset people want to hold in their portfolios. It states that Holding all other factors constant: 1. The quantity demanded of an asset is positively related to wealth 2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets These results are summarized in Table 1. Table 1 : Theory of Portfolio Choice 13  Ch05- The meaning and behavior of Interest Rates Supply, Demand, and Equilibrium in the Bond Market The demand Curve shows the negative relationship between the quantity demanded of bonds and the price level when all other economic variables are held constant. Figure 3 : The demand Curve The supply curve shows the positive relationship between the quantity supplied of bonds and the price level when all other economic variables are held constant. Figure 4 : The supply curve 14  Ch05- The meaning and behavior of Interest Rates Market Equilibrium : Occurs when the number of people are willing to buy (demand) equals the number of people who are willing to sell (supply) at a given price. Bd = Bs defines the equilibrium (or market clearing) price and interest rate. When Bd > Bs, there is excess demand (people want to buy more bonds than others are willing to sell). As A Result, the price will rise, and the interest rate will fall. When Bs > Bd, there is excess supply( people want to sell more bonds than others want to buy). Resulting price will fall, and the interest rate will rise. The interest rate and price of a bond are always negatively related for all kinds of bonds. Figure 5 : Supply and Demand for Bonds 15  Ch05- The meaning and behavior of Interest Rates Movement along demand and supply curve in the Bond Market At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher(excess demand): an inverse relationship ( - P, QDB ) At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship ( + P, QSB ) At higher prices (lower interest rates), ceteris paribus, the quantity supplied of bonds is higher (excess supply): an inverse relationship ( - P, QSB ) At higher prices (lower interest rates), ceteris paribus, the quantity demanded of bonds is lower: a positive relationship (+ P, QDB ) Changes in Equilibrium Interest Rates Shifts in the demand curve for bonds: 1. Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right 2. Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, the demand curve for bonds shifts to the left 3. Expected Inflation: an increase in the expected rate of inflation lowers the expected return for bonds, causing the demand curve to shift to the left 16  Ch05- The meaning and behavior of Interest Rates 4. Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left 5. Liquidity: increased liquidity of bonds results in the demand curve shifting right Figure 6 : Shift in the Demand Curve for Bonds 17  Ch05- The meaning and behavior of Interest Rates Table 2 : Shifts in the Demand for Bonds Shifts in the supply curve for bonds: 1.Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right 2.Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right. Higher inflation reduces the real interest which in turn reduces the cost of borrowing. 3.Government budget: increased budget deficits shift the supply curve to the right. Higher government deficits increase the supply of bonds. 18  Ch05- The meaning and behavior of Interest Rates Figure 7 : Shift in the Supply Curve for Bonds Table 3 : Shifts in the Supply of Bonds 19  Ch06, P1/2 - Banking and the Management of Financial Institutions Objectives By the end of this lesson the student is expected to be able to: Summarize the features of a bank balance sheet. Identify General Principles of Bank Management. 3  Ch06, P1/2 - Banking and the Management of Financial Institutions An overview of the Bank Balance Sheet To understand how banking works, we start by looking at the bank balance sheet, a list of the bank’s assets and liabilities. As the name implies, this list balances; it has the characteristic that: total assets = total liabilities + capital A bank’s balance sheet is also a list of its sources of bank funds (liabilities and capital) and uses to which the funds are put (assets). The bank obtains funds by borrowing and by issuing other liabilities, such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by earning interest on their asset holdings of securities and loans that are higher than the interest and other expenses on their liabilities. Table 1 : Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2014) 4  Ch06, P1/2 - Banking and the Management of Financial Institutions Understanding the Bank Balance Sheet The bank Balance sheet is a list of the bank’s assets and liabilities. 1-Liabilities: a bank acquires funds by issuing (selling) liabilities, which are the sources of funds the bank uses. The funds obtained from issuing liabilities are used to purchase income-earning assets. - Checkable deposits: are bank accounts that allow the owner of the account to write checks to third parties. - Nontransaction deposits are the primary source of bank funds(58% of bank liabilities in table 1). Owners cannot write checks on non- transaction deposits. The interest rates paid on these accounts are higher than those on checkable deposits (for example: saving accounts, time deposits, and certificates of deposit) - Borrowings: banks also obtain funds by borrowings from the central bank (called: discount loans also known as advances). - Bank capital : (also called the bank’s net worth )which equals the difference between total assets and liabilities(Total Assets – Total Liabilities). 2- Assets: a bank uses the funds that it has acquired by issuing liabilities to purchase income-earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits. - Reserves: all banks hold some of the funds they acquire as deposits in an account at the central bank. The reserve consists of these deposits + 5  Ch06, P1/2 - Banking and the Management of Financial Institutions currency that is physically held by banks (also called Vault cash ).banks hold them for 2 reasons: First: some reserves called required reserves are held because of reserve requirements, the regulation of the central bank. Second: Banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn. - Cash items in process of collection: suppose that a check written on an account at another bank is deposited in your bank, and the funds for this check have not yet been received (collected) from the other bank. The check is classified as a “cash item in the process of collection“ and it's an asset for your bank because it`s a claim on another bank for funds that will be paid within a few days. - Deposits at other banks: many small banks deposit in larger banks in exchange for a variety of services, including check collection and foreign exchange transactions. - Securities: a bank’s holdings of securities are an important income- earning asset: securities (made up entirely of debt instruments for commercial banks, because banks are not allowed to hold stocks ) - Loans: banks make their profits primarily by issuing loans. A loan is a liability for the individual or corporation receiving it, but an asset for a bank, because it provides income to the bank. Loans are less liquid than other assets because they cannot be turned into cash until the loan matures. 6  Ch06, P1/2 - Banking and the Management of Financial Institutions - Other assets: the physical capital (bank buildings, computers, and other equipment) owned by the bank is included in the other assets category. Basic Banking Cash Deposit: First National Bank First National Bank Assets Liabilities Assets Liabilities Vault Cash Checkable deposits Reserves Checkable deposits +$100 +$100 +$100 +$100 Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits. First National Bank Assets Liabilities Cash items in process of collection Checkable deposits +$100 +$100 Check Deposit: When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. First National Bank Second National Bank Assets Liabilities Assets Liabilities Reserves Checkable deposits Reserves - Checkable deposits +$100 +$100 $100 -$100 7  Ch06, P1/2 - Banking and the Management of Financial Institutions Making a profit: First National Bank First National Bank Assets Liabilities Assets Liabilities Required reserves +$100 Checkable deposits +$100 Required reserves +$100 Checkable deposits +$100 Excess reserves +$90 Loans +$90 Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long General Principles of Bank Management Let’s look at how a bank manages its assets and liabilities to earn the highest possible profit. The bank manager has four primary concerns: 1. The first is to make sure that the bank has enough ready cash to pay its depositors when there is deposit outflow (when deposits are lost because depositors make withdrawals and demand payment).To keep enough cash on hand, banks must engage in liquidity management (the acquisition of assets that are liquid enough to meet the bank’s obligation to depositors). 2. The bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). 3. The managers’ third concern is acquiring funds at low cost (liability management) 8  Ch06, P1/2 - Banking and the Management of Financial Institutions 4. The manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management). After understanding the four concerns, we will discuss how a financial institution manages credit risk. The risk arises because borrowers may default. Liquidity Management and the Role of Reserve : - Reserves Deposits: A bank keeps cash in its vault or on deposit with the Federal Reserve. - Required reserves: Reserves that a bank is legally required to hold, based on its checking account deposits. - Required reserve ratio: The minimum fraction of deposits banks are required by law to keep as reserves. - Excess reserves: Reserves that banks hold over and above the legal requirement. (insurance against the costs associated with deposit outflows.) Liquidity, or the ability to fund increases in assets and meet obligations as they come due, is crucial to the ongoing viability of any banking organization. Therefore, liquidity management can reduce the probability of serious problems. The analysis of liquidity requires bank management to measure the liquidity position of the bank on an ongoing basis and examine how funding requirements are likely to evolve under various scenarios, including adverse conditions. The principal sources of liquidity demand for a financial fir 9  Ch06, P1/2 - Banking and the Management of Financial Institutions The utmost demands for liquidity arise principally from customers withdrawing money from their deposits and credit requests. However, demands for liquidity can also come from paying off previous borrowings, operating expenses, and taxes incurred during operations and from payment of a cash dividend to stockholders. Liquidity Management and the Role of Reserves Excess reserves: Assets Liabilities Assets Liabilities Reserves $20M Deposits Reserves $10M Deposits $90M $100M Loans $80M Bank Capital Loans $80M Bank Capital $10M $10M Securities $10M Securities $10M - Suppose a bank’s required reserves are 10%. - If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet. Insufficient excess reserves: Assets Liabilities Assets Liabilities Reserves $10M Deposits Reserves Deposits $90M $100M $0M 10  Ch06, P1/2 - Banking and the Management of Financial Institutions Loans $90M Bank Capital Loans Bank Capital $10M $90M $10M Securities $10M Securities $10M Borrowing: Assets Liabilities Reserves $9M Deposits $90M Loans Borrowing $9M $90M Securities Bank capital $10M $10M Securities sale: Assets Liabilities Reserves Deposits $9M $90M Loans Bank capital $90M $10M 11  Ch06, P1/2 - Banking and the Management of Financial Institutions Securities $1M - The cost of selling securities is the brokerage and other transaction costs. Reduce loans: Assets Liabilities Reserves Deposits $9M $90M Loans Bank capital $81M $10M Securities $10M - Reduction of loans is the costliest way of acquiring reserves. - Calling in loans antagonizes customers. - Other banks may only agree to purchase loans at a substantial discount. 12 Chapter 6, Part 2 : Banking and the Management of Financial Institutions Money & Banking  Ch06, P2 - Banking and the Management of Financial Institutions Objectives By the end of this chapter the student is expected to be able to: Identify ways in which banks can manage their assets, liabilities, and Capital Adequacy Management to maximize profit. List how banks deal with credit risk. 3  Ch06, P2 - Banking and the Management of Financial Institutions Asset Management To maximize its profit, a bank must simultaneously seek three goals: 1. The highest expected returns possible on loans and securities. 2. Reduce risk. 3. Make adequate provisions for liquidity. Four Tools to achieve the goals: 1. Find borrowers who will pay high interest rates and have a low possibility of defaulting: Seek the highest possible returns on loans and securities: banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans. They use advertising loan rates to seek out loans. It’s important that banks not be conservative in their loan policies so that they miss out on attractive lending opportunities that earn high-interest rates. 2. Purchase securities with high returns and low risk. 3. Lower risk by diversifying. 4. Have adequate liquidity: Hold adequate amounts of liquid assets (Balance need for liquidity against increased returns from less liquid assets) Finally, the bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy its reserve requirement without bearing huge costs. Also, banks should balance its desire for liquidity against the benefits of the increased earnings that can be obtained from less liquid assets, such as loans. 4  Ch06, P2 - Banking and the Management of Financial Institutions Liability Management Liability management: is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss. Starting in the 1960s, large banks (called money center banks) in key financial centers such as New York and Chicago began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity by issuing negotiable CDs. Recent phenomenon due to the rise of money center banks. This new flexibility in liability management meant that banks could take different approaches to bank management. They no longer needed to depend on checkable deposits as the primary source of bank funds and as a result no longer treated their sources of funds (liabilities) as given. Instead, they aggressively set target goals for their asset growth and tried to acquire funds (by issuing liabilities) as they were needed. Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as a source of bank funds. 5  Ch06, P2 - Banking and the Management of Financial Institutions Capital Adequacy Management Banks must make decisions about the amount of capital they need to hold for three reasons: 1. Bank capital helps prevent bank failure: a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors, and so goes out of business. 2. The amount of capital held affects returns for the owners (equity holders) of the bank. 3. Regulatory requirement: a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities. Capital = total assets - total liabilities Credit Risk Management Banks and other financial institutions must make successful loans that are paid back in full (and so subject to little credit risk) if they are to earn high profits. Credit risk is understood simply as the risk a bank takes while lending out money to borrowers. The economic concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institutions must follow if they are to reduce credit risk and make successful loans. 6  Ch06, P2 - Banking and the Management of Financial Institutions Adverse selection in loan markets occurs because of bad credit risks who are usually lined up for loans (Borrowers with very risky investment projects have much to gain if their projects are successful, so they are eager to obtain loans. They are the least desirable borrowers because of the greater possibility that they will be unable to pay back their loans. Moral hazard exists in the loan markets because borrowers may have incentives to engage in activities that are undesirable from the lender’s point of view. Once borrowers have obtained a loan, they are more likely to invest in high-risk investment projects that pay high returns to the borrower if successful. The high risk associated with these investments, however, makes it less likely that these borrowers will be able to pay back their loans. To be profitable, financial institutions attempt to solve these problems by using several principles for managing credit risk Such as : 1. Screening and Monitoring: asymmetric information is present in loan markets because lenders have less information about the investment opportunities and activities of borrowers than borrowers do. - Screening: adverse selection in loan markets requires that lenders screen out the bad credit risks from the good ones so that loans are 7  Ch06, P2 - Banking and the Management of Financial Institutions profitable for them. To accomplish effective screening, lenders must collect reliable information from prospective borrowers. Effective screening and information collection together form an important principle of credit risk management. - Specialization in lending: one puzzling feature of bank lending is that a bank often specializes in lending to local firms or firms in particular industries, such as energy. In one sense, this behavior seems surprising because it means that the bank is not diversifying its portfolio of loans and thus is exposing itself to more risk. From another perspective, such a specialization makes perfect sense. The adverse selection problem requires that the bank screen out bad credit things. By concentrating on firms in specific industries, the bank becomes more knowledgeable about these industries and will reduce credit risks. - Monitoring and enforcement of restrictive covenants: once a loan has been made, the borrower has an incentive to engage in risky activities that make it less likely that the loan will be paid off. To reduce this moral hazard, financial institutions must write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities. 8  Ch06, P2 - Banking and the Management of Financial Institutions The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and information-collecting activities. 2. Long-term customer relationships: an additional way that banks can obtain information about their borrowers by checking the customer’s accounts and loans over a long period. Thus, long- term customer relations reduce the cost of information collection and make it easier to screen out bad credit risks. 3. Loan commitments is a bank's commitment (for a specified future period) to provide a firm with loans up to a given amount at an interest rate that is tied to some market interest rate. A loan commitment agreement is a powerful method for reducing the bank`s costs of screening and information collection. 4. Collateral and compensating balances: collateral requirements for loans are important to credit risk management tools. Collateral which is property promised to the lender as compensation if the borrower defaults lessens the consequences of adverse selection because it reduces the lenders' losses in the case of a loan default. It also reduces moral hazard because the borrower has more to lose from a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for its losses on the loan. 9  Ch06, P2 - Banking and the Management of Financial Institutions - Compensating balances: A firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank. In addition to serving as collateral, compensating balances the likelihood that a loan will be paid off. They do this by helping the bank monitor the borrower and consequently reduce moral hazard. 5. Credit Rationing: another way in which financial institutions deal with adverse selection and moral hazard is through credit rationing: refusing to make loans even though borrowers are willing to pay the stated interest rate, or an even higher rate. Credit rationing takes two forms: 1. The first occurs when a lender refuses to make a loan of any amount to a borrower even if the borrower is willing to pay a higher interest rate (why).The answer is that adverse selection prevents this from being a wise course of action. Because charging a higher interest rate just makes the adverse selection worse for the lender and the best for the borrower (who will become extremely rich). 2. The second occurs when a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like (why). The answer is that It’s a guard against moral hazard: they grant loans to borrowers but loans that are not as large as the borrowers want. The larger the loan, the greater the benefits from moral hazard. 10 Chapter 7: Central Banks Money & Banking  Ch07- Central Banks ? Meaning of Central Banks A central Bank is a monetary institution that fully controls the Production, Circulation, and Supply of Money in the market, seeking to regulate the banks and stabilise a nation’s economy and national currency. Print notes and coins in circulation (The central bank is given the sole monopoly of issuing currency to secure control over the volume of currency) Holds commercial bank reserves (commercial banks are required to keep a certain amount of public deposits as cash reserve) Manages public debt: buying government bonds Provides supervision to government and commercial banks (the central bank advises the government regarding economic policy matters, money market, capital market, and government loans) Example of Central Banks USA: The Federal Reserve Bank Europe: The European Central Bank Saudi Arabian Central Bank (SAMA) Main Functions of Central Bank 1- Bank of Issue: The Central Bank is given the sole monopoly of issuing currency to secure control over the volume of currency and Credit. These notes Circulate throughout the country as legal tender money. 4  Ch07- Central Banks ? 2- Government's Banker, agent, and advisor: Implies that a central bank performs different functions for the government. As a banker, the central bank performs banking functions for the government by accepting government deposits and granting loans to the government. As an agent, the central bank manages the public debt, undertakes the payment of interest on this debt, and provides all other services related to the debt. As an Advisor, the central bank advises the government regarding economic policy matters, the money market, the capital market, and government loans. Apart from this, the central bank formulates and implements fiscal and monetary policies to regulate the supply of money in the market and control inflation. 3- Custodian of cash reserve of commercial banks: Commercial banks are required to keep a certain amount of public deposits as a cash reserve, with the central bank granting loans to commercial banks. Therefore, the central bank is also called a banker's bank. 4- Exchange control: Another duty of a central bank is to see that the external value of currency is maintained. 5  Ch07- Central Banks ? 5- Lender of last resort: The central bank by acting as the lender of the last resort assumes the responsibility of meeting all reasonable demands for accommodation by commercial banks in times of difficulties and strains. 6- Clearing house : Central bank also acts as a clearing house for the settlement of accounts of commercial banks. A clearing house is an organisation where mutual claims of banks on one another are offset, and a settlement is made by the payment of the difference. The purpose of a clearing house is to act as an intermediary between a buyer and a seller. The clearinghouse inspects a transaction and finalises it, ensuring that both parties fulfil their obligations correctly and fairly. 7- Controller of credit and money supply : Central banks control credit and money supply through their monetary policy which consists of two parts- currency and credit. Commercial banks create lots of credit which sometimes results in inflation. So, the need for credit control is mandatory also to make sure of the price stability in the economy. On a macro basis, central banks influence interest rates and participate in open market operations to control the cost of borrowing and lending throughout the economy. An example of How the Central Bank Deals with a Recession occurs in the economy by using monetary policy: 6  Ch07- Central Banks ? Recession (high inflation and unemployment): interest rate  , required reserve ratio  , lending more,  spending,  investment,  unemployment US Case Study High inflation (target around 2%) To control inflation, the Federal Reserve has increased interest rates. High-interest rate 🡺 lowers consumption and investment, lower demand 🡺 lowers inflation It is more costly for businesses to borrow and invest when interest rates are high 🡺 and lower prices. Cost of borrowing is high 🡺 high-cost mortgage 🡺 lower demand on houses 🡺 prices go down. 7 Chapter 8: Tools of Monetary Policy Money & Banking  Ch08- Tools of Monetary Policy Conventional Monetary Policy Tools During normal times, the Central Bank uses three tools of monetary policy to control the money supply and interest rates, and these are referred to as Conventional monetary policy tools: 1- Open market operations 2- Discount lending 3- Reserve requirements 1. Open Market Operations (OMO) Open market operations are the most important conventional monetary policy tool because they are the primary determinants of changes in interest rates and the monetary base, and the main source of fluctuations in the money supply. buying and selling securities are important because those are the basic operations in OMO. Buying (purchasing)securities by the central bank means more money supply and selling securities means less money supply in the economy. When the central bank purchases securities, reserves will expand, thereby increasing the money supply and lowering short-term interest rates. When the central bank sells securities, reserves will shrink, thereby decreasing the money supply and raising short-term interest rates. 4  Ch08- Tools of Monetary Policy OMO fall into two categories : 1. Dynamic OMO: These are intended to change the level of reserves and the monetary base. 2. Defensive OMO: are intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury Deposits. There are two basic types of Defensive OMO: I. Repurchase agreements (often called a repo) II. Matched sale-purchase agreements (sometimes called a reverse repo) OMO are conducted electronically through a specific set of dealers in government securities, known as Primary dealers by a computer system called TRAPS (Trading Room Automated Processing System). 2. Discount Policy (Discount lending) and the Lender of Last Resort The facility at which banks can borrow reserves from the Central Bank is called the Discount window. To understand how the Central Bank affects the volume of borrowed reserves, look at the discount window operation. Operation of the discount window: the Central Bank’s loans to banks are of three types: 1. Primary credit: healthy banks can borrow all they want at very short maturities from the primary credit facility, and it’s referred to as a standing lending facility. 2. Secondary credit: given to banks that are in financial trouble and are experiencing severe liquidity problems. 5  Ch08- Tools of Monetary Policy 3. Seasonal credit: credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. Lender of last resort: lender of last resort can prevent bank failures from spinning out of control, so the central bank was to provide reserves to banks when no one else would, thereby preventing bank and financial panics. 3. Reserve Requirements A rise in reserve requirements reduces the amount of deposits and raises the interest rates. This will lead to a contraction of the money supply. A decline in reserve requirements increases the number of deposits and the interest rates will decrease. This will lead to an expansion of the money supply. Relative Advantages of the Different Monetary Policy Tools Open market operations are the dominant policy tool of the Central Banks. Because these operations are flexible and precise, easily reversed, and can be quickly implemented. The discount rate is less well used since it is no longer binding for most banks, can cause liquidity problems, and increases uncertainty for banks. Reserve Requirements are rarely used because they take time to implement because banks must be given warnings to calculate required reserves. It is costly to adjust computer systems reversing a change in reserve requirement. 6  Ch08- Tools of Monetary Policy Nonconventional Monetary Policy Tools In normal times, conventional monetary policy tools, which expand the money supply and lower interest rates, are enough to stabilize the economy. When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job. So, Central Banks need non-conventional monetary policy tools to stimulate the economy. These Tools take three forms: 1- Liquidity provision 2- Large-scale Asset purchases 3- Commi