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summary money and banking book the economics of money banking and financial markets european
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lOMoARcPSD|11700591Summary Money and Banking: book " The Economics of
Money, Banking and Financial Markets, European Edition,"
Mishkin, Matthews, Giuliodori
Geld en Bankwezen (Universiteit van Amsterdam)
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Summary Money and Banking
Part I
Chapter 1 – Why study money, banking and financial markets
Financial markets – markets in which funds are transferred from people with an excess to people
with a shortage. Well-functioning ones are a key factor in producing high economic growth while
poorly performing ones are one reason many countries remain desperately poor.
Security (financial instrument) – the claim on the issuer’s future income or assets
Interest rate – the cost of borrowing or the price paid for the rental of funds. While rates can differ
substantially (3 month Treasury bills fluctuate more than 10 year ones), they have a tendency to
move in unison which is why they are frequently lumped and referred to as “the” interest rate. Rates
differ between countries because of differing inflation, political and default risks.
Common stock (stock) – represents a share of ownership in a corporation
Indirect quote – expresses the foreign currency per unit of domestic. Advantageous because a rise is
an appreciation and a fall a depreciation
Financial intermediaries – institutions that borrow funds from people who save and in turn make
loans to others
Financial crises – major disruptions in financial markets that are characterized by sharp declines in
asset prices and the failures of many financial and non-financial firms
Banks – financial institutions that accept deposits and make loans
Money (money supply) – anything that is generally accepted in payment for goods or services or in
the repayment of debts
Aggregate output – total production of goods and services
Unemployment rate – the percentage of the available labour force unemployed
Monetary theory – the theory that relates changes in the quantity of money to changes in aggregate
economic activity
(Aggregate) price level – the price of goods and services in an economy
Inflation – a continual increase in the price level that affects individuals, business and the
government
Monetary policy – the management of money and interest rates
Fiscal policy – decisions about government spending and taxation
Budget surplus – G<T G = Government spending T = Taxation
Budget deficit – G>T
Central bank – the organization responsible for conducting a nation’s monetary policy
Gross domestic product (GDP) – a measure of aggregate output relative to the size of the economy.
It includes the market value of all final goods and services produced in a country during the course of
the year. It excludes two sets of items; purchases of goods that were produced in the past (houses,
stocks or bonds) and intermediate goods used to produce a final good (otherwise they’d be counted
twice).
Aggregate income – the total income of factors of production (labour, land and capital) from
producing goods and services during the course of the year
GDP-deflator Pt = Nominal GDP / Real GDP = Paasche, underestimated outcome
CPI (PCE) deflator Pt = Price of basket of goods and services / Price same basket in base period =
Laspeyres, overestimated outcome
Growth/inflation rate ((xt – xt-1) / xt-1)*100
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Chapter 4 – Understanding interest rates
There are four basic types of credit market instruments
1. Simple loan – the lender provides the borrower with an amount of funds, called the
principal, that must be repaid at the maturity date along with an additional payment for the
interest.
PV = CF/(1 + i)n
For a simple loan, the simple interest rate equals the yield to maturity.
2. Fixed payment loan (fully amortized loan/annuity) – the lender provides the borrower with
an amount of funds which must be repaid by making the same payment every period
consisting of part of the principal and interest for a set number of years.
PV = (C/i) (1-1/(1+i)n)
This rate can be solved using a computer or with trial and error on a calculator. i ≠ YTM.
3. Coupon bond – the owner gets a fixed interest payment every year until the maturity date,
when a specified final amount (face or par value) is repaid. Remember that the final
payment also includes a coupon payment. This type of bond is identified by three pieces of
information; the issuing corporation or government agency, the maturity date and the
coupon rate.
PV = CPN/(1 + YTM) + CPN/(1 + YTM)2 + … + (CPN + FV)/(1 + YTM)n
There are three interesting facts about this type of bond:
• If P = FV, YTM = coupon rate
• P and FV are negative related, i.e. if YTM rises – P falls.
• YTM is greater than the coupon rate when the bond price is below FV.
Consol (perpetuity) – a special case of a coupon bond without maturity date.
P = C/i
For a long term bond the yearly coupon payment divided by the price of the security is called
current yield, often used as an approximation of the interest rate on long-term bonds.
4. Discount (zero) coupon bond – bought at a price below its value and repaid at face value
which includes the interest rate.
PV = FV/(1 + i)n
Yield to maturity – the interest rate that equates the present value of cash flows received from a
debt instrument, with its value today. Economists consider it the accurate measure of interest rates.
It can happen that YTM is (slightly) negative (recently in Japan -.004%), implying that you are willing
to pay more for something today than you will receive in the future. This is driven by the weakness of
the economy and a flight to quality; investors found it more convenient to hold treasury bills as a
store of value than holding cash.
How well someone does by holding a security is measured by the rate of return. The return on a
bond is not necessarily equal to the YTM of that bond; an increase in interest rate leads to a lower
price and perhaps to a loss.
R= = + = i + g = Current yield + Rate of capital gain
Several findings are generally true for all bonds
• The only bond whose return equals the initial YTM, is one whose time to maturity is the
same as the holding period.
• A rise in interest rates comes with a fall in bond prices, resulting in capital losses when the
terms to maturity are longer than the holding period
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• The more distant a bond’s maturity…
- The greater the size of the percentage price change associated with the interest rate
change
- The lower the rate of return that occurs as a result of the increase in the interest rate
Prices and returns for long-term bonds are more volatile than those for shorter term bonds.
Therefore long-term bonds are regarded more risky, the results are referred to as interest-rate risk.
Real interest is the difference between the nominal rate and the expected inflation, as according to
Fischer’s equation.
i = ir + π e
When the real interest rate is low, there are greater incentives to borrow and fewer incentives to
lend. Especially during recessions the real rate may be negative.
Chapter 5 – The behaviour of interest rates
Four factors influence the demand in the bond market. A change in the price or interest rate causes a
movement along the curve. A change in the demand for every price (or interest) level means the
whole curve shifts.
1. Wealth. Holding everything else constant, an increase in wealth raises the quantity
demanded of an asset. A business cycle expansion shifts the curve to the right. An increased
propensity to save also increases the demand, shifting the curve to the right.
2. Expected returns. Ceteris paribus, an asset’s expected return relative to that of an
alternative asset, raises the quantity demanded. Higher expected interest rates in the future
lower the expected returns for long-term bonds which shifts the demand curve to the left. A
higher expected inflation lowers the real interest rate (Fischer) and makes lending less
profitable. The demand declines and the curve shifts to the left.
3. Risk. Ceteris paribus, if an asset’s risk rises relative to that of alternative assets, the quantity
demanded will fall. An increased riskiness shifts the curve to the left.
4. Liquidity. Ceteris paribus, the more liquid an asset is relative to alternative assets, the more
desirable it is and the greater the quantity demanded. Increased liquidity of alternative
assets lowers the demand for bonds (relatively) and shifts the demand to the left.
Three factors influence the supply in the bond market.
1. Expected profitability of investment opportunities. A rapidly growing economy comes with
profitable opportunities and the supply of bonds increases.
2. Expected inflation. In real terms, increased inflation lowers the cost of borrowing. So while
increased inflation lowers the demand because of the lowered profitability, it increases the
supply and shifts the curve to the right.
3. Government budget. The higher the government deficits, the greater the needs for extra
funding thus the greater the supply.
Two pointers: remember that price and interest is negatively related and that you are assuming
ceteris paribus.
The Fischer effect – when expected inflation rises, interest rates will rise. This is because expected
inflation lowers demand (if nominal rates are held constant, real returns on bonds decrease), raises
supply (borrowing money gets cheaper in real terms) and leads to an equilibrium where prices are
lower interest rates higher.
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