Chapter 9

The Financial System, Money, and Prices

 Financial Intermediaries
• Firms that extended credit to borrowers using
funds raised from savers
• Why we need Financial Intermediaries?
– Specialization
– Safe Earn Returns
– Payment Mediator
 Your Savings flow in Firm

• A is cash flow in
• B is working capital
• C is profit
• D is interest rate, dividend, cash, and other costs
• E is retained earnings
Risk Ladder
Bonds
• A legal Promise to repay a debt
• The repayment is divided into two parts:
– Principal Amount
– Coupon Payment
• Bond Owners are not require to hold their
Bonds until maturation date (The date at
which the principal will be repaid).
• The Market Value of particular bond at any
given point in time is the Bond Price
 Problems 1
• Understanding bond prices:
– The principal amount is $1000, the term is three years, the coupon
rate is 6%, and the coupon payment is $60.
– At the end of the second year, the only remaining payment is the final
$1060 to be paid in one year. If the interest rate is 3%, the value of
$1060 one year from today is $1060/1.03 = $1029. If the interest rate
is 8%, the value of the bond today is $1060/1.08 = $981. And if the
interest rate is 10%, the value of the bond today is $1060/1.10 = $964.
– One possible reason is that bad news arrives about Amalgamated
Corporation, leading financial investors to fear that the firm might go
bankrupt and not pay off its debt in one year. If there is some chance
that the final payment of $1060 will not be made, financial investors
will not be willing to pay $1000 for the bond, as they know they can
earn 6% without risk by holding the debt of the government or very
stable companies.
 Problems 3
A. When interest rates of newly issued government bonds
rise, both bond and stock prices fall. The reason is that
the value of one dollar in the future is now lower than it
was at the original interest rate, so investors are only
willing to purchase existing stocks and bonds if their
prices fall.
B. First, recall the Fisher effect: the nominal interest rate
equals the real interest rate plus the inflation rate. Thus,
for a given real interest rate, a lower inflation implies
lower nominal interest rates. The lower nominal interest
rate increases the value of one dollar in the future, so
investors are willing to purchase existing stocks and
bonds at higher prices.
 Problems 3
C. Increased risk premium lowers the stock price because the value of
one dollar received in the future has fallen. There are two
possibilities for bond prices. First, it’s possible that the bond price
will be unaffected if investors view events in the stock market as
having no effect on the rest of the economy. Second, the bond price
could rise; investors become worried by the stock market swings and
are willing to accept lower-than-safe interest rates just to keep their
principle safe. This is sometimes called a “flight to quality.”
D. The development of a new drug will probably make the firm more
profitable after the drug is introduced five years from now. This will
probably translate into increased future dividends, and an increase
in dividends raises the current stock price.
E. If financial investors previously expected the company to pay a
dividend, this news will reduce the stock price.
F. Price controls will probably reduce future profits and dividends and
therefore this lowers the current stock price.
 Stocks
• A claim to partial ownership of a firm
• The Difference between the required rate of
return to hold risky assets and the rate of
return on safe assets is called Risk Premium
(Rm-Rf)
• Benefits from Stocks
– Capital Gains: The Difference between Today Stock
prices and Yesterday Stock Prices
– Dividend: A regular payment received by
stockholders for each share that they own
 Money and its Uses
• Money has three principle
uses: a medium of exchange,
unit of account, and store of
value
• Medium of Exchange: an asset
used in purchasing products
• Unit of Account: a basic
measure of economic value
• Store of Value: an asset that
• serves as a means Unit of account

• of holding wealth
•
• If there is no
• Money? Barter!
Store of value
 Measuring Money
• M1: sum of currency outstanding and
balances held in checking accounts
• M2: All the assets in M1 plus some additional
assets that are usable in making payments but
at greater cost or inconvenience than currency
• M3: All the assets in M2 plus certificate of
dollars, foreign deposit, and repurchase
agreement
 Creation of Money
• Bank Reserves: cash or similar assets held by
commercial banks for the purpose of meeting
depositor withdrawals and payments
• Reserve-Deposit Ratio: Bank Reserves divided
by deposito
• Bank Deposits: Bank Re serves
Desiredreserve  deposit ratio

• Note that not all money is in bank, but you

keep it as currency. So, how to calculate the
money supply?
 Money Supply
Money Supply  Currency held by public  Bank Deposits

Bank Re serves
Money Supply  Currency held by public 
Desired reserve  deposit ratio
 Problems 7
– Deposits equal bank reserves/(desired reserve/deposit ratio) =
100/0.25 = 400. The money supply equals currency held by the public
+ deposits = 200 + 400 = 600.
– Let X = currency held by the public = bank reserves. Then the money
supply equals X + X/(reserve/deposit ratio); substituting what we
know from the problem,
• 500 = X + X/0.25
• 500 = 5X
• X = 100
• Thus currency and bank reserves both equal 100.
– Since the money supply equals 1250 and the public holds 250 in
currency, bank deposits must equal 1000. If bank reserves are 100,
the desired reserve/deposit ratio equals 100/1000 = 0.10.