Chapter 4 notes - Summary Money Banking and the Financial System PDF

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Notes from chapter 4 of the Money Banking and the Financial System...

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Determinants of portfolio choice (or determinants of asset demand) 1. The investor’s wealth (total amount of savings to be allocated among investments) 2. Expected rate of return from an investment vs expected rate of returns of other investments 3. The degree of risk in an investment compared with the degree of risk in other investments 4. The liquidity of an investment compared with the liquidity of other investments 5. The cost of acquiring information about an investment compared to the cost of acquiring information about other investments Wealth = assets a person owns – liabilities that a person owes  While income is the amount of money someone makes over a period of time Expected ROR = the ror expected on an asset during a future period IBM BOND (current price = $950) Possibility 1

BOND PRICE @ END OF YR

COUPON PAYMENT

$1,016.50

Possibility 2

$921.50

$80 (8 % coupon 7% gain rate) $80 (8 % coupon -3% loss rate)

CAPITAL GAIN/LOSS

ROR FOT THE YEAR 8% + 7% = 15% 8% - 3% = 5%

Say that each of these possibilities has a 50% chance of occurring…to calculate expected ROR you would use this formula: Expected return = [(Probability of event 1 occurring) * (Value of event 1)] + [(Probability of event 2 occurring) * [(Value of event 2)] Therefore: Expected return = (.5 * .15) + (.5 * .05) = .1 or 10% Think of expected return as long-run averages Risk = degree of uncertainty on the return of the asset  The greater the chance of receiving a return that is farther away than its expected return the greater the asset’s risk  To provide a numerical measure of risk, economists measure the volatility of an asset’s returns by calculating the standard deviation of an asset’s actual returns over the years  Most investors are risk averse which means that in choosing between two assets with the same expected returns they would choose the asset with the lower risk  Investors will invest in an asset that has greater risk only if they are compensated by receiving a higher return  Investors that are risk loving will prefer to gamble by holding a risky asset with the possibility of maximizing returns  Some are risk neutral basing their decisions on expected returns, ignoring risk

Investors will accept a lower rate of return on a more liquid asset than on a less liquid asset, just as there is a trade-off between risk and return there is also a trade-off between liquidity and return There is also a trade-off between cost of acquiring information and return, that is investors will accept a lower return that has lower costs of acquiring information Desirable characteristics of a financial asset causes the quantity of the asset demanded by investors to increase, and undesirable characteristics of a financial asset cause the quantity of the asset demand to decrease An increase in…

Wealth

Causes the quantity demanded of the asset in the portfolio to… Rise

Expected return on an asset relative to expected returns on other assets Risk (that is, the variability of returns) Liquidity (the ease an asset can be converted to cash)

Rise

Information costs

Fall

Because…

Investors have a greater stock of savings to allocate Investors gain more from holding the asset

Fall

Most investors are risk averse

Rise

Investors can easily convert the asset into cash to finance consumption Investors must spend more time and money acquiring and analyzing information on the asset and its returns

To compensate for the inability to find the perfect asset, investors hold various types of assets, diving wealth amongst many assets…this is diversification  More stable than investing in one particular asset market/systematic risk = risk that is common to all assets of a certain type, such as the increases and decreases stocks resulting from the business cycle idiosyncratic/unsystematic risk = risk that is unique to a particular asset rather than the market as a whole Market interest rates and the demand and supply for bonds Using a supply and demand model to determine market interest rates for bonds Recall i = (FV-P)/P

As the price of the bond increases, the interest rate on the bonds will fall, and the bonds will become less desirable to investors, so the demand will decline, therefore a downward sloping demand Supply curve represents the relationship between the price of bonds and the quantity of bonds supplied by investors who own existing bonds and by firms that are considering issuing new bonds  As price of the bond increases, the rates will fall, and the holders will be more illing to sell them  Some firms will also find it less expensive to finance projects by borrowing at the lower interest rates and will issue new bonds  For both reasons shows the upward sloping curve for supply

Buyers also have an incentive to increase the price they are willing to pay so that firms and other investors will sell bonds to them If wealth or expected rate of inflation changes then the demand/supply curve shifts Factors that shift the demand curve for bonds 1. Wealth a. Increase in wealth shift the demand curve to the right as savers are willing and able to buy more bonds at any given price

b. Opposite will happen with decline of wealth

2. Expected return on bonds a. Relative to expected returns on other assets b. If expected return on stocks higher than bonds than the demand for bonds will decrease and opposite will happen when expected return for bonds > stocks c. The expected return on bonds is affected by the inflation rate, an increase in the expected inflation rate reduces the expected real return on bonds as real interest rate = nominal interest rate – expected inflation rate, thus reducing the willingness of investors to buy bonds at any given price, shifting the demand to the left 3. Risk a. Increase in riskiness of bonds relative to the riskiness of other assets decreases the willingness of investors to buy bonds causing a shift in the demand curve to the left b. If stocks seem to be riskier than bonds demand for bonds will increase 4. Liquidity a. If liquidity of bonds increases investors demand more bonds at any given price and the demand curve shifts to the right 5. Information costs a. If information costs to evaluate assets increases the demand curve shifts to the left b. When information costs decrease demand curves shift to the right

(review table 4.1) Factors that will shift the supply curve 1. Expected pretax profitability of physical capital investment a. Firms borrow funds to finance the purchase of real physical capital assets to use for several years to produce goods/services b. The more profitable firms expect investment in physical capital to be, the more funds firms want to borrow to borrow by issuing bonds

2. Business taxes a. When the government raises business taxes, the profits firm earn on new investment in physical capital decline and firms issue fewer bonds causing the supply curve to shift to the left b. When the government cuts taxes, businesses issue more bonds causing the supply curve to shift to the right 3. Expected inflation a. A lower expected real interest rate is attractive because it means the firm pays less in real terms to borrow funds b. So an increase in expected inflation rate results in the supply curve for bonds shifting to the right c. A decrease in expected inflation rate makes the supply curve shift to the left 4. Government borrowing

a. When the economy enters a recession, tax receipts decline as household income and business profits decline causing the federal government to increase its spending on unemployment programs b. Government finances resulting deficit by issuing bonds, the supply curve shifts to the right c. Increase in government borrowing shifts the bond supply curve to the right, decreasing the price of bonds and increasing the interest rate d. Decrease in government borrowing shifts the supply to the left increasing the price of bonds and decreasing the interest rate (table 4.3 in the book) Movements in interest rates occur because of shifts in either the demand for bonds, the supply of bonds, or both Two examples of using the bond market model to explain changes in interest rates 1. The movement on interest rates over the business cycle, which refers to the alternating periods of economic expansion and economic recession experienced by the US and most other economies 2. The Fisher effect, describes the movement of interest rates in response to changes in the rate of inflation Interest rates during recessions  Households and firms expect that for a period, levels of production and employment will be lower than usual  Declining wealth and more pessimistic attitude about future profitability of investing in physical capital  This causes the demand curve for bonds to shift to the left and firms declining expectations of the profitability of investments cause issuance of fewer bonds  Shifting supply curve for bonds to the left, in turn causing the price of bonds to rise making interest rates drop

Evidence from US data suggests interest rates typically fall during the recession and (and rise during economic expansion) Equilibrium in the market determines the price of bonds and the nominal interest rat, but borrowers/lenders are more interested in the real interest rate as it reflects value of payments made or received after adjusting for effects of inflation Fisher effect = the nominal interest rate rises or falls point-for-point with changes in the expected inflation rate  If current nominal interest rate in 5% and expected inflation is 2%, the expected real interest rate is 3%  If the future inflation rate is believed to be 4% then the nominal interest rate must rise from 5% to 7%

Points to two important facts about the bond market 1. Higher inflation rates result in higher nominal interest rates, and lower inflation rates result in nominal interest rates 2. Changes in expected inflation can lead to changes in nominal interest rates before a change in actual inflation has occurred The Fed has targeted the federal funds rate – the rate that banks charge each other on overnight loans – in order to determine interest rates Money market model = a model that shows the short-term nominal interest rate is determined by the demand and supply for money  Utilizes m1 definition of money, which equals currency in circulation plus checking account deposits

Money has one particular desirable characteristic, and that is that it is perfectly liquid, so you can use it to buy goods, services, or financial assets Money also has one particular undesirable characteristic, is that the money in your wallet earns no interest  When the nominal interest rate increases on financial assets the amount of interest that households/firms lose by holding money increases  The nominal interest rate is the opportunity cost of holding money Shifts in the money demand curve 1. Real GDP a. Increase in GDP means the amount of buying and selling of goods/services increases, consumers need more money to conduct such transactions, so the Q of money increases at interest rate, shifting the demand curve to the right b. Higher price level increase the q of money required to buy and sell, shifting the demand curve to the right 2. The price level

Equilibrium in the money market  We assume that the Fed is able to set the supply of money at whatever level it chooses  Given this assumption the money supply is a vertical line, and changes the nominal interest rate has no effect of the q of money supplied

The money market model shows us that in the short run, the Fed can cause a decline in the shortterm nominal interest rate by increasing the money supply...