Summary
Summary Mishkin (11th) Chapter 1,2,4,5,6,7,8,9,10,11,12,13 sheets
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Summary of Mishkin (11th) chapter 1,2,4,5,6,7,8,9,10,11,12,13 and lectures
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Mishkin, the Economics of money, banking and financial marketsChapter 1, why study money, banking, and financial markets?
Monetary policy:
o The management of money and interest rates, the central bank is responsible
Fiscal policy:
o Involves decisions about government spending and taxation
3 financial markets:
o bond market (interest rates)
o stock market (peoples’ wealth)
o foreign exchange market (country’s economy)
Monetary policy has a major influence on:
o Inflation
o Business cycles
o Interest rates
A security
o A claim on the issuer’s future income or assets
A bond
o Is a debt security that promises to make payments periodically for a specified period of time
An interest rate
o The cost of borrowing or the price paid for the rental of funds
A common stock
o Represents a share of ownership in a corporation
A share of stock
o A claim on the residual earnings and assets of the corporation
Financial markets
o Markets in which funds are transferred from people and firms, who have an excess of available funds to people and firms who have a need of funds
Financial intermediaries
o Institutions that borrow funds from people who have saved and in return make loans to other people
For example; banks, insurance companies, pension funds, mutual funds
Interest rates are the price of money
3 measures of the aggregate price level:
o GDP deflator
o PCE deflator
o CPI
1
,Chapter 2, an overview of the financial system
Direct finance
o Borrowers borrow funds directly from lenders in financial markets by selling the lenders securities, also called financial instruments
Indirect finance
o A financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrowers-spenders
Financial markets are essential to promoting economic efficiency
o By allocating capital
Wealth, either financial or physical, that is employed to produce more wealth
o Perform the essential function of channelling funds from economic players that have saved surplus to those that have a shortage of funds
o Directly improve the well-being of consumers by allowing them to time purchases better
2 ways to obtain funds through the financial market
o Debt
Bonds, mortgages
o Equity
Stocks
Maturity
o Number of years (term) until that instrument’s expiration date
Short <1 year
Intermediate >1 &<10 years
Long >10 years
Stock
o Claims to share in the net income and assets of a business
o Long term, no maturity
o Dividends are periodic payments to holders
o Vote right
Disadvantage of owning a corporation’s equities rather than debt, is that an equity holder is a residual claimant
Advantage of holding equities
o Holders directly benefit from an increase in asset value and profits
The size of the debt market is larger than the size of the equity market
Primary market
o A financial market in which new issues of a security are sold to initial buyers by the corporation or government agency borrowing the funds
Primary markets are not well known to the public because selling of securities to initial buyers often takes place behind closed doors,
such as the investment bank.
Investment bank
o An important financial institution that assists in the initial sale of securities in the primary market. By underwriting
securities, meaning that it guarantees a price for a corporation’s securities and then sells them to the public
Secondary market
o A financial market in which securities that have been previously issued can be resold, such as the NASDAQ, futures markets, option markets
o Securities brokers and dealers are crucial to a well-functioning secondary market
Broker
Agents of investors who match buyers with sellers of securities, on behalf of someone else
Dealer
Link buyers and sellers by buying and selling securities at stated prices, on their own behalf
o 2 functions of the secondary market
they make it easier and quicker to sell these financial instruments to raise cash, more liquid. So the demand for these liquid assets are
higher
secondary markets determine the price of the security that the issuing firm sells in the primary market. Because investors in the primary
market won’t pay a higher price than they think the security will sell for in the secondary market
When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the
corporation that issued the security acquires no new funds, only when the securities are sold in the primary market.
The secondary market gives the most relevant information
Secondary markets can be organized in two ways
o Through exchanges
Buyers and sellers of securities meet in one central location to conduct trades
o Through OTC (over the counter)
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, many stocks are sold in this way
Very competitive market, not very different from a market with organized exchange
Dealers are in contact via computers and know the prices set by others
Another way of distinguishing between markets is on the basis of the maturity of the securities traded in the market
o Money market
Financial market in which only short-term debt instruments are traded
Very liquid
o Capital market
Financial market in which longer-term debt instruments and equity instruments are traded
2
, Money market debt instruments undergo the least price fluctuations and so are the least risky instruments
o For example (MONEY MARKET)
US treasury bills
short-term debt instrument with no interest payments, only a set amount and maturity, they effectively pay interest by
initially selling at a discount. Most liquid of all money market instruments, because they are the most actively traded. They are
also the safest because of the low probability of default
the federal government can always meet its debt obligations by raising taxes or issuing new currency.
Mainly held by banks
negotiable bank certificates
debt instrument sold by banks, pays annual interest, sold in secondary markets
commercial paper
short-term debt instrument issued by large banks and well-known corporations
security repurchase agreements
short-term loans, <2 weeks, for which treasury bills serve as a collateral, an asset that the lender receives if the borrower does
not pay back the loan
federal funds
overnight loans between banks of their deposits at the federal reserve
the interest rate on these loans is called the federal funds rate
not made by the federal government or by the federal reserve, but by banks to other banks, this is somewhat confusing
regarding the name
used to meet the obligations for having reserves
this market is very sensitive to the credit needs of the banks
when the rate is high, the federal funds rate indicates that banks are strapped for funds, when low; it indicates that banks’
credit needs are low
Capital market instruments
o Debt and equity instruments with maturities of greater than one year
o Wider price fluctuations
o Fairly risky investments
For example
Corporate stocks
Residential mortgages
o The mortgage market is the largest debt market in the US
o Mortgage backed securities
Key role in the financial crisis
Bond like debt instruments backed by a bundle of individual mortgages, whose interest and principal
payments are collectively paid to the holders of the security
Corporate bonds
o Long term, issued by corporations with very strong credit ratings
o Interest payment twice a year and pays off the face value when the bond matures
o Can be converted into stocks
o Not very liquid
US government securities
o Long term debt instruments
o Used to finance the deficits of the federal government
o Highly liquid
Foreign bonds
o Are sold in a foreign country and are denominated in that country’s currency
EURODOLLARS
o US dollars deposited in foreign banks outside the US or in foreign branches of US banks, they have nothing to do with euros
o A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro
Financial intermediation
o The process of indirect financing using financial intermediaries
o The primary route for moving funds from lenders to borrowers
Transaction costs
o The time and money spent in carrying out financial transactions
Financial intermediaries can substantially reduce transaction costs because they have developed expertise in lowering them and because their size allows them
to take advantage of economies of scale
The reduction in transaction costs per dollar of transactions as the size of transactions increases
o Liquidity services
Services that make it easier for customers to conduct transactions
o Another advantage of the low transaction costs is that the exposure of investors to risk is reduced
Risk
Uncertainty about the returns investors will make on assets
Risk sharing
o Also called asset transformation
o Financial intermediaries create and sell assets with risk characteristics that people are comfortable with and the
intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far
more risk
o This is also seen as diversification by investors
3
, Asymmetric information
o Before the transaction
Adverse selection
When the potential borrowers who are the most likely to produce an undesirable outcome, are the ones who most actively
seek out a loan and are thus most likely to be selected
o After the transaction
Moral hazard
The risk in financial markets that the borrower might engage in activities that are undesirable from the lender’s point of view
because they make it less likely that the loan will be paid back
In short, financial intermediaries provide
o Liquidity services
o Promote risk sharing, lower exposure to risk
o Solve information problems
o Low transaction costs
o A way for small savers and borrowers to benefit from the existence of financial markets
Economies of scope
o Financial intermediation can lower the cost of information production for each service by applying one information resource to many different
services
Conflicts of interest
o A type of moral hazard problem, arises when a person or institution has multiple objectives, some of which conflict with each other. Likely to occur
when a financial institution provides multiple services, this will lead to concealed information, asymmetric information
3 types of financial intermediaries
o depository institutions (banks), credit unions
o contractual savings institutions, insurance companies
o investment intermediaries
thrift institutions
o savings and loan associations
o mutual savings banks
o credit unions
it obtains the majority of its funds by public savings
investment banks
o it does not take in funds and then lend them out
o it advises a corporation on which type of securities to issue, then it helps sell the securities by purchasing them from the corporation at a
predetermined price and selling them at the market, underwriting!
The government regulates the financial market because
o To increase the information available to investors
o To ensure the soundness of the financial system
Financial panic
o Asymmetric information can lead to the widespread collapse of financial intermediaries
To protect the public and the economy, there are 6 types of regulations
o Restrictions on entry, who is allowed to set up a financial intermediary
o Disclosure, reporting requirements
o Restrictions on assets and activities
o Deposit insurance
o Limits on competition, reduction in the amount of physical locations
o Restriction on interest rates
Financial markets can be classified as
o Debt and equity markets
o Primary and secondary markets
o Exchanges and over the counter markets
o Money and capital markets
Money market, <1 year
Treasury bills
Commercial papers
Repurchase agreements
Federal funds
Capital market, >1 year
Mortgages
Stocks
Corporate bonds
Loans
The growing internalization of financial markets is an important trend in recent years
Eurobonds are now the dominant security in the international bond market
When there is more information available, inside trading is reduced.
4
, Chapter 4, the meaning of interest rates
Present value
o A dollar paid to you one year from now is less valuable than a dollar paid to you today, because you can deposit the dollar now and earn interest
Simple loan
o The lender provides the borrower with an amount of funds, the principal, that must be repaid to the lender at the maturity date, along with an
additional payment for the interest
𝐶𝐹
𝑃𝑉 = (1+𝑖)𝑛
4 types of credit market instruments
o simple loan
o fixed payment loan (fully amortized loan)
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 for a set number of years
o coupon bond
pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when the face value or par value
is repaid
a coupon is identified by 4 pieces of information
o face value
o corporation or government that issues the bond
o maturity date of the bond
o coupon rate, the amount of the yearly coupon payment expressed as a % of the face value
o discount bond (zero coupon bond)
bought at a price below its face value, and the face value is repaid at the maturity date, it does not make interest payments
yield to maturity (internal rate of return)
o the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
o it is the most accurate measure of interest rates
for simple loans the interest rate equals the YTM
to calculate the YTM, set todays value of the loan equal to the sum of the present values of all payments
3 remarks on bonds
o when the coupon bond is priced at its face value, the YTM equals the coupon rate
o the price of a coupon bond and the YTM are negatively related.
As the YTM rises, the price of bonds falls. (divide by a larger amount)
o The YTM is greater than the coupon rate when the bond price is below its face value, and is less than the coupon rate when the bond price is above its
face value.
Perpetuity or consol
o A bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever
𝐶 𝐶
o 𝑃𝑐 = 𝑖 𝑜𝑟 𝑖𝑐 = 𝑃 , in which Pc= price of perpetuity, and C=yearly payment
𝑐 𝑐
when a coupon bond has a long term to maturity, it is very much like a perpetuity, because the terms beyond 20 years have such a low present value
Current yield
o The yearly coupon payment divided by the price of the security
The YTM for a discount bond
𝐹−𝑃
o 𝑖 = 𝑃 , in which F=face value and P=current price
Rate of return
o The amount of each payment to the owner plus the change in the security’s value, expressed as a fraction of its purchase price
The return on a bond will not necessarily equal the yield to maturity on that bond
Return on a bond
𝐶+𝑃𝑡+1 −𝑃𝑡 𝐶 𝑃 −𝑃
o 𝑅= 𝑜𝑟 𝑅 = 𝑃 + 𝑡+1𝑃 𝑡 , in which the R=return from tt+1, C=coupon payment
𝑃 𝑡 𝑡 𝑡
o first part of the second equation is the current yield, second part is the rate of capital gain
𝐶
o 𝑖𝑐 = 𝑃 , 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑
𝑡
𝑃𝑡+1 −𝑃𝑡
o 𝑔= , 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛
𝑃𝑡
o so 𝑅 = 𝑖𝑐 + 𝑔
the only bonds whose returns will equal their initial yields to maturity are those whose times to maturity are the same as their holding periods
The more distant a bond’s maturity date the lower the rate of return that occurs as a result of an increase in the interest rate
Prices and returns for long term bonds are more volatile than those for shorter term bonds
Interest rate risk
o The risk level associated with an asset’s return that results from interest rate changes
Bonds with a maturity term that is as short as the holding period have no interest rate risk
Real interest rate
o The interest rate that is adjusted by subtracting expected changes in the price level, so that it more accurately reflects the cost of
borrowing, EX ANTE
Fisher equations
o 𝑖 = 𝑟 + 𝜋 𝑒 𝑎𝑛𝑑 𝑟 = 𝑖 − 𝜋 𝑒 i=nominal interest, r=real interest, 𝜋 𝑒 =expected inflation
When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
5
, Chapter 5, the behaviour of interest rates
Determinants of asset demand
o Wealth
The total resources owned by the individual, including all assets
Holding everything else constant, an increase in wealth raises the quantity demanded of an asset
o Expected return
On a particular asset relative to alternative assets
An increase in an assets expected return relative to that of an alternative asset, holding everything else constant, raises the quantity
demanded of that asset
o Risk
Degree of uncertainty
If risk rises of an asset, demand will fall
o Liquidity
The ease and speed with which an asset can be turned into cash
The more liquid an asset relative to alternative assets, holding everything else constant, the more desirable it is and the greater the
quantity demand will be
Theory of portfolio choice
o Quantity demand of an asset is positively related to wealth
o Quantity demand of an asset is positively related to its expected return
o Quantity demand of an asset is negatively related to the risk of its returns
o Quantity demand of an asset is positively related to its liquidity
When a bond’s price rises, its interest rate falls
At lower prices, the demand for bonds is higher
At lower prices, the supply for bonds is lower
Borrower is the issuer, is the supply
Buyer is the lender
Bd>Bs, excess demand, P increases, I decreases
Bd<Bs, excess supply, P decreases, I increases
In an expansion, with growing wealth, Bd moves to the right
Higher expected interest rates in the future, lower the expected return for long term bonds, Bd moves to the left
An increase in the expected inflation lowers the expected return for bonds, Bd moves to the left
An increase in the riskiness of bonds, Bd moves to the left
Increased liquidity of bonds, Bd moves to the right
Asset market approach
o Supply and demand are always described in terms of stocks of assets, not in flows. It is the dominant methodology used by economists
Higher expected future interest rates lower the expected return for long term bonds, decrease the demand, and shift the demand curve to the left
Lower expected future interest rates increase the demand for long term bonds and shift the demand curve to the right
An increase in the expected return on alternative assets lowers the demand for bonds and shifts the demand curve to the left
An increase in the expected inflation rate lowers the expected return on bonds, causing their demand to decline and the demand curve to shift to the left
An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right
Increased liquidity of bonds results in an increased demand for bonds and the demand curve shifts to the right.
The supply curve of bonds can also shift, because of:
o Expected profitability of investment opportunities
o Expected inflation
o Government budget deficits
When the expected inflation increases, the real cost of borrowing falls
so the quantity of bonds supplied increases
When the expected inflation rises, the interest rates will rise
The quantity of bonds that a firm will sell is the supply of bonds
Expansion in the economy leads to an increase in the supply and
demand of bonds
Interest rates tend to rise during expansions and fall during recessions
6
, Liquidity preference framework
o It determines the equilibrium interest rate in terms of the supply and demand for money, rather than the supply and demand for bonds
o 𝐵 𝑠 + 𝑀 𝑠 = 𝐵 𝑑 + 𝑀𝑑 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑎𝑠 𝐵 𝑠 − 𝐵 𝑑 = 𝑀𝑑 − 𝑀 𝑠
o This can be used to determine the equilibrium interest rate
The supply and demand framework is easier to use when analysing the effects caused by changes in expected inflation
The liquidity preference framework is easier to use when analysing the effects caused by changes in income, the price level and money supply
The quantity of money demanded and the interest rate are negatively related, because of opportunity costs
A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right
A rise in the price level causes demand to increase at each interest rate and the demand curve shifts to the right
When income is rising during a business cycle expansion, interest rates will rise
When the price level increases, with the supply of money and other economic variables constant, the interest rate will rise
When the money supply increases, interest rates will fall
o Liquidity effect
The income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income
4 effects on interest rates by an increase in the money supply
o liquidity effect, Ms increases, interest rates will fall
o income effect, Ms increases, interest rates will increase
o price-level effect, Ms increases, interest rates will increase
o expected inflation effect, Ms increases, interest rates will increase
A one-time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rates will rise via the
increased prices
o Price level effect remains, even after prices have stopped rising
o A rising pric level will raise the interest rates because people will expect inflation to be higher over the course of the year
o When the price level stops rising, expectations of inflation will return to zero
o Expected inflation effect persists only as long as the price level continues to rise
Liquidity effect
o An increase in the money supply will lower interest rates
Income effect
o Interest rates increase because an increase in the money supply is an expansionary influence to the economy., the demand curve shifts to the
right
Price level effect
o An increase in the money supply leads to an increase in the interest rates in response to the rise in the price level, the demand curve shifts to the
right
Expected inflation effect
o Interest rates increase because an increase in the money supply may lead people to expect a higher price level in the future.
there are four possible effects on interest rates of an increase in the money supply; the liquidity effect, the income effect, the price level effect and the
expected inflation effect. The liquidity effect indicates that a rise in the money supply leads to a decline in interest rates, the other effects work in the
opposite direction. The evidence seems to indicate that the income, price-level and expected inflation effect dominate the liquidity effect such that an
increase in money supply growth leads to higher –rather than lower- interest rates
7
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