Money Banking MGT 411 Lectures

Money & Banking MGT411 VU
MGT411 MONEY& BANKING

Lesson No. TOPICS Page No.
1 Text and Reference Material &Five Parts of The Financial Syste!!"" #1
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Five %ore Princi&les of Money and Banking!!!!!!!!!!""""
#'
'
Money & the Payent Syste!!!!!!!!!!!!!!!!"
#(
4
)ther Fors of Payents!!!!!!!!!!!!!!!!!"""
#*
+ Financial ,nterediaries!!!!!!!!!!!!!!!!!!"""
14
(
Financial ,nstr-ents & Financial Markets!!!!!!!!!!!""
1.
.
Financial ,nstit-tions!!!!!!!!!!!!!!!!!!!"""
$#
/
Tie 0al-e of Money!!!!!!!!!!!!!!!!!!!"
$$
* 1&&lication of Present 0al-e %once&ts!!!!!!!!!!!!"""
$+
1#
Bond Pricing & Risk!!!!!!!!!!!!!!!!!!!"""
$*
11
Meas-ring Risk!!!!!!!!!!!!!!!!!!!!!!
'4
1$
2val-ating Risk!!!!!!!!!!!!!!!!!!!!!"""
'.
1' Bonds & Bonds Pricing!!!!!!!!!!!!!!!!!!"""
4#
14
3ield to Mat-rity!!!!!!!!!!!!!!!!!!!!!"
4'
1+
Shifts in 24-ili5ri- in the Bond Market & Risk!!!!!!!!!
4*
1(
Bonds & So-rces of Bond Risk!!!!!!!!!!!!!!!"""
+1
1. Tax 2ffect & Ter Str-ct-re of ,nterest Rate!!!!!!!!!!"
++
1/
The 6i4-idity Prei- Theory!!!!!!!!!!!!!!!"""
+*
1*
0al-ing Stocks!!!!!!!!!!!!!!!!!!!!!!"
($
$#
Risk and 0al-e of Stocks!!!!!!!!!!!!!!!!!!"
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$1 Role of Financial ,nterediaries!!!!!!!!!!!!!!!""
(*
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Role of Financial ,nterediaries 7%ontin-ed8!!!!!!!!!!""
.1
$'
Banking!!!!!!!!!!!!!!!!!!!!!!!!!
.4
$4
Balance Sheet of %oercial Banks!!!!!!!!!!!!!!
..
$+ Bank Risk!!!!!!!!!!!!!!!!!!!!!!!!
/1
$(
,nterest Rate Risk!!!!!!!!!!!!!!!!!!!!!"
/4
$.
9on: ;e&ository ,nstit-tions!!!!!!!!!!!!!!!!"""
/(
$/
9on:;e&ository ,nstit-tions 7%ont8 !!!!!!!!!!!!!"""
!!!!!!!!!
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$* The Governent Safety 9et!!!!!!!!!!!!!!!!!
*$
'#
The Governent<s Bank!!!!!!!!!!!!!!!!!!""
*4
'1
6o=> Sta5le ,nflation!!!!!!!!!!!!!!!!!!!!
*(
'$
Meeting the %hallenge? %reating a S-ccessf-l %entral Bank!!!!!""
*/
'' The Monetary Base!!!!!!!!!!!!!!!!!!!!""
1#$
'4
;e&osit %reation in a Single Bank!!!!!!!!!!!!!!!
1#+
'+
Money M-lti&lier!!!!!!!!!!!!!!!!!!!!!"
11#
'(
Target Federal F-nds Rate and )&en Market )&eration!!!!!!"
11'
'. @hy ;o @e %are 15o-t Monetary 1ggregatesA !!!!!!!!!"
11(
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The Facts 15o-t 0elocity!!!!!!!!!!!!!!!!!!
11*
'*
The Portfolio ;eand for Money!!!!!!!!!!!!!!"""
1$'
4#
Money Gro=th> ,nflation> and 1ggregate ;eand!!!!!!!!""
1$+
41 ;eriving the Monetary Policy Reaction %-rve!!!!!!!!!!"
1$.
B %o&yright 0irt-al Cniversity of Pakistan
1
4$
The 1ggregate ;eand %-rve!!!!!!!!!!!!!!!!
1''
4'
The 1ggregate S-&&ly %-rve!!!!!!!!!!!!!!!!!
1'+
44
24-ili5ri- and The ;eterination of )-t&-t and ,nflation!!!!"""
1'*
4+ Shifts in Potential )-t&-t 1nd Real B-siness %ycle Theory!!!!!"
14'
2
Lesson 1
TEXT AND E!EENCE MATEIAL &
!IVE PATS O! T"E !INANCIAL SYSTEM
T#e P$%&a$' (e)(*oo+ ,o$ (#e -o.$se /%00 *e
DMoney> Banking and Financial MarketsE 5y Ste&han G" %ecchetti
,nternational 2dition> McGra= Fill P-5lishers> ,SB9 #:#.:111+(+:GE
e,e$en-e *oo+s /%00 *e
DThe 2conoics of Money> Banking and Financial MarketsE> 5y Fredrick S" Mishkin
.
th
2dition 1ddison @esley 6ongan P-5lishers
DPrinci&les of Money> Banking and Financial MarketsE 5y 6a=rence S" Ritter> @illai 6" Sil5er and
Gregory F" Cdell> 1ddison @esley 6ongan P-5lishers
Co.$se Con(en(s
Mone' an1 (#e !%nan-%a0 S's(e&
Money and the Payents Syste
Financial ,nstr-ents> Financial Markets> and Financial ,nstit-tions
In(e$es( $a(e2 ,%nan-%a0 %ns($.&en(s an1 ,%nan-%a0 &a$+e(s
F-t-re 0al-e> Present 0al-e and ,nterest Rates
Cnderstanding Risk
Bonds> Pricing and ;eterination of ,nterest Rates
The Risk and Ter Str-ct-re of ,nterest Rates
Stocks> Stock Markets and Market 2fficiency
!%nan-%a0 Ins(%(.(%ons
2conoics of Financial ,nterediation
;e&ositary ,nstit-tions? Banks and 5ank Manageent
Financial ,nd-stry Str-ct-re
Reg-lating the financial syste
Cen($a0 Ban+s2 Mone(a$' Po0%-' an1 !%nan-%a0 s(a*%0%('
Str-ct-re of central 5anks
Balance sheet and Money S-&&ly &rocess
Monetary &olicy
2xchange rate &olicy
Mo1e$n Mone(a$' E-ono&%-s
Money gro=th and Money ;eand
1ggregate deand
B-siness %ycle
)-t&-t and inflation in the short r-n
Mone' an1 Ban+%ng %n Is0a&
Monetary and financial &olicy and str-ct-re for an ,nterest:free econoy
,slaic Banking in the conte&orary =orld
!%3e Pa$(s o, (#e !%nan-%a0 S's(e&
Money
Financial ,nstr-ents
Financial Markets
Financial ,nstit-tions
%entral Banks
1. Mone'
To &ay for &-rchases
To store =ealth
2volved fro gold and silver coins to &a&er oney to todayHs electronic f-nds transfers
1
Traditional Paycheck syste vs" 1TM @ithdra=als and Mailed transactions vs" 2:5anking
4. !%nan-%a0 Ins($.&en(s
To transfer =ealth fro savers to 5orro=ers
To transfer risk to those 5est e4-i&&ed to 5ear it"
)nce investing =as an activity reserved for the =ealthy
%ostly individ-al stock transactions thro-gh stock5rokers
,nforation collection =as not so easy
9o=> sall investors have the o&&ort-nity to &-rchase shares in D-t-al f-nds"E
5. !%nan-%a0 Ma$+e(s
To 5-y and sell financial instr-ents 4-ickly and chea&ly
2volved fro coffeeho-ses to trading &laces 7Stock exchanges8 to electronic net=orks
Transactions are -ch ore chea&er no=
Markets offer a 5roader array of financial instr-ents than =ere availa5le even +# years ago
4. !%nan-%a0 Ins(%(.(%ons
Provide access to financial arkets
Banks evolved fro 0a-lts and develo&ed into de&osits: and loans:agency
TodayHs 5anks are ore like financial s-&erarkets offering a h-ge assortent of financial
&rod-cts and services for sale"
1ccess to financial arkets
,ns-rance
Foe: and car:loans
%ons-er credit
,nvestent advice
6. Cen($a0 Ban+s
Monitors financial ,nstit-tions
Sta5iliIes the 2conoy
,nitiated 5y Monarchs to finance the =ars
The govt" treas-ries have evolved into the odern central 5ank
%ontrol the availa5ility of oney and credit in s-ch a =ay as to ens-re
6o= inflation>
Figh gro=th> and
The sta5ility of the financial syste
State Bank of Pakistan ==="s5&"org"&k
S.&&a$'
!%3e Pa$(s o, (#e !%nan-%a0 S's(e&
Money
Financial Markets
%entral Banks
2
Lesson 4
!IVE COE PINCIPLES O! MONEY AND BANKING
1. T%&e #as Va0.e
Tie affects the val-e of financial instr-ents"
,nterest &ayents exist 5eca-se of tie &ro&erties of financial instr-ents
E)a&70e
1t (J interest rate> 4 year loan of K1#>### for a car
Re4-ires 4/ onthly installents of K$'+ each
Total re&ayent L K$'+ x 4/ L K11>$/#
K11>$/# M K1#>### 7Total
re&ayent8 71o-nt of loan8
Reason? yo- are co&ensating the lender for the tie d-ring =hich yo- -se the f-nds
4. %s+ e8.%$es Co&7ensa(%on
,n a =orld of -ncertainty> individ-als =ill acce&t risk only if they are co&ensated in soe for"
The =orld is filled =ith -ncertaintyN soe &ossi5ilities are =elcoe and soe are not
To deal effectively =ith risk =e -st consider the f-ll range of &ossi5ilities?
2liinate soe risks>
Red-ce others>
Pay soeone else to ass-e &artic-larly onero-s risks> and
O-st live =ith =hatHs left
,nvestors -st 5e &aid to ass-e risk> and the higher the risk the higher the re4-ired &ayent
%ar ins-rance is an exa&le of &aying for soeone else to sho-lder a risk yo- donHt =ant to take"
Both &arties to the transaction 5enefit
;rivers are s-re of co&ensation in the event of an accident
The ins-rance co&anies ake &rofit 5y &ooling the ins-rance &rei-s and investing the
9o= =e can -nderstand the val-ation of a 5road set of financial instr-ents
2"g"> lenders charge higher rates if there is a chance the 5orro=er =ill not re&ay"
5. In,o$&a(%on %s (#e *as%s ,o$ 1e-%s%ons
@e collect inforation 5efore aking decisions
The ore i&ortant the decision the ore inforation =e collect
The collection and &rocessing of inforation is the 5asis of fo-ndation of the financial syste"
Soe transactions are arranged so that inforation is 9)T needed
Stock exchanges are organiIed to eliinate the need for costly inforation gathering and th-s
facilitate the exchange of sec-rities
)ne =ay or another> inforation is the key to the financial syste
4. Ma$+e(s se( 7$%-es an1 a00o-a(e $eso.$-es
Markets are the core of the econoic systeN the &lace> &hysical or virt-al>
@here 5-yers and sellers eet
@here firs go to iss-e stocks and 5onds>
@here individ-als go to &-rchase assets
Financial arkets are essential to the econoy>
%hanneling its reso-rces
MiniiIing the cost of gathering inforation
Making transactions
@ell:develo&ed financial arkets are a necessary &recondition for healthy econoic gro=th
The role of setting &rices and allocation of reso-rces akes the arkets vital so-rces of
inforation
Markets &rovide the 5asis for the allocation of ca&ital 5y attaching &rices to different stocks or
5onds
3
Financial arkets re4-ire r-les to o&erate &ro&erly and a-thorities to &olice the
The role of the govt" is to ens-re investor &rotection
,nvestor =ill only &artici&ate if they &erceive the arkets are fair
6. S(a*%0%(' %&7$o3es /e0,a$e
To red-ce risk> the volatility -st 5e red-ced
Govt" &olicyakers &lay &ivotal role in red-cing soe risks
1 sta5le econoy red-ces risk and i&roves everyone<s =elfare"
By sta5iliIing the econoy as =hole onetary &olicyakers eliinate risks that individ-als canHt
and so i&rove everyoneHs =elfare in the &rocess"
Sta5iliIing the econoy is the &riary f-nction of central 5anks
1 sta5le econoy gro=s faster than an -nsta5le one
!%nan-%a0 S's(e& P$o&o(es E-ono&%- E,,%-%en-'
The Financial Syste akes it 2asier to Trade
Facilitate Payents : 5ank checking acco-nts
%hannel F-nds fro Savers to Borro=ers
2na5le Risk Sharing : %lassic exa&les are ins-rance and for=ard arkets
1. !a-%0%(a(e Pa'&en(s
%ash transactions 7Trade Dval-e for val-eE8" %o-ld hold a lot of cash on hand to &ay for things
Financial interediaries &rovide checking acco-nts> credit cards> de5it cards> 1TMs
Make transactions easier"
4. C#anne0 !.n1s ,$o& Sa3e$s (o Bo$$o/e$s
6ending is a for of trade 7Trade Dval-e for a &roiseE8
Give -& &-rchasing &o=er today in exchange for &-rchasing &o=er in the f-t-re"
Savers? have ore f-nds than they c-rrently needN =o-ld like to earn ca&ital incoe
Borro=ers? need ore f-nds than they c-rrently haveN =illing and a5le to re&ay =ith interest in the
f-t-re"
@hy is this i&ortantA
A9 1llo=s those =itho-t f-nds to ex&loit &rofita5le investent o&&ort-nities"
%oercial loans to gro=ing 5-sinessesN
0ent-re ca&italN
St-dent loans 7investent in h-an ca&ital8N
,nvestent in &hysical ca&ital and ne= &rod-ctsP&rocesses to &roote econoic gro=th
B9 Financial Syste allo=s the tiing of incoe and ex&endit-res to 5e deco-&led"
Fo-sehold earning &otential starts lo=> gro=s ra&idly -ntil the id +#s> and then declines =ith age"
Financial syste allo=s ho-seholds to 5orro= =hen yo-ng to &ro& -& cons-&tion 7ho-se loans>
car loans8> re&ay and then acc--late =ealth d-ring iddle age> then live off =ealth d-ring
retireent"
4
!%g.$e: C#anne0 !.n1s ,$o& Sa3e$s (o Bo$$o/e$s
5. Ena*0e %s+ S#a$%ng
The =orld is an -ncertain &lace" The financial syste allo=s trade in risk" 7Trade Dval-e for a
&roiseE8
T=o &rinci&al fors of trade in risk are ins-rance and for=ard contracts"
S-&&ose everyone has a 1P1### chance of dying 5y age 4# and one =o-ld need K1 illion to
re&lace lost incoe to &rovide for their faily"
@hat are yo-r o&tions to address this riskA
S.&&a$'
Five %ore Princi&les of Money and Banking
Tie has 0al-e
Risk Re4-ires %o&ensation
,nforation is the 5asis for decisions
Markets set &rices and allocate reso-rces
Sta5ility i&roves =elfare
Financial Syste Prootes 2conoic 2fficiency
Facilitate Payents
%hannel F-nds fro Savers to Borro=ers
2na5le Risk Sharing
Consumption
Income
$
Time
Retirement
Begins
Dissavings
Dissavings
Savings
5
Lesson 5
MONEY & T"E PAYMENT SYSTEM
Money
%haracteristics of Money
6i4-idity
Payent syste
%oodity vs" Fiat Money
%he4-es
)ther fors of &ayents
F-t-re of Money
Mone'
Money is an asset that is generally acce&ted as &ayent for goods and services or re&ayent of
de5t"
9ot the sae as =ealth or incoe
Money is a co&onent of =ealth that is held in a readily: s&end a5le for
Money is ade -& of
%oin and c-rrency
%he4-ing acco-nt 5alances
)ther assets that can 5e t-rned into cash or deand de&osits nearly instantaneo-sly> =itho-t risk
or cost 7li4-id =ealth8
D%s(%n-(%ons a&ong Mone'2 ;ea0(#2 an1 In-o&e
@hile oney> incoe and =ealth are all eas-red in soe c-rrency -nit> they differ significantly in
their eaning"
Peo&le have oney if they have large ao-nts of c-rrency or 5ig 5ank acco-nts at a &oint in tie"
7Stock varia5le8
Soeone earns incoe 7not oney8 fro =ork or investents over a &eriod of tie" 7Flo=
varia5le8
Peo&le have =ealth if they have assets that can 5e converted into ore c-rrency than is necessary
to &ay their de5ts at a &oint in tie" 7Stock varia5le8
C#a$a-(e$%s(%-s o, Mone'
1 eans of &ayent
1 -nit of 1cco-nt
1 Store of 0al-e
A &eans o, 7a'&en(
The &riary -se of oney is as a eans of &ayent"
Money is acce&ted in econoic exchanges"
Barter is an alternative to -sing oney 5-t it doesnHt =ork very =ell"
Barter re4-ires a Ddo-5le coincidence of =ants>E eaning that in order for trade to take &lace 5oth
&arties -st =ant =hat the other has"
Money finaliIes &ayents so that 5-yers and sellers have no f-rther clai on each other"
1s econoies have 5ecoe ore co&lex and &hysically dis&ersed the need for oney has gro=n"
O-st as the division of la5or and s&ecialiIation allo= for efficient &rod-ction> oney allo=s for
efficient exchange"
A .n%( o, A--o.n(
@e eas-re val-e -sing r-&ees and &aisas"
Money is the -nit of acco-nt that =e -se to 4-ote &rices and record de5ts"
6
Money can 5e referred to as a standard of val-e"
Csing oney akes co&arisons of val-e easy
Cnder 5arter the general for-la for n goods> =e =ill have n 7n : 18 P $ &rices
T=o goods 1 &rice
' goods ' &rices
1## goods 4>*+# &rices
1#>### goods +# illion &rices
A S(o$e o, Va0.e
For oney to f-nction as a eans of &ayent it has to 5e a store of val-e too 5eca-se it -st
retain its =orth fro day to day"
The eans of &ayent has to 5e d-ra5le and ca&a5le of transferring &-rchasing &o=er fro one
day to the next"
Money is not the only store of val-eN =ealth can 5e held in a n-5er of other fors"
)ther stores of val-e can 5e &refera5le to oney 5eca-se they &ay interest or deliver other services"
Fo=ever> =e hold oney 5eca-se it is li4-id> eaning that =e can -se it to ake &-rchases"
6i4-idity is a eas-re of the ease =ith =hich an asset can 5e t-rned into a eans of &ayent
7naely oney8"
The ore costly an asset is to t-rn into oney> the less li4-id it is"
%onstantly transforing assets into oney every tie =e =ish to ake a &-rchase =o-ld 5e
extreely costlyN hence =e hold oney
L%8.%1%('
6i4-idity is a eas-re of the ease an asset can 5e t-rned into a eans of &ayent> naely oney
1n asset is li4-id if it can 5e easily converted into oney and illi4-id if it is costly to convert"
%ash is &erfectly li4-id"
Stocks and 5onds are soe=hat less li4-id"
6and is least li4-id"
T#e Pa'&en(s S's(e&
The &ayent syste is a =e5 of arrangeents that allo=s for the exchange of goods and services>
as =ell as assets aong different &eo&le
Money is at the heart of &ayent systeQ
T'7es o, Mone'
%oodity Money Things that have intrinsic val-e
Fiat Money 0al-e coes fro governent decree 7or fiat8
Co&&o1%(' Mone'
The first eans of &ayent =ere things =ith intrinsic val-e like silk or salt"
S-ccessf-l coodity onies had the follo=ing characteristics
They =ere -sa5le in soe for 5y ost &eo&leN
They co-ld 5e ade into standardiIed 4-antitiesN
They =ere d-ra5leN
They had high val-e relative to their =eight and siIe so that they =ere easily trans&orta5leN and
They =ere divisi5le into sall -nits so that they =ere easy to trade
For ost of h-an history> gold has 5een the ost coon coodity oney
!%a( Mone'
Today =e -se &a&er oney that is fiat oney> eaning that its val-e coes fro governent
decree 7or fiat8"
1 note costs a5o-t #"#4J its =orth to &rod-ce"
These notes are acce&ted as &ayent for goods or in settleent of de5ts for t=o reasons?
@e take the 5eca-se =e 5elieve =e can -se the in the f-t-re"
7
The la= says =e -st acce&t theN that is =hat the =ords Dlegal tenderE &rinted on the note
eans"
1s long as the governent stands 5ehind its &a&er oney> and doesnHt iss-e too -ch of it> =e =ill
-se it" ,n the end> oney is a5o-t tr-st"
!%a( o$ Co&&o1%(' Mone'<
;oes oney need to 5e 5acked 5y a coodity at allA
The logical ans=er to this 4-estion is no"
,f the onetary syste is sta5le and f-nctions effectively> D5ackingE is ex&ensive> inconvenient> and
-nnecessary"
Today> oney is only 5acked 5y confidence that governent =ill res&onsi5ly liit the 4-antity of
oney to ens-re that oney in circ-lation =ill hold its val-e"
A13an(ages o, !%a( Mone'
Fe=er reso-rces are -sed to &rod-ce oney"
The 4-antity of oney in circ-lation can 5e deterined 5y rational h-an R-dgent rather than 5y
discovering f-rther ineral de&ositsSlike gold or diaonds
D%sa13an(age
1 corr-&t or &ress-red governent ight iss-e excessive ao-nts of oney> there5y -nleashing
severe inflation"
C#e8.es
%he4-es are another =ay of &aying for things> 5-t
They are not legal tender
They are not even oney"
%he4-es are instr-ctions to the 5ank to take f-nds fro yo-r acco-nt and transfer those f-nds to
the &erson or fir =hose nae is =ritten in the DPay to the )rder ofE line"
@hen yo- give soeone a %he4-e in exchange for a good or service> it is not a final &ayentN
1 series of transactions -st still take &lace that lead to the final &ayent
Follo=ing are the ste&s in the &rocess
1= 3o- hand a &a&er che4-e fro yo-r 5ank to a erchant in exchange for soe good
4= The erchant de&osits the che4-e into erchantHs 5ank and erchantHs acco-nt is credited
5= The erchantHs 5ank sends the che4-e to the local central 5ank
4= The %entral Bank
>a9 %redits the erchantHs 5ankHs reserve acco-nt
>*9 ;e5its yo-r 5ankHs reserve acco-nt
7This ste& involves oney8
6= The %entral Bank ret-rns the che4-e to yo-r 5ank
?= 3o-r 5ank de5its yo-r %he4-ing acco-nt 5y the ao-nt of the che4-e
The =hole &rocess is tie cons-ing and ex&ensiveN
Tho-gh che4-e vol-es have 5eg-n to fall> &a&er %he4-es are still =ith -s 5eca-se a cancelled
che4-e is legal &roof of &ayent
O(#e$ !o$&s o, Pa'&en(s
;e5it %ards
%redit %ards
2lectronic F-nds transfers
Stored 0al-e %ards
8
Lesson 4
OT"E !OMS O! PAYMENTS
De*%( Ca$1
The oney in yo-r acco-nt is -sed for &ayents
@orks like a che4-e and there is -s-ally a fee for the transaction
C$e1%( -a$1
,t is a &roise 5y a 5ank to lend the cardholder oney =ith =hich to ake &-rchases"
@hen the card is -sed to 5-y erchandise the seller receives &ayent iediately
The oney that is -sed for &ayent does not 5elong to the 5-yer
Rather> the 5ank akes the &ayent> creating a loan that the 5-yer -st re&ay"
So> they do not re&resent oneyN rather> they re&resent access to soeone elseHs oney
E0e-($on%- !.n1s T$ans,e$
Move f-nds directly fro one acco-nt to another"
Banks -se these transfers to handle transactions aong theselves
,ndivid-als ay 5e failiar =ith s-ch transfers thro-gh direct de&osit of their &ayche4-es and the
&ayent of their -tility 5ills> etc
E=&one'
Csed for &-rchases on the ,nternet"
3o- o&en an acco-nt 5y transferring f-nds to the iss-er of the e:oney
@hen sho&&ing online> instr-ct the iss-er to send yo-r e:oney to the erchant
,t is really a for of &rivate oney"
S(o$e1=3a0.e -a$1
Retail 5-sinesses are ex&erienting =ith ne= fors of electronic &ayent
Pre&aid cell-lar cards> ,nternet scratch cards> calling cards etc
T#e !.(.$e o, Mone'
The tie is ra&idly a&&roaching =hen safe and sec-re systes for &ayent =ill -se virt-ally no
oney at all
@e =ill also likely see
Fe=er DvarietiesE of c-rrency> 7a sort of standardiIation of oney8 and
1 draatic red-ction in the n-5er of -nits of acco-nt
Money as a store of val-e is clearly on the =ay o-t as any financial instr-ents have 5ecoe
highly li4-id"
Meas.$%ng Mone'
;ifferent ;efinitions of oney 5ased -&on degree of li4-idity" Federal Reserve Syste defines
onetary aggregates"
%hanges in the ao-nt of oney in the econoy are related to changes in interest rates> econoic
gro=th> and ost i&ortant> inflation"
,nflation is a s-stained rise in the general &rice level
@ith inflation yo- need ore oney to 5-y the sae 5asket of goods 5eca-se it costs ore"
,nflation akes oney less val-a5le
The &riary ca-se of inflation is the iss-ance of too -ch oney
Beca-se oney gro=th is related to inflation =e need to 5e a5le to eas-re ho= -ch oney is
circ-lating
Money as a eans of &ayents
@e eas-re the 4-antity of oney as the 4-antity of c-rrency in circ-lation an -nrealistically
liited eas-re> since there are other =ays of &ayents
1lternatively> 5roadly categoriIe financial assets and sort the 5y the degree of li4-idity
Sort the 5y the ease =ith =hich they can 5e converted into a eans of &ayents
1rrange the fro ost li4-id to least li4-id
;ra= a line and incl-de everything on one side of the line in the eas-re of the oney
9
@here to dra= the lineA
,n reality> =e dra= line at different &laces and co&-te several eas-res of oney called the
onetary aggregates
M1> M$> and M'
M1 is the narro=est definition of oney and incl-des only c-rrency and vario-s de&osit acco-nts
on =hich &eo&le can =rite %he4-es"
%-rrency in the hands of the &-5lic>
TravelerHs %he4-es>
;eand de&osits and
)ther che4-ea5le de&osits
M$ incl-des everything that is in M1 &l-s assets that cannot 5e -sed directly as a eans of &ayent
and are diffic-lt to t-rn into c-rrency 4-ickly>
Sall:denoination tie de&osits>
Money arket de&osit acco-nts>
Money arket -t-al f-nd shares
M$ is the ost coonly 4-oted onetary aggregate since its oveents are ost closely related
to interest rate and econoic gro=th"
M' adds to M$ other assets that are i&ortant to large instit-tions
6arge:denoination tie de&osits>
,nstit-tional oney arket -t-al f-nd shares>
Re&-rchase agreeents and
2-rodollars
@S'&*o0 Asse(s %n-0.1e1
% %-rrency
M1 % T deand de&osits> travelersH %he4-es>
other che4-ea5le de&osits
M$ M1 T sall tie de&osits> savings de&osits>
oney arket -t-al f-nds> oney arket de&osit acco-nts
M' M$ T large tie de&osits> re&-rchase agreeents> instit-tional oney arket
-t-al f-nd 5alances
10
Mone(a$' Agg$ega(es !%g.$es %n &%00%ons as o, Ma$-# 4AA6
1. %-rrency iss-ed .11>**.
4. %-rrency held 5y SBP '>1//
5. %-rrency in tills of Sched-led Banks 4'>*14
4. %-rrency in circ-lation 71 $ '8 ((4>/*+
6. Sched-led Banks deand de&osits *'>$.$
?. )ther ;e&osits =ith SBP 4>/$(
B. M1 74T+T(8 1>(#$>4$'
C. Sched-led Banks Tie ;e&osits 1>#'.>(./
D. Resident Foreign %-rrency ;e&osits 1.$>#.4
1A. Total Monetary 1ssets 7M$8 $>/1$>1.+
11. M' '>/''>(/(
So.$-e: S(a(e Ban+ o, Pa+%s(an
Ta*0e : T#e Mone(a$' Agg$ega(es
Mone(a$' Agg$ega(es Va0.e as o, A.g.s( 4AA4 >U.S.E *%00%on9
M1L %-rrency in the hands of the &-5lic
T TravelerHs checks
T ;eand de&osits
T )ther checka5le de&osits
To(a0 M1
(/("$
."(
'1+"'
'$/"+
1255B.?
M4LM1
T Sall:denoination tie de&osits
T Savings de&osits incl-ding oney arket de&osit
acco-nts
T Retail oney arket -t-al f-nd shares
To(a0 M4
.*4".
'41+"'
.'+"+
?24C5.1
M5LM$
T 6arge:denoination tie de&osits
T ,nstit-tional oney arket -t-al f-nd shares
T Re&-rchase agreeents
T 2-rodollars
To(a0 M5
1>#'("'
1>1#4".
+1("(
'44"+
D24C6.4
11
!%g.$e: G$o/(# a(es %n Mone(a$' Agg$ega(es
-5
0
5
10
15
20
25
30
35
40
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
M1
M2
M3
0
5
10
15
20
25
30
1
9
9
0
-
9
1
1
9
9
1
-
9
2
1
9
9
2
-
9
3
1
9
9
3
-
9
4
1
9
9
4
-
9
5
1
9
9
5
-
9
6
1
9
9
6
-
9
7
1
9
9
7
-
9
8
1
9
9
8
-
9
9
1
9
9
9
-
0
0
2
0
0
0
-
0
1
2
0
0
1
-
0
2
2
0
0
2
-
0
3
2
0
0
3
-
0
4
Years
%
Meas.$es o, In,0a(%on
Fixed:=eight ,ndex : %P,
;eflator G;P or Personal %ons-&tion 2x&endit-re ;eflator
Cons.&e$ P$%-e In1e) >CPI9
Meas-re of the overall level of &rices -sed to
Track changes in the ty&ical ho-seholdHs cost of living
1llo= co&arisons of dollar fig-res fro different years
S-rvey cons-ers to deterine co&osition of the ty&ical cons-erHs D5asketE of goods"
2very onth> collect data on &rices of all ites in the 5asketN co&-te cost of 5asket
%P, in any onth e4-als
!%g.$e: Mone' G$o/(# an1 In,0a(%on
12
Cost of basket in that month
100
Cost of basket in base period

E)a&70e:
The 5asket contains $# &iIIas and 1# co&act discs"
P$%-es
Yea$s P%FFa CDs
$##$ K1# K1+
$##' K11 K1+
$##4 K1$ K1(
$##+ K1' K1+
Fro this ta5le> =e can calc-late the inflation rate as?
Yea$s Cos( o, Bas+e( CPI In,0a(%on $a(e
$##$ K'+# 1##"# n"a"
$##' '.# 1#+". +".J
$##4 4## 114"' /"1J
$##+ 41# 11."1 $"+J
GDP De,0a(o$
The G;P deflator> also called the i&licit &rice deflator for G;P> eas-res the &rice of o-t&-t relative to
its &rice in the 5ase year" ,t reflects =hatHs ha&&ening to the overall level of &rices in the econoy
G;P ;eflator L 79oinal G;P P Real G;P8 U1##
Yea$s No&. GDP ea0 GDP GDP De,0a(o$ In,0a(%on a(e
$##1 Rs4(> $## Rs4(> $## 1##"# n"a"
$##$ +1>4## +#>### 1#$"/ $"/J
$##' +/>'## +$>### 11$"1 *"1J
13
Lesson 6
!INANCIAL INTEMEDIAIES
Financial ,nterediaries
Cses
%haracteristics
0al-e
2xa&les
!%nan-%a0 In(e$&e1%a$%es
The inforal arrangeents that =ere the ainstay of the financial syste cent-ries ago have since
given =ay to the foral financial instr-ents of the odern =orld
Today> the international financial syste exists to facilitate the design> sale> and exchange of a 5road
set of contracts =ith a very s&ecific set of characteristics"
@e o5tain the financial reso-rces =e need fro this syste in t=o =ays?
;irectly fro lenders and
,ndirectly fro financial instit-tions called financial interediaries"
In1%$e-( !%nan-e
1 financial instit-tion 7like a 5ank8 5orro=s fro the lender and then &rovides f-nds to the
5orro=er"
,f soeone 5orro=s oney to 5-y a car> the car 5ecoes his or her asset and the loan a lia5ility"
D%$e-( !%nan-e
Borro=ers sell sec-rities directly to lenders in the financial arkets"
Governents and cor&orations finance their activities this =ay
The sec-rities 5ecoe assets to the lenders =ho 5-y the and lia5ilities to the 5orro=er =ho sells
the
!%nan-%a0 an1 E-ono&%- De3e0o7&en(
Financial develo&ent is inextrica5ly linked to econoic gro=th
o There arenHt any rich co-ntries that have very lo= levels of financial develo&ent"
14
!%g.$e: !%nan-%a0 an1 E-ono&%- De3e0o7&en(
!%nan-%a0 Ins($.&en(s
1 financial instr-ent is the =ritten legal o5ligation of one &arty to transfer soething of val-e
-s-ally oney to another &arty at soe f-t-re date> -nder certain conditions> s-ch as stocks>
loans> or ins-rance"
@ritten legal o5ligation eans that it is s-5Rect to governent enforceentN
The enforcea5ility of the o5ligation is an i&ortant feat-re of a financial instr-ent"
The D&artyE referred to can 5e a &erson> co&any> or governent
The f-t-re date can 5e s&ecified or can 5e =hen soe event occ-rs
Financial instr-ents generally s&ecify a n-5er of &ossi5le contingencies -nder =hich one &arty
is re4-ired to ake a &ayent to another
Stocks> loans> and ins-rance are all exa&les of financial instr-ents
Uses o, !%nan-%a0 Ins($.&en(s
1. Means of Payent P-rchase of Goods or Services
4. Store of 0al-e Transfer of P-rchasing Po=er into the f-t-re
5. Transfer of Risk Transfer of risk fro one &erson or co&any to another
C#a$a-(e$%s(%-s o, !%nan-%a0 Ins($.&en(s
StandardiIation
StandardiIed agreeents are -sed in order to overcoe the &otential costs of co&lexity
Beca-se of standardiIation> ost of the financial instr-ents that =e enco-nter on a day:to:day
5asis are very hoogeneo-s
%o-nicate ,nforation
S-ariIe certain essential inforation a5o-t the iss-er
;esigned to handle the &ro5le of Dasyetric inforationE>
Borro=ers have soe inforation that they donHt disclose to lenders
C0asses o, !%nan-%a0 Ins($.&en(s
Cnderlying ,nstr-ents 7Priary or Priitive Sec-rities8
2"g" Stocks and 5onds
Financial ;evelo&ent is
eas-red 5y the coonly
-sed ratio of 5roadly defined
oney to G;P" 2conoic
develo&ent is eas-red 5y
the real G;P &er ca&ita"
0
50 100 150 200 250
5000
10000
15000
20000
Financial Ma!et Development
25000
"
e

C
a
p
i
t
a

#
e
a
l

$
D
"
%oea
Mala&sia
Coelation'0(62
)ong %ong
C*ina
++++++++++++,,
,
,,,
,
,
,
,
,
,,
,
,
,
15
;erivative ,nstr-ents
0al-e and &ayoffs are Dderived froE the 5ehavior of the -nderlying instr-ents
F-t-res and o&tions
Va0.e o, !%nan-%a0 Ins($.&en(s
SiIe of the &roised &ayent
Peo&le =ill &ay ore for an instr-ent that o5ligates the iss-er to &ay the holder a greater s-"
The 5igger the siIe of the &roised &ayent> the ore val-a5le the financial instr-ent
@hen the &ayent =ill 5e received
The sooner the &ayent is ade the ore val-a5le is the &roise to ake it
The likelihood the &ayent =ill 5e ade 7risk8"
The ore likely it is that the &ayent =ill 5e ade> the ore val-a5le the financial instr-ent
The conditions -nder =hich the &ayent =ill 5e ade
Payents that are ade =hen =e need the ost are ore val-a5le than other &ayents
Va0.e o, !%nan-%a0 Ins($.&en(s
1. SiIe Payents that are larger are ore val-a5le
4. Tiing Payents that are ade sooner are ore val-a5le
5. 6ikelihood Payents that are ore likely to 5e ade are ore val-a5le
4. %irc-stances Payents that are ade =hen =e need the ost are ore val-a5le
16
Lesson ?
!INANCIAL INSTUMENTS & !INANCIAL MAKETS
2xa&les
Financial Markets
Roles
Str-ct-re
E)a&70es o, !%nan-%a0 Ins($.&en(s
P$%&a$%0' S(o$es o, Va0.e
Bank 6oans
1 5orro=er o5tains reso-rces fro a lender iediately in exchange for a &roised set of
&ayents in the f-t-re
Bonds
1 for of a loan> =here5y in exchange for o5taining f-nds today a governent or cor&oration
&roises to ake &ayents in the f-t-re
Foe Mortgages
1 loan that is -sed to &-rchase real estate
The real estate is collateral for the loan>
,t is a s&ecific asset &ledged 5y the 5orro=er in order to &rotect the interests of the lender in the
event of non&ayent"
,f &ayent is not ade the lender can foreclose on the &ro&erty"
Stocks
1n o=ner of a share o=ns a &iece of the fir and is entitled to &art of its &rofits"
P$%&a$%0' (o ($ans,e$ $%s+
,ns-rance %ontracts
The &riary &-r&ose is to ass-re that &ayents =ill 5e ade -nder &artic-lar 7and often rare8
circ-stances
F-t-res %ontracts
1n agreeent to exchange a fixed 4-antity of a coodity> s-ch as =heat or corn> or an asset>
s-ch as a 5ond> at a fixed &rice on a set f-t-re date
,t is a derivative instr-ent since its val-e is 5ased on the &rice of soe other asset"
,t is -sed to transfer the risk of &rice fl-ct-ations fro one &arty to another
)&tions
;erivative instr-ents =hose &rices are 5ased on the val-e of soe -nderlying assetN
They give the holder the right 75-t not the o5ligation8 to &-rchase a fixed 4-antity of the
-nderlying asset at a &redeterined &rice at any tie d-ring a s&ecified &eriod"
!%nan-%a0 Ma$+e(s
Financial Markets are the &laces =here financial instr-ents are 5o-ght and sold"
2na5le 5oth firs and individ-als to find financing for their activities"
Proote econoic efficiency 5y ens-ring that reso-rces are &laced at the dis&osal of those =ho can
&-t the to 5est -se"
@hen they fail to f-nction &ro&erly> reso-rces are no longer channeled to their 5est &ossi5le -se
and the society s-ffers at large
17
o0e o, !%nan-%a0 Ma$+e(s
6i4-idity 2ns-re that o=ners of financial instr-ents can 5-y and sell the chea&ly and easily
,nforation Pool and co-nicate inforation a5o-t the iss-er of a financial instr-ent
Risk Sharing Provide individ-als =ith a &lace to 5-y and sell risk> sharing the =ith individ-als
Financial arkets need to 5e designed in a =ay that kee&s transactions costs lo=
S($.-(.$e o, !%nan-%a0 Ma$+e(s
P$%&a$' 3s. Se-on1a$' Ma$+e(s
,n a &riary arket a 5orro=er o5tains f-nds fro a lender 5y selling ne=ly iss-ed sec-rities"
Most co&anies -se an investent 5ank> =hich =ill deterine a &rice and then &-rchase the
co&anyHs sec-rities in &re&aration for resale to clientsN this is called -nder=riting"
,n the secondary arkets &eo&le can 5-y and sell existing sec-rities
Cen($a0%Fe1 E)-#anges 3s. O3e$=(#e=-o.n(e$ Ma$+e(s
,n the centraliIed exchange 7e"g" Varachi Stock 2xchange ==="kse"co"&k 8> the trading is done
Don the floorE
O3e$=(#e=-o.n(e$ >o$ OTC9
)T% arket are electronic net=orks of dealers =ho trade =ith one another fro =herever they are
located
De*( an1 E8.%(' 3s. De$%3a(%3e Ma$+e(s
24-ity arkets are the arkets for stocks> =hich are -s-ally traded in the co-ntries =here the
co&anies are 5ased"
;e5t instr-ents can 5e categoriIed as
Money arket 7at-rity of less than one year8 or Bond arkets 7at-rity of ore than one year8
C#a$a-(e$%s(%-s o, a /e00=$.n ,%nan-%a0 &a$+e(
6o= transaction costs"
,nforation co-nicated -st 5e acc-rate and =idely availa5le
,f not> the &rices =ill not 5e correct
Prices are the link 5et=een the financial arkets and the real econoy
,nvestors -st 5e &rotected"
1 lack of &ro&er safeg-ards da&ens &eo&leHs =illingness to invest
18
!%g.$e: Ma$+e( s%Fe an1 %n3es(o$s 7$o(e-(%on

-2(5 -1(5 -0(5 0(5 1(5
0(5
1(0
1(5
2(0
Measue o. investo potection
2(5
S
t
o
c
!

m
a
!
e
t

e
l
a
t
i
v
e

t
o

$
D
"
$eece
,"otugal
/%
,
0o1a&
,
++++++++++++,,
,,,,
,,,,
,
,
,
,,
,
,
-3(5
0
3(0
3(5
/S
,
2ess Moe
19
Lesson B
!INANCIAL INSTITUTIONS
Str-ct-re of Financial ,nd-stry
Tie 0al-e of Money
!%nan-%a0 Ins(%(.(%ons
Financial instit-tions are the firs that &rovide access to the financial arketsN
They sit 5et=een savers and 5orro=ers and so are kno=n as financial interediaries"
Banks> ins-rance co&anies> sec-rities firs and &ension f-nds
1 syste =itho-t financial instit-tions =o-ld not =ork very =ell for three reasons
,ndivid-al transactions 5et=een saver:lenders and 5orro=er:s&enders =o-ld 5e extreely
ex&ensive"
6enders need to eval-ate the credit=orthiness of 5orro=ers and then onitor the> and
individ-als are not e4-i&&ed to do this"
Most 5orro=ers =ant to 5orro= long ter> =hile lenders favor short:ter loans
o0e o, !%nan-%a0 Ins(%(.(%ons
Red-ce transactions cost 5y s&ecialiIing in the iss-ance of standardiIed sec-rities
Red-ce inforation costs of screening and onitoring 5orro=ers"
%-r5 inforation asyetries> hel&ing to ens-re that reso-rces flo= into their ost &rod-ctive
-ses
Make long:ter loans 5-t allo= savers ready access to their f-nds"
Provide savers =ith financial instr-ents 7ore li4-id and less risky than the individ-al stocks and
5onds8 that savers =o-ld &-rchase directly in financial arkets
!%g.$e: !0o/ o, ,.n1s (#$o.g# !%nan-%a0 Ins(%(.(%ons: A--ess (o !%nan-%a0 Ma$+e(s
20
2en3es4Saves
5"imail& )ouse*ol3s6
7oo1es4Spen3es
5"imail& $ovenments
an3 Fims6
Financial Institutions t*at
act as 7o!es
Financial Institutions t*at
tans.om assets
Bonds & Stocks
Funds
2en3es4Saves
5"imail& )ouse*ol3s6
7oo1es4Spen3es
5"imail& $ovenments
an3 Fims6
Financial Institutions
t*at act as 7o!es
Financial Institutions
t*at tans.om assets
7on3s 8 Stoc!s
Fun3s
Fun3s
7on3s 8 Stoc!s
2oans9 7on3s9
Stoc!s an3 #eal
:state
Fun3s
Deposits 8 Insuance
"olicies
Fun3s
Indirect Finance
T#e s%&70%,%e1 Ba0an-e S#ee( o, a !%nan-%a0 Ins(%(.(%on
Asse(s L%a*%0%(%es
Bonds
Stocks
6oans
Real estate
;e&osits
,ns-rance &olicies
T#e s($.-(.$e o, (#e ,%nan-%a0 %n1.s($'
The str-ct-re of the financial ind-stry?
Financial instit-tions or interediaries can 5e divided into t=o 5road categories
De7os%(o$' %ns(%(.(%ons : take de&osits and ake loans"
7%oercial 5anks> savings 5anks> and credit -nions8
Non1e7os%(o$' %ns(%(.(%ons
,ns-rance co&anies> sec-rities firs> -t-al f-nd co&anies> finance co&anies> and &ension
f-nds
Ins.$an-e -o&7an%es
1cce&t &rei-s> =hich they invest in sec-rities and real estate in ret-rn for &roising
co&ensation to &olicyholders sho-ld certain events occ-rs 7like death> &ro&erty losses> etc"8
Pens%on ,.n1s
,nvest individ-al and co&any contri5-tions into stocks> 5onds and real estate in order to &rovide
&ayents to retired =orkers"
Se-.$%(%es ,%$&s
They incl-de 5rokers> investent 5anks> and -t-al f-nd co&anies
Brokers and investent 5anks iss-e stocks and 5onds to cor&orate c-stoers> trade the> and
advise clients"
M-t-al f-nd co&anies &ool the reso-rces of individ-als and co&anies and invest the in
&ortfolios of 5onds> stocks> and real estate"
Go3e$n&en( S7onso$e1 En(e$7$%ses:
Federal credit agencies that &rovide loans directly for farers and hoe ortgages> as =ell as
g-arantee &rogras that ins-re the loans ade 5y &rivate lenders"
FBF%> WTB6> Vh-shhali 5ank> SM2 Bank
The governent also &rovides retireent incoe and edical care to the elderly 7and disa5led8
thro-gh Social Sec-rity and Medicare"
!%nan-e Co&7an%es:
Raise f-nds directly in the financial arkets in order to ake loans to individ-als and firs"
The onetary aggregates are ade -& of lia5ilities of coercial 5anks> so clearly the financial
str-ct-re is tied to the availa5ility of oney and credit"
21
Lesson C
TIME VALUE O! MONEY
Tie 0al-e of Money
F-t-re 0al-e %once&ts
Present val-e
1&&lication in financial environent
T%&e Va0.e o, Mone'
%redit is one of the critical echaniss =e have for allocating reso-rces"
2ven the si&lest financial transaction> like saving soe of yo-r &aycheck each onth to 5-y a
car> =o-ld 5e i&ossi5le"
%or&orations> ost of =hich s-rvive fro day to day 5y 5orro=ing to finance their activities>
=o-ld not 5e a5le to f-nction"
3et even so> ost &eo&le still take a di vie= of the fact that lenders charge interest"
The ain reason for the end-ring -n&o&-larity of interest coes fro the fail-re to a&&reciate the
fact that lending has an o&&ort-nity cost"
Think of it fro the &oint of vie= of the lender"
2xtending a loan eans giving -& the alternatives" @hile lenders can event-ally reco-& the s-
they lend> neither the tie that the loan =as o-tstanding nor the o&&ort-nities issed d-ring that
tie can 5e gotten 5ack"
So interest isn<t really Xthe 5reeding of oney fro oney><< as 1ristotle &-t itN it<s ore like a
rental fee that 5orro=ers -st &ay lenders to co&ensate the for lost o&&ort-nities"
,t<s no s-r&rise that in today<s =orld> interest rates are of enoro-s i&ortance to virt-ally
everyone
,ndivid-als> 5-sinesses> and governents
They link the &resent to the f-t-re> allo=ing -s to co&are &ayents ade on different dates"
,nterest rates also tell -s the f-t-re re=ard for lending today> as =ell as the cost of 5orro=ing no=
and re&aying later"
To ake so-nd financial decisions> =e -st learn ho= to calc-late and co&are different rates on
vario-s financial instr-ents
!.(.$e Va0.e
F-t-re 0al-e is the val-e on soe f-t-re date of an investent ade today"
To calc-late f-t-re val-e =e -lti&ly the &resent val-e 5y the interest rate and add that ao-nt of
interest to the &resent val-e"
P0 T ,nterest L F0
P0 T P0Yi L F0
K1## T K1##7#"#+8 L K1#+
P0 L Present 0al-e
F0 L F-t-re 0al-e
i L interest rate 7as a &ercentage8
The higher the interest rate 7or the ao-nt invested8 the higher the f-t-re val-e"
!.(.$e Va0.e %n one 'ea$
F0 L P0Y71Ti8
22
9o= =e need to fig-re o-t =hat ha&&ens =hen the tie to re&ayent varies
@hen =e consider investents =ith interest &ayents ade for ore than one year =e need to
consider co&o-nd interest> or the fact that interest =ill 5e &aid on interest
!.(.$e Va0.e %n (/o 'ea$s
K1##TK1##7#"#+8 TK1##7#"#+8 T K+7#"#+8 LK11#"$+
Present 0al-e of the ,nitial ,nvestent T ,nterest on the initial investent in the 1st 3ear T ,nterest on the
initial investent in the $nd 3earT ,nterest on the ,nterest fro the 1st3ear in the $nd 3ear
L F-t-re 0al-e in T=o 3ears
General For-la for co&o-nd interest F-t-re val-e of an investent of P0 in n years at interest rate i
7eas-red as a decial> or +J L "#+8
F0
n L
P0Y71Ti8
n
Ta*0e: Co&7.(%ng (#e !.(.$e Va0.e o, E1AA a( 6G ann.a0 %n(e$es( $a(e
Yea$s %n(o ,.(.$e Co&7.(a(%on !.(.$e 3a0.e
1 K1##7#"+8 K1#+"##
$ K1##7#"+8
$
K11#"$+
' K1##7#"+8
'
K11+".(
4 K1##7#"+8
4
K1$1"++
+ K1##7#"+8
+
K1$."('
1# K1##7#"+8
1#
K1($"/*
No(e:
Both n and i -st 5e eas-red in sae tie -nitsSif i is ann-al> then n -st 5e in years> so f-t-re val-e of
K1## in 1/ onths at +J is
F0 L 1## Y71T"#+8
1"+
Fo= -sef-l it isA
,f yo- &-t K1>### &er year into 5ank at 4J interest> ho= -ch =o-ld yo- have saved after 4#
yearsA
Taking hel& of f-t-re val-e conce&t> the acc--lated ao-nt thro-gh the saving =ill 5e K*/>/$(
ore than t=ice the K4#>### yo- invested
Fo= does it =orkA
The first K1>### is de&osited for 4# years so its f-t-re val-e is
K1>### x 71"#48
4#
L 4>/#1"#$
The $
nd
K1>### is de&osited for '* years so its f-t-re val-e is
K1>### x 71"#48
'*
L 4>(1("'.
1nd so on!""-& to the K1>### de&osited in the 4#
th
year
1dding -& all the f-t-re val-es gives yo- the ao-nt of K*/>/$(
P$esen( Va0.e
Present 0al-e 7P08 is the val-e today 7in the &resent8 of a &ayent that is &roised to 5e ade in
the f-t-re" )R
Present 0al-e is the ao-nt that -st 5e invested today in order to realiIe a s&ecific ao-nt on a
given f-t-re date"
To calc-late &resent val-e =e invert the f-t-re val-e calc-lationN
@e divide f-t-re val-e 5y one &l-s the interest rate 7to find the &resent val-e of a &ayent to 5e
ade one year fro no=8"
Solving the F-t-re 0al-e 24-ation
23
F0 L P0Y71Ti8
Present 0al-e of an ao-nt received in one year"
E)a&70e:
K1## received in one year> iL+J
P0LK1##P 71T"#+8 L K*+"$4
9ote?
F0 L P0Y71Ti8 L K*+"$4Y71"#+8 L K1##
For &ayents to 5e ade ore than one year fro no= =e divide f-t-re val-e 5y one &l-s the
interest rate raised to the n
th
&o=er =here n is the n-5er of years
Present 0al-e of K1## received n years in the f-t-re?
E)a&70e
Present 0al-e of K1## received in $ Z years and an interest rate of /J"
P0 L K1## P 71"#/8
$"+
L K/$"+#
No(e:
F0 LK/$"+# Y 71"#/8
$"+
L K1##
24
Lesson D
APPLICATION O! PESENT VALUE CONCEPTS
1&&lication of Present 0al-e %once&t
%o&o-nd 1nn-al Rate
,nterest Rates vs" ;isco-nt Rate
,nternal Rate of Ret-rn
Bond Pricing
I&7o$(an( P$o7e$(%es o, P$esen( Va0.e
P$esen( Va0.e %s #%g#e$:
The higher the f-t-re val-e 7F08 of the &ayent
The shorter the tie &eriod -ntil &ayent 7n8
The lo=er the interest rate 7i8
T#e s%Fe o, (#e 7a'&en( >!V
n
9
;o-5ling the f-t-re val-e of the &ayent 7=itho-t changing tie of the &ayent or interest rate8>
do-5les the &resent val-e
1t +J interest rate> K1## &ayent has a P0 of K*#".#
;o-5ling it to K$##> do-5les the P0 to K1/1"4#
,ncreasing or decreasing F0
n
5y any &ercentage =ill change P0 5y the sae &ercentage in the sae
direction
T#e (%&e .n(%0 (#e 7a'&en( %s &a1e >n9
%ontin-ing =ith the &revio-s exa&le of K1## at +J> =e allo= the tie to go fro # to '# years"
This &rocess sho=s -s that the P0 &ayent is =orth K1## if it is ade iediately> 5-t grad-ally
declines to K$' for a &ayent ade in '# years
!%g.$e: P$esen( 3a0.e o, E1AA a( 6G %n(e$es( $a(e
T#e $.0e o, B4
For reasona5le rates of ret-rn> the tie it takes to do-5le the oney> is given a&&roxiately 5y
t L .$ P iJ
,f =e have an interest rate of 1#J> the tie it takes for investent to do-5le is?
t L .$ P 1# L ."$ years
This r-le is fairly a&&lica5le to disco-nt rates in +J to $#J range"
25
T#e In(e$es( $a(e >%9
Figher interest rates are associated =ith lo=er &resent val-es> no atter =hat siIe or tiing of the
&ayent
1t any fixed interest rate> an increase in the tie -ntil a &ayent is ade red-ces its &resent val-e
Ta*0e: P$esen( Va0.e o, a E1AA 7a'&en(
Pa'&en( 1.e %n
In(e$es( $a(e 1 Yea$ 6 Yea$s 1A Yea$s 4A Yea$s
1J K**"#1 K*+"1+ K*#"+' K/1"*+
$J E5.BB K*/"#4 K*#"+. E4D.14 K/$"#' K(."'#
'J 4G K*."#* K/("$( 54G K.4"41 K++"'.
4J K*("1+ K/$"1* K(."+( K4+"(4
+J K*+"$4 K./"'+ K(1"'* K'."(*
(J K*4"'4 K.4".' K++"/4 K'1"1/
.J K*'"4( K.1"'# K+#"/' K$+"/4
/J K*$"+* K(/"#( K4("'$ K$1"4+
*J K*1".4 K(4"** K4$"$4 K1."/4
1#J K*#"*1 K($"#* K'/"++ K14"/(
11J K*#"#* K+*"'+ K'+"$$ K1$"4#
1$J K/*"$* K+(".4 K'$"$# K1#"'.
1'J K//"+# K+4"$/ K$*"4( K/"(/
14J K/.".$ K+1"*4 K$("*. K."$/
1+J K/("*( K4*".$ K$4".$ K("11
!%g.$e: T#e $e0a(%ons#%7 *e(/een P$esen( 3a0.e an1 In(e$es( a(es
Co&7o.n1 Ann.a0 a(es
%o&aring changes over days> onths> years and decades can 5e very diffic-lt"
The =ay to deal =ith s-ch &ro5les is to t-rn the onthly gro=th rate into co&o-nd:ann-al rate"
1n investent =hose val-e gro=s #"+J &er onth goes fro 1## at the 5eginning of the onth to
1##"+ at the end of the onth?
@e can verify this as follo=ing
1## 71##"+ : 1##8 L [71##"+P1##8 1\ L #"+J
1##
@hat if the investentHs val-e contin-ed to gro= at #"+J &er onth for next 1$ onthsA
26
@e cant si&ly -lti&ly #"+ 5y 1$
,nstead =e need to co&-te a 1$ onth co&o-nd rate
So the f-t-re val-e of 1## at #"+ J7 #"##+8 &er onth co&o-nded for 1$ onths =ill 5e?
F0
n
L P0 71Ti8
n
L 1##71"##+8
1$
L 1#("1.
1n increase of ("1.J =hich is greater than (J> had =e -lti&lied #"+J 5y 1$
The difference 5et=een the t=o ans=ers gro=s as the interest rate gro=s
1t 1J onthly rate> 1$ onth co&o-nded rate is1$"(/J
1nother -se for co&o-nding is to co&-te the &ercentage change &er year =hen =e kno= ho=
-ch an investent has gro=n over a n-5er of years
This rate is called average ann-al rate
,f an investent has increased $#J> fro 1## to 1$# over + years
,s average ann-al rate is si&ly dividing $#J 5y +A
This =ay =e ignore co&o-nding effect
,ncrease in $
nd
year -st 5e calc-lated as &ercentage of the investent =orth at the end of 1
st
year
To calc-late the average ann-al rate> =e revert to the sae e4-ation?
F0
n
L P0 71Ti8
n

1$# L 1##71 T i8
+
Solving for i
i L [71$#P1##8
1P+
: 1\ L #"#'.1
+ consec-tive ann-al increases of '".1J =ill res-lt in an overall increase of $#J
In(e$es( a(e an1 D%s-o.n( a(e
The interest rate -sed in the &resent val-e calc-lation is often referred to as the disco-nt rate
5eca-se the calc-lation involves disco-nting or red-cing f-t-re &ayents to their e4-ivalent val-e
today"
1nother ter that is -sed for the interest rate is yield
Saving 5ehavior can 5e considered in ters of a &ersonal disco-nt rateN
Peo&le =ith a lo= rate are ore likely to save> =hile &eo&le =ith a high rate are ore likely to
5orro=
@e all have a disco-nt rate that descri5es the rate at =hich =e need to 5e co&ensated for
&ost&oning cons-&tion and saving o-r incoe
,f the arket offers an interest rate higher than the individ-alHs &ersonal disco-nt rate> =e =o-ld
ex&ect that &erson to save 7and vice versa8
Figher interest rates ean higher saving
A770'%ng P$esen( Va0.e
To -se &resent val-e in &ractice =e need to look at a se4-ence or strea of &ayents =hose
&resent val-es -st 5e s-ed" Present val-e is additive"
To see ho= this is a&&lied =e =ill look at internal rate of ret-rn and the val-ation of 5onds
In(e$na0 a(e o, e(.$n
The ,nternal Rate of Ret-rn is the interest rate that e4-ates the &resent val-e of an investent =ith
it cost"
,t is the interest rate at =hich the &resent val-e of the reven-e strea e4-als the cost of the
investent &roRect"
,n the calc-lation =e solve for the interest rate
1 achine =ith a &rice of K1>###>### that generates K1+#>###Pyear for 1# years
27
10 3 2 1
6 1 5
000 9 150 ;
((((((
6 1 5
000 9 150 ;
6 1 5
000 9 150 ;
6 1 5
000 9 150 ;
000 9 000 9 1 ;
i i i i +
+ +
+
+
+
+
+
=
Solving for i> iL"#/14 or /"14J
The internal rate of ret-rn -st 5e co&ared to a rate of interest that re&resents the cost of f-nds
to ake the investent"
These f-nds co-ld 5e o5tained fro retained earnings or 5orro=ing" ,n either case there is an
interest cost
1n investent =ill 5e &rofita5le if its internal rate of ret-rn exceeds the cost of 5orro=ing
28
Lesson 1A
BOND PICING & ISK
Bond Pricing
Real 0s 9oinal ,nterest Rates
Risk
%haracteristics
Meas-reent
Bon1 P$%-%ng
1 5ond is a &roise to ake a series of &ayents on s&ecific f-t-re date"
,t is a legal contract iss-ed as &art of an arrangeent to 5orro=
The ost coon ty&e is a co-&on 5ond> =hich akes ann-al &ayents called co-&on &ayents
The &ercentage rate is called the co-&on rate
The 5ond also s&ecifies a at-rity date 7n8 and has a final &ayent 7F8> =hich is the &rinci&al> face
val-e> or &ar val-e of the 5ond
The &rice of a 5ond is the &resent val-e of its &ayents
To val-e a 5ond =e need to val-e the re&ayent of &rinci&al and the &ayents of interest
Va0.%ng (#e P$%n-%7a0 Pa'&en(
1 straightfor=ard a&&lication of &resent val-e =here n re&resents the at-rity of the 5ond
0al-ing the %o-&on Payents?
Re4-ires calc-lating the &resent val-e of the &ayents and then adding theN ree5er> &resent
val-e is additive
0al-ing the %o-&on Payents &l-s Princi&al
Means co5ining the a5ove
Pa'&en( s(o7s a( (#e &a(.$%(' 1a(e. >n9
1 &ayent is for the face val-e 7F8 or &rinci&le of the 5ond
%o-&on Bonds ake ann-al &ayents called> %o-&on Payents 7%8> 5ased -&on an interest rate>
the co-&on rate 7i
c
8> %Li
c
YF
1 5ond that has a K1## &rinci&le &ayent in n years" The &resent
0al-e 7P
BP
8 of this is no=?
n n BP
i i
F
P
6 1 5
100 ;
6 1 5 +
=
+
=
,f the 5ond has n co-&on &ayents 7%8> =here %L i
c
Y F> the Present 0al-e 7P
%P
8 of the co-&on
&ayents is?
n CP
i
C
i
C
i
C
i
C
P
6 1 5
((((((
6 1 5 6 1 5 6 1 5
3 2 1
+
+ +
+
+
+
+
+
=
29
Present 0al-e of %o-&on Bond 7P
%B
8 L Present val-e of 3early %o-&on Payents 7P
%P
8 T Present 0al-e of
the Princi&al Payent 7P
BP
8
n n BP CP CB
i
F
i
C
i
C
i
C
i
C
P P P
6 1 5 6 1 5
((((((
6 1 5 6 1 5 6 1 5
3 2 1
+
+
+
+ +
+
+
+
+
+
= + =
No(e:
The val-e of the co-&on 5ond rises =hen the yearly co-&on &ayents rise and =hen the interest
rate falls
6o=er interest rates ean higher 5ond &rices and vice versa"
The val-e of a 5ond varies inversely =ith the interest rate -sed to disco-nt the &roised &ayents
ea0 an1 No&%na0 In(e$es( a(es
So far =e have 5een co&-ting the &resent val-e -sing noinal interest rates 7i8> or interest rates
ex&ressed in c-rrent:dollar ters
B-t inflation affects the &-rchasing &o=er of a dollar> so =e need to consider the real interest rate
7r8> =hich is the inflation:adR-sted interest rate"
The Fisher e4-ation tells -s that the noinal interest rate is e4-al to the real interest rate &l-s the
ex&ected rate of inflation
Fisher 24-ation?
i L r T ]
e
)r
r L i : ^
e
!%g.$e: No&%na0 In(e$es( $a(es2 In,0a(%on2 an1 $ea0 %n(e$es( $a(es
1 1985 1 1 1994
-5
0
5
10
-10
15
20
1997 2000 2003 1979
30
!%g.$e: In,0a(%on an1 No&%na0 In(e$es( a(es2 A7$%0 4AA4
%s+
2very day =e ake decisions that involve financial and econoic risk"
Fo= -ch car ins-rance sho-ld =e 5-yA
Sho-ld =e refinance the hoe loan no= or a year fro no=A
Sho-ld =e save ore for retireent> or s&end the extra oney on a ne= carA
,nterestingly eno-gh> the tools =e -se today to eas-re and analyIe risk =ere first develo&ed to
hel& &layers analyIe gaes of chance"
For tho-sands of years> &eo&le have &layed gaes 5ased on a thro= of the dice> 5-t they had little
-nderstanding of ho= those gaes act-ally =orked
Since the invention of &ro5a5ility theory> =e have coe to realiIe that any everyday events>
incl-ding those in econoics> finance> and even =eather forecasting> are 5est tho-ght of as
analogo-s to the fli& of a coin or the thro= of a die
Still> =hile ex&erts can ake ed-cated g-esses a5o-t the f-t-re &ath of interest rates> inflation> or
the stock arket> their &redictions are really only thatSg-ess"
1nd =hile eteorologists are fairly good at forecasting the =eather a day or t=o ahead> econoists>
financial advisors> and 5-siness g-r-s have disal records"
So -nderstanding the &ossi5ility of vario-s occ-rrences sho-ld allo= everyone to ake 5etter
choices" @hile risk cannot 5e eliinated> it can often 5e anaged effectively"
Finally> =hile ost &eo&le vie= risk as a c-rse to 5e avoided =henever &ossi5le> risk also creates
o&&ort-nities"
The &ayoff fro a =inning 5et on one hand of cards can often erase the losses on a losing hand"
Th-s the i&ortance of &ro5a5ility theory to the develo&ent of odern financial arkets is hard
to overe&hasiIe"
Peo&le re4-ire co&ensation for taking risks" @itho-t the ca&acity to eas-re risk> =e co-ld not
calc-late a fair &rice for transferring risk fro one &erson to another> nor co-ld =e &rice stocks and
5onds> -ch less sell ins-rance"
The arket for o&tions didn<t exist -ntil econoists learned ho= to co&-te the &rice of an o&tion
-sing &ro5a5ility theory
@e need a definition of risk that foc-ses on the fact that the o-tcoes of financial and econoic
decisions are alost al=ays -nkno=n at the tie the decisions are ade"
Risk is a eas-re of -ncertainty a5o-t the f-t-re &ayoff of an investent> eas-red over soe
tie horiIon and relative to a 5enchark"
5 10 15
20
25
5
10
15
20
25
30
30
0
45< line
=u!e&
,
7a>il
,
#ussia
,
Sout* ?.ica
/S
/%
In.lation 5@6
0
o
m
i
n
a
l

I
n
t
e
e
s
t

#
a
t
e

5
@
6
31
C#a$a-(e$%s(%-s o, $%s+
Risk can 5e 4-antified"
Risk arises fro -ncertainty a5o-t the f-t-re"
Risk has to do =ith the f-t-re &ayoff to an investent> =hich is -nkno=n"
)-r definition of risk refers to an investent or gro-& of investents"
Risk -st 5e eas-red over soe tie horiIon"
Risk -st 5e eas-red relative to soe 5enchark> not in isolation"
,f yo- =ant to kno= the risk associated =ith a s&ecific investent strategy> the ost a&&ro&riate
5enchark =o-ld 5e the risk associated =ith other investing strategies
Meas.$%ng %s+
Meas.$%ng %s+ $e8.%$es:
6ist of all &ossi5le o-tcoes
%hance of each one occ-rring
The tossing of a coin
@hat are &ossi5le o-tcoesA
@hat is the chance of each one occ-rringA
,s coin fairA
Pro5a5ility is a eas-re of likelihood that an even =ill occ-r
,ts val-e is 5et=een Iero and one
The closer &ro5a5ility is to Iero> less likely it is that an event =ill occ-r"
9o chance of occ-rring if &ro5a5ility is exactly Iero
The closer &ro5a5ility is to one> ore likely it is that an event =ill occ-r"
The event =ill definitely occ-r if &ro5a5ility is exactly one
Pro5a5ilities can also 5e ex&ressed as fre4-encies
Ta*0e: A S%&70e E)a&70e: A00 Poss%*0e O.(-o&es o, a S%ng0e Co%n Toss
Poss%*%0%(%es P$o*a*%0%(' O.(-o&e
_1 1P$ Feads
_$ 1P$ Tails
@e -st incl-de all &ossi5le o-tcoes =hen constr-cting s-ch a ta5le
The s- of the &ro5a5ilities of all the &ossi5le o-tcoes -st 5e 1> since one of the &ossi5le
o-tcoes -st occ-r 7=e R-st donHt kno= =hich one8
To calc-late the ex&ected val-e of an investent> -lti&ly each &ossi5le &ayoff 5y its &ro5a5ility
and then s- all the res-lts" This is also kno=n as the ean"
Case 1
1n ,nvestent can rise or fall in val-e" 1ss-e that an asset &-rchased for K1### is e4-ally likely to fall to
K.## or rise to K14##
Ta*0e: In3es(%ng E12AAA: Case 1
Poss%*%0%(%es P$o*a*%0%(' Pa'o,, Pa'o,, HP$o*a*%0%('
_1 1P$ K.## K'+#
_$ 1P$ K1>4## K.##
2x&ected 0al-e L S- of 7Pro5a5ility ties Payoff8 L K1>#+#
32
2x&ected 0al-e L Z 7K.##8 T Z 7K14##8 L K1#+#
Case 4
The K1>### investent ight &ay off
K1## 7&ro5L"18 or
K$### 7&ro5L"18 or
K.## 7&ro5L"48 or
K14## 7&ro5L"48
Ta*0e: In3es(%ng E12AAA: Case 4
Poss%*%0%(%es P$o*a*%0%(' Pa'o,, Pa'o,, HP$o*a*%0%('
_1 #"1 K1## K1#
_$ #"4 K.## K$/#
_' #"4 K1>4## K+(#
_4 #"1 K$>### K$##
E)7e-(e1 Va0.e I S.& o, >P$o*a*%0%(' (%&es Pa'o,,9 I E12A6A
,nvestent &ayoffs are -s-ally disc-ssed in &ercentage ret-rns instead of in dollar ao-ntsN this
allo=s investors to co&-te the gain or loss on the investent regardless of its siIe
Tho-gh 5oth cases have the sae ex&ected ret-rn> K+# on a K1### investent> or +J> the t=o
investents have different levels or risk"
1 =ider &ayoff range indicates ore risk"
33
Lesson 11
MEASUING ISK
Meas-ring Risk
0ariance and Standard ;eviation
0al-e at Risk 701R8
Risk 1version & Risk Prei-
Meas.$%ng %s+
Most of -s have an int-itive sense for risk and its eas-reentN
The =ider the range of o-tcoes the greater the risk
1 financial instr-ent =ith no risk at all is a risk:free investent or a risk:free assetN
,ts f-t-re val-e is kno=n =ith certainty and
,ts ret-rn is the risk:free rate of ret-rn
,f the risk:free ret-rn is + &ercent> a K1### risk:free investent =ill &ay K1#+#> its ex&ected val-e>
=ith certainty"
,f there is a chance that the &ayoff =ill 5e either ore or less than K1#+#> the investent is risky"
@e can eas-re risk 5y eas-ring the s&read aong an investentHs &ossi5le o-tcoes" There are
t=o eas-res that can 5e -sed?
0ariance and Standard ;eviation
Meas-re of s&read
0al-e at Risk 701R8
Meas-re of riskiness of =orst case
Va$%an-e
The variance is defined as the &ro5a5ility =eighted average of the s4-ared deviations of the
&ossi5le o-tcoes fro their ex&ected val-e
To -a0-.0a(e (#e 3a$%an-e o, an %n3es(&en(2 ,o00o/%ng s(e7s a$e %n3o03e1:
%o&-te ex&ected val-e
S-5tract ex&ected val-e fro each &ossi5le &ayoff
S4-are each res-lt
M-lti&ly 5y its &ro5a5ility
1dd -& the res-lts
Co&7.(e (#e e)7e-(e1 3a0.e:
7K14## x Z8 T 7K.## x Z8 L K1#+#"
S.*($a-( (#%s ,$o& ea-# o, (#e 7oss%*0e 7a'o,,s:
K14##:K1#+#L K'+#
K.##:K1#+#L K'+#
S8.a$e ea-# o, (#e $es.0(s:
K'+#
$
L 1$$>+##7dollars8
$
and
7K'+#8
$
L 1$$>+##7dollars8
$

M.0(%70' ea-# $es.0( (%&es %(s 7$o*a*%0%(' an1 a11s .7 (#e $es.0(s:

Z [1$$>+##7dollars8
$
\ T Z [1$$>+##7dollars8
$
\

L 1$$>+##7dollars8
$
34
More co&actlyN
0ariance L Z7K14##:K1#+#8
$
T Z7K.##:K1#+#8
$
L 1$$>+##7dollars8
$
S(an1a$1 De3%a(%on
The standard deviation is the s4-are root of the variance> or?
Standard ;eviation 7case 18 LK'+#
Standard ;eviation 7case $8 LK+$/
The greater the standard deviation> the higher the risk
,t ore -sef-l 5eca-se it is eas-red in the sae -nits as the &ayoffs 7that is> dollars and not
s4-ared dollars8
The standard deviation can then also 5e converted into a &ercentage of the initial investent>
&roviding a 5aseline against =hich =e can eas-re the risk of alternative investents
Given a choice 5et=een t=o investents =ith the sae ex&ected &ayoff> ost &eo&le =o-ld
choose the one =ith the lo=er standard deviation 5eca-se it =o-ld have less risk
Va0.e a( %s+
Soeties =e are less concerned =ith the s&read of &ossi5le o-tcoes than =e are =ith the val-e
of the =orst o-tcoe"
To assess this sort of risk =e -se a conce&t called Dval-e at risk"E
0al-e at risk eas-res risk at the axi- &otential loss
%s+ A3e$s%on
Most &eo&le donHt like risk and =ill &ay to avoid itN ost of -s are risk averse
1 risk:averse investor =ill al=ays &refer an investent =ith a certain ret-rn to one =ith the sae
ex&ected ret-rn> 5-t any ao-nt of -ncertainty"
B-ying ins-rance is &aying soeone to take o-r risks> so if soeone =ants -s to take on risk =e
-st 5e &aid to do so
%s+ P$e&%.&
The riskier an investent the higher the co&ensation that investors re4-ire for holding it the
higher the risk &rei-
Riskier investents -st have higher ex&ected ret-rns
There is a trade:off 5et=een risk and ex&ected ret-rnN
3o- canHt get a high ret-rn =itho-t taking considera5le risk"
35
!%g.$e: T#e T$a1e=o,, *e(/een %s+ an1 E)7e-(e1 e(.$n
The higher the risk> the higher
the ex&ected ret-rn" The risk
&rei- e4-als the ex&ected
ret-rn on the risky investent
in-s the risk:free ret-rn"
:
A
p
e
c
t
e
3

#
e
t
u
n
#is!
#is!- Fee #etun
#is! "emium
)ig*e #is!')ig*e :Apecte3 #etun
36
Lesson 14
EVALUATING ISK
So-rces of Risk
,diosyncratic
Systeatic
Red-cing Risk thro-gh ;iversification
Fedging Risk
S&reading Risk
Bond and Bond Pricing
"o/ (o E3a0.a(e %s+
6ets go 5ack to o-r &revio-s exa&le =here K1>### yields either K1>4## and K.## =ith e4-al
&ro5a5ility
,f =e think a5o-t this investent in ters of gains and losses> this investent offers an e4-al
chance of gaining K4## or loosing K'##
Sho-ld yo- take the riskA
Ta*0e: E3a0.a(%ng (#e %s+ o, a E12AAA %n3es(&en(
A. T#e Ga%n
Pa'o,, P$o*a*%0%('
T K4## Z
K# Z
B. T#e Loss
Pa'o,, P$o*a*%0%(%es
K# Z
: K'## Z
De-%1%ng %, a $%s+ %s /o$(# (a+%ng
6ist all the &ossi5le o-tcoes or &ayoffs
1ssign a &ro5a5ility to each &ossi5le &ayoff
;ivide the &ayoffs into gains and losses
1sk ho= -ch yo- =o-ld 5e =illing to &ay to receive the gain
1sk ho= -ch yo- =o-ld 5e =illing to &ay to avoid the loss
,f yo- are =illing to &ay ore to receive the gain than to avoid the loss> yo- sho-ld take the risk
So.$-es o, %s+
Risk is every=here" ,t coes in any fors and fro alost every iagina5le &lace
Regardless of the so-rce> risks can 5e classified as either idiosyncratic or systeatic
,diosyncratic> or -ni4-e> risks affect only a sall n-5er of &eo&le"
Systeatic risks affect everyone"
,n the context of the entire econoy>
Figher oil &rices =o-ld 5e an idiosyncratic risk and
%hanges in general econoic conditions =o-ld 5e systeatic risk"
37
e1.-%ng %s+ (#$o.g# D%3e$s%,%-a(%on
Risk can 5e red-ced thro-gh diversification> the &rinci&le of holding ore than one risk at a tie"
Folding several different investents red-ces the overall risk that an investor 5ears
1 co5ination of risky investents is often less risky than any one individ-al investent
There are t=o =ays to diversify yo-r investents?
3o- can hedge risks or
3o- can s&read the aong the any investents
"e1g%ng %s+
Fedging is the strategy of red-cing overall risk 5y aking t=o investents =ith o&&osing risks"
@hen one does &oorly> the other does =ell> and vice versa"
So =hile the &ayoff fro each investent is volatile> together their &ayoffs are sta5le"
Ta*0e: Pa'o,,s on T/o Se7a$a(e In3es(&en(s o, E1AA
Pa'o,, ,$o& O/n%ng On0'
Poss%*%0%(' ABC E0e-($%- XYJ O%0 P$o*a*%0%('
)il &rice rises K1## K1$# 1P$
)il &rice falls K1$# K1## 1P$
6etHs co&are three strategies for investing K1##> given the relationshi&s sho=n in the ta5le?
,nvest K1## in 1B% 2lectric
,nvest K1## in G3W )il
,nvest half in each co&any K+# in 1B% and K+# in G3W
Ta*0e: es.0(s o, Poss%*0e In3es(&en( S($a(eg%es:
"e1g%ng %s+2 In%(%a0 In3es(&en( I E1AA
In3es(&en( S($a(eg' E)7e-(e1 Pa'o,, S(an1a$1 De3%a(%on
1B% )nly K11# K1#
G3W )nly K11# K1#
Z and Z K11# K#
ABCs
!are
ABCs
!are
"#i$s%n&rati& Ris'
ABCs
!are
%stemati& Ris'
ABCs s!are $(
e)isting mar'et
s!rin's
T$ta* A+t$m$,i*e mar'et
38
S7$ea1%ng %s+
,nvestents donHt al=ays ove &redicta5ly in o&&osite directions> so yo- canHt al=ays red-ce risk
thro-gh hedging
3o- can lo=er risk 5y si&ly s&reading it aro-nd and finding investents =hose &ayoffs are
co&letely -nrelated
The ore inde&endent so-rces of risk yo- hold the lo=er yo-r overall risk
1dding ore and ore inde&endent so-rces of risk red-ces the standard deviation -ntil it 5ecoes
negligi5le"
%onsider three investent strategies?
a. 1B% 2lectric only>
*. 2FG Soft only> and
-. Falf in 1B% and half in 2FG
The ex&ected &ayoff on each of these strategies is the sae? K11#"
For the first t=o strategies> K1## in either co&any> the standard deviation is still 1#> R-st as it =as
5efore"
B-t for the third strategy> K+# in 1B% and K+# in 2FG> the analysis is ore co&licated"
There are fo-r &ossi5le o-tcoes> t=o for each stock
Ta*0e: Pa'o,,s ,$o& In3es(%ng E6A %n ea-# o, (/o S(o-+s
In%(%a0 In3es(&en( I E1AA
Poss%*%0%(%es ABC E!G So,( To(a0 Pa'o,, P$o*a*%0%('
_1 K(# K(# K1$# `
_$ K(# K+# K11# `
_' K+# K(# K11# `
_4 K+# K+# K1## `
Ta*0e: es.0(s o, Poss%*0e In3es(&en( S($a(eg%es:
S7$ea1%ng %s+
In%(%a0 In3es(&en( I E1AA
In3es(&en( S($a(eg' E)7e-(e1 Pa'o,, S(an1a$1 De3%a(%on
1B% K11# K1#
2FG Soft K11# K1#
Z and Z K11# K."1
39
Lesson 15
BONDS & BONDS PICING
Bond & Bond &ricing
Wero %o-&on Bond
Fixed Payent 6oan
%o-&on Bonds
%onsols
Bond 3ield
3ield to Mat-rity
%-rrent 3ield
Bon1s
0irt-ally any financial arrangeent involving the c-rrent transfer of reso-rces fro a lender to a
5orro=er> =ith a transfer 5ack at soe tie in the f-t-re> is a for of 5ond"
%ar loans> hoe ortgages> even credit card 5alances all create a loan fro a financial interediary
to an individ-al aking a &-rchase
Governents and large cor&orations sell 5onds =hen they need to 5orro=
The ease =ith =hich individ-als> cor&orations> and governents 5orro= is essential to the
f-nctioning of o-r econoic syste"
@itho-t this free flo= of reso-rces thro-gh the 5ond arkets> the econoy =o-ld grind to a halt"
Fistorically> =e can trace the conce&t of -sing 5onds to 5orro= to onarchs< alost insatia5le
a&&etite for reso-rces"
The ;-tch invented odern 5onds to finance their lengthy =ar of inde&endence
The British refined the -se of 5onds to finance governent activities"
The &ractice =as soon &o&-lar aong other co-ntries
1 standard 5ond s&ecifies the fixed ao-nt to 5e &aid and the exact dates of the &ayents
Fo= -ch sho-ld yo- 5e &aying for a 5ondA
The ans=er de&ends on 5ondHs characteristics
Bon1 P$%-es
Je$o=-o.7on *on1s
Proise a single f-t-re &ayent> s-ch as a Treas-ry 5ill"
!%)e1 7a'&en( 0oans
%onventional ortgages"
%ar loans
Co.7on Bon1s
Make &eriodic interest &ayents and re&ay the &rinci&al at at-rity"
Treas-ry Bonds and ost cor&orate 5onds are co-&on 5onds"
Conso0s
Make &eriodic interest &ayents forever> never re&aying the &rinci&al that =as 5orro=ed"
Je$o=Co.7on Bon1s
These are &-re disco-nt 5onds since they sell at a &rice 5elo= their face val-e
The difference 5et=een the selling &rice and the face val-e re&resents the interest on the 5ond
The &rice of s-ch a 5ond> like a Treas-ry 5ill 7called DT:5illE8> is the &resent val-e of the f-t-re
&ayent
40
Price of a K1## face val-e Iero:co-&on 5ond
n
i6 1 5
100 ;
+
=
@here
i is the interest rate in decial for and
n is tie -ntil the &ayent is ade in the sae tie -nits as the interest rate
Given n> the &rice of a 5ond and the interest rate ove in o&&osite directions
The ost coon at-rity of a T:5ill is ( onthsN the Treas-ry does not iss-e the =ith a
at-rity greater than 1 year
The shorter the tie -ntil the &ayent is ade the higher the &rice of the 5ond> so ( onth T:5ills
have a higher &rice that a one:year T:5ill
E)a&70es: 1ss-e iL4J
Price of a )ne:3ear Treas-ry 5ill
15 ( 96 ;
6 04 ( 0 1 5
100
=
+
=
Price of a Six:Month Treas-ry 5ill
06 ( 98 ;
6 04 ( 0 1 5
100
2 4 1
=
+
=
The interest rate and the &rice for the T:5ill ove inversely"
,f =e kno= the face val-e and the &rice then =e can solve for the interest rate
!%)e1 Pa'&en( Loans
They &roise a fixed n-5er of e4-al &ayents at reg-lar intervals
Foe ortgages and car loans are exa&les of fixed &ayent loansN
These loans are aortiIed> eaning that the 5orro=er &ays off the &rinci&al along =ith the interest
over the life of the loan"
2ach &ayent incl-des 5oth interest and soe &ortion of the &rinci&al
The &rice of the loan is the &resent val-e of all the &ayents
0al-e of a Fixed Payent 6oan L
Co.7on Bon1
The val-e of a co-&on 5ond is the &resent val-e of the &eriodic interest &ayents &l-s the &resent val-e of
the &rinci&al re&ayent at at-rity
The latter &art> the re&ayent of the &rinci&al> is R-st like a Iero:co-&on 5ond"
41
n
i
FixedPaymen
t i
nt FixedPayme
i
nt FixedPayme
6 1 5 6 1 5 6 1 5
2
+
+ +
+
+
+
-
n n CB
i
FaceValue
i
ent CouponPaym
i
ent CouponPaym
i
ent CouponPaym
P
6 1 5 6 1 5
((((((
6 1 5 6 1 5
2 1
+
+
+
+ +
+
+
+
=
Conso0s
1 consol offers only &eriodic interest &ayentsN the 5orro=er never re&ays the &rinci&al
There are no &rivately iss-ed consols 5eca-se only governents can credi5ly &roise to ake
&ayents forever
The &rice of a consol is the &resent val-e of all the f-t-re interest &ayents> =hich is a 5it
co&licated 5eca-se there are an infinite n-5er of &ayents
Bon1 Y%e01s
9o= that =e kno= ho= to &rice a 5ond =hile interest rate is kno=nN =e no= ove to other
direction and calc-late the interest rate or ret-rn to an investor
So co5ining inforation a5o-t the &roised &ayents =ith the &rice to o5tain =hat is called the
yield a eas-re of cost of 5orro=ing or re=ard for lending"
,nterest rate and yield are -sed interchangea5ly
Y%e01 (o Ma(.$%('
The ost -sef-l eas-re of the ret-rn on holding a 5ond is called the yield to at-rity 73TM8"
This is the yield 5ondholders receive if they hold the 5ond to its at-rity =hen the final &rinci&al
&ayent is ade
,t can 5e calc-lated fro the &resent val-e for-la
Price of )ne:3ear + &ercent %o-&on Bond L
The val-e of i that solves this e4-ation is the yield to at-rity
,f the &rice of the 5ond is K1##> then the yield to at-rity e4-als the co-&on rate"
Since the &rice rises as the yield falls> =hen the &rice is a5ove K1##> the yield to at-rity -st 5e
5elo= the co-&on rate"
Since the &rice falls as the yield rises> =hen the &rice is 5elo= K1##> the yield to at-rity -st 5e
a5ove the co-&on rate"
3ield to Mat-rity
%onsidering +J co-&on 5ond
,f 3TM is +J then &rice is
,f 3TM is 4J then &rice is
,f 3TM is (J then &rice is
Generally
,f the yield to at-rity e4-als the co-&on rate> the &rice of the 5ond is the sae as its face val-e"
,f the yield is greater than the co-&on rate> the &rice is lo=erN
,f the yield is 5elo= the co-&on rate> the &rice is greater
100 ;
6 1 5
5 ;
.05
+
+ 6 1 5 .05 +
' ;100
100 ;
6 1 5
5 ;
.04
+
+ 6 1 5 .04 +
' ;100(96
100 ;
6 1 5
5 ;
.06
+
+
6 1 5 .06
+
' ;99(06
42
6 1 5
100 ;
6 1 5
5 ;
i i +
+
+
Lesson 14
YIELD TO MATUIY
3ield to Mat-rity
%-rrent 3ield
Folding Period Ret-rns
Bond S-&&ly & ;eand
Factors affecting Bond S-&&ly
Factors affecting Bond ;eand
Y%e01 (o Ma(.$%(': Gene$a0 e0a(%ons#%7s
General Relationshi&s
,f the yield to at-rity e4-als the co-&on rate> the &rice of the 5ond is the sae as its face val-e"
,f the yield is greater than the co-&on rate> the &rice is lo=erN
if the yield is 5elo= the co-&on rate> the &rice is greater
,f yo- 5-y a 5ond at a &rice less than its face val-e yo- =ill receive its interest and a ca&ital gain>
=hich is the difference 5et=een the &rice and the face val-e"
1s a res-lt yo- have a higher ret-rn than the co-&on rate
@hen the &rice is a5ove the face val-e> the 5ondholder inc-rs a ca&ital loss and the 5ondHs yield to
at-rity falls 5elo= its co-&on rate"
Ta*0e: e0a(%ons#%7 *e(/een P$%-e an1 Y%e01 (o Ma(.$%('
YTM on a 1AG Co.7on $a(e *on1 &a(.$%ng %n (en 'ea$s >!a-e Va0.e I E12AAA9
P$%-e o, Bon1 >E9 Y%e01 (o Ma(.$%(' >G9
1>$## ."1'
1>1## /"4/
1>### 1#"##
*## 11".+
/## 1'"/1

T#$ee In(e$es(%ng !a-(s %n (#e a*o3e Ta*0e
1. @hen 5ond is at &ar> yield e4-als co-&on rate
4. Price and yield are negatively related
5. 3ield greater than co-&on rate =hen 5ond &rice is 5elo= &ar val-e
C.$$en( Y%e01
%-rrent yield is a coonly -sed> easy:to:co&-te eas-re of the &roceeds the 5ondholder
receives for aking a loan
,t is the yearly co-&on &ayent divided 5y the &rice
The c-rrent yield eas-res that &art of the ret-rn fro 5-ying the 5ond that arises solely fro the
co-&on &ayentsN
,t ignores the ca&ital gain or loss that arises =hen the 5ondHs &rice differs fro its face val-e
6etHs ret-rn to 1:year +J co-&on 5ond ass-ing that it is selling for K**"
%-rrent yield is +P** L #"#+#+ or +"#+J
3TM for this 5ond is calc-lated to 5e ("#(J thro-gh the follo=ing calc-lations
,f yo- 5-y the 5ond for K**> one year later yo- get not only the K+ co-&on &ayent 5-t also a
g-aranteed K1 ca&ital gain> totaling to K(
6 1 5
100 ;
6 1 5
5 ;
i i +
+
+
' ;99
43
"ai3 "ice
"a&ment Coupon Beal&
Biel3 Cuent =
Re&eating this &rocess for the 5ond selling for K1#1> c-rrent yield is 4"*+J and 3TM is '"*(J
The c-rrent yield oves inversely to the &riceN
,f the &rice is a5ove the face val-e> the c-rrent yield falls 5elo= the co-&on rate"
@hen the &rice falls 5elo= the face val-e> the c-rrent yield rises a5ove the co-&on rate"
,f the &rice and the face val-e are e4-al the c-rrent yield and the co-&on rate are e4-al"
Since the yield to at-rity takes acco-nt of ca&ital gains 7and losses8>
@hen the 5ond &rice is less than its face val-e the yield to at-rity is higher than the c-rrent yield>
,f the &rice is greater than face val-e> the yield to at-rity is lo=er than the c-rrent yield> =hich is
lo=er than the co-&on rate
Relationshi& 5et=een a BondHs Price and its %o-&on Rate> %-rrent 3ield and 3ield to Mat-rity
Bond Price a Face 0al-e?
%o-&on Rate a %-rrent 3ield a 3ield to Mat-rity
Bond Price L Face 0al-e?
%o-&on Rate L %-rrent 3ield L 3ield to Mat-rity
Bond Price M Face 0al-e?
%o-&on Rate M %-rrent 3ield M 3ield to Mat-rity
"o01%ng Pe$%o1 e(.$ns
The investorHs ret-rn fro holding a 5ond need not 5e the co-&on rate
Most holders of long:ter 5onds &lan to sell the =ell 5efore they at-re> and 5eca-se the &rice
of the 5ond ay change in the tie since its &-rchase> the ret-rn can differ fro the yield to
at-rity
The holding &eriod ret-rn the ret-rn to holding a 5ond and selling it 5efore at-rity"
The holding &eriod ret-rn can differ fro the yield to at-rity
The longer the ter of the 5ond> the greater the &rice oveents and associated risk can 5e
E)a&70es:
3o- &ay for K1## for a 1#:year (J co-&on 5ond =ith a face val-e of K1##> yo- intend to hold the
5ond for one year> i"e" 5-y a 1# year 5ond and sell a * year 5ond an year later
,f interest rate does not change yo-r ret-rn =ill 5e K(P1## L #"#( L (J
,f interest rate falls to +J over the year then thro-gh -sing 5ond &ricing for-la =e can see that
3o- 5o-ght a 1#:year 5ond for K1## and sold a *:year 5ond for K1#."11
9o= the one year holding ret-rn has t=o &arts
K( co-&on &ayent and
K."11 ca&ital gain
So no=> one year holding Period ret-rn L

)r 1'"11J
,f the interest rate in one year is .J"""
44
1311 (
100 ;
11 ( 13 ;
100 ;
100 ; 11 ( 107 ;
100 ;
6 ;
= =
+
)ne year holding Period ret-rn L
)r :#"+$J
GeneraliIing> 1:year holding ret-rn is
Bon1 Ma$+e( an1 In(e$es( a(es
To find o-t ho= 5ond &rices are deterined and =hy they change =e need to look at the s-&&ly
and deand in the 5ond arket"
6etHs consider the arket for existing 5onds at a &artic-lar tie 7the stock of 5onds8 and consider
&rices and not interest rates"
)ne 3ear Wero:co-&on 7disco-nt8 Bond
Bon1 S.770'2 De&an1 an1 E8.%0%*$%.&
Bon1 S.770'
The Bond s-&&ly c-rve is the relationshi& 5et=een the &rice and the 4-antity of 5onds &eo&le are
=illing to sell> all other things 5eing e4-al"
Fro the &oint of vie= of investors> the higher the &rice> the ore te&ting it is to sell a 5ond they
c-rrently hold"
Fro the &oint of vie= of co&anies seeking finance for ne= &roRects> the higher the &rice at
=hich they can sell 5onds> the ore advantageo-s it is to do so"
For a K1## one:year Iero:co-&on 5ond> the s-&&ly =ill 5e higher at K*+ than it =ill 5e at K*#> all
other things 5eing e4-al"
Bon1 De&an1
The 5ond deand c-rve is the relationshi& 5et=een the &rice and 4-antity of 5onds that investors
deand> all other things 5eing e4-al"
1s the &rice falls> the re=ard for holding the 5ond rises> so the deand goes -&
The lo=er the &rice &otential 5ondholders -st &ay for a fixed:dollar &ayent on a f-t-re date> the
ore likely they are to 5-y a 5ond
The Iero:co-&on 5ond &roising to &ay K1## in one year =ill 5e ore attractive at K*# than it =ill
at K*+> all other things 5eing e4-al"
45
0052 (
100 ;
52 ;(
100 ;
100 ; 48 ( 93 ;
100 ;
6 ;
=
+
7on3 t*e o. "ice
7on3 t*e o. "ice in C*ange

"ai3 "ice
"a&ment Coupon Beal&
+ =
@6 a 5as $ain Capital Biel3 Cuent + =
"
" 100 ;
i o
i 1
100 ;
"

=
+
=
!%g.$e: S.770'2 1e&an1 an1 e8.%0%*$%.& %n (#e *on1 &a$+e(
24-ili5ri- in the 5ond arket is the &oint at =hich s-&&ly e4-als deand"
,f the &rice is too high 7a5ove e4-ili5ri-8 the excess s-&&ly of 5onds =ill &-sh the &rice 5ack
do=n"
,f the &rice is too lo= 75elo= e4-ili5ri-8 the excess deand for 5onds =ill &-sh it -&
)ver tie the s-&&ly and deand c-rves can shift> leading to changes in the e4-ili5ri- &rice
!a-(o$s (#a( s#%,( Bon1 S.770'
C#anges %n go3e$n&en( *o$$o/%ng
1ny increase in the governentHs 5orro=ing needs increases the 4-antity of 5onds o-tstanding>
shifting the 5ond s-&&ly c-rve to the right"
This red-ces &rice and increases the interest rate on the 5ond"
C#anges %n *.s%ness -on1%(%ons
B-siness:cycle ex&ansions ean ore investent o&&ort-nities> &ro&ting firs to increase their
5orro=ing and increasing the s-&&ly of 5onds
1s 5-siness conditions i&rove> the 5ond s-&&ly c-rve shifts to the right"
By the sae logic> =eak econoic gro=th can lead to rising 5ond &rices and lo=er interest rates
C#anges %n e)7e-(e1 %n,0a(%on
Bond iss-ers care a5o-t the real cost of 5orro=ing>
So if inflation is ex&ected to increase then the real cost falls and the desire to 5orro= rises> res-lting
in the 5ond s-&&ly c-rve shifting to the right
Ta*0e: !a-(o$s (#a( %n-$ease Bon1 S.770'2 0o/e$ Bon1 P$%-es2 an1 a%se In(e$es( a(es
C#ange E,,e-( on Bon1 S.770'2 Bon1 P$%-es2 an1
In(e$es( a(es
1n increase in the governentHs desired ex&endit-re
relative to its reven-e
Bond S-&&ly shifts to the right> Bond &rices
decrease and interest rates increase
1n i&roveent in general 5-siness conditions Bond S-&&ly shifts to the right> Bond &rices
1n increase in ex&ected inflation> red-cing the real
cost of re&ayent
Bond S-&&ly shifts to the right> Bond &rices
The s-&&ly of 5onds fro
the 5orro=ers slo&es -&
and the deand for 5onds
fro the lenders slo&es
do=n" 24-ili5ri- in the
5ond arket is deterined
5y the interaction of
s-&&ly and deand"
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!%g.$e: A s#%,( %n (#e s.770' o, *on1s
!a-(o$s (#a( s#%,( Bon1 De&an1
;ea0(#
1n increase in =ealth shifts the deand for 5onds to the right as =ealthier &eo&le invest ore"
This =ill ha&&en as the econoy gro=s d-ring an ex&ansion"
This =ill increase Bond Prices and lo=er yields"
E)7e-(e1 %n,0a(%on
1 fall in ex&ected inflation shifts the 5ond deand c-rve to the right> increasing deand at each
&rice and lo=ering the yield and increasing the BondHs &rice"
E)7e-(e1 $e(.$n on s(o-+s an1 o(#e$ asse(s
,f the ret-rn on 5onds rises relative to the ret-rn on alternative investents> the deand for 5onds
=ill rise"
This =ill increase 5ond &rices and lo=er yields"
%s+ $e0a(%3e (o a0(e$na(%3es
,f a 5ond 5ecoes less risky relative to alternative investents> the deand for the 5ond shifts to
the right"
L%8.%1%(' o, *on1s $e0a(%3e (o a0(e$na(%3es
@hen a 5ond 5ecoes ore li4-id relative to alternatives> the deand c-rve shifts to the right
Ta*0e: !a-(o$s (#a( %n-$ease Bon1 1e&an12 $a%se Bon1 P$%-es2 an1 0o/e$ In(e$es( a(es
C#ange E,,e-( on Bon1 1e&an1
1n increase in =ealth increases deand for all assets>
incl-ding 5onds
Bond deand shifts to the right> Bond &rices
increase and interest rates decrease
1 red-ction in ex&ected inflation akes 5onds =ith fixed
noinal &ayents ore desira5le
1n increase in ex&ected ret-rn on the 5ond relative to the
ex&ected ret-rn on alternatives akes 5onds ore
attractive
1 decrease in the ex&ected f-t-re interest rate akes
5onds ore attractive
1 fall in the riskiness of the 5ond relative to the riskiness
of alternatives akes 5onds ore attractive"
1n increase in the li4-idity of the 5ond relative to the
li4-idity of alternatives akes 5onds ore attractive
@hen 5orro=erHs desire for
f-nds increases> the 5ond
s-&&ly c-rve shifts to the right>
lo=ering 5ond &rices and
raising interest rates"
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!%g.$e: A s#%,( %n Bon1 De&an1
@hen there is an increase in
investorHs =illingness to hold
5onds> the 5ond deand c-rve
shifts to the right> increasing 5ond
&rices and red-cing interest rates"
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Lesson 16
S"I!TS IN EKUILIBIUM IN T"E BOND MAKET & ISK
Shifts in 24-ili5ri- in 5ond arket
Bond and Risk
;efa-lt Risk
,nflation Risk
,nterest Rate Risk
S#%,(s %n E8.%0%*$%.&
An %n-$ease %n e)7e-(e1 %n,0a(%on:
1n increase in ex&ected inflation shifts 5ond s-&&ly to the right and 5ond deand to the left"
The t=o effects reinforce each other> res-lting in a lo=er 5ond &rice and a higher interest rate
!%g.$e: E,,e-( o, an %n-$ease %n e)7e-(e1 %n,0a(%on
A *.s%ness=-'-0e 1o/n(.$n:
1 5-siness:cycle do=nt-rn shifts the 5ond s-&&ly to the left and the 5ond deand to the left"
,n this case the 5ond &rice can rise or fall> de&ending on =hich shift is greater"
B-t interest rates tend to fall in recessions> so 5ond &rices are likely to increase
So
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!%g.$e: E,,e-( o, a *.s%ness -'-0e 1o/n (.$n
Bon1s an1 %s+
So.$-es o, Bon1 %s+
;efa-lt Risk
,nflation Risk
,nterest:Rate Risk
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Lesson 1?
BONDS & SOUCES O! BOND ISK
Bonds and Risk
;efa-lt Risk
,nflation Risk
,nterest Rate Risk
Bond Ratings
Bond Ratings and Risk
Tax 2ffect
Bon1s an1 %s+
So.$-es o, Bon1 %s+
;efa-lt Risk
,nflation Risk
,nterest:Rate Risk
De,a.0( %s+
There is no g-arantee that a 5ond iss-er =ill ake the &roised &ayents
,nvestors =ho are risk averse re4-ire soe co&ensation for 5earing riskN the ore risk> the ore
co&ensation they deand
The higher the defa-lt risk the higher the &ro5a5ility that 5ondholders =ill not receive the
&roised &ayents and th-s> the higher the yield
S-&&ose risk:free rate is +J
W2;2G %or&" iss-es one:year 5ond at +J
Price =itho-t risk L 7K1## T K+8P1"#+ L K1##
S-&&ose there is 1#J &ro5a5ility that W2;2G %or&" goes 5ankr-&t> get nothing
T=o &ossi5le &ayoffs? K1#+ and K#
Ta*0e: E)7e-(e1 Va0.e o, JEDEX Bon1 Pa'&en(
Poss%*%0%(%es Pa'o,, P$o*a*%0%(' Pa'o,, H P$o*a*%0%(%es
F-ll Payent K1#+ #"*# K*4"+#
defa-lt K# #"1# K#
E)7e-(e1 Va0.eI S.& o, Pa'o,,s (%&es P$o*a*%0%(%es I ED4.6A
2x&ected P0 of W2;2G 5ond &ayent L K*4"+P1"#+ L K*#
,f the &roised &ayent is K1#+> 3TM =ill 5e K1#+P*# 1 L #"1((. or 1("(.J
;efa-lt risk &rei- L 1("(.J : +J L 11"(.J
In,0a(%on %s+
Bonds &roise to ake fixed:dollar &ayents> and 5ondholders are concerned a5o-t the
&-rchasing &o=er of those &ayents
The noinal interest rate =ill 5e e4-al to the real interest rate &l-s the ex&ected inflation rate &l-s
the co&ensation for inflation risk
The greater the inflation risk> the larger =ill 5e the co&ensation for it
1ss-ing real interest rate is 'J =ith the follo=ing inforation
51
P$o*a*%0%(%es
In,0a(%on Case I Case II Case III
1J #"+# #"$+ #"1#
$J : #"+# #"/#
'J #"+# #"$+ #"1#
2x&ected ,nflation $J $J $J
Standard ;eviation 1"#J #".1J #"4+J
9oinal rate L 'J real rate T $J ex&ected inflation T co&ensation for inflation risk
In(e$es(=a(e %s+
,nterest:rate risk arises fro the fact that investors donHt kno= the holding &eriod yield of a long:
ter 5ond"
,f yo- have a short investent horiIon and 5-y a long:ter 5ond yo- =ill have to sell it 5efore it
at-res> and so yo- -st =orry a5o-t =hat ha&&ens if interest rates change
Beca-se the &rice of long:ter 5onds can change draatically> this can 5e an i&ortant so-rce of
risk
Bon1 a(%ngs
The risk of defa-lt 7i"e"> that a 5ond iss-er =ill fail to ake a 5ondHs &roised &ayents8 is one of
the ost i&ortant risks a 5ondholder faces> and it varies aong iss-ers"
%redit rating agencies have coe into existence to assess the defa-lt risk of different iss-ers
The 5ond ratings are an assessent of the credit=orthiness of the cor&orate iss-er"
The definitions of credit=orthiness -sed 5y the rating agencies are 5ased on ho= likely the iss-er
fir is to defa-lt and the &rotection creditors have in the event of a defa-lt"
These ratings are concerned only =ith the &ossi5ility of the defa-lt" Since they do not address the
iss-e of interest rate risk> the &rice of a highly rated 5ond ay 5e 4-ite volatile"
Long Te$& a(%ngs *' PACA
In3es(&en( G$a1es:
AAA: Fighest credit 4-ality" b111H ratings denote the lo=est ex&ectation of credit risk"
AA: 0ery high credit 4-ality" b11H ratings denote a very lo= ex&ectation of credit risk"
A: Figh credit 4-ality" b1H ratings denote a lo= ex&ectation of credit risk"
BBB: Good credit 4-ality" bBBBH ratings indicate that there is c-rrently a lo= ex&ectation of credit
risk"
S7e-.0a(%3e G$a1es:
BB: S&ec-lative"
LBBM ratings indicate that there is a &ossi5ility of credit risk develo&ing>
B: Fighly s&ec-lative" bBH ratings indicate that significant credit risk is &resent> 5-t a liited argin
of safety reains"
CCC2 CC2 C: Figh defa-lt risk" ;efa-lt is a real &ossi5ility"
52
S#o$( Te$& a(%ngs *' PACA
A1N: highest ca&acity for tiely re&ayent
A1? Strong ca&acity for tiely re&ayent
A4? satisfactory ca&acity for tiely re&ayent ay 5e s-sce&ti5le to adverse econoic conditions
A5? an ade4-ate ca&acity for tiely re&ayent" More s-sce&ti5le to adverse econoic condition
B? tiely re&ayent is s-sce&ti5le to adverse changes in 5-siness> econoic> or financial conditions
C? an inade4-ate ca&acity to ens-re tiely re&ayent
D? high risk of defa-lt or =hich are c-rrently in defa-lt
Bon1 a(%ngs an1 %s+
Bon1 a(%ngs
MoodyHs and Standard & PoorHs
a(%ngs G$o.7s
,nvestent Grade
9on:,nvestent S&ec-lative Grade
Fighly S&ec-lative
Co&&e$-%a0 Pa7e$ a(%ngs
MoodyHs and Standard & PoorHs
a(%ng G$o.7s
,nvestent
S&ec-lative
;efa-lt
Bon1 >C$e1%(9 a(%ngs
S & P Moo1'Ms ;#a( %( &eans
111 1aa Fighest 4-ality and credit =orthiness
11 1a Slightly less likely to &ay &rinci&al T interest
1 1 Strong ca&acity to ake &ayents> -&&er edi- grades
BBB Baa Medi- grade> ade4-ate ca&acity to ake &ayents
BB Ba Moderate a5ility to &ay> s&ec-lative eleent> v-lnera5le
B B 9ot desira5le investent> long ter &ayent do-5tf-l
%%% %aa Poor standing> kno=n v-lnera5ilities> do-5tf-l &ayent
%% %a Fighly s&ec-lative> high defa-lt likelihood> kno=n reasons
% % 6o=est rated class> ost -nlikely to reach investent grades
; 1lready defa-lted on &ayents
9R 9o &-5lic rating has 5een re4-ested
T )r : &1> $> ' @ithin:class refineent of 11 to %%% ratings
The lo=er a 5ondHs rating the lo=er its &rice and the higher its yield"
53
!%g.$e: T#e e,,e-( o, an %n-$ease %n $%s+ on e8.%0%*$%.& %n (#e *on1 &a$+e(
In-$ease1 %s+ $e1.-es Bon1 De&an1
The res-lting shift to the left ca-ses a decline in e4-ili5ri- &rice and an increase in the 5ond yield"
1 5ond yield can 5e tho-ght of as the s- of t=o &arts?
The yield on the Treas-ry 5ond 7called D5enchark 5ondsE 5eca-se they are close to 5eing risk:
free8 and
1 risk s&read or defa-lt risk &rei-
,f the 5ond ratings &ro&erly reflect the &ro5a5ility of defa-lt> then lo=er the rating of the iss-er> the
higher the defa-lt risk &rei-
So =e ay concl-de that =hen Treas-ry 5ond yields change> all other yields =ill change in the sae
direction
,ncreased risk red-ces the deand for
the 5ond at every &rice> shifting the
deand c-rve to the left fro ;o to
;1" The res-lt is a decline in the
e4-ili5ri- &rice and 4-antity in the
arket" ,&ortantly> the &rice falls
fro Po to P1> so the yield on the
5ond -st rise"
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Lesson 1B
TAX E!!ECT & TEM STUCTUE O! INTEEST ATE
Tax 2ffect
Ter Str-ct-re of ,nterest Rate
2x&ectations Fy&othesis
6i4-idity Prei-
Ta) E,,e-(
The second i&ortant factor that affects the ret-rn on a 5ond is taxes
Bondholders -st &ay incoe tax on the interest incoe they receive fro &rivately iss-ed 5onds
7taxa5le 5onds8> 5-t governent 5onds are treated differently
,nterest &ayents on 5onds iss-ed 5y state and local governents> called D-nici&alE or Dtax:
exe&tE 5onds are s&ecifically exe&t fro taxation
1 tax exe&tion affects a 5ondHs yield 5eca-se it affects ho= -ch of the ret-rn the 5ondholder
gets to kee&
Tax:2xe&t Bond 3ield L 7Taxa5le Bond 3ield8 x 71: Tax Rate8"
Te$& S($.-(.$e o, In(e$es( a(es
The relationshi& aong 5onds =ith the sae risk characteristics 5-t different at-rities is called
the ter str-ct-re of interest rates"
1 &lot of the ter str-ct-re> =ith the yield to at-rity on the vertical axis and the tie to at-rity
on the horiIontal axis> is called the yield c-rve"
!%g.$e: T#e U.S. T$eas.$' Y%e01 C.$3e
The fig-re &lots the
yields on Treas-ry
5ills and 5onds for
1-g-st $.> $##4"
0 6 2 1 3 5 10 30
1(0
2(0
3(0
4(0
5(0
6(0@
DDDDDDDD Matuit&DDDDDDDD
B
=
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s

a
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3

E
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DDDBeste3a&
DDD1 mont* ago
DDD1 &ea ago
Mont *s Beas
55
!%g.$e: T#e Te$& S($.-(.$e o, T$eas.$' In(e$es( a(es
Te$& S($.-(.$e O!a-(sP
,nterest Rates of different at-rities tend to ove together
3ields on short:ter 5ond are ore volatile than yields on long:ter 5onds
6ong:ter yields tend to 5e higher than short:ter yields"
E)7e-(a(%ons "'7o(#es%s
The risk:free interest rate can 5e co&-ted> ass-ing that there is no -ncertainty a5o-t the f-t-re
Since certainty eans that 5onds of different at-rities are &erfect s-5stit-tes for each other> an
investor =o-ld 5e indifferent 5et=een holding
1 t=o:year 5ond or
1 series of t=o one:year 5onds
%ertainty eans that 5onds of different at-rities are &erfect s-5stit-tes for each other
1ss-ing that c-rrent 1:year interest rate is +J" The ex&ectations hy&othesis i&lies that the
c-rrent $:year interest rate sho-ld e4-al the average of +J and 1:year interest rate one year in
f-t-re"
,f f-t-re interest rate is .J> then c-rrent $:year interest rate =ill 5e 7+T.8 P $ L (J
Therefore> =hen interest rates are ex&ected to rise long:ter rates =ill 5e higher than short:ter
rates and the yield c-rve =ill slo&e -& 7and vice versa8
1197
5
1979 1983 1987 1991
4

0
8
10
2
12
14
1995 1999 2003 1971
6
16
18
B
i
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3

5
@
6
DDD3 mont*s =(7illsDDDDD10 &eas =-7on3s
56
!%g.$e: Y%e01 C.$3e
Fro this =e can constr-ct investent strategies that -st have the sae yield"
1ss-ing the investor has a t=o:year horiIon> the investor can?
,nvest in a t=o:year 5ond and hold it to at-rity
,nterest rate =ill 5e i
$y
,nvestent =ill yield 71 T i
$y
8 71 T i
$y
8 t=o years later
,nvest in a one:year 5ond today and a second one a year fro no= =hen the first one at-res
,nterest rate =ill 5e i
e
yT1
,nvestent =ill yield 71 T i
1y
8 71 T i
e
yT1
8 in t=o years
The hy&othesis tells -s that investors =ill 5e indifferent 5et=een the t=o strategies> so the strategies
-st have the sae ret-rn
Total ret-rn fro $ year 5onds over $ years
Ret-rn fro one year 5ond and then another one year 5ond
,f one and t=o year 5onds are &erfect s-5stit-tes> then?
)r
=ime to matuit&
F
G
H
I
J
L
M
N
O
L
P
Q
G
L
R
Biel3 cuve 1*en inteest ates ae eApecte3 to
ise
57
6 i 651 i 51
2& 2&
+ +
6 651 i 51 6 i 651 i 51
e
1& 1& 2& 2&
+ + = + +
2
i i
i
2
1& 1&
2&
+
=
6 i 651 i 51
e
1& 1&
+ +
)r in general ters
Therefore the rate on the t=o:year 5ond -st 5e the average of the c-rrent one:year rate and the
ex&ected f-t-re one:year rate
,&lications =o-ld 5e the sae old
,nterest rates of different at-rities tend to ove together"
3ields on short:ter 5onds are ore volatile than those on long:ter 5onds"
6ong:ter yields tend to 5e higher than short:ter yields
Fo=ever> ex&ectations theory can not ex&lain =hy long:ter rates are -s-ally a5ove short ter
rates
,n order to ex&lain =hy the yield c-rve norally slo&es -&=ard> =e need to extend the hy&othesis
to incl-de risk
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1 1 2 1 1 1 1
((((
+ + +
+ + + +
=
Lesson 1C
T"E LIKUIDITY PEMIUM T"EOY
Bonds
6i4-idity Prei- Theory
Stocks
2ssential %haracteristics
Process
Meas-ring 6evel of a Stock Market
0al-ing Stocks
T#e L%8.%1%(' P$e&%.& T#eo$'
Risk is the key to -nderstanding the slo&e of the yield c-rve
The yield c-rveHs -&=ard slo&e is d-e to long:ter 5onds 5eing riskier than short:ter 5onds
Bondholders face 5oth inflation and interest:rate" The longer the ter the greater the inflation
and interest:rate risk
,nflation risk increases over tie 5eca-se investors> =ho care a5o-t the real ret-rn> -st
forecast inflation over longer &eriods"
,nterest:rate risk arises =hen an investorHs horiIon and the 5ondHs at-rity do not atch" ,f
holders of long:ter 5onds need to sell the 5efore at-rity and interest rates have increased>
the 5onds =ill lose val-e
,ncl-ding risk in the odel eans that =e can think of yield as having t=o &arts?
Risk:free and
Risk &rei-
!%g.$e: e0a(%ons#%7 *e(/een (#e L%8.%1%(' P$e&%.& an1 E)7e-(a(%ons T#eo$%es
Risk premium Pure expectations theory
=ime to matuit&
S
T
L
H
Q
H
U
L
Q
O
L
H
:Apectations =*eo& Biel3 cuve
."( s!$rt term interest rates are e)/e&te# t$ remain
&$nstant0
2iVui3it&
pemium
2iVui3it& "emium =*eo& Biel3 cuve
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n
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e
n t
e
t
e
t t
n nt
1 1 2 1 1 1 1
((((
+ + +
+ + + +
+ =
1gain> =e arrive at the sae three concl-sions a5o-t the ter str-ct-re of interest rates
,nterest rates of different at-rities tend to ove together"
3ields on short:ter 5onds are ore volatile than those on long:ter 5onds"
6ong:ter yields tend to 5e higher than short:ter yields
S(o-+s: An In($o1.-(%on
Stocks &rovide a key instr-ent for holding &ersonal =ealth as =ell as a =ay to diversify> s&reading
and red-cing the risks that =e face
For co&anies> they are one of several =ays to o5tain financing"
1dditionally>
Stocks and stock arkets are one of the central links 5et=een the financial =orld and the real
econoy"
Stock &rices are f-ndaental to the f-nctioning of a arket:5ased econoy
They indicate the val-e of the co&anies that iss-ed the stocks and>
They allocate scarce investent reso-rces
The firs deeed ost val-a5le in the arket&lace for stocks are the ones that =ill 5e a5le to
o5tain financing for gro=th" @hen reso-rces flo= to their ost val-ed -ses> the econoy o&erates
ore efficiently
Most &eo&le see stock arket as a &lace =here fort-nes are easily ade or lost> and they recoil at its
-nfathoa5le 5oos and 5-sts"
Great 1erican ;e&ression 71*$*8
Post:Se&te5er 11> $##1 scenario
Pakistan stock arket on roller:coaster:ride 7March $##+8
@hat ha&&ens in realityA
Stock &rices tend to rise steadily and slo=ly> and
%olla&se rarely =hen noral arket echaniss are o-t of alignent
For ost &eo&le the ex&erience of losing or gaining =ealth s-ddenly is ore eora5le than the
ex&erience of aking it grad-ally"
By 5eing &reocc-&ied =ith the &otential short:ter losses associated =ith crashes> =e lose sight of
the gains =e co-ld realiIe if =e took a longer:ter vie=
Essen(%a0 C#a$a-(e$%s(%-s o, Co&&on S(o-+
Stocks> also kno=n as coon stock or e4-ity> are shares in a firHs o=nershi&
Fro their early days> stocks had t=o i&ortant characteristics that today are taken for granted?
The shares are iss-ed in sall denoinations and
The shares are transfera5le
Cntil recently> stocko=ners received a certificate fro the iss-ing co&any> 5-t no= it is a
co&-teriIed &rocess =here the shares are registered in the naes of 5rokerage firs that hold
the on the o=nerHs 5ehalf
The o=nershi& of coon stock conveys a n-5er of rights
1 stockholder is entitled to &artici&ate in the shares of the enter&rise> 5-t this is a resid-al clai i"e"
eaning the leftovers after all other creditors have 5een &aid"
Stockholders also have liited lia5ility>
2ven if a co&any fails> the axi- ao-nt that the stockholder can lose is the initial
investent
Stockholders are entitled to vote at the firHs ann-al eeting incl-ding voting to elect 7or reove8
the firHs 5oard of directors
Follo=ing are soe salient feat-res of stock trading
1. 1n individ-al share re&resents only a sall fraction of the val-e of the co&any that iss-ed
it
4. 1 large n-5er of shares are o-tstanding
60
5. Prices of individ-al shares are lo=> allo=ing individ-als to ake relatively sall
investents
4. 1s resid-al claiants> stockholders receive the &roceeds of a firHs activities only after all
other creditors have 5een &aid
6. Beca-se of liited lia5ility> investorHs losses cannot exceed the &rice they &aid for the
stockN and
?. Shareholders can re&lace anagers =ho are doing a 5ad Ro5
Meas.$%ng (#e Le3e0 o, (#e S(o-+ Ma$+e(
Stocks are one =ay in =hich =e choose to hold o-r =ealth> so =hen stock val-es rise =e get richer
and =hen they fall =e get &oorer
These changes affect o-r cons-&tion and saving &atterns> ca-sing general econoic activity to
fl-ct-ate
@e need to -nderstand the dynaics of the stock arket> in order to
Manage o-r &ersonal finances and
See the connections 5et=een stock val-es and econoic conditions
Stock arket indexes
;esigned to give -s a sense of the extent to =hich stock &rices are going -& or do=n
Tell -s 5oth ho= -ch the val-e of an average stock has changed> and ho= -ch total =ealth has
gone -& or do=n
Provide 5encharks for &erforance of oney anagers> co&aring ho= they have done to the
arket as a =hole
2very aRor co-ntry in the =orld has a stock arket> and each of these arkets has an index
For the ost &art> these are val-e:=eighted indices
To analyIe the &erforance of these different arkets it is -sef-l to look at &ercentage changes>
5-t &ercentage change isnHt everything
The ;o= Oones ,nd-strial 1verage
The Standard & Poor<s +## ,ndex
91S;1c %o&osite index
Financial Ties Stock 2xchange 1## ,ndex
Fang Seng 1##
9ikkei $$+
VS2 1## ,ndex
The VS21##
,t contains a re&resentative sa&le of coon stock that trade on the Varachi Stock 2xchange"
The VS2 stocks that co&rise the index have a total arket val-e of aro-nd Rs" 1>1*. Billion
co&ared to total arket val-e of Rs" 1>'(+ Billion for over (.* stocks listed on the Varachi Stock
2xchange"
This eans that the VS21## ,ndex re&resents // &ercent of the total arket ca&italiIation of the
Varachi Stock 2xchange> as of Fe5r-ary> $##4
61
Lesson 1D
VALUING STOCKS
0al-ing Stocks
F-ndaental 0al-e and ;ividend ;isco-nt Model
Risk and 0al-e of Stocks
Va0.%ng S(o-+s
Peo&le differ in their o&inions of ho= stocks sho-ld 5e val-ed
%hartists 5elieve that they can &redict changes in a stockHs &rice 5y looking at &atterns in its &ast
&rice oveents
Behavioralists estiate the val-e of stocks 5ased on their &erce&tions of investor &sychology and
5ehavior
)thers estiate stock val-es 5ased on a detailed st-dy of the f-ndaentals> =hich can 5e analyIed
5y exaining the firHs financial stateents"
,n this vie= the val-e of a firHs stock de&ends 5oth on its c-rrent assets and estiates of its f-t-re
&rofita5ility
The f-ndaental val-e of stocks can 5e fo-nd 5y -sing the &resent val-e for-la to assess ho=
-ch the &roised &ayents are =orth> and then adR-sting to allo= for risk
%hartists and Behavioralists foc-s instead on estiates of the deviation of stock &rices fro those
f-ndaental val-es
!.n1a&en(a0 Va0.e an1 (#e D%3%1en1=D%s-o.n( Mo1e0
1s =ith all financial instr-ents> a stock re&resents a &roise to ake onetary &ayents on
f-t-re dates> -nder certain circ-stances
@ith stocks the &ayents are in the for of dividends> or distri5-tions of the firHs &rofits
The &rice of a stock today is e4-al to the &resent val-e of the &ayents the investor =ill receive
fro holding the stock
This is e4-al to
The selling &rice of the stock in one yearHs tie &l-s
The dividend &ayent received in the interi
Th-s the c-rrent &rice is the &resent val-e of next yearHs &rice &l-s the dividend
,f P
today
is the &-rchase &rice of stock> P
next year
is the sales &rice one year later and ;
next year
is the siIe
of the dividend &ayent> =e can say?
@hat if investor &lans to hold stock for t=o yearsA
GeneraliIing for n years?
Next year year next
today
i
P
i
D
P
6 1 5 6 1 5 +
+
+
=
In two
year next
today
i
P
i
D
P
6
2
1 5 6 1 5
+
+
+
=
In two
i
D
6
2
1 5
+
+
62
n
now from year n
n
now from year n
year two in year next
today
i
P
i
D
i
D
i
D
P
6 1 5 6 1 5
(((((
6 1 5 6 1 5
D D D D D D
2
D D D
+
+
+
+ +
+
+
+
=
,f a stock does not &ay dividends the calc-lation can still 5e &erforedN a val-e of Iero is -sed for
the dividend &ayents
F-t-re dividend &ayents can 5e estiated ass-ing that c-rrent dividends =ill gro= at a constant
rate of g &er year"
For -lti&le &eriods?
Price e4-ation can no= 5e re:=ritten as?
1ss-ing that the fir &ays dividends forever solves the &ro5le of kno=ing the selling &rice of
the stockN the ass-&tion allo=s -s to treat the stock as =e did a consol
This relationshi& is the dividend disco-nt odel
The odel tells -s that stock &rice sho-ld 5e high =hen
;ividends are high
;ividend gro=th is ra&id> or
,nterest rate is lo=
;#' s(o-+s a$e $%s+'<
Stockholders receive &rofits only after the fir has &aid everyone else> incl-ding 5ondholders
,t is as if the stockholders 5o-ght the fir 5y &-tting -& soe of their o=n =ealth and 5orro=ing
the rest
This 5orro=ing creates leverage> and leverage creates risk
,agine a soft=are 5-siness that needs only one co&-ter costing K1>### and &-rchase can 5e
financed 5y any co5ination of stocks 7e4-ity8 and 5onds 7de5t8" ,nterest rate on 5onds is 1#J"
%o&any earns K1(# in good years and K/# in 5ad years =ith e4-al &ro5a5ility
1 5
!
D D
today
n year from now
+
= 6
n
63
6 1 5
D
! D D
today year next
+ =
n
now from year n
n
n
today
today today
today
i
P
i
! D
i
! D
i
! D
P
6 1 5 6 1 5
6 1 5
(((((
6 1 5
6 1 5
6 1 5
6 1 5
D D D
2
2
+
+
+
+
+ +
+
+
+
+
+
=
! i
D
P
today
today
=
Ta*0e: e(.$ns 1%s($%*.(e1 (o 1e*( an1 e8.%(' #o01e$s .n1e$ 1%,,e$en( ,%nan-%ng ass.&7(%ons
Pe$-en(
E8.%(' >G9
Pe$-en(
De*( >G9
e8.%$e1
7a'&en(s on
1AG *on1s
Pa'&en( (o
e8.%('
#o01e$s
E8.%('
e(.$n >G9
E)7e-(e1
E8.%('
e(.$n >G9
S(. De3. o,
E8.%(' e(.$n
1##J # # K/#:1(# /:1(J 1$J 4J
+#J +#J K+# K'#:11# (:$$J 14J /J
'#J .#J K.# K1#:*# '"':'#J 1("(.J 1'"'J
$#J /#J K/# K#:/# #:4#J $#J $#J
,f the fir =ere only 1#J e4-ity financed> shareholdersH lia5ility co-ld coe into &lay"
,ss-ing K*## =orth of 5onds eans K*# for interest &ayents"
,f the 5-siness t-rned o-t to 5e 5ad> the K/# reven-e =o-ld not 5e eno-gh to &ay the interest
@itho-t their liited lia5ility> stockholders =ill 5e lia5le for K1# shortfall" B-t act-ally> they =ill lose
only K1## investent and not ore and the fir goes 5ankr-&t"
Stocks are risky 5eca-se the shareholders are resid-al claiants" Since they are &aid last> they never
kno= for s-re ho= -ch their ret-rn =ill 5e"
1ny variation in the firHs reven-e flo=s thro-gh to stockholders dollar for dollar> aking their
ret-rns highly volatile
64
Lesson 4A
ISK AND VALUE O! STOCKS
Stocks
Risk and the 0al-e of Stocks
Theory of 2fficient Markets
,nvesting in Stocks for 6ong R-n
Stock MarketsH Role in the 2conoy
Financial ,nterediation
Role of Financial ,nterediaries
%s+ an1 3a0.e o, s(o-+s
The dividend:disco-nt odel -st 5e adR-sted to incl-de co&ensation for a stockHs risk
Ret-rn to Folding Stock for )ne 3ear L
Since the -ltiate f-t-re sale &rice is -nkno=n the stock is risky>
The investor =ill re4-ire co&ensation in the for of a risk &rei-
Re4-ired Stock Ret-rn 7i8 L Risk:free Ret-rn 7r
f
8 T Risk Prei- 7r
&
8
The risk:free rate can 5e tho-ght of as the interest rate on a treas-ry sec-rity =ith a at-rity of
several onths
)-r dividend disco-nt odel 5ecoes?
%s+ an1 3a0.e o, s(o-+s
Stock Prices are high =hen
%-rrent dividends are high 7;
today
is high8
;ividends are ex&ected to gro= 4-ickly 7g is high8
The risk:free rate is lo= 7r
f
is lo=8
The risk &rei- on e4-ity is lo= 7r
&
is lo=8
The S&P +## index finished the year $##' at R-st over 1>1##" =as this level =arranted 5y
f-ndaentalsA
Risk free real interest rate is a5o-t $J or r
f
L #"#$
Risk &rei- is ass-ed to 5e 4J or r
&
L #"#4
;ividend gro=th rate is aro-nd $J or g L #"#$
The o=ner of a K1>### &ortfolio =o-ld have received K'# in dividends d-ring $##'
S-5stit-ting the inforation in o-r adR-sted dividend disco-nt odel?
B-t the act-al stock &rices =ere s-5stantially higher than this calc-lated fig-re
This ay 5e d-e to =rong ass-&tion on risk &rei-" The investors ay have 5een deanding
lo=er risk &rei- in $##'"
To co&-te it> =e -se the sae e4-ation
0.0" 0.04 0.0"
;30
P
today
+
=
= ;750
65
today
today year next
today
year next
P
P P
P
D
+
D D
! rp rf
D
P
today
today
+
=
The ans=er is a&&roxiately $".+J
T#e T#eo$' o, E,,%-%en( Ma$+e(s
The 5asis for the theory of efficient arkets is the notion that the &rices of all financial
instr-ents> incl-ding stocks> reflect all availa5le inforation
1s a res-lt> arkets adR-st iediately and contin-o-sly to changes in f-ndaental val-es
@hen arkets are efficient> the &rices at =hich stocks c-rrently trade reflect all availa5le
inforation> so that f-t-re &rice oveents are -n&redicta5le"
,f the theory is correct then no one can consistently 5eat the arket averageN active &ortfolio
anageent =ill not yield a ret-rn that is higher than that of a 5road stock:arket index
,f anagers clai to exceed the arket average year after year> it ay 5e 5eca-se
They -st 5e taking on risk>
They are l-cky>
They have &rivate inforation 7=hich is illegal8> or
Markets are not efficient
In3es(%ng %n S(o-+s ,o$ (#e Long .n
Stocks a&&ear to 5e risky> and yet any &eo&le hold s-5stantial &ro&ortions of their =ealth in the
for of stock
This is d-e to the difference 5et=een the short ter and the long terN
,nvesting in stocks is risky only if yo- hold the for a short tie
,n fact> =hen held for the long ter> stocks are less risky than 5onds"
!%g.$e: S&P 1=Yea$ S(o-+ e(.$ns2 1CB1 (o 4AA5>e(.$ns a$e ea02 A1Q.s(e1 ,o$ In,0a(%on .s%ng (#e
CPI9
0.0" r
p
50.0"
;30
1910
0

+
=
1883
1895 1 1 1931
-40
0
20
-60
40

60
1943 1955 1967 1
-20

5
@
6

a
g
e

c
*
a
n
g
e
1 1991 2
Beas
66
!%g.$e: S&P Long=.n S(o-+ e(.$ns2 1CB1 (o 4AA5>e(.$ns a$e ea02 a1Q.s(e1 ,o$ %n,0a(%on .s%ng
(#e CPI9
T#e S(o-+ Ma$+e(Ms o0e %n (#e E-ono&'
The stock arket &lays a cr-cial role in every odern ca&italist econoy"
The &rices deterined there tell -s the arket val-e of co&anies> =hich deterines the allocation
of reso-rces"
Firs =ith a high stock arket val-e are the ones investorsH &riIe> so they have an easier tie
garnering the reso-rces they need to gro="
,n contrast> firs =hose stock val-e is lo= have diffic-lty financing their o&erations
So long as stock &rices acc-rately reflect f-ndaental val-es> this reso-rce allocation echanis
=orks =ell"
1t ties> ho=ever> stock &rices deviate significantly fro the f-ndaentals and &rices ove in
=ays that are diffic-lt to attri5-te to changes in the real interest rate> the risk &rei-> or the
gro=th rate of f-t-re dividends"
T#e S(o-+ Ma$+e(Ms o0e %n (#e E-ono&'
Shifts in investor &sychology ay distort &ricesN 5oth e-&horia and de&ression are contagio-s
@hen investors 5ecoe -nR-stifia5ly ex-5erant a5o-t the arketHs f-t-re &ros&ects> &rices rise
regardless of the f-ndaentals> and s-ch ass enth-sias creates 5-55les"
B.**0es
B-55les are &ersistent and ex&anding ga&s 5et=een act-al stock &rices and those =arranted 5y the
f-ndaentals"
These 5-55les inevita5ly 5-rst> creating crashes"
They affect all of -s 5eca-se they distort the econoic decisions co&anies and cons-ers ake
,f 5-55les res-lt in real investent that is 5oth excessive and inefficiently distri5-ted> crashes do
the o&&ositeN the shift to excessive &essiis ca-ses a colla&se in investent and econoic gro=th
@hen 5-55les gro= large eno-gh and res-lt in crashes the stock arket can desta5iliIe the real
econoy
1188
3
1895 1 1 1931
-40
0
20
-60
40

60
1943 1955 1967 1
-20

5
@
6

a
g
e

c
*
a
n
g
e
9

?
n
n
u
a
l

#
a
t
e
DDDD1-Bea #etuns DDDD25 &ea #etuns
1 1991 2
67
!%nan-%a0 In(e$&e1%a(%on
2conoic =ell:5eing is essentially tied to the health of the financial interediaries that ake -& the
financial syste"
@e kno= that financial interediaries are the 5-sinesses =hose assets and lia5ilities are &riarily
financial instr-ents"
0ario-s sorts of 5anks> 5rokerage firs> investent co&anies> ins-rance co&anies> and &ension
f-nds all fall into this category"
These are the instit-tions that &ool f-nds fro &eo&le and firs =ho save and lend the to &eo&le
and firs =ho need to 5orro=
Financial interediaries f-nnel savers< s-r&l-s reso-rces into hoe ortgages> 5-siness loans> and
investents"
They are involved in 5oth
;irect financeSin =hich 5orro=ers sell sec-rities directly to lenders in the financial arkets
,ndirect financeSin =hich a third &arty stands 5et=een those =ho &rovide f-nds and those =ho
-se the
,nterediaries investigate the financial condition of the individ-als and firs =ho =ant financing
to fig-re o-t =hich have the 5est investent o&&ort-nities"
1s &roviders of indirect finance> 5anks =ant to ake loans only to the highest:4-ality 5orro=ers"
@hen they do their Ro5 correctly> financial interediaries increase investent and econoic gro=th
at the sae tie that they red-ce investent risk and econoic volatility
o0e o, !%nan-%a0 In(e$&e1%a$%es
1s a general r-le> indirect finance thro-gh financial interediaries is -ch ore i&ortant than
direct finance thro-gh the stock and 5ond arkets
,n virt-ally every co-ntry for =hich =e have co&rehensive data> credit extended 5y financial
interediaries is larger as a &ercentage of G;P than stocks and 5onds co5ined
1ro-nd the =orld> firs and individ-als dra= their financing &riarily fro 5anks and other
financial interediaries
The reason for this is inforationN
O-st think of an online store
3o- can 5-y virt-ally 202R3TF,9G fro K+ dinner &lates to K'##>### s&orts car
B-t yo- =ill notice an a5sence of financial &rod-cts> like st-dent loans> car loans> credit cards or
hoe ortgages
3o- can not 5onds on =hich iss-er is still aking &ayents> nor can yo- have the services of
checking acco-nt"
@hy s-ch online store does not deal in ortgagesA
S-&&ose a co&any needs a ortgage of K1##>### and the store can 7if at all8 esta5lish a syste in
=hich 1## &eo&le sign -& to lend K1>### each to the co&any
B-t the store has to do ore
%ollecting the &ayents
Fig-ring o-t ho= to re&ay the lenders
@riting legal contracts
2val-ating the credit=orthiness of the co&any and feasi5ility of the ortgaged &roRect
%an it do it allA
Financial interediaries exist so that individ-al lenders donHt have to =orry a5o-t getting ans=ers
to all of the i&ortant 4-estions concerning a loan and a 5orro=er
6ending and 5orro=ing involve transactions costs and inforation costs> and financial
interediaries exist to red-ce these costs
Financial interediaries &erfor five f-nctions?
1. They &ool the reso-rces of sall saversN
4. They &rovide safekee&ing and acco-nting services as =ell as access to the &ayents
systeN
5. They s-&&ly li4-idityN
4. They &rovide =ays to diversify riskN and
6. They collect and &rocess inforation in =ays that red-ce inforation costs
68
Lesson 41
OLE O! !INANCIAL INTEMEDIAIES
Role of Financial ,nterediaries?
Pool Savings
Safekee&ing> acco-nting services and access to the &ayents syste
6i4-idity
Risk diversification
,nforation Services
o0e o, !%nan-%a0 In(e$&e1%a$%es
1s a general r-le> indirect finance thro-gh financial interediaries is -ch ore i&ortant than
direct finance thro-gh the stock and 5ond arkets
,n virt-ally every co-ntry for =hich =e have co&rehensive data> credit extended 5y financial
interediaries is larger as a &ercentage of G;P than stocks and 5onds co5ined
1ro-nd the =orld> firs and individ-als dra= their financing &riarily fro 5anks and other
financial interediaries
The reason for this is inforationN
Financial interediaries exist so that individ-al lenders donHt have to =orry a5o-t getting ans=ers
to all of the i&ortant 4-estions concerning a loan and a 5orro=er
6ending and 5orro=ing involve transactions costs and inforation costs> and financial
interediaries exist to red-ce these costs
Financial interediaries &erfor five f-nctions?
They &ool the reso-rces of sall saversN
They &rovide safekee&ing and acco-nting services as =ell as access to the &ayents systeN
They s-&&ly li4-idityN
They &rovide =ays to diversify riskN and
They collect and &rocess inforation in =ays that red-ce inforation costs
,nternational 5anks handle transactions that cross 5orders> =hich ay ean converting c-rrencies
Taking de&osits fro savers in one co-ntry and &roviding the to investors in another co-ntry
%onverting c-rrencies to facilitate transactions for c-stoers =ho do 5-siness or travel
Poo0%ng Sa3%ngs
The ost straightfor=ard econoic f-nction of a financial interediary is to &ool the reso-rces of
any sall savers
To s-cceed in this endeavor the interediary -st attract s-5stantial n-5ers of savers
This is the essence of indirect finance> and it eans convincing &otential de&ositors of the
so-ndness of the instit-tion
Banks rely on their re&-tations and governent g-arantees like de&osit ins-rance to ake s-re
c-stoers feel that their f-nds =ill 5e safe
Sa,e+ee7%ng2 Pa'&en(s S's(e& A--ess2 an1 A--o.n(%ng
Goldsiths =ere the original 5ankersN
Peo&le asked the goldsiths to store gold in their va-lts in ret-rn for a recei&t to &rove it =as there
Peo&le soon realiIed that trading the recei&ts =as easier than trading the gold itself"
2vent-ally the goldsiths noticed that there =as gold left in the va-lts at the end of the day> so it
co-ld safely 5e lent to others
Today> 5anks are the &laces =here =e &-t things for safekee&ingN
@e de&osit o-r &aychecks and entr-st o-r savings to a 5ank or other financial instit-tion 5eca-se
=e 5elieve it =ill kee& o-r reso-rces safe -ntil =e need the
Banks also &rovide other services> like 1TMs> check5ooks> and onthly stateents> giving &eo&le
access to the &ayents syste
Financial interediaries also red-ce the cost of transactions and so &roote s&ecialiIation and
trade> hel&ing the econoy to f-nction ore efficiently"
69
1ccording to the &rinci&le of co&arative advantage> &eo&le and co&anies concentrate on the
activities
1t =hich they are the 5est and
For =hich their o&&ort-nity cost is lo=er
This leads to s&ecialiIation in a &artic-lar activity
More s&ecialiIation LM ore trading LM ore financial transaction LM calls for lo= cost of
transaction
The 5ookkee&ing and acco-nting services that financial interediaries &rovide hel& -s to anage
o-r finances
Pay:%he4-es
Fo-se:rents
Ctility 5ills
6oan &ayents
Food clothing and other ex&enses
Savings and retireent &lans
Providing safekee&ing and acco-nting services as =ell as access to the &ayents syste forces
financial interediaries to =rite legal contracts> =hich are standardiIed
M-ch of =hat financial interediaries do takes advantage of econoies of scale>
The average cost of &rod-cing a good or service falls as the 4-antity &rod-ced increases
,nforation is also s-5Rect to econoies of scale
70
Lesson 44
OLE O! !INANCIAL INTEMEDIAIES >CONTINUED9
Role of Financial ,nterediaries 7cont8
6i4-idityN
Risk diversification
,nforation Services
,nforation 1syetry and ,nforation %osts
1dverse Selection
Moral FaIards
P$o3%1%ng L%8.%1%('
6i4-idity is a eas-re of the ease and cost =ith =hich an asset can 5e t-rned into a eans of
&ayent
Financial interediaries offer -s the a5ility to transfor assets into oney at relatively lo= cost
71TMs are an exa&le8
Financial interediaries &rovide li4-idity in a =ay that is efficient and 5eneficial to all of -s
By collecting f-nds fro a large n-5er of sall investors> a 5ank can red-ce the cost of their
co5ined investent> offering the individ-al investor 5oth li4-idity and high rates of ret-rn
Financial interediaries offer de&ositors soething they canHt get fro financial arkets on their
o=n
Financial interediaries offer 5oth individ-als and 5-sinesses lines of credit> =hich are &re:
a&&roved loans that can 5e dra=n on =henever a c-stoer needs f-nds
D%3e$s%,'%ng %s+
Financial interediaries ena5le -s to diversify o-r investents and red-ce risk
@hile investing> donHt &-t all yo-r eggs in one 5asket
P-tting K1 in 1## stocks is 5etter than investing K1## in R-st one stock
Financial instit-tions ena5le -s to diversify o-r investent and red-ce risk"
Banks itigate risk 5y taking de&osits fro a large n-5er of individ-als and ake tho-sands of
loans =ith the> th-s giving each de&ositor a sall stake in each of the loans
Bank ay collect K1>### fro each of one illion de&ositors and then -se K1 5illion to ake
1#>### loans of K1##>### each
Th-s each has a 1P1>###>### share in each of the 1#>### loans" This is diversificationQ
1nd since 5ank are ex&ert at this gae> it can iniiIe the cost of all s-ch transactions
1ll financial interediaries &rovide a lo=:cost =ay for individ-als to diversify their investents
M-t-al f-nds
In,o$&a(%on Se$3%-es
)ne of the 5iggest &ro5les individ-al savers face is fig-ring o-t =hich &otential 5orro=ers are
tr-st=orthy and =hich are not
There is an inforation asyetry 5eca-se the 5orro=er kno=s =hether or not he or she is
tr-st=orthy> 5-t the lender faces s-5stantial costs to o5tain the sae inforation
Financial interediaries red-ce the &ro5les created 5y inforation asyetries 5y collecting and
&rocessing standardiIed inforation
Screen loan a&&lications to g-arantee the credit=orthiness
Monitor loan reci&ients to ens-re &ro&er -sage of f-nds
In,o$&a(%on As'&&e($%es an1 In,o$&a(%on Cos(s
,nforation &lays a central role in the str-ct-re of financial arkets and financial instit-tions
Markets re4-ire so&histicated inforation in order to =ork =ell> and =hen the cost of o5taining
inforation is too high> arkets cease to f-nction
71
As'&&e($%- %n,o$&a(%on
,ss-ers of financial instr-ents 5orro=ers =ho =ant to iss-e 5onds and firs that =ant to iss-e
stock kno= -ch ore a5o-t their 5-siness &ros&ects and their =illingness to =ork than
&otential lenders or investors
Solving this &ro5le is one key to aking o-r financial syste =ork as =ell as it does
6ets take -& o-r online store exa&le
B-yers -st 5elieve that ite has 5een descri5ed acc-rately and they -st 5e s-re that the seller
=ill send the ite in exchange for their &ayent
Fere sellers have -ch ore inforation than 5-yers have> creating an inforation asyetry
To resolve this iss-e>
,nd-ct an ins-rance syste
;evise an inforation syste collecting data of &-rchases and delivery
1syetric inforation &oses t=o o5stacles to the sooth flo= of f-nds fro savers to investors?
1dverse selection> : involves 5eing a5le to disting-ish good credit risks fro 5ad 5efore the
transactionN
Moral haIard> : arises after the transaction and involves finding o-t =hether 5orro=ers =ill -se the
&roceeds of a loan as they clai they =ill"
A13e$se Se0e-(%on
Potential 5orro=ers kno= ore a5o-t the &roRects they =ish to finance than &ros&ective lenders
Use1 Ca$s an1 (#e Ma$+e( ,o$ Le&ons:
,n a arket in =hich there are good cars 7D&eachesE8 and 5ad cars 7DleonsE8 for sale> 5-yers are
=illing to &ay only the average val-e of all the cars in the arket"
This is less than the sellers of the D&eachesE =ant> so those cars disa&&ear fro the arkets and
only the DleonsE are left
To solve this &ro5le ca-sed 5y asyetric inforation> co&anies like %ons-er Re&orts
&rovide inforation a5o-t the relia5ility and safety of different odels> and car dealers =ill certify
the -sed cars they sell
A13e$se Se0e-(%on %n !%nan-%a0 Ma$+e(s:
,nforation asyetries can drive good stocks and 5onds o-t of the financial arket
,f yo- canHt tell the difference 5et=een a fir =ith a good &ros&ects and a fir =ith 5ad &ros&ects>
yo- =ill 5e =illing to &ay a &rice 5ased only on their average 4-alities
The stocks of the good co&any =ill 5e -nderval-ed so the angers of these co&anies =ill kee&
the stocks a=ay fro the arket
This leaves only the firs =ith 5ad &ros&ects in the arket
The sae ha&&ens in the 5ond arket
,f a lender can not tell =hether a 5orro=er is a good or a 5ad credit risk> the deand for a risk
&rei- =ill 5e 5ased on the average risk
Borro=ers having good credit risk =ill not &ay higher risk &rei-s and =o-ld =ithdra= fro the
arket
)nly 5ad credit risk 5onds are left in the arket
So03%ng (#e A13e$se Se0e-(%on P$o*0e&:
The adverse selection &ro5le res-lting in good investents not to 5e -ndertaken> the econoy
=ill not gro= as ra&idly as it co-ld"
So there -st 5e soe =ay of disting-ishing good firs fro the 5ad ones
;isclos-re of ,nforation
%ollateral and 9et @orth
D%s-0os.$e o, In,o$&a(%on:
Generating ore inforation is one o5vio-s =ay to solve the &ro5le created 5y asyetric
inforation
This can 5e done thro-gh governent re4-ired disclos-re and the &rivate collection and
&rod-ction of inforation
2"g" Sec-rities and 2xchange %oission reg-lations
Re&orts fro &rivate so-rces s-ch as rating agencies> 5rokerage co&anies and financial analysts
The cost and credi5ility of s-ch inforation are to 5e ke&t in ind
72
Co00a(e$a0 an1 Ne( ;o$(#:
%ollateral is soething of a val-e &ledged 5y a 5orro=er to the lender in the event of 5orro=erHs
defa-lt
6enders can 5e co&ensated even if 5orro=ers defa-lt> and if the loan is so ins-red then the
5orro=er is not a 5ad credit risk
9et =orth is the o=nerHs stake in the fir> the val-e of the fir in-s the vale of its lia5ilities
,f a fir defa-lts on loan> the lender can ake a clai against the firHs net =orth
The sae is tr-e for hoe loans
The i&ortance of net =orth in red-cing adverse selection is the reason o=ners of ne= 5-sinesses
have so -ch diffic-lty 5orro=ing oney
Mo$a0 "aFa$1s
Moral haIard arises =hen =e cannot o5serve &eo&leHs actions> and so cannot R-dge =hether a &oor
o-tcoe =as intentional or R-st a res-lt of 5ad l-ck
Moral FaIard in 24-ity Finance
@hile &-rchasing stocks of a co&any> are yo- s-re that it =ill -se the f-nds in a =ay that is 5est
for yo-A
Princi&al:agent &ro5le
The se&aration of o=nershi& fro control
@hen the anagers of a co&any are the o=ners> the &ro5le of oral haIard in e4-ity financing
disa&&ears"
Moral FaIard in ;e5t Finance
Beca-se de5t contracts allo= o=ners to kee& all the &rofits in excess of the loan &ayents> they
enco-rage risk taking
1 good legal contract can solve the oral haIard &ro5le that is inherent in de5t finance"
Bonds and loans often carry restrictive covenants
T#e Nega(%3e Conse8.en-es o, In,o$&a(%on Cos(s
1. A13e$se Se0e-(%on:
6enders canHt disting-ish good fro 5ad credit risks> =hich disco-rages transactions fro taking
&lace"
Sol-tions incl-de
Governent:re4-ired inforation disclos-re
Private collection of inforation
The &ledging of collateral to ins-re lenders against the 5orro=erHs defa-lt
Re4-iring 5orro=ers to invest s-5stantial reso-rces of their o=n
4. Mo$a0 "aFa$1:
6enders canHt tell =hether 5orro=ers =ill do =hat they clai they =ill do =ith the 5orro=ed
reso-rcesN 5orro=ers ay take too any risks"
Sol-tions incl-de
Forced re&orting of anagers to o=ners
Re4-iring anagers to invest s-5stantial reso-rces of their o=n
%ovenants that restrict =hat 5orro=ers can do =ith 5orro=ed f-nds
!%nan-%a0 In(e$&e1%a$%es an1 In,o$&a(%on Cos(s
The &ro5les of adverse selection and oral haIard ake direct finance ex&ensive and diffic-lt to
get"
These dra=5acks lead -s iediately to indirect finance and the role of financial instit-tions"
M-ch of the inforation that financial interediaries collect is -sed to red-ce inforation costs
and iniiIe the effects of adverse selection and oral haIard
Screening and %ertifying to Red-ce 1dverse Selection
Monitoring to Red-ce Moral FaIard
73
Lesson 45
BANKING
Banking
Ty&es of 5anks
Balance Sheet of %oercial Banks
1ssets
6ia5ilities
Ban+%ng
Banking is a co5ination of 5-sinesses designed to deliver the services
Pool the savings of and aking loans
;iversification
1ccess to the &ayents syste
1cco-nting and record:kee&ing
The intent of 5anks is to &rofit fro each of these lines of 5-siness
There are three 5asic ty&es of de&ository instit-tions?
%oercial 5anks>
Savings instit-tions
%redit -nions
%oercial 5anks "
They acce&t de&osits and -se the &roceeds to ake cons-er> coercial and real estate loans"
%o-nity 5anks
Sall local 5anks foc-sed on serving cons-ers and sall 5-siness
Regional and S-&er:regional 5anks
They ake cons-er> residential> coercial and ind-strial loans
Money center 5ank
These 5anks rely ore on 5orro=ing for their f-nding
Saving ,nstit-tions
Financial interediaries to serve ho-seholds and individ-als
Provide ortgage and lending as =ell as saving de&osit services
%redit Cnions
9on&rofit de&ository instit-tions that are o=ned 5y &eo&le =ith a coon 5ond
These -nions s&ecialiIe in aking sall cons-er loans
T#e Ba0an-e S#ee( o, Co&&e$-%a0 Ban+s
Ba0an-e S#ee( I1en(%('
To(a0 Ban+ Asse(s I To(a0 Ban+ L%a*%0%(%es N Ban+ Ca7%(a0
Banks o5tain f-nds fro individ-al de&ositors and 5-siness as =ell as 5y 5orro=ing fro other
financial instit-tions and thro-gh the financial arkets"
They -se these f-nds to ake loans> &-rchase arketa5le sec-rities and hold cash"
The difference 5et=een a 5ankHs assets and lia5ilities is the 5ankHs ca&ital or 9et @orth
The 5ankHs &rofits coe 5oth fro service fees and the difference 5et=een interest earned and
interest &aid"
74
ITEMS 4AA6 >s.AAA9 4AA4 >s.AAA9
ASSETS
%ash and 5alances =ith treas-ry 5anks
Balances =ith other 5anks
6endings to financial instit-tions
,nvestents net
1dvances net
)ther assets net
)&erating fixed assets
;eferred tax assets : net
$'>((+>+4*
1>4(*>'''
*>**/>/$/
(*>4/1>4/.
1/#>'$$>.+'
+>4(4>4$(
/>1/$>4+4
1*1>*(.
4DC2BB?2BDB
$'>/''>$+'
+>.#/>'$'
1#>*(+>$*.
(.>1*4>*.1
1'.>'1.>..'
(>1+4>'.#
.>***>/$1
ddddddddd
46D21B52CAC
LIABILITIES
Bills &aya5le
Borro=ings fro financial instit-tions
;e&osits and other acco-nts
S-5:ordinated loan
6ia5ilities against assets s-5Rect to finance lease
)ther lia5ilities
;eferred tax lia5ilities : net
/>+'(>(.4
$.>'..>+#$
$$*>'4+>1./
1>+*/>#/#
:::::
/>(11>(##
dddddddd
4B624?D2A54
.>+((>(/4
.>+*#>/(4
$$1>#(*>1+/
1>+*/>.$#
::::
(>+$+>***
$(*>4**
4442?4A2D44
NET ASSETS 4525AB2B?5 1426642CC4
EPESENTED BY:
Share ca&ital
Reserves
Cna&&ro&riated &rofit
4>$(+>'$.
1'>4#/>##+
$1#>(($
1B2CC52DD4
'>'.1>/##
+>((1>++'
1(+>$#/
D21DC26?1
S.$70.s on $e3a0.a(%on o, asse(s = ne( o, (a) +>4$'>.(*
4525AB2B?5
+>'+4>'$'
1426642CC4
Ba0an-e S#ee( o, U.S Co&&e$-%a0 Ban+s2 A.g.s( 4AA4
Asse(s %n *%00%ons o, 1o00a$s>n.&*e$s %n 7a$en(#eses a$e Gage o, (o(a0 asse(s9
%ash ites 7incl-ding reserves8
Sec-rities
o C"S" Governent and agency
o State and local governent and other
6oans
o %oercial and ind-strial
o Real estate 7incl-ding ortgage8
o %ons-er
o ,nter5ank
o )ther
)ther assets
To(a0 Co&&e$-%a0 Ban+ Asse(s
'$1"( 74"18
1>/*'"+ 7$'"*8
1>1.#.". 714"/8
.$$"/ 7*"18
+>#44"( 7('".8
//."1 711"$8
$>411"( 7'#"+8
(.$"' 7/"+8
'(4". 74"(8
.#/"* 7*"#8
(++"1 7/"'8
B2D14.C
L%a*%0%(%es %n *%00%ons o, 1o00a$s >n.&*e$s %n 7a$en(#eses a$e Gage o, (o(a0 0%a*%0%(%es9
%hecka5le de&osits
9ontransactions de&osits
o Savings de&osits and tie de&osits
o 6arge> negotia5le tie de&osits
Borro=ings
o Fro 5anks in C"S"
o Fro non5anks in C"S"
)ther lia5ilities
To(a0 Co&&e$-%a0 Ban+ L%a*%0%(%es
(4+"# 7/"*8
4>4/.". 7($"'8
'>'4#"* 74("'8
1>14("/ 71+"*8
1>+/*"# 7$$"#8
4+*"1 7("48
1>1$*"* 71+".8
4/."4 7("/8
B24AD.1
Ban+ asse(s Ban+ L%a*%0%(%es I Ban+ Ca7%(a0 BA6.B
75
Asse(s: Uses o, !.n1s
%ash ,tes
Reserves
%ash ites in &rocess of collection
0a-lt cash
Sec-rities
Secondary reserves
6oans
Cas# I(e&s
ese$3es
,ncl-des cash in the 5ankHs va-lt and its de&osits at the central 5ank
Feld to eet c-stoersH =ithdra=al re4-ests
%ash ites in the &rocess of collections
Cncollected f-nds the 5ank ex&ects to receive
The 5alances of acco-nts that 5anks hold at other 5anks 7corres&ondent 5anking8
Beca-se cash earns no interest> it has a high o&&ort-nity cost" So 5anks iniiIe the ao-nt of
cash holding
Se-.$%(%es:
Stocks
T:Bills
Governent and cor&orate 5onds
Sec-rities are soeties called secondary reserves 5eca-se they are highly li4-id and can 5e sold
4-ickly if the 5ank needs cash"
Loans:
The &riary asset of odern coercial 5anksN
B-siness loans 7coercial and ind-strial loans8>
Real estate loans>
%ons-er loans>
,nter:5ank loans>
6oans for the &-rchase of other sec-rities
The &riary difference aong the vario-s ty&es of de&ository instit-tions is in the co&osition of
their loan &ortfolios
%oercial 5anks ake loans &riarily to 5-siness
Savings and loans &rovide ortgages to individ-als
%redit -nions s&ecialiIe in cons-er loans
76
Lesson 44
BALANCE S"EET O! COMMECIAL BANKS
Balance Sheet of %oercial Banks
1ssets? -ses of f-nds
Bank %a&ital and Profita5ility
)ff:Balance:Sheet 1ctivities
Bank Risk
6i4-idity Risk
%redit Risk
,nterest Rate Risk
Trading Risk
)ther Risks
L%a*%0%(%es: So.$-es o, !.n1s
%hecka5le ;e&osits
9on:transactions ;e&osits
Borro=ings
;isco-nt loans
Federal f-nds arket
C#e-+a*0e 1e7os%(s:
1 ty&ical 5ank =ill offer ( or ore ty&es of checking acco-nts"
,n recent decades these de&osits have declined 5eca-se the acco-nts &ay lo= interest rates
Non($ansa-(%ons De7os%(s:
These incl-de savings and tie de&osits and acco-nt for nearly t=o:thirds of all coercial 5ank
lia5ilities"
@hen yo- &lace yo-r savings in a %ertificate of ;e&osit 7%;8 at the 5ank> it is as if yo- are 5-ying a
5ond iss-ed 5y that 5ank
%;s can vary in ters of their val-e> the large ones can 5e 5o-ght and sold in financial arkets
Bo$$o/%ngs:
Banks 5orro= fro the central 5ank 7disco-nt loans8
They can 5orro= fro other 5anks =ith excessive reserves in the inter:5ank oney arket"
Banks can also 5orro= 5y -sing a re&-rchase agreeent or re&o> =hich is a short:ter
collateraliIed loan
1 sec-rity is exchanged for cash> =ith the agreeent that the &arties =ill reverse the transaction on
a s&ecific f-t-re date 7ight 5e as soon as the next day8
77
Me-#an%-s o, an O3e$n%g#( e7.$-#ase Ag$ee&en(
Ban+ Ca7%(a0 an1 P$o,%(a*%0%('
The net =orth of 5anks is called 5ank ca&italN it is the o=nersH stake in the 5ank
%a&ital is the c-shion that 5anks have against a s-dden dro& in the val-e of their assets or an
-nex&ected =ithdra=al of lia5ilities
1n i&ortant co&onent of 5ank ca&ital is loan loss reserves> an ao-nt the 5ank sets aside to
cover &otential losses fro defa-lted loans
,t is red-ced 5y the defa-lted loans =ritten:off
There are several 5asic eas-res of 5ank &rofita5ility
Ret-rn on 1ssets>
OA I Ne( 7$o,%( a,(e$ (a)es
To(a0 *an+ asse(s
,t is a eas-re of ho= efficiently a &artic-lar 5ank -ses its assets
1 anager can co&are the &erforance of 5ankHs vario-s lines of 5-sinesses 5y looking at
different -nitsH R)1
The 5ankHs ret-rn to its o=ners is eas-red 5y the Ret-rn on 24-ity
OE I Ne( 7$o,%( a,(e$ (a)es
Ban+ -a7%(a0
R)1 and R)2 are related to leverage
1 eas-re of leverage is the ratio of 5ank assets to 5ank ca&ital" M-lti&lying R)1 5y this ratio
yields R)2
OA ) Ban+ Asse(s
Ban+ Ca7%(a0
U.S Treasury bill to pension fund
Cash to bank
Pension
Fund Bank
Day 1
Bank sells U.S. Treasury bill to pension fund in exchane for cash
Day !
Bank repurchases U.S. Treasury bill fro" the pension fund in exchane for
cash plus interest
Pension
Fund Bank
U.S. Treasury bill returned to bank
Cash # interest paid to pension fund
78
L 9et &rofit after taxes x Bank 1ssets
Total 5ank assets Bank %a&ital
I Ne( 7$o,%( a,(e$ (a)es I OE
Ban+ Ca7%(a0
Ret-rn on e4-ity tends to 5e higher for larger 5anks> s-ggesting the existence of econoies of scale
9et interest incoe is another eas-re of &rofita5ilityN
,t is the difference 5et=een the interest the 5ank &ays and =hat it receives
,t can also 5e ex&ressed as a &ercentage of total assets to yield 7net interest argin8" ,t is the 5ankHs
interest rate s&read
@ell r-n 5anks have high net interest incoe and a high net interest argin"
,f a 5ankHs net interest argin is c-rrently i&roving> its &rofita5ility is likely to i&rove in the
f-t-re"
Ta*0e: P$o,%(a*%0%(' o, U.S. Co&&e$-%a0 Ban+s> %n &%00%ons o, E2 e)-e7( *o((o& ,o.$ $o/s9
I(e&s 1DD1 1DD? 4AA1
A. ,nterest incoe:interest ex&ense 79et
interest incoe8
K1$1>>$// K1(1>1.$ K$1#>/#*
B. )ther reven-e +/>4/$ *$>+1+ 1+'>.'4
C. )&erating costs 1$4>$'' 1+*>$41 $1/>.#(
D. Gross &rofit 71TB:%8 ++>+'. *4>44( 14+>/'.
E. 6oan losses7&rovisions8 '4>1$/ 1+>4/' 41>##/
!. 9et o&erating &rofit 7;:28 $1>4#* ./>*(' 1#4>/$*
G. RealiIed ca&ital gains fro sale of real estate $>*.1 +'# 4>4'4
". 9et &rofits 5efore taxes 7FTG8 $4>'/# .*>4*' 1#*>$('
I. 1ssets '>4$#>'/1 4>++4>$'4 (>4+4>+4'
9et interest argin 71P,8 #"#'++J #"#'+4J #"#'$.J
Ret-rn on assets 7FP,8 7R)18 #"##.1 #"#1.+ #"#1(*
Ret-rn on e4-ity 7R)28 #"1$+/ #"$14. #"1/(#
9et interest incoeP Total incoe [1P71TB8\ #"(.4. #"('+' #"+./$
O,,=Ba0an-e=S#ee( A-(%3%(%es
Banks engage in these activities in order to generate fee incoeN these activities incl-de &roviding
tr-sted c-stoers =ith lines of credit
6etters of credit are another i&ortant off:5alance:sheet activityN they g-arantee that a c-stoer
=ill 5e a5le to ake a &roised &ayent"
,n so doing> the 5ank> in exchange for a fee> s-5stit-tes its o=n g-arantee for that of the c-stoer
and ena5les a transaction to go for=ard
Buyer
$I"porter%
O Sale Contract
Seller
$&xporter%
O Deliver Goods
O
Request
for Credit
I"porter's Bank
$Issuin Bank%
O
Documents
& Claim for
Payment
O
Present
Documents
O
Deliver
Letter of
Credit
O Present
Documents
O Send Credit
&xporter's Bank
$(d)isin Bank%
O Payment
79
1 stand5y letter of credit is a for of ins-ranceN the 5ank &roises that it =ill re&ay the lender
sho-ld the 5orro=er defa-lt
)ff:5alance:sheet activities create risk for financial instit-tions and so have coe -nder increasing
scr-tiny in recent years
80
Lesson 46
BANK ISK
Bank Risk
6i4-idity Risk
%redit Risk
,nterest Rate Risk
Trading Risk
)ther Risks
Ban+ %s+
Banking is risky 5eca-se de&ository instit-tions are highly leveraged and 5eca-se =hat they do
,n all the lines of 5anking trades> the goal of every 5ank is to &ay less for the de&osits the 5ank
receives than for the loan it akes and the sec-rities it 5-ys"
L%8.%1%(' %s+
6i4-idity risk is the risk of a s-dden deand for f-nds and it can coe fro 5oth sides of a 5ankHs
5alance sheet 7de&osit =ithdra=al on one side and the f-nds needed for its off:5alance sheet
activities on the lia5ilities side
,f a 5ank cannot eet c-stoersH re4-ests for iediate f-nds it r-ns the risk of fail-reN even =ith
a &ositive net =orth> illi4-idity can drive it o-t of 5-siness
Ta*0e: Ba0an-e s#ee( o, a *an+ #o01%ng E6 &%00%on %n e)-ess $ese$3es
Asse(s L%a*%0%(%es
Reserves K1+illion ;e&osits K1##illion
6oans K1##illion Borro=ed f-nds K'#illion
Sec-rities K'+illion Bank ca&ital K$#illion
)ne =ay to anage li4-idity risk is to hold s-fficient excess reserves 75eyond the re4-ired reserves
andated 5y the central 5ank8 to accoodate c-stoersH =ithdra=als"
Fo=ever> this is ex&ensive 7interest is foregone8
T=o other =ays to anage li4-idity risk are?
1dR-sting assets
1dR-sting lia5ilities
Ta*0e: Ba0an-e s#ee( o, a *an+ #o01%ng no e)-ess $ese$3es
Asse(s L%a*%0%(%es
Reserves K1#illion ;e&osits K1## illion
6oans K1## illion Borro=ed f-nds K'# illion
Sec-rities K4# illion Bank ca&ital K$# illion
,f a c-stoer akes a K+ illion =ithdra=al> the 5ank canHt si&ly ded-ct it fro reserves"
Rather it =ill adR-st another &art of 5alance sheet
1 5ank can adR-st its assets 5y
Selling a &ortion of its sec-rities &ortfolio>
)r 5y selling soe of its loans>
)r 5y ref-sing to rene= a c-stoer loan that has coe d-e
81
Ta*0e: Ba0an-e s#ee( o, a *an+ ,o00o/%ng a E6 &%00%on /%(#1$a/a0 an1 asse( a1Q.s(&en(
@ithdra=al is et 5y selling sec-rities
Asse(s L%a*%0%(%es
Reserves K1#illion ;e&osits K*+ illion
6oans K1## illion Borro=ed f-nds K'# illion
Sec-rities K'+ illion Bank ca&ital K$# illion
@ithdra=al is et 5y red-cing loans
Asse(s 0%a*%0%(%es
Reserves K1# illion ;e&osits K*+ illion
6oans K*+ illion Borro=ed f-nds K'# illion
Banks do not like to eet their de&osit o-tflo=s 5y contracting the asset side of the 5alance sheet
5eca-se doing so shrinks the siIe of the 5ank
Banks can -se lia5ility anageent to o5tain additional f-nds 5y
Borro=ing 7fro the central 5ank or fro another 5ank8 or
By attracting additional de&osits 75y iss-ing large %;s8
Ta*0e: Ba0an-e s#ee( o, a *an+ ,o00o/%ng a E6 &%00%on /%(#1$a/a0 an1 0%a*%0%(' a1Q.s(&en(
@ithdra=al is et 5y 5orro=ing
Asse(s L%a*%0%(%es
Reserves K1#illion ;e&osits K*+ illion
6oans K1## illion Borro=ed f-nds K'+ illion
@ithdra=al is et 5y attracting de&osits
Asse(s 0%a*%0%(%es
Reserves K1# illion ;e&osits K1## illion
6oans K1##illion Borro=ed f-nds K'# illion
C$e1%( %s+
This is the risk that loans =ill not 5e re&aid and it can 5e anaged thro-gh diversification and
credit:risk analysis
;iversification can 5e diffic-lt for 5anks> es&ecially those that foc-s on certain kinds of lending
%redit:risk analysis &rod-ces inforation that is very siilar to the 5ond:rating systes and is done
-sing a co5ination of statistical odels and inforation s&ecific to the loan a&&licant
6ending is &lag-ed 5y adverse selection and oral haIard> and financial instit-tions -se a variety of
ethods to itigate these &ro5les
Screen loan a&&lication
Monitor 5orro=ers after they have received loan
%ollateral or high net:=orth deand
;evelo&ing long ter relationshi&s
In(e$es(=a(e %s+
The t=o sides of a 5ankHs 5alance sheet often do not atch -& 5eca-se lia5ilities tend to 5e short:
ter =hile assets tend to 5e long:terN this creates interest:rate risk
,n order to anage interest:rate risk> the 5ank -st deterine ho= sensitive its 5alance sheet
7assets and lia5ilities8 is to a change in interest ratesN
,f =e think of 5ankHs assets and lia5ilities as 5onds> the change in interest rate =ill affect the val-e
of these 5onds> ore i&ortantly d-e to the ter of 5onds
So if interest rate rises> the 5ank face the risk that the val-e of their assets ay fall ore than the
val-e of their lia5ilities 7red-cing the 5ankHs ca&ital8
S-&&ose $#J of 5ankHs assets fall into the category of assets sensitive to changes in the interest
rate" @hile rest of /#Jare not sensitive to changes in interest rate
82
,f interest rate is sta5le +J> then each K1## yields K+ in interest
9o= s-&&ose +#J of 5ankHs de&osits 7lia5ilities8 are interest rate sensitive and +#J are not
Falf of the lia5ilities are de&osits that earn varia5le ret-rns so costs vary =ith arket rate
For aking &rofit> interest rate on lia5ilities -st 5e lo=er than the interest rate on assets"
The difference is the 5ankHs arginQ
1ss-ing interest rate on lia5ilities is 'J> the net interest argin is + ' L $J
@hat ha&&ens as interest rate rises 5y 1J
Ta*0e: An e)a&70e o, %n(e$es( $a(e $%s+
The i&act of an interest rate increase on 5ank &rofits 7&er K1## of assets8
I(e&s Asse(s L%a*%0%(%es
,nterest rate sensitive K$# K+#
9ot interest rate sensitive K/# K+#
,nitial interest rate +J 'J
9e= interest rate on interest rate
sensitive assets and lia5ilities
(J 4J
e3en.e ,$o& asse(s Cos( o, 0%a*%0%(%es
1t initial interest rate 7#"#+UK$#8T7#"#+UK/#8LK+"## 7#"#'UK+#8T7#"#'UK+#8LK'"##
1fter interest rate change 7#"#(UK$#8T7#"#+UK/#8LK+"$# 7#"#4UK+#8T7#"#'UK+#8LK'"+#
P$o,%(s a( %n%(%a0 %n(e$es( $a(e: 7K+"##8 7K'"##8 L K$"## &er K1## in assets
P$o,%(s a,(e$ %n(e$es( $a(e -#ange: 7K+"$#8 7K'"+#8 L K1".# &er K1## in assets
Ga7 ana0's%s
Ga& 5et=een interest rate sensitive assets and interest rate sensitive lia5ilities?
7,nterest rate sensitive assets of K$#8 7,nterest rate sensitive lia5ilities of K+#8
L7Ga& of :K'#8
@hen 5ank has ore interest rate sensitive lia5ilities than does interest rate assets> an increase in
interest rate =ill c-t into the 5ankHs &rofits"
83
Lesson 4?
INTEEST ATE ISK
Bank Risk
,nterest Rate Risk 7%ont"8
Trading Risk
)ther Risks
Glo5aliIation of Banking
The F-t-re of Banks
9on:de&ository ,nstit-tions
,ns-rance %o&anies
Sec-rities Firs
Finance %o&anies
Governent S&onsored 2nter&rises
In(e$es(=a(e %s+
Ga& analysis highlights the ga& or difference 5et=een the yield on interest sensitive assets and the
yield on interest:sensitive lia5ilities
M-lti&lying the ga& 5y the &roRected change in the interest rate yields the change in the 5ankHs
&rofit
Ga& analysis can 5e f-rther refined to take acco-nt of differences in the at-rity of assets and
lia5ilities
Banks can anage interest:rate risk 5y atching the interest:rate sensitivity of assets =ith the
interest:rate sensitivity of lia5ilities>
P-rchase short ter sec-rities to atch varia5le rate de&osits
Make long ter loans at floating rates
B-t this a&&roach increases credit risk
T$a1%ng %s+
Banks today hire traders to actively 5-y and sell sec-rities> loans> and derivatives -sing a &ortion of
the 5ankHs ca&ital in the ho&e of aking additional &rofits
Fo=ever> trading s-ch instr-ents is risky 7the &rice ay go do=n instead of -&8N this is called
trading risk or arket risk
Managing trading risk is a aRor concern for todayHs 5anks> and 5ank risk anagers &lace liits on
the ao-nt of risk any individ-al trader is allo=ed to ass-e
Banks also need to hold ore ca&ital if there is ore risk in their &ortfolio
O(#e$ %s+s
Banks that o&erate internationally =ill face
Foreign exchange risk 7the risk fro -nfavora5le oves in the exchange rate8
Sovereign risk 7the risk fro a governent &rohi5iting the re&ayent of loans8
Banks anage their foreign exchange risk 5y attracting de&osits denoinated in the sae c-rrency
as the loans and 5y -sing foreign exchange f-t-res and s=a&s to hedge the risk
Banks anage sovereign risk 5y diversification> 5y ref-sing to do 5-siness in a &artic-lar co-ntry or
set of co-ntries> and 5y -sing derivatives to hedge the risk
Banks also face o&erational risk> the risk that their co&-ter syste ay fail or that their 5-ildings
ay 5-rn do=n
To anage o&erational risk the 5ank -st ake s-re that its co&-ter systes and 5-ildings are
s-fficiently ro5-st to =ithstand &otential disasters
T#e G0o*a0%Fa(%on o, Ban+%ng
To=ard the end of the $#th cent-ry> shar& rise in international trade increased the need for
international financial services
Banks can o&erate in other co-ntries 5y
84
)&ening a foreign 5ranch>
)ffer sae services as in hoe co-ntry
%reating an ,nternational Banking Facility 7,BF8
1cce&t de&osits fro and ake loans to foreigners o-tside the co-ntry
%reating an 2dge 1ct s-5sidiary>
2ngage in international 5anking transactions
P-rchasing a controlling interest in a foreign 5ank
Foreign 5anks can take advantage of siilar o&tions"
The gro=th of international 5anking has had an econoic i&act> increasing the co&etition in
and efficiency of 5anking arkets
1 5orro=er fro France> BraIil> Singa&ore or Pakistan can sho& for loan virt-ally any=here in the
=orld> =hile a de&ositor seeking the highest ret-rn can do the sae
This &henoenon has ade 5anking a to-gher Ro5
Profits are harder to coe 5y as 5orro=ers and de&ositors have ore o&tions
B-t overall the i&roved efficiency of financial syste has enhanced gro=th every=here
)ne of the ost i&ortant as&ects of international 5anking is the 2-rodollar arket> in =hich
dollar:denoinated de&osits in foreign 5anks are exchanged
The 2-rodollar arket =as created in res&onse to restrictions on the oveent of international
ca&ital i&osed at the end of @orld @ar ,, =ith the creation of Bretton @oods syste
Today> the 2-rodollar arket in 6ondon is one of the 5iggest and ost i&ortant financial
arkets in the =orld>
The interest rate at =hich 5anks lend each other 2-rodollars 7the 6ondon ,nter5ank )ffered Rate
or 6,B)R8 is the standard against =hich any &rivate loan rates are eas-red
T#e !.(.$e o, Ban+s
TodayHs 5anks are 5igger> fe=er in n-5er and ore international than those of the &ast> and they
offer ore services
Financial holding co&anies are a liited for of -niversal 5anks> firs that engage in non:
financial as =ell as financial activities
Banking> ,ns-rance and sec-rities
The o=ners and anagers of these financial firs cite three reasons to create the?
They are =ell diversified>
They are large eno-gh to take advantage of econoies of scale>
They ho&e to 5enefit fro econoies of sco&e
)ffering any &rod-cts -nder the sae D5randE nae can also red-ce costs
,ndivid-al firs &rovide the sae services as ore traditional interediaries do
Money arket -t-al f-nds &rovide li4-idity
Mortgage 5rokers hel& in 5orro=ing for hoe &-rchase
6easing co&anies &rovide car> and cons-er financing
;isco-nt 5rokers &rovide lo= cost access to financial arkets
Thanks to recent technological advances> alost every service traditionally &rovided 5y financial
interediaries can no= 5e &rod-ced inde&endently> =itho-t the hel& of a large organiIation
Moreover> the &rod-ction of inforation to itigate the &ro5les of adverse selection and oral
haIard has 5ecoe a 5-siness in and of itself
1s =e s-rvey the financial ind-stry =e can discern t=o o&&osite trends?
6arge firs are =orking hard to &rovide one:sto& sho&&ing for financial services
,nd-stry is s&lintering into a host of sall firs> each of =hich serves a very s&ecific &-r&ose
85
Lesson 4B
NON= DEPOSITOY INSTITUTIONS
9on:de&ository ,nstit-tions
,ns-rance %o&anies
Sec-rities Firs
Finance %o&anies
Non=1e7os%(o$' Ins(%(.(%ons
,ns-rance %o&anies
Sec-rities Firs
Brokerage firs
,nvestent 5anks
M-t-al f-nd co&anies
Finance %o&anies
Ins.$an-e Co&7an%es
,ns-rance co&anies 5egan h-ndreds of years ago =ith long sea voyages
The ost fao-s ins-rance co&any> 6loydHs of 6ondon> =as esta5lished in 1(//
Besides ins-ring traditional assets like air&lane and shi&s> it also ins-res singersH voices> &ianistsH
fingers and even food criticsH taste 5-ds
Cnder=riting &rocess refers to the risk assessent and loss rei5-rseent g-arantee 5y the
individ-al risk ex&erts of the relevant field Roining together to for a syndicate"
@hen an ins-rance contract is offered> these syndicates sign -& for a certain &ortion of the risk in
ret-rn for a &ortion of the risk &rei-s
,ns-rance &rocess
,ns-rance co&anies acce&t &rei-s in exchange for the &roise of co&ensation if certain
event occ-rs
1 hoe o=ner &ays &rei- in ret-rn for the &roise that if the ho-se 5-rns do=n> the ins-rance
co&any =ill &ay to re5-ild it
So for individ-als> ins-rance is =ay for transferring the risk
,n ters of financial syste as =hole> ins-rance co&anies?
Pool sall &olicies and ake large investents
;iversify risks across a large &o&-lation
Screen and onitor &olicyholders to itigate the &ro5le of asyetric inforation
T=o Ty&es of ,ns-rance %o&any?
6ife ins-rance
Pro&erty and cas-alty ins-rance
T'7e o, L%,e %ns.$an-e
Te$& 0%,e %ns.$an-e
@hich akes a &ayent to the ins-redHs 5eneficiaries -&on the death of the ins-red
Gro-& ins-rance is o5tained thro-gh e&loyers
;#o0e 0%,e %ns.$an-e
%o5ination of ter life ins-rance and a savings acco-nt
1 &ayent of a fixed &rei- over lifetie in ret-rn for a fixed 5enefit in case of death of &olicy
holder
The cash val-e can 5e ref-nded if the &olicyholder decides to discontin-e the &olicy
)ver the years> the e&hasis shifts fro ins-rance to savings
Pro&erty and cas-alty ,ns-rance
86
1-to ins-rance is a co5ination of &ro&erty ins-rance on the car and cas-alty ins-rance on the
driver
The &olicyholder &ays &rei- in exchange for &rotection
Balance sheet
6ia5ilities
Proises to &olicyholders
1ssets
%o5ination of 5onds and stocks
Short ter oney arket instr-ents 7in case of &ro&erty and cas-alty ins-rance8
The Role of ,ns-rance %o&anies?
,ns-rance co&anies &ool risk to generate &redicta5le &ayo-ts
1dverse selection and oral haIard create &ro5les in the ins-rance arket that are =orse than
those in the stock and 5ond arkets
%ancer Patients
Fire ,ns-rance
To deal =ith this> ins-rance co&anies caref-lly screen a&&licants 5efore iss-ing the &olicies
Medical 2xaination
;riving Records
Policies ay also incl-de restrictive covenants in order to red-ce oral haIard
Fire exting-ishing syste and training
%aref-l
The f-t-re of ins-rance -st 5e considered in the light of advances in edical technology>
&artic-larly =ith regard to the decoding of the h-an genoe"
,n the f-t-re> &eo&le =ith inherited tendencies to=ard certain diseases ay not 5e a5le to get
ins-rance
Se-.$%(%es !%$&s
The 5road class of sec-rities firs incl-des 5rokerages> investent 5anks> and -t-al f-nd
co&anies"
,n one =ay or another> these are all financial interediaries
The &riary services of 5rokerage firs are acco-nting and the &rovision of access to secondary
arkets"
They also &rovide loans to c-stoers =ho =ish to &-rchase stock on argin> and they &rovide
li4-idity 5y offering check:=riting &rivileges and 5y allo=ing investors to sell assets 4-ickly
1ll sec-rities firs are very -ch in the 5-siness of &rod-cing inforationN 5-t this is tr-ly at the
heart of the investent 5anking 5-siness
87
Lesson 4C
NON= DEPOSITOY INSTITUTIONS >CONTINUED9
Sec-rities Firs
,nvestent Banks
M-t-al F-nds
Finance %o&anies
Banking %risis
So-rces of R-ns> Panics and %risis
Governent Safety 9et
Governent? 6ender of 6ast Resort
Se-.$%(%es !%$&s
,nvestent 5anks are the cond-its thro-gh =hich firs raise f-nds in the ca&ital arkets
Thro-gh their -nder=riting services> investent 5anks iss-e ne= stocks and a variety of other de5t
instr-ents
,n -nder=riting> the investent 5ank g-arantees the &rice of a ne= iss-e and then sells it to
investors at a higher &riceN
Fo=ever> this is not =itho-t risk> since the selling &rice ay not in fact 5e higher than the &rice
g-aranteed to the fir iss-ing the sec-rity
,nforation and re&-tation are central to the -nder=riting 5-sinessN
Cnder=riters collect inforation to deterine the &rice of the ne= sec-rities and then &-t their
re&-tations on the line =hen they go o-t to sell the iss-es
,n addition to -nder=riting> investent 5anks &rovide advice to firs that =ish to erge =ith or
ac4-ire other firs> for =hich advice they are &aid a fee
!%nan-e Co&7an%es
Finance co&anies raise f-nds in the financial arkets 5y iss-ing coercial &a&er and sec-rities
and -se the f-nds to ake loans to individ-als and cor&orations
These co&anies are largely concerned =ith red-cing the transactions and inforation costs that
are associated =ith interediated finance
Most finance co&anies s&ecialiIe in one of three loan ty&es?
%ons-er loans>
B-siness loans>
Sales loans 7for exa&le> the financing for a cons-er to &-rchase a large:ticket ite like an
a&&liance8
Soe also &rovide coercial and hoe ortgages
B-siness finance co&anies &rovide loans to 5-sinesses> for e4-i&ent leasing
B-siness finance co&anies also &rovide short:ter li4-idity to firs 5y offering
,nventory loans 7so that firs can kee& the shelves stocked8
1cco-nts receiva5le loans 7=hich &rovide iediate reso-rces against antici&ated reven-e streas8
Go3e$n&en(=S7onso$e1 En(e$7$%ses
The governent is directly involved in the financial interediation syste thro-gh loan g-arantees
and in the chartering of financial instit-tions to &rovide s&ecific ty&es of financing
Warai Tara4iati Bank 6iited 7WTB68
Sall and Medi- 2nter&rise 7SM28 Bank
Fo-se B-ilding Finance %or&oration 7FBF%8
Vh-shhali Bank
88
S.&&a$' o, (#e ,%nan-%a0 %n1.s($' s($.-(.$e
!%nan-%a0
%n(e$&e1%a$'
P$%&a$'
so.$-es o,
,.n1s
>0%a*%0%(%es9
P$%&a$' .ses
o, ,.n1s
>asse(s9
Se$3%-es 7$o3%1e1
De7os%(o$'
%ns(%(.(%on
>Ban+s9
%hecka5le
de&osits
Saving and tie
de&osits
Borro=ing fro
other 5anks
%ash
6oans
sec-rities
=Pooling of sall savings to &rovide large
loans
=;iversified> li4-id de&osit acco-nts
=1ccess to &ayents syste
Screening and onitoring of 5orro=ers
Ins.$an-e
Co&7an'
Se-.$%(%es !%$&
2x&ected clais
Short ter loans
%or&orate 5onds
Governent
5onds
Stocks
Mortgages
%oercial
&a&er
Bonds
=Pooling of risk
=Screening and onitoring of &olicy holders
=Manageent of asset &ools
=%learing and settling trades
In3es(&en( Ban+ =,ediate sale of assets
=1ccess to s&ectr- of assets> allo=ing
diversification
=2val-ation of firs =ishing to iss-e
sec-rities
=Research and advice for investors
M.(.a0=!.n1
Co&7an'
Shares sold to
c-stoers
%oercial
&a&er
Bonds
Mortgages
Stocks
Real estate
=Pooling of sall savings to &rovide access
to large> diversified &ortfolios> =hich can 5e
li4-id
!%nan-e
Co&7an'
Bonds
Bank loans
%oercial
&a&er
Mortgages
%ons-er
loans
B-siness loans
=Screening and onitoring of 5orro=ers
Go3e$n&en(=
S7onso$e1
En(e$7$%ses
%oercial
&a&er
Bonds
6oan
g-arantees
Mortgages
Far loans
St-dent loans
=1ccess to financing for 5orro=ers =ho
cannot o5tain it else=here
Ban+%ng C$%s%s
Banking crises are not a ne= &henoenaN the history of coercial 5anking over the last t=o
cent-ries is re&lete =ith &eriod of t-roil and fail-re"
By their very nat-re> financial systes are fragile and v-lnera5le to crisis
89
Ta*0e: ;o$s( Ban+%ng C$%ses s%n-e 1DCA
Co.n($' C$%ses Da(es Es(%&a(e1 -os( o,
eso0.(%on >as Gage o,
GDP9
1rgentina 1*/#:/$ ++J
,ndonesia 1**.:*/ ++J
%hina 1**#s 4.J
Oaaica 1**4 44J
%hile 1*/1:/' 4$J
Thailand 1**. '+J
Macedonia 1**':*4 '$J
,srael 1*..:/' '#J
T-rkey $### '#J
Cr-g-ay 1*/1:/4 $*J
Vorea 1**/ $/J
%ote dHivoire 1*//:*1 $+J
Oa&an 1**#s $4J
Cr-g-ay 1*/1:/4 $4J
Malaysia 1**.:*/ $#J
!%g.$e: e0a(%ons#%7 *e(/een s%Fe o, a ,%nan-%a0 -$%ses an1 -#ange %n GDP G$o/(#
T#e So.$-es an1 Conse8.en-es o, .ns2 Pan%-s2 an1 C$%ses
,n a arket 5ased econoy> the o&&ort-nity to s-cceed is also the o&&ort-nity to failQ
Banks serve soe essential f-nctions in the econoy
1ccess to &ayent syste
Screen and onitor 5orro=ers to red-ce inforation &ro5les
So if 5ank fails> =e lose a5ility to ake financial transactions" %ollectively> the econoy is
endangered"
BanksH fragility arises fro the fact that they &rovide li4-idity to de&ositors> allo=ing the to
=ithdra= their 5alances on deand> on a first:coe> first:served 5asis
,f 5ank can not eet this &roise of =ithdra=al> 5eca-se of ins-fficient f-nds> it =ill fail
Re&orts that a 5ank has 5ecoe insolvent can s&read fear that it =ill r-n o-t of cash and close its
doorsN
0 10 20 30 40 50 60
-15
-10
-5
0
5
15
Fiscal Cost as pecent age o. $D" 5@6
C
*
a
n
g
e

i
n

$
D
"

5
@
6
$*ana
1982-89
,
,
0o1a&
1990-93
MeAico
1994-2000
,
7ulgaia
1996-97
,
,
Wamaica
1996-2000
?gentina
1980-82
,
10
,In3onesia
1997-2002
,
/ugua&
1981-84
,
Mala&sia
1997-2001
,
Finlan3
1991-94
90
South
(sian
Crises
;e&ositors =ill r-sh to convert their 5alances into cash
S-ch a r-n on a 5ank can ca-se it to fail
@hat atters d-ring a 5ank r-n is not =hether a 5ank is solvent 5-t =hether it is li4-id
Fere solvency eans that the val-e of the 5ankHs assets exceeds its lia5ilities 7&ositive net =orth8
6i4-idity refers to the s-fficient reserves of the 5ank to eet =ithdra=al deands
False r-ors that a 5ank is insolvent can lead to a r-n =hich renders it illi4-id
@hen a 5ank fails> de&ositors ay lose soe or all of their de&osits> and inforation a5o-t
5orro=ersH credit=orthiness ay disa&&earN
For this reason> governents take ste&s to try to iniiIe the risk of fail-re
1 single 5ank fail-re can also t-rn into a syste:=ide &anicN this is called contagion
@hile 5anking &anics and financial crises can res-lt fro false r-ors> they can also occ-r for ore
concrete reasonsN
1nything that affects 5orro=ersH a5ility to re&ay their loans or drives do=n the arket &rice of
sec-rities has the &otential to i&eril the 5ankHs finances
Recessions have a clear negative i&act on 5ankHs 5alance sheet
6o= &rofita5ility of fir akes de5t re&ayent -ch harder
Peo&le lose Ro5s and cant &ay their loan
@ith the rise of defa-lt risk> 5ankHs assets lose val-e and ca&ital dro&s
@ith less ca&ital> 5anks are forced to contract the 5alance sheet aking fe=er loans"
The overall 5-siness investent falls and 5ank fail-re is ore &ossi5le
Fistorically> do=nt-rns in the 5-siness cycle &-t &ress-re on 5anks> s-5stantially increasing the risk
of &anics
Financial disr-&tions can also occ-r =henever 5orro=ersH net =orth falls> as it does d-ring deflation
91
Lesson 4D
T"E GOVENMENT SA!ETY NET
There are three reasons for the governent to get involved in the financial syste
To &rotect investors
To &rotect 5ank c-stoers fro ono&olistic ex&loitation
To ens-re the sta5ility of the financial syste
In3es(o$ P$o(e-(%on
Sall investors are -na5le to R-dge the so-ndness of financial instit-tions
,n &ractice only force of la= ens-re the 5ankHs integrity> th-s investors rely on governent to
&rotect the fro isanageent and alfeasance
P$o(e-(%on ,$o& &ono7o0%s(%- e)70o%(a(%on
Mono&olists ex&loit their c-stoers 5y raising &rices to earn -n=arranted &rofits
Governent intervenes to &revent firs in an ind-stry fro 5ecoing too large" The sae ay
a&&ly to 5anks as =ell
S(a*%0%(' o, ,%nan-%a0 s's(e&
6i4-idity risk and inforation asyetry indicate the insta5ility of financial syste
Financial instit-tion can create and destroy the val-e of its assets in a very short &eriod> and a single
firHs fail-re can 5ring do=n the =hole syste
Governent officials e&loy a co5ination of strategies to &rotect investors and ens-re the
sta5ility of the financial syste
They &rovide the safety net to ins-re sall de&ositors
They o&erate as the lender of last resort
T#e Un%8.e o0e o, De7os%(o$' Ins(%(.(%ons
;e&ository instit-tions receive a dis&ro&ortionate ao-nt of attention fro governent reg-lators
5eca-se
They &lay a central role in the econoy
They face a -ni4-e set of &ro5les
@e all rely heavily on 5anks for access to the &ayents syste
Banks are also &rone to r-ns> as they hold illi4-id assets to 5ack their li4-id lia5ilities> &roising f-ll
and constant val-e to the de&ositors 5ased on assets of -ncertain val-e
They are linked to each other 5oth on their 5alance sheets and in their c-stoersH indsN
This interconnectedness of 5anks is alost -ni4-e to the financial ind-stry
T#e Go3e$n&en( as Len1e$ o, Las( eso$(
The 5est =ay to sto& a 5ank fail-re fro t-rning into a &anic is to ake s-re solvent instit-tions
can eet their de&ositorsH =ithdra=al deands
The existence of a lender of last resort significantly red-ces> 5-t does not eliinate> contagion
For the syste to =ork> central 5ank officials =ho a&&rove the loan a&&lications -st 5e a5le to
disting-ish an illi4-id fro an insolvent instit-tion
,t is i&ortant for a lender of last resort to o&erate in a anner that iniiIes the tendency for
5ankers to take too -ch risk in their o&erations
P$o*0e&s C$ea(e1 *' (#e Go3e$n&en( Sa,e(' Ne(
Protected de&ositors have no incentive to onitor their 5anksH 5ehavior> and kno=ing this> 5anks
take on ore risk than they =o-ld norally
,n &rotecting de&ositors the governent creates oral haIard
Soe 5anks are too 5ig to fail> eaning that their fail-re =o-ld ca-se havoc in the financial syste"
The anagers of s-ch instit-tions kno= that if they 5egin to fo-nder the governent =ill have to
5ail the o-t
The too:5ig:to:fail &olicy liits the extent of the arket disci&line that de&ositors can i&ose on
5anks and co&o-nds the oral haIard &ro5le
92
eg.0a(%on an1 S.7e$3%s%on o, (#e !%nan-%a0 S's(e&
Governent officials e&loy three strategies to ens-re that the risks created 5y the safety net are
contained?
Reg-lation esta5lishes r-les for 5ank anagers to follo=>
S-&ervision &rovides general oversight of financial instit-tions>
2xaination &rovides detailed inforation on the firsH o&erations
Reg-latory re4-ireents are designed to iniiIe the cost of fail-res to the tax:&aying &-5lic
)ne exa&le of reg-lation is the re4-ireent that 5anks o5tain a charter in order to o&erateN
This &rovides screening to ake s-re that the &eo&le =ho o=n and r-n 5anks =ill not 5e criinals"
)nce a 5ank is o&erating other reg-lations control the assets> the ao-nt of ca&ital> and akes
inforation a5o-t the 5ankHs 5alance sheet &-5lic
Governent s-&ervisors enforce the reg-lationsN
They onitor> ins&ect> and exaine 5anks to ake s-re that their 5-siness &ractices confor to
reg-latory re4-ireents
State Bank of Pakistan 7SBP8 is s-&ree reg-latory a-thority for 5anking sector in Pakistan
==="s5&"org"&k
Asse( "o01%ng es($%-(%ons an1 M%n%&.& Ca7%(a0
e8.%$e&en(s
The si&lest =ay to &revent 5ankers fro ex&loiting their safety net is to restrict 5anksH 5alance
sheetsN
This can 5e thro-gh restrictions on the kinds of assets 5anks can hold and re4-ireents that they
aintain ini- levels of ca&ital
The siIe of the loans a 5ank can ake to &artic-lar 5orro=ers is also liited
Mini- ca&ital re4-ireents co&leent these liitations on 5ank assets
%a&ital serves as a c-shion against declines in the val-e of the 5ankHs assets> lo=ering the likelihood
of the 5ankHs fail-re> and is a =ay to red-ce the &ro5le of oral haIard
%a&ital re4-ireents take t=o 5asic fors?
The first re4-ires 5anks to kee& their ratio of ca&ital to assets a5ove soe ini- level
regardless of the str-ct-re of their 5alance sheetsN
The second re4-ires 5anks to hold ca&ital in &ro&ortion to the riskiness of their o&erations
Banks -st &rovide inforation to the financial arkets a5o-t their 5alance sheetsN
S.7e$3%s%on an1 E)a&%na(%on
The governent enforces 5anking r-les and reg-lations thro-gh an ela5orate oversight &rocess
called s-&ervision> =hich relies on a co5ination of onitoring and ins&ection
S-&ervision is done reotely> thro-gh an exaination of the detailed re&orts 5anks -st s-5it> as
=ell as thro-gh on:site exaination
1t the largest instit-tions> exainers are on site all the tieN this is called contin-o-s exaination
The ost i&ortant &art of a 5ank exaination is the eval-ation of &ast:d-e loans> to see if they
sho-ld 5e declared in defa-lt
S-&ervisors -se the acrony %1M26S to descri5e the criteria -sed to eval-ate the health of the
5ank?
%a&ital ade4-acy>
1sset 4-ality>
Manageent>
2arnings>
6i4-idity>
Sensitivity to risk
%-rrent &ractice is for exainers to act as cons-ltants to 5anks> advising the on ho= to get the
highest ret-rn &ossi5le =hile kee&ing risk at an acce&ta5le level that ens-res the 5ank =ill stay in
5-siness
93
Lesson 5A
T"E GOVENMENTRS BANK
The central 5ank started o-t as the governentHs 5ank> originally created 5y r-lers to finance =ars
Fo=ever> the early exa&les are really the exce&tions> as central 5anking is largely a $#th cent-ry
&henoenon"
The central 5ank occ-&ies a &rivileged &osition? it has a ono&oly on the iss-ance of c-rrency
The central 5ank creates oney and there5y controls the availa5ility of oney and credit in a
co-ntryHs econoy
Most central 5anks go a5o-t this 5y adR-sting short:ter interest rates> an activity called onetary
&olicy"
,n todayHs =orld> central 5anks -se onetary &olicy to sta5iliIe econoic gro=th and inflation"
1n ex&ansionary or accoodative &olicy 7lo=er interest rates8 raises gro=th and inflationN tighter
or restrictive &olicy red-ces the"
Governents =ant to control the &rinting of oney 5eca-se it is a very &rofita5le 5-sinessN also>
losing control of the ao-nt of c-rrency eans losing control of inflation"
T#e Ban+e$sR Ban+
The ost i&ortant day:to:day Ro5s of the central 5ank are to?
Provide loans d-ring ties of financial stress 7the lender of last resort8"
Manage the &ayents syste 7settles inter5ank &ayents8"
)versee coercial 5anks and the financial syste 7handles the sensitive inforation a5o-t
instit-tions =itho-t conflicts of interest8"
By ens-ring that so-nd 5anks and financial interediaries can contin-e to o&erate> the central 5ank
akes the =hole financial syste ore sta5le"
%entral 5anks are the 5iggest and ost &o=erf-l &layers in a co-ntryHs financial and econoic
syste and are s-&&osed to -se this &o=er to sta5iliIe the econoy> aking -s all 5etter off"
Fo=ever> central 5anks that are -nder extree &olitical &ress-re> or that are si&ly inco&etent>
can =reak havoc on the econoic and financial systes"
1 central 5ank does not control?
Sec-rities arkets
The governentHs 5-dget
The coon arrangeent today is for the central 5ank to serve the governent in the sae =ay
that a coercial 5ank serves a 5-siness or an individ-al"
S(a*%0%(': T#e P$%&a$' O*Qe-(%3e o, A00 Cen($a0 Ban+s
@hen econoic and financial systes are left on their o=n they are &rone to e&isodes of extree
volatilityN central 5ankers =ork to red-ce that volatility
%entral 5ankers &-rs-e five s&ecific o5Rectives?
6o= and sta5le inflation
Figh and sta5le real gro=th> together =ith high e&loyent
Sta5le financial arkets
Sta5le interest rates
1 sta5le exchange rate
,nsta5ility in any of those =o-ld &ose an econoy:=ide econoic risk that diversification co-ld
9ot itigate
Th-s the Ro5 of the central 5ank is to i&rove general econoic =elfare 5y anaging and red-cing
systeatic risk"
,t is &ro5a5ly i&ossi5le to achieve all five of these o5Rectives si-ltaneo-sly> and so tradeoffs
-st 5e ade
Lo/2 S(a*0e In,0a(%on
Many central 5anks take as their &riary Ro5 the aintenance of &rice sta5ilityN they strive to
eliinate inflation"
94
The rationale for kee&ing the econoy inflation:free is that oneyHs -sef-lness as a -nit of acco-nt
and as a store of val-e is enhanced =hen its &-rchasing &o=er is aintained"
,nflation degrades the inforation content of &rices and i&edes the arketHs f-nction of
allocating reso-rces to their 5est -ses"
The higher the inflation is> the less &redicta5le it is> and the ore systeatic risk it creates"
1lso> high inflation is 5ad for gro=th"
@hile there is agreeent that lo= inflation sho-ld 5e the &riary o5Rective of onetary &olicy>
there is no agreeent on ho= lo= inflation sho-ld 5e"
Wero inflation is too lo=> 5eca-se it 5rings the risk of deflation 7a dro& in &rices8 =hich in t-rn
res-lts in increased defa-lts on loans and a threat to the health of 5anks"
F-rtherore> if inflation =ere Iero> an e&loyer =ishing to c-t la5or costs =o-ld need to c-t
noinal =ages> =hich is diffic-lt to do"
1 sall ao-nt of inflation ay act-ally ake la5or arkets =ork 5etter> at least fro the
e&loyerHs &oint of vie="
95
Lesson 51
LO;2 STABLE IN!LATION
Many central 5anks take as their &riary Ro5 the aintenance of &rice sta5ilityN they strive to
eliinate inflation"
The rationale for kee&ing the econoy inflation:free is that oneyHs -sef-lness as a -nit of acco-nt
and as a store of val-e is enhanced =hen its &-rchasing &o=er is aintained"
,nflation degrades the inforation content of &rices and i&edes the arketHs f-nction of
allocating reso-rces to their 5est -ses"
The higher the inflation is> the less &redicta5le it is> and the ore systeatic risk it creates"
1lso> high inflation is 5ad for gro=th"
@hile there is agreeent that lo= inflation sho-ld 5e the &riary o5Rective of onetary &olicy>
there is no agreeent on ho= lo= inflation sho-ld 5e"
Wero inflation is too lo=> 5eca-se it 5rings the risk of deflation 7a dro& in &rices8 =hich in t-rn
res-lts in increased defa-lts on loans and a threat to the health of 5anks"
F-rtherore> if inflation =ere Iero> an e&loyer =ishing to c-t la5or costs =o-ld need to c-t
noinal =ages> =hich is diffic-lt to do"
1 sall ao-nt of inflation ay act-ally ake la5or arkets =ork 5etter> at least fro the
e&loyerHs &oint of vie="
"%g#2 S(a*0e ea0 G$o/(#
%entral 5ankers =ork to da&en the fl-ct-ations of the 5-siness cycleN 5oos are &o&-lar 5-t
recessions are not"
%entral 5ankers =ork to oderate these cycles and sta5iliIe gro=th and e&loyent 5y adR-sting
interest rates"
Monetary &olicyakers can oderate recessions 5y lo=ering interest rates and can oderate
5oos 5y raising the 7to kee& gro=th at a s-staina5le level8"
1long =ith gro=th and e&loyent> sta5ility is also i&ortant> 5eca-se fl-ct-ations in general
5-siness conditions are the &riary so-rce of systeatic risk"
!%nan-%a0 S's(e& S(a*%0%('
Financial syste sta5ility is an integral &art of every odern central 5ankerHs Ro5"
The &ossi5ility of a severe disr-&tion in the financial arkets is a ty&e of systeatic risk that central
5anks -st control"
In(e$es( a(e an1 E)-#ange a(e S(a*%0%('
,nterest rate sta5ility and exchange rate sta5ility are a eans for achieving the -ltiate goal of
sta5iliIing the econoyN they are not ends -nto theselves"
96
,nterest rate volatility is a &ro5le 5eca-se?
it akes o-t&-t -nsta5le as 5orro=ing and ex&endit-re fl-ct-ate =ith changing rates"
it eans higher risk and a higher risk &rei- and akes financial decisions ore diffic-lt"
2ven tho-gh the exchange rate affects the &rices of i&orts and ex&orts> sta5iliIing exchange rates
is the last ite on the list of central 5ank o5Rectives"
;ifferent co-ntries have different &riorities =hen it coes to the exchange rateN
Sta5le exchange rates are ore i&ortant in develo&ing co-ntries 5eca-se i&orts and ex&orts are
central to their econoies"
T#e o*Qe-(%3es o, a Mo1e$n Cen($a0 Ban+
Lo/ S(a*0e In,0a(%on ,nflation creates conf-sion and akes &lanning diffic-lt" @hen inflation
is high> gro=th is lo=
"%g# S(a*0e g$o/(# Sta5le &redicta5le gro=th is higher than -nsta5le> -n&redicta5le gro=th
!%nan-%a0 S's(e&
S(a*%0%('
1 sta5le financial syste is necessity for an econoy to o&erate
efficiently
S(a*0e In(e$es( a(es ,nterest rate volatility creates risk for 5oth lenders and 5orro=ers
S(a*0e E)-#ange a(es 0aria5le exchange rates ake the reven-es fro foreign sales and the
cost of &-rchasing i&orted goods hard to &redict
Mee(%ng (#e C#a00enge: C$ea(%ng a S.--ess,.0 Cen($a0 Ban+
The 5oo in the &ast decade =ith its associated decrease in volatility ay have ha&&ened 5eca-se
technology s&arked a 5oo R-st as central 5anks 5ecae 5etter at their Ro5s"
Policyakers realiIed that s-staina5le gro=th had gone -&> so interest rates co-ld 5e ke&t lo=
=itho-t =orrying a5o-t inflation> and central 5anks =ere redesigned"
Today there is a clear consens-s a5o-t the 5est =ay to design a central 5ank and =hat to tell
&olicyakers to do"
1 central 5ank -st 5e
,nde&endent of &olitical &ress-re>
1cco-nta5le to the &-5lic>
Trans&arent in its &olicy actions>
%lear in its co-nications =ith financial arkets and the &-5lic
97
Lesson 54
MEETING T"E C"ALLENGE: CEATING A SUCCESS!UL CENTAL BANK
The 5oo in the &ast decade =ith its associated decrease in volatility ay have ha&&ened 5eca-se
technology s&arked a 5oo R-st as central 5anks 5ecae 5etter at their Ro5s"
Policyakers realiIed that s-staina5le gro=th had gone -&> so interest rates co-ld 5e ke&t lo=
=itho-t =orrying a5o-t inflation> and central 5anks =ere redesigned"
Today there is a clear consens-s a5o-t the 5est =ay to design a central 5ank and =hat to tell
&olicyakers to do"
1 central 5ank -st 5e
,nde&endent of &olitical &ress-re>
1cco-nta5le to the &-5lic>
Trans&arent in its &olicy actions>
%lear in its co-nications =ith financial arkets and the &-5lic"
,n addition> there is general agreeent
That &olicy decisions are 5etter ade 5y coittee than 5y individ-als>
That everyone is =ell served =hen &olicyakers o&erate =ithin an ex&licit frae=ork that clearly
states their goals and the tradeoffs aong the"
T#e nee1 ,o$ %n1e7en1en-e
The idea that central 5anks sho-ld 5e inde&endent of &olitical &ress-re is a ne= one> 5eca-se
central 5anks originated as the governentsH 5anks"
,nde&endence has t=o co&onents?
Monetary &olicyakers -st 5e free to control their o=n 5-dgets
The 5ankHs &olicies -st not 5e reversi5le 5y &eo&le o-tside the central 5ank"
S-ccessf-l onetary &olicy re4-ires a long tie horiIon> =hich is inconsistent =ith the need of
&oliticians to foc-s on short:ter goals"
Given a choice> ost &oliticians =ill choose onetary &olicies that are too accoodative> kee&ing
interest rates lo= and oney gro=th rates high"
@hile this raises o-t&-t and e&loyent in the near ter it ay res-lt in inflation over the longer
ter"
To ins-late &olicyakers fro the daily &ress-res faced 5y &oliticians> governents have given
central 5anks control of their o=n 5-dgets> a-thority to ake irreversi5le decisions> and a&&ointed
the to long ters"
De-%s%on=Ma+%ng *' Co&&%((ee
,n the co-rse of noral o&erations> it is 5etter to rely on a coittee than on an individ-al"
Pooling the kno=ledge> ex&erience> and o&inions of a gro-& of &eo&le red-ces the risk that &olicy
=ill 5e dictated 5y an individ-alHs 4-irks> not to ention that in a deocracy> vesting so -ch
&o=er in one individ-al &oses a legitiacy &ro5le"
T#e Nee1 ,o$ A--o.n(a*%0%(' an1 T$ans7a$en-'
%entral 5ank inde&endence is inconsistent =ith re&resentative deocracy"
To solve this &ro5le> &oliticians have esta5lished a set of goals and re4-ire the &olicyakers to
re&ort their &rogress in &-rs-ing these goals"
2x&licit goals foster acco-nta5ility and disclos-re re4-ireents create trans&arency"
The instit-tional eans for ass-ring acco-nta5ility and trans&arency differ fro one co-ntry to the
nextN
,n soe cases the governent sets an ex&licit n-erical target for inflation> =hile in others the
central 5ank defines the target"
Siilar differences exist in the tiing and content of inforation ade &-5lic 5y central 5anks"
98
!%g.$e: In,0a(%on an1 Cen($a0 Ban+ In1e7en1en-e 1DB5=1DCC
Today it is -nderstood that secrecy daages 5oth the &olicyakers and the econoies they are
trying to anage> and that &olicyakers need to 5e as clear as &ossi5le a5o-t =hat they are trying
to achieve and ho= they are going to achieve it"
T#e Po0%-' !$a&e/o$+2 Po0%-' T$a1e=o,,s2 an1 C$e1%*%0%('
The onetary &olicy frae=ork is ade -& of the o5Rectives of central 5anks and the re4-ireents
that central 5anks 5e inde&endent> acco-nta5le> and good co-nicators"
The onetary &olicy frae=ork exists to resolve the a5ig-ities that arise in the co-rse of the
central 5ankHs =ork and also clarifies the likely res&onses =hen goals are in conflict =ith one
another"
%entral 5ankers face the tradeoff 5et=een inflation and gro=th on a daily 5asis"
Since &olicy goals often conflict> central 5ankers -st ake their &riorities clear"
1 =ell:designed &olicy frae=ork also hel&s &olicyakers esta5lish credi5ility"
T#e P$%n-%70es o, Cen($a0 Ban+ Des%gn
In1e7en1en-e
To kee& inflation lo=> onetary decisions -st 5e ade free of &olitical
infl-ence
De-%s%on &a+%ng
*' -o&&%((ee
Pooling the kno=ledge of a n-5er of &eo&le yields 5etter decisions than
decision aking 5y an individ-al
A--o.n(a*%0%(' an1
($ans7a$en-'
Policy akers -st 5e held acco-nta5le to the &-5lic they serve and clearly
co-nicate their o5Rectives> decisions and ethods
Po0%-' ,$a&e/o$+
Politicians -st clearly state their &olicy goals and the tradeoffs aong
the
!%((%ng E3e$'(#%ng Toge(#e$:
Cen($a0 Ban+s an1 !%s-a0 Po0%-'
The central 5ank does not control the governentHs 5-dgetN fiscal &olicy 7the decisions a5o-t taxes
and s&ending8 is the res&onsi5ility of elected officials
@hile fiscal and onetary &olicyakers share the sae -ltiate goal of i&roving the =ell:5eing
of the &o&-lation> conflicts can arise 5et=een the t=o"
0(5 1(0 1(5 2(0 2(5 3(0 3(5
2
3
4
5
6
8
In3eA o. Cental 7an! In3epen3ence
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Denma!
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/nite3 States
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,0et*elan3s
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99
F-nding needs create a nat-ral conflict 5et=een onetary and fiscal &olicyakers"
Fiscal &olicyakers also tend to ignore the long:ter inflationary effects of their actions"
Politicians often t-rn to 5orro=ing 7instead of taxes8 as a =ay to finance soe &ortion of their
s&ending> 5-t a co-ntry can iss-e only so -ch de5t"
,nflation is a real te&tation to shortsighted fiscal &olicyakers 5eca-se it is a =ay to get oney in
their hands and itHs a =ay for governents to defa-lt on a &ortion of the de5t they o=e"
Res&onsi5le fiscal &olicy is essential to the s-ccess of onetary &olicy"
T#e Cen($a0 Ban+Ms Ba0an-e S#ee(
The central 5ank engages in n-ero-s financial transactions> all of =hich ca-se changes in its
5alance sheet"
%entral 5anks &-5lish their 5alance sheets reg-larly" P-5lication is a cr-cial &art of trans&arency
Ta*0e: T#e Cen($a0 Ban+Ms Ba0an-e S#ee(
Asse(s L%a*%0%(%es
Go3e$n&en(Ms *an+ Sec-rities
Foreign exchange reserves
%-rrency
GovernentHs acco-nt
Ban+e$Ms *an+ 6oans 1cco-nts of the coercial 5anks
7reserves8
Asse(s
The central 5ankHs 5alance sheet sho=s three 5asic assets?
Sec-rities>
Foreign exchange reserves>
6oans
Se-.$%(%es:
The &riary assets of ost central 5anksN
,nde&endent central 5anks deterine the 4-antity of sec-rities that they &-rchase
!o$e%gn E)-#ange ese$3es:
The central 5ankHs and governentHs 5alances of foreign c-rrency are held as 5onds iss-ed 5y
foreign governents"
These reserves are -sed in foreign exchange arket interventions"
Loans are extended to coercial 5anks> and can fall into t=o categories? disco-nt loans and float
;isco-nt loans? the loans the central 5ank akes =hen coercial 5anks need short:ter cash"
Float? a 5y&rod-ct of the central 5ankHs check:clearing 5-siness" The central 5ank credits the
reserve acco-nt of the 5ank receiving the check 5efore it de5its the acco-nt of the 5ank on =hich
the check =as dra=n and this creates float
Thro-gh its holdings of Treas-ry sec-rities the central 5ank controls the disco-nt rate and the
availa5ility of oney and credit"
Gold reserves> =hile still an asset of any central 5anks> are virt-ally irrelevant these days"
L%a*%0%(%es
There are three aRor lia5ilities?
%-rrency>
The governentHs de&osit acco-nt>
The de&osit acco-nts of the coercial 5anks"
The first t=o ites re&resent the central 5ank in its role as the governentHs 5ank> and the third
sho=s it as the 5ankersH 5ank"
C.$$en-':
9early all central 5anks have a ono&oly on the iss-ance of c-rrency> and c-rrency acco-nts for
over *# &ercent of the central 5ankHs lia5ilities"
Go3e$n&en(Ms a--o.n(:
The central 5ank &rovides the governent =ith an acco-nt into =hich it de&osits f-nds 7&riarily
tax reven-es8 and fro =hich it =rites checks and akes &ayents"
100
ese$3es:
%oercial 5ank reserves consist of cash in the 5ankHs o=n va-lt and de&osits at the central 5ank>
=hich f-nction like the coercial 5ankHs checking acco-nt"
%entral 5anks r-n their onetary &olicy o&erations thro-gh changes in 5anking syste reserves"
101
Lesson 55
T"E MONETAY BASE
%-rrency in the hands of the &-5lic and the reserves of the 5anking syste are the t=o
co&onents of the onetary 5ase> also called high:&o=ered oney"
Bank Reserves L 0a-lt %ash &l-s ;e&osits at the central 5ank
The central 5ank can control the siIe of the onetary 5ase and therefore the 4-antity of oney
C#ang%ng (#e S%Fe an1 Co&7os%(%on o, (#e Ba0an-e S#ee(
The central 5ank controls the siIe of its 5alance sheet" Policyakers can enlarge or red-ce their
assets and lia5ilities at =ill
The central 5ank can 5-y things> like a 5ond> and create lia5ilities to &ay for the" ,t can increase
the siIe of its 5alance sheet as -ch as it =ants"
There are fo-r s&ecific ty&es of transactions =hich can affect the 5alance sheets of 5oth the central
5ank and the 5anking syste?
1n o&en arket o&eration> in =hich the central 5ank 5-ys or sells a sec-rityN
1 foreign exchange intervention> in =hich the central 5ank 5-ys or sells foreign c-rrency reservesN
The central 5ankHs extension of a disco-nt loan to a coercial 5ankN
The decision 5y an individ-al to =ithdra= cash fro a 5ank
)&en arket o&erations> foreign exchange interventions> and disco-nt loans> all affect the siIe of
the central 5ankHs 5alance sheet
They change the siIe of the onetary 5aseN
%ash =ithdra=als 5y the &-5lic create shifts aong the different co&onents of the onetary 5ase>
changing the co&osition of the central 5ankHs 5alance sheet 5-t leaving its siIe -naffected
)ne si&le r-le =ill hel& in -nderstanding the i&act of each of these fo-r transactions on the
central 5ankHs 5alance sheet?
@hen the val-e of an asset on the 5alance sheet increases> either the val-e of another asset
decreases 7so that the net change is Iero8 or the val-e of a lia5ility rises 5y the sae ao-nt 7and
siilarly for an increase in lia5ilities8
O7en Ma$+e( O7e$a(%ons
)M) is =hen the central 5ank 5-ys or sells sec-rities in financial arkets
These &-rchases and sales have a straightfor=ard i&act on the central 5ankHs 5alance sheet?
,ts assets and lia5ilities increase 5y the ao-nt of a &-rchase> and the onetary 5ase increases 5y
the sae ao-nt
Ta*0e: C#ange %n (#e Cen($a0 Ban+Ms Ba0an-e s#ee( ,o00o/%ng 7.$-#ase o, a T$eas.$' Bon1
Asse(s L%a*%0%(%es
Sec-rities7Treas-ry Bond8 TK15illion Reserves TK15illion
Ta*0e: C#ange %n (#e Ban+%ng s's(e&Ms *a0an-e s#ee( ,o00o/%ng (#e Cen($a0 Ban+Ms 7.$-#ase
o, a T$eas.$' Bon1
Asse(s L%a*%0%(%es
Reserves TK15illion
Sec-rities 7C"S" Treas-ry Bond8 :K15illion
,n ters of the 5anking systeHs 5alance sheet> the &-rchase has no effect on the lia5ilities> and
res-lts in t=o co-nter5alancing changes on the asset side> so the net effect there is Iero
For an o&en arket sale> the effects =o-ld 5e the sae 5-t in the o&&osite direction
!o$e%gn E)-#ange In(e$3en(%on
The i&act of a foreign exchange &-rchase is alost identical to that of an o&en arket &-rchase?
The central 5ankHs assets and lia5ilities increase 5y the sae ao-nt> as does the onetary 5ase"
102
,f the central 5ank 5-ys fro a coercial 5ank> the i&act again is like the o&en arket
&-rchase> exce&t the assets involved are different"
Ta*0e: -#ange %n (#e Cen($a0 *an+Ms Ba0an-e s#ee( ,o00o/%ng 7.$-#ase o, E.$o=1eno&%na(e1
Ge$&an Go3e$n&en( Bon1s
Asse(s L%a*%0%(%es
Foreign exchange reserves TK15illion
7Geran governent 5onds in e-ros8
Reserves TK15illion
Ta*0e: C#ange %n (#e Ban+%ng s's(e&Ms Ba0an-e s#ee( ,o00o/%ng (#e Cen($a0 *an+Ms 7.$-#ase o,
E.$o=1eno&%na(e1 Ge$&an Go3e$n&en( Bon1s
Asse(s L%a*%0%(%es
Reserves TK15illion
Sec-rities :K15illion
7Geran governent 5onds8
D%s-o.n( Loans
The central 5ank does not force coercial 5anks to 5orro= oneyN the 5anks ask for loans and
-st &rovide collateral> -s-ally a Treas-ry 5ond"
@hen the central 5ank akes a loan it creates an asset and a atching increase in its reserve
lia5ilities"
Ta*0e: C#ange %n (#e Cen($a0 Ban+Ms Ba0an-e s#ee( ,o00o/%ng a D%s-o.n( Loan
Asse(s L%a*%0%(%es
;isco-nt loans TK1##illion Reserves TK1##illion
Ta*0e: C#ange %n (#e Ban+%ng S's(e&Ms Ba0an-e S#ee( ,o00o/%ng a D%s-o.n( Loan
Asse(s L%a*%0%(%es
Reserves TK1##illion ;isco-nt loans :K1##illion
The extension of credit to the 5anking syste raises the level of reserves and ex&ands the onetary
5ase"
The 5anking syste 5alance sheet sho=s an increase in assets 7reserves8 and an increase in lia5ilities
7the loan8"
Cas# ;%(#1$a/a0
%ash =ithdra=als affect only the co&osition> not the siIe> of the onetary 5ase"
@hen &eo&le =ithdra= cash they force a shift fro reserves to c-rrency on the central 5ankHs
5alance sheet"
Ta*0e: C#ange %n (#e Non*an+ P.*0%-Ms Ba0an-e S#ee( ,o00o/%ng a Cas# ;%(#1$a/a0
Asse(s L%a*%0%(%es
%-rrency TK1##
%hecka5le de&osits :K1##
The =ithdra=al red-ces the 5anking systeHs reserves> =hich is a decrease in its assets> and if the
f-nds coe fro a checking acco-nt> there is a atching decrease in lia5ilities"
Ta*0e: C#ange %n (#e Ban+%ng s's(e&Ms Ba0an-e s#ee( ,o00o/%ng a Cas# ;%(#1$a/a0
Asse(s L%a*%0%(%es
Reserves :K1## %hecka5le de&osits :K1##
103
)n the central 5ankHs 5alance sheet 5oth c-rrency and reserves are lia5ilities> so there is R-st a
change 5et=een the t=o =ith a net effect of Iero"
Ta*0e: C#ange %n (#e Cen($a0 Ban+Ms Ba0an-e S#ee( ,o00o/%ng a Cas# ;%(#1$a/a0
Asse(s L%a*%0%(%es
%-rrency TK1##
Reserves :K1##
C#anges %n S%Fe an1 Co&7os%(%on o, Cen($a0 Ban+Ms Ba0an-e S#ee( an1 Mone(a$' Base
T$ansa-(%on In%(%a(e1 *' T'7%-a0 a-(%on I&7a-(
)&en arket
o&eration
%entral 5ank P-rchase of Treas-ry
5ond
,ncreases reserves> the siIe of central 5ankHs
5alance sheet and Monetary 5ase
Foreign 2xchange
,ntervention
%entral 5ank P-rchase of foreign
govt" 5onds
;isco-nt 6oans %oercial
5ank
2xtension of loan to
coercial 5ank
%ash =ithdra=als 9on5ank &-5lic @ithdra=al of cash
fro 1TM
;ecreases reserves and increases c-rrency>
leaving siIe of central 5ankHs 5alance sheet
and Monetary 5ase -nchanged
104
Lesson 54
DEPOSIT CEATION IN A SINGLE BANK
,f the central 5ank 5-ys a sec-rity fro a 5ank> the 5ank has excess reserves> =hich it =ill seek to
lend
The loan re&laces the sec-rities as an asset on the 5ankHs 5alance sheet
Ta*0e: C#ange %n !%$s( Ban+Ms Ba0an-e S#ee( ,o00o/%ng Cen($a0 Ban+Ms 7.$-#ase o, a T$eas.$' *on1
Asse(s L%a*%0%(%es
Reserves TK1##>###
Sec-rities :K1##>###

1ss-ing First 5ank has granted a loan of K1##>### to )ffice B-ilders ,ncor&orated 7)B,8
Ta*0e: C#ange %n !%$s( Ban+Ms Ba0an-e s#ee( ,o00o/%ng Cen($a0 Ban+Ms 7.$-#ase o, a T$eas.$' *on1
an1 E)(ens%on o, a 0oan
Asse(s L%a*%0%(%es
Reserves TK1##>###
6oans TK1##>###
)B, %hecking acco-nt TK1##>###
)B, &aid off its e&loyees and s-&&liers thro-gh checks =orth K1##>###
Ta*0e: C#ange %n !%$s( Ban+Ms *a0an-e s#ee( ,o00o/%ng Cen($a0 Ban+Ms 7.$-#ase o, a T$eas.$'
Bon12 E)(ens%on o, a 0oan2 an1 /%(#1$a/a0 *' (#e *o$$o/e$
Asse(s L%a*%0%(%es
Reserves K#
6oans TK1##>###
%hecka5le de&osits K#
De7os%( E)7ans%on %n a S's(e& o, Ban+s
The loan that the First 5ank ade =as s&ent and as the checks cleared> reserves =ere transferred to
other 5anks
The 5anks that receive the reserves =ill seek to lend their excess reserves> and the &rocess
contin-es -ntil all of the f-nds have ended -& in re4-ired reserves
T'7es o, ese$3es
1ct-al Reserves 7R8
Re4-ired Reserves 7RRLr
;
;8
2xcess Reserves 72R8
1ss-e
Bank holds no excess reserves"
The reserve re4-ireent ratio is 1#J
%-rrency holding does not change =hen de&osits and loans change"
@hen a 5orro=er =rites a check> none of the reci&ients of the f-nds de&osit the 5ack in the 5ank
that initially ade the loan"
6etHs say> )B, -ses the K1##>### loan to &ay its s-&&lier 1erican Steel %o 71S%8> =hich it
de&osits in its 5ank the Second 5ank"
105
Ta*0e: C#ange %n Se-on1 Ban+Ms Ba0an-e s#ee( ,o00o/%ng A&e$%-an S(ee0Ms De7os%(
Asse(s L%a*%0%(%es
Reserves TK1##>### 1erican SteelHs checking TK1##>###
acco-nt
Ta*0e: C#ange %n Se-on1 Ban+Ms Ba0an-e s#ee( ,o00o/%ng a De7os%( an1 E)(ens%on o, a 0oan
1ss-ing a 1#J reserve re4-ireent> 5anks hold no excess reserves> and there are no changes in c-rrency
holdings"
Asse(s 0%a*%0%(%es
Reserves TK1#>###
6oan TK*#>###
1erican SteelHs %hecking TK1##>###
acco-nt
Ta*0e: C#ange %n T#%$1 Ban+Ms Ba0an-e S#ee( ,o00o/%ng a De7os%( an1 E)(ens%on o, a 0oan
1ss-ing a 1#J reserve re4-ireent> 5anks hold no excess reserves> and there are no changes in c-rrency
holdings"
Asse(s L%a*%0%(%es
Reserves TK*>###
6oan TK/1>###
%hecking acco-nt TK*#>###
106
M.0(%70e De7os%( C$ea(%on
1ss-ing a 1#J reserve re4-ireent> 5anks hold no excess reserves and there are no
changes in c-rrency holdings"
Cen($a0 Ban+
K1##>### Reserves K1##>### Sec-rities
!%$s( Ban+

K1##>### 6oan
O,,%-e B.%01e$s 0n-.
K1##>### Payent
A&e$%-an S(ee0 Co.
K1##>### ;e&osit
Se-on1 Ban+ $e(a%ns E1A2AAA %n $ese$3es
K*#>### 6oans
T#%$1 Ban+ $e(a%ns EDA2AAA %n $ese$3es

K/1>### 6oan
!o.$(# Ban+ $e(a%ns EC21AA %n $ese$3es
K.$>*## 6oan
!%,(# Ban+ $e(a%ns EB24DA %n $ese$3es
K(+>(1# 6oan
1nd so on
1nd so on
Ta*0e: M.0(%70e De7os%( E)7ans%on ,o00o/%ng a E1AA2AAA O7en Ma$+e( P.$-#ase Ass.&%ng a 1AG
$ese$3e $e8.%$e&en(
Ban+ In-$ease %n De7os%(s In-$ease %n Loans In-$ease %n ese$3es
First 5ank K# K1##>### K#
Second 5ank K1##>### K*#>### K1#>###
Third 5ank K*#>### K/1>### K*>###
Fo-rth 5ank K/1>### K.$>*## K/>1##
Fifth 5ank K.$>*## K(+>(1# K.>$*#
Sixth 5ank K(+>(1# K+*>#4* K(>+(1
: : : :
: : : :
: : : :
T#e Ban+%ng S's(e& E12AAA2AAA E12AAA2AAA E1AA2AAA
De7os%( E)7ans%on M.0(%70%e$
1ss-ing
9o excess reserves are held
There are no changes in the ao-nt of c-rrency held 5y the &-5lic>
The change in de&osits =ill 5e the inverse of the re4-ired de&osit reserve ratio 7r;8 ties the
change in re4-ired reserves> or
107
e; L 71Pr;8 eRR
1lternatively
RR L r
;
; or fRR L r
;
f;
So for every dollar increase in reserves> de&osits rise 5y 1Pr
;
The ter 71Pr
;
8 re&resents the si&le de&osit ex&ansion -lti&lier"
1 decrease in reserves =ill generate a de&osit contraction in a -lti&le ao-nt too
R
;
L1#J 7#"1#8> and fRRLK1##>###
f;L
f;L K1>###>###
De7os%( E)7ans%on /%(# E)-ess ese$3es an1 Cas# ;%(#1$a/a0s
The si&le de&osit ex&ansion -lti&lier =as derived ass-ing no excess reserves are held and that
there is no change in c-rrency holdings 5y the &-5lic"
These ass-&tions are no= relaxed as
+J =ithdra= of cash"
2xcess reserves of +J of de&osits
%ontin-ing =ith o-r &revio-s exa&le> if 1erican Steel %o 71S%8 reoves +J of its ne= f-nds
in cash> =hich leaves K*+>### in the checking acco-nt and K*+>### in the Second 5ankHs reserve
acco-nt
Ban+ /%s#es (o #o01 e)-ess%3e $ese$3es o, 6G o, 1e7os%(s2 %( /o.01 +ee7
$ese$3es o, 16G o, ED62AAA o$ E14246A an1 &a+%ng a 0oan o, ECA2B6A
Ta*0e: C#ange %n Se-on1 Ban+Ms Ba0an-e s#ee( ,o00o/%ng a De7os%( an1 E)(ens%on o, a Loan
1ss-ing excess reserves and cash holdings" 9ote? 1erican Steel also has K+>### in cash"
Asse(s L%a*%0%(%es
Re4-ired reserves TK*>+##
2xcess reserves TK4>.+#
6oan TK/#>.+#
1erican SteelHs checking TK*+>###
acco-nt
The desire of 5anks to hold excess reserves and the desire of acco-nt holders to =ithdra= cash
5oth red-ce the i&act of a given change in reserves on the total de&osits in the syste"
The ore excess reserves 5anks desire to hold> and the ore cash that is =ithdra=n> the saller
the i&act"
Mone' M.0(%70%e$
The oney -lti&lier sho=s ho= the 4-antity of oney 7checking acco-nt &l-s c-rrency8 is related
to the onetary 5ase 7reserves in the 5anking syste &l-s c-rrency held 5y the non5ank &-5lic8
Taking for oney -lti&lier and MB for onetary 5ase> the c-antity of Money> M is
M L x MB
7This is =hy the MB is called Figh Po=ered Money8
%onsider the follo=ing relationshi&s
Money L %-rrency T %hecka5le de&osits
M L % T ;
Monetary Base L %-rrency T Reserves
108
000 9 100 ;
1 (
1
MB L % TR
Reserves L Re4" Res" T 2xc" Res
R L RR T 2R
The ao-nt of excess reserves a 5ank holds de&ends on the costs and 5enefits of holding the>
The cost is the interest foregone
The 5enefit is the safety fro having the reserves in case there is an increase in =ithdra=als
The higher the interest rate> the lo=er 5anksH excess reserves =ill 5eN the greater the concern over
&ossi5le de&osit =ithdra=als> the higher the excess reserves =ill 5e
,ntrod-cing 2xcess Reserve Ratio g2RP;h
R L RR T 2R
L r
;
; T g2RP;h ;
L 7r
;
T g2RP;h8 ;
109
Lesson 56
MONEY MULTIPLIE
Ree5er> =e disc-ssed that
1ss-ing
9o excess reserves are held
There are no changes in the ao-nt of c-rrency held 5y the &-5lic>
The change in de&osits =ill 5e the inverse of the re4-ired de&osit reserve ratio 7r
;
8 ties the
change in re4-ired reserves> or e; L 71Pr
;
8 eRR
1lternatively
RR L r
;
; or fRR L r
;
f;
For every dollar increase in reserves> de&osits increase 5y 1P r
;

The ter 71Pr
;
8 re&resents the si&le de&osit ex&ansion -lti&lier"
1 decrease in reserves =ill generate a de&osit contraction in a -lti&le ao-nt too
The oney -lti&lier sho=s ho= the 4-antity of oney 7checking acco-nt &l-s c-rrency8 is related
to the onetary 5ase 7reserves in the 5anking syste &l-s c-rrency held 5y the 9on5ank &-5lic8
Taking for oney -lti&lier and MB for onetary 5ase> the c-antity of Money> M is
M L x MB
7This is =hy the MB is called Figh Po=ered Money8
%onsider the follo=ing relationshi&s
Money L %-rrency T %hecka5le de&osits
M L % T ;
Monetary Base L %-rrency T Reserves
MB L % TR
Reserves L Re4" Res" T 2xc" Res
R L RR T 2R
The ao-nt of excess reserves a 5ank holds de&ends on the costs and 5enefits of holding the>
The cost is the interest foregone
The 5enefit is the safety fro having the reserves in case there is an increase in =ithdra=als
The higher the interest rate> the lo=er 5anksH excess reserves =ill 5eN the greater the concern over
&ossi5le de&osit =ithdra=als> the higher the excess reserves =ill 5e"
In($o1.-%ng E)-ess ese$3e a(%o SETDU
R L RR T 2R
L r
;
; T g2RP;h ;
L 7r
;
T g2RP;h8 ;
The decision of ho= -ch c-rrency to hold de&ends on the costs and 5enefits> =here the cost is
the interest foregone and the 5enefit is the lo=er risk and greater li4-idity of c-rrency"
1s interest rates rise cash 5ecoes less desira5le> 5-t if the riskiness of alternative holdings rises or
li4-idity falls> then it 5ecoes ore desira5le
No/ (a+%ng C.$$en-' a(%o as SCTDU
MB L % T R
110
L g%P;h ; T 7r
;
T g2RP;h8 ;
L 7g%P;h T r
;
T g2RP;h8 ;
This sho=s that onetary 5ase has three -ses
Re4-ired reserves
2xcessive reserves
%ash in the hands of non5ank &-5lic
De7os%( E)7ans%on /%(# E)-ess ese$3es an1 Cas# ;%(#1$a/s
T#e K.an(%(' o, Mone' >M9 De7en1s on:
The Monetary 5ase 7MB8> %ontrolled 5y the central 5ank
Reserve Re4-ireents
BankHs desired to hold excess reserves
The &-5licHs deand for c-rrency
The 4-antity of oney changes directly =ith the 5ase> and for a given ao-nt of the 5ase> an
increase in either the reserve re4-ireent or the holdings of excess reserves =ill decrease the
4-antity of oney"
B-t c-rrency holdings affect 5oth the n-erator and the denoinator of the -lti&lier> so the
effect is not iediately o5vio-s" 6ogic tells -s that an increase in c-rrency decreases reserves and
so decreases the oney s-&&ly"
Ta*0e: !a-(o$s A,,e-(%ng (#e K.an(%(' o, Mone'
!a-(o$s ;#o -on($o0s %( C#ange I&7a-( on M
Monetary Base %entral 5ank ,ncrease ,ncrease
Re4-ired reserve:to:de&osit ratio Bank reg-lators ,ncrease ;ecrease
2xcess reserve:to:de&osit ratio %oercial 5anks ,ncrease ;ecrease
%-rrency:to:de&osit ratio 9on5ank &-5lic ,ncrease ;ecrease
T#e Cen($a0 Ban+Ms Mone(a$' Po0%-' Too0*o)
%entral 5ank controls the 4-antity of reserves that coercial 5anks hold
Besides the 4-antity of reserves> the central 5ank can control either the siIe of the onetary 5ase
or the &rice of its co&onents
The t=o &rices it concentrates on are
,nterest rate at =hich 5anks 5orro= and lend reserves overnight 7the federal f-nds rate8
,nterest rate at =hich 5anks can 5orro= reserves fro the central 5ank 7the disco-nt rate8
The central 5ank has three onetary &olicy tools> or instr-ents?
The target federal f-nds rate>
The disco-nt rate> and
The reserve re4-ireent
T#e Ta$ge( !e1e$a0 !.n1s a(e an1 O7en Ma$+e( O7e$a(%ons
The target federal f-nds rate is the central 5ankHs &riary &olicy instr-ent"
The federal f-nds rate is deterined in the arket> rather than 5eing controlled 5y the central 5ank"
The nae Dfederal f-ndsE coes fro the fact that the f-nds 5anks trade their de&osit 5alances at
the federal reserves or central 5ank"
#B D
)
+ +
=
12R345 r 1C345
4
1
#B
D C
#
)
+ +
+
=
12R345 r 1C345
4
1 Y 4 Z
111
%entral 5ank holds the ca&acity to force the arket federal f-nds rate to e4-al the target rate all the
tie 5y &artici&ating directly in the arket for overnight reserves> 5oth as a 5orro=er and as a
lender"
1s a lender> the central 5ank =o-ld need to ake -nsec-red loans to coercial 5anks> and as a
5orro=er> the central 5ank =o-ld in effect 5e &aying interest on excess reserves
The central 5ank chooses to control the federal f-nds rate 5y ani&-lating the 4-antity of reserves
thro-gh o&en arket o&erations? the central 5ank 5-ys or sells sec-rities to add or drain reserves as
re4-ired"
112
Lesson 5?
TAGET !EDEAL !UNDS ATE AND OPEN MAKET OPEATION
The central 5ank chooses to control the federal f-nds rate 5y ani&-lating the 4-antity of reserves
thro-gh o&en arket o&erations? the central 5ank 5-ys or sells sec-rities to add or drain reserves as
re4-ired"
!%g.$e: T#e Ma$+e( ,o$ Ban+ ese$3es

D%s-o.n( Len1%ng2 (#e Len1e$ o, Las( eso$( an1 C$%s%s Manage&en(
6ending to coercial 5anks is not an i&ortant &art of the central 5ankHs day:to:day onetary
&olicy"
Fo=ever> s-ch lending is the central 5ankHs &riary tool for ens-ring short:ter financial sta5ility>
for eliinating 5ank &anics and &reventing the s-dden colla&se of instit-tions that are ex&eriencing
financial diffic-lties"
The central 5ank is the lender of last resort> aking loans to 5anks =hen no one else can or =ill>
5-t a 5ank -st sho= that it is so-nd to get a loan in a crisis"
The c-rrent disco-nt lending &roced-res also hel& the central 5ank eet its interest:rate sta5ility
o5Rective"
The central 5ank akes three ty&es of loans?
Priary credit>
Secondary credit>
Seasonal credit
Priary credit is extended on a very short:ter 5asis> -s-ally overnight> to so-nd instit-tions"
,t is designed to &rovide additional reserves at ties =hen the dayHs reserve s-&&ly falls short of the
5anking systeHs deand"
The syste &rovides li4-idity in ties of crisis> ens-res financial sta5ility> and restricts the range
over =hich the arket federal f-nds rate can ove 7hel&ing to aintain interest:rate sta5ility8"
Secondary credit is availa5le to instit-tions that are not s-fficiently so-nd to 4-alify for &riary
credit"
Banks ay seek secondary credit d-e to a te&orary shortfall in reserves or 5eca-se they have
longer:ter &ro5les that they need to =ork o-t"
Seasonal credit is -sed &riarily 5y sall agric-lt-ral 5anks to hel& in anaging the cyclical nat-re
of farersH loans and de&osits
113
#eseve Suppl&
#eseve Deman3
Cuantit& o. #eseves
=aget #ate
M
a
!
e
t

F
e
3
e
a
l

F
u
n
3
s

#
a
t
e
ese$3e e8.%$e&en(s
By adR-sting the reserve re4-ireent> the central 5ank can infl-ence econoic activity 5eca-se
changes in the re4-ireent affect de&osit ex&ansion"
Cnfort-nately> the reserve re4-ireent t-rns o-t not to 5e very -sef-l 5eca-se sall changes in the
reserve re4-ireent have large 7really too large8 i&acts on the level of de&osits"
Today> the reserve re4-ireent exists &riarily to sta5iliIe the deand for reserves and hel& the
%entral 5ank to aintain the arket federal f-nds rate close to targetN it is not -sed as a direct
tool of onetary &olicy"
T#e -en($a0 *an+Ms Mone(a$' Po0%-' Too0*o)
T#e Too0s o, Mone(a$' Po0%-'
;#a( %s %(< "o/ %s %( -on($o00e1< ;#a( %s %(s %&7a-(<
Ta$ge( !e1e$a0
!.n1s a(e
,nterest rate charged on
overnight loans 5et=een
5anks
S-&&ly of reserves adR-sted
thro-gh o&en arket
o&erations to eet ex&ected
deand at the target rate
%hanges interest rates
thro-gho-t the econoy
D%s-o.n( $a(e ,nterest rate charged 5y the
central 5ank on loans to
coercial 5anks
Set as a &rei- over the
target federal f-nds rate
Provides short:ter
li4-idity to 5ank in ties
of crisis and aids in
controlling the federal
f-nds rate
ese$3e
$e8.%$e&en(
Fraction of de&osits that
5ank -st kee& either on
de&osit at the central 5ank
or as cash in their va-lts
Set 5y the central 5ank
=ithin a li4-idity i&osed
range
Sta5iliIes the deand
for reserves
L%n+%ng Too0s (o O*Qe-(%3es
;esira5le Feat-res of a Policy ,nstr-ent
2asily o5serva5le 5y everyone
%ontrolla5le and 4-ickly changed
Tightly linked to the &olicyakersH o5Rectives
These re4-ireents leave &olicyakers =ith fe= choices> and over the years central 5anks have
s=itched 5et=een controlling the 4-antity and controlling the &rices"
!%g.$e: T#e Ma$+e( ,o$ Ban+ ese$3es /#en (#e -en($a0 *an+ (a$ge(s (#e 8.an(%(' o, $ese$3es
@hen central 5ank targets the 4-antity of reserves> a shift in reserve deand ca-ses the arket federal
f-nds rate to ove" 1n increase in reserve deand forces the interest rate -&> =hile a fall in reserve deand
forces the interest rate do=n"
Ta$ge(s an1 Ins($.&en(s
)&erating instr-ents refer to act-al tools of &olicy> instr-ents that the central 5ank controls
directly"
114
#eseve Suppl&
Incease in #eseve Deman3
#eseve Deman3
=aget Cuantit&
Fall in
#eseve
Deman3
M
a
!
e
t

F
e
3
e
a
l

F
u
n
3
s

#
a
t
e
Cuantit& o. #eseves
,nterediate target refers to instr-ents that are not directly -nder the control of the central 5ank
5-t that lie 5et=een their &olicyaking tools and their o5Rectives"
)ver the last t=o cent-ries> central 5ankers largely a5andoned interediate targets> having realiIed
that they didnHt ake -ch sense"
,nstead> &olicyakers foc-s on ho= their actions directly affect their target o5Rectives
Ins($.&en(s2 Ta$ge(s an1 O*Qe-(%3es
Csing &olicy instr-ents to target o5Rectives directly
115
*peratin
Instru"ents
&xa"ples+
Interest ,ates
-onetary Base
Inter"ediate Tarets
&xa"ples+
.ro/th in -onetary
(reates
Final *b0ecti)es
&xa"ples+
1o/ inflation
2ih .ro/th
2in! [ 1 2in! [ 2
2in! [ 3
Lesson 5B
;"Y DO ;E CAE ABOUT MONETAY AGGEGATES<
2very co-ntry =ith high inflation has high oney gro=thN th-s to avoid s-stained e&isodes of high
inflation> a central 5ank -st 5e concerned =ith oney gro=th"
,t is i&ossi5le to have high> s-stained inflation =itho-t onetary accoodation"
Mone(a$' Agg$ega(es
!%g.$e: In,0a(%on an1 Mone' G$o/(#:
Mo1e$a(e=In,0a(%on Co.n($%es2 1DC1=4AA5
!%g.$e: Mone'2 G$o/(# an1 In,0a(%on
@hen the c-rrency that &eo&le are holding loses val-e -ch ra&idly> they =ill =ork to s&end =hat
they have as 4-ickly as &ossi5le
This =ill have the sae effect on inflation as an increase in oney gro=th
,t is i&ossi5le to have high> s-stained inflation =itho-t onetary accoodation"
Soething 5eyond R-st differences in oney gro=th acco-nts for the differences in inflation across
co-ntries"
Ve0o-%(' an1 (#e E8.a(%on o, E)-#ange
To -nderstand the relationshi& 5et=een inflation and oney gro=th =e need to foc-s on oney as
a eans of &ayent"
%onsider an exa&le of fo-r st-dents
116
45 2ine
0 10 20 30 40 50
10
20
30
40
50
?veage ?nnual Mone& $o1t* 5@6
?
v
e
a
g
e

?
n
n
u
a
l

I
n
.
l
a
t
i
o
n

5
@
6

?veage ?nnual Mone& $o1t*

?
v
e
a
g
e

?
n
n
u
a
l

I
n
.
l
a
t
i
o
n
45 2ine In.lation\Mone& $o1t*
Mone& $o1t* ]In.lation
1li has Rs" 1## in cash
Bilal has a Rs" 1## calc-lator
%hohan has $ tickets =orth Rs" +# each for a cricket atch
;ila=er has a set of $+ dra=ing &encils =orth Rs" 4 each
1li needs a calc-lator =hich he 5-ys fro Bilal"
Bilal =ishes to see the atch so he 5-ys the tickets fro %hohan
%hohan -ses the &roceeds to &-rchase the dra=ing &encils fro ;ila=er
Total 0al-e of the transactions is
7Rs" 1## x 1 calc-lator8 T 7Rs" +# x $ tickets8 T 7Rs" 4 x $+ &encils8 L Rs" '##
Generally
9o" of R-&ees x 9o" of tie each Re is -sed L Rs" 0al-e of Transactions
The n-5er of ties each r-&ee is -sed 7&er -nit of tie8 in aking &ayents is called the velocity
of oneyN the ore fre4-ently each r-&ee is -sed> the higher the velocity of oney
1&&lying to econoy =ide transactions?
c-antity of Money x 0elocity of Money L 9oinal G;P
Csing data on the 4-antity of oney and noinal G;P =e can co&-te the velocity of oneyN
each onetary aggregate has its o=n velocity
,f =e re&resent
Money =ith M
0elocity =ith 0
Price level =ith P
Real G;P =ith 3
9oinal G;P L P x 3
S-5stit-ting> =e get
M x 0 L P x 3
The e4-ation of exchange> M0LP3 &rovides the link 5et=een oney and &rices if =e re=rite it in
ters of &ercentage changes
T#e K.an(%(' T#eo$' an1 (#e Ve0o-%(' o, Mone'
Money Gro=th T 0elocity Gro=th L ,nflation T )-t&-t Gro=th
,n the early $#th cent-ry> ,rving Fisher =rote do=n the e4-ation of exchange and derived the
i&lication that
Money gro=th T velocity gro=th L inflation T real gro=th
1ss-ing
9o i&ortant changes occ-r in &ayent ethods or the cost of holding oney>
Real o-t&-t is deterined solely 5y econoic reso-rces and &rod-ction technology>
Then changes in the aggregate &rice level are ca-sed solely 5y changes in the 4-antity of oney"
,n other =ords
1ss-e that Jf0 L # and Jf3 L #"
;o-5ling the 4-antity of oney do-5les the &rice level"
,nflation is a onetary &henoenon 7Milton Friedan8"
,n o-r exa&le of fo-r st-dents> n-5er of r-&ees needed e4-aled total r-&ee val-e of the
transaction divided 5y no" of ties each r-&ee =as -sed
Money deand L Total val-e of transaction
0elocity of Money
For the econoy as a =hole>
117
Y % 6 % 7 % M %
$r
6Y M7
+ = +
=
Money deand L 9oinal G;P
0elocity
M
d
L 1P0 x P3
Money S-&&ly 7M
s
8 is deterined 5y central 5ank and the 5ehavior of the 5anking syste
24-ili5ri- eans M
d
L M
s
L M
Rearranging the Money deand f-nction gives M0 L P3
The 4-antity theory of oney tells -s =hy high inflation and high oney gro=th go together> and
ex&lains =hy co-ntries can have oney gro=th that is higher than inflation 75eca-se they are
ex&eriencing real gro=th8"
T#e !a-(s a*o.( Ve0o-%('
FisherHs logic led Milton Friedan to concl-de that central 5anks sho-ld si&ly set oney gro=th
at a constant rate"
Policyakers sho-ld strive to ens-re that the onetary aggregates gro= at a rate e4-al to the rate of
real gro=th &l-s the desired level of inflation"
118
Lesson 5C
T"E !ACTS ABOUT VELOCITY
FisherHs logic led Milton Friedan to concl-de that central 5anks sho-ld si&ly set oney gro=th
at a constant rate"
Policyakers sho-ld strive to ens-re that the onetary aggregates gro= at a rate e4-al to the rate of
real gro=th &l-s the desired level of inflation"
Vno=ing that the -lti&lier is a varia5le> Friedan s-ggested changes in reg-lations that =o-ld
6iit 5anksH discretion in creating oney
Tighten the relationshi& 5et=een the onetary aggregates and the onetary 5ase"
Fo=ever> even =ith FriedanHs recoendations> the central 5ank =o-ld sta5iliIe inflation 5y
kee&ing oney gro=th constant only if velocity =ere constant"
,n the long r-n> the velocity of oney is sta5le> tho-gh there can 5e significant short:r-n variations"
Fro the &oint of vie= of &olicyakers> these fl-ct-ations in velocity are enoro-s"
1ss-ing that central 5ank can acc-rately control the gro=th rate of M$ as =ell as acc-rately
forecast real gro=th"
Mone' G$o/(# N Ve0o-%(' G$o/(# I In,0a(%on N ea0 G$o/(#
@ith an inflation o5Rective of $J and a real gro=th forecast of '"+J> e4-ation of exchange tells -s
that &olicy akers sho-ld set oney gro=th +"+J in-s the gro=th rate of velocity"
,f velocity increases 5y 'J then oney gro=th needs to 5e $"+J
,f it falls 5y 'J then oney gro=th needs to 5e /"+J
@hen inflation is lo=> short r-n velocity gro=th can 5e several ties the &olicy akersH inflation
o5Rectives"
So to -se oney gro=th targets to sta5iliIe inflation> &olicy akers -st -nderstand ho= velocity
changes
Fl-ct-ations in velocity are tied to changes in &eo&leHs desire to hold oney and so in order to
-nderstand and &redict changes in velocityN &olicyakers -st -nderstand the deand for oney"
!%g.$e: Ve0o-%(' o, M1 an1 M4 >on (#e sa&e 3e$(%-a0 s-a0e9
119
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
0
1
2
3
4
5
6
7
8
9
10
^
e
l
o
c
i
t
&
DDDM1 ^elocit& DDDDM2 ^elocit&
!%g.$e: Pe$-en(age -#ange %n (#e s#o$(=$.n 3e0o-%(' o, M42 1D?A=4AA4
T#e T$ansa-(%ons De&an1 ,o$ Mone'
The 4-antity of oney &eo&le hold for transactions &-r&oses de&ends on
Their noinal incoe>
The cost of holding oney>
The availa5ility of s-5stit-tes
9oinal oney deand rises =ith noinal incoe> as ore incoe eans ore s&ending> =hich
re4-ires ore oney
Folding oney allo=s &eo&le to ake &ayents> 5-t has cost of interest foregone"
There ay also 5e costs in s=itching 5et=een interest:5earing assets and oney"
E)a&70e
,f yo-r onthly earning is Rs"'#> ### 7de&osited in 5ank each onth8 and ass-ing yo- s&end
Rs"1> ### each day> after 1+ days yo-r checking acco-nt 5alance =ill decline to Rs"1+> ### and to
Iero on '#
th
day
!%g.$e: Ve0o-%(' o, M4 >on %(s o/n s-a0e9
120
1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
1(6
1(7
1(8
1(9
2(0
2(1
2(2
^
e
l
o
c
i
t
&

o
.

M
2
Beas
1975 1980 1985 1990 1995 2000
-8
-6
-4
-2
0
2
4
6
8
F
o
u
-
C
u
a
t
e

@
a
g
e

c
*
a
n
g
e

5
@
6
Beas
3o-r 5ank offers yo- a choice of leaving the entire '#>### in the acco-nt or shifting f-nds 5ack
and forth 5et=een checking and a 5ond f-nd"
The 5ond f-nd &ays interest 5-t adds a service charge of Rs"$# for each =ithdra=al"
Fo= =o-ld yo- anage yo-r f-nds and =hat sho-ld 5e yo-r fre4-ency of shifting the f-nds
5et=een the 5ond f-nd and checking acco-ntA
%onsider the follo=ing alternatives"
T/o a0(e$na(%3es ,o$ &anag%ng 'o.$ -as# *a0an-e
Strategy 1? 6eave entire 5alance in checking acco-nt
S($a(eg' 4: T$ans,e$ #a0, (o *on1 ,.n12 (#en ($ans,e$ *a-+ a( &%1=&on(#
3o-r choice de&ends -&on the interest rate yo- receive on the 5ond f-nd
,f interest incoe is at least as -ch as the service charge then yo- =ill s&lit yo-r &ay check at the
5eginning of the onth"
)ther=ise yo- =ill not =ant to invest in 5ond f-nd"
,f yo- shift half yo-r f-nds once > at the iddle of the onth> yo-Hll have Rs"1+>### in 5ond f-nd
d-ring the first half of the onth and Rs"# d-ring the second half> so yo-r average 5alance =ill 5e
Rs".>+##"
Making shift =ill cost yo- Rs"$# so if the interest on Rs".> +## is greater than $#> yo- sho-ld ake
the shift"
1t onthly interest rate of #"$.J> Rs".> +## =ill &rod-ce an incoe of Rs"$#
7$# P .+##L #"##$.8
So if 5ond f-nd offers a higher rate yo- sho-ld ake the shift"
1s the noinal interest rate rises> &eo&le red-ce their checking acco-nt 5alances> =hich allo= -s to
&redict that velocity =ill change =ith the interest rate"
Figher the noinal interest rate> the less oney individ-als =ill hold for a given level of
transactions> and higher the velocity of oney
The transactions deand for oney is also affected 5y technology> as financial innovation allo=s
&eo&le to liit the ao-nt of oney they hold"
The lo=er the cost of shifting oney 5et=een acco-nts> the lo=er the oney holdings and the
higher the velocity"
121
309000
C*ec!ing account Ealance
30 0
Da& o. t*e mont*
7on3 .un3
Ealance is >eo
t*oug*out t*e
mont*(
0 15 30
159000
C*ec!ing account
Ealance
Da& o. t*e Mont*
159000
0 15 30
Da& o. t*e mont*
7on3 Fun3 7alance
S-&&ose yo-r 5ank offers free a-toatic transfer acco-nt" 3o- sign -& for it 5-t contin-e -sing
yo-r old check and de5it acco-nt
3o-r take hoe &ay is the sae Rs"'#> ###" 2ach tie yo- ake a &-rchase> yo-r 5ank
a-toatically shifts the ao-nt of &-rchase fro yo-r 5ond f-nd to yo-r checking acco-nt =here
it reains for one day 5efore 5eing &aid to yo-r creditor"
S&ending yo-r Rs"'#>### in '# days> yo-r average oney holding =ill 5e Rs"1### far 5elo=
Rs"1>+## yo- =o-ld hold if yo- si&ly left the '#>### in yo-r checking acco-nt and s&ent it at a
rate of Rs"1>### &er day
So lo=er the cost of shifting f-nds fro yo-r 5ond f-nd to yo-r checking acco-nt> the lo=er yo-r
oney holdings at a given level of incoe and the higher the velocity of yo-r oney
1n increase in the li4-idity of stocks> 5onds> or any other asset red-ces the transactions deand for
oney"
Peo&le also hold oney to ens-re against -nex&ected ex&ensesN this is called the &reca-tionary
deand for oney and can 5e incl-ded =ith the transactions deand"
The higher the level of -ncertainty a5o-t the f-t-re> the higher the deand for oney and the
lo=er the velocity of oney
T#e Po$(,o0%o De&an1 ,o$ Mone'
Money is R-st one of any financial instr-ents that =e can hold in o-r investent &ortfolios"
2x&ectations that interest rates =ill change in the f-t-re are related to the ex&ected ret-rn on a
5ond and also affect the deand for oney"
122
1esson 34
T"E POT!OLIO DEMAND !O MONEY
Money is R-st one of any financial instr-ents that =e can hold in o-r investent &ortfolios"
2x&ectations that interest rates =ill change in the f-t-re are related to the ex&ected ret-rn on a
5ond and also affect the deand for oney"
@hen interest rates are ex&ected to rise> oney deand goes -& as &eo&le s=itch fro holding
5onds into holding oney"
The deand for oney =ill also 5e affected 5y changes in the riskiness of other assetsN as their risk
increases so does the deand for oney"
Money deand =ill increase if other assets 5ecoe less li4-id"
De(e$&%nan(s o, Mone' De&an1: !a-(o$s (#a( -a.se %n1%3%1.a0s (o #o01 &o$e &one'
T$ansa-(%ons De&an1 ,o$ Mone'
9ational ,ncoe
,nterest rates
1vaila5ility of alternative eans
of &ayent
The higher noinal incoe> the higher the deand for oney
The lo=er interest rates> the higher the deand for oney
The less availa5le alternatives eans of &ayent> the higher the deand
for oney
Po$(,o0%o De&an1 ,o$ Mone'
@ealth
Ret-rn relative to alternatives
2x&ected f-t-re interest rates
Risk relative to alternatives
6i4-idity relative
1s =ealth rises> the deand for oney goes -&
1s the ret-rn on alternatives falls> the deand for oney goes -&
1s ex&ected f-t-re interest rates rise> the deand for oney goes -&
1s the riskiness of alternatives rises> the deand for oney goes -&
1s the li4-idity of alternatives falls> the deand for oney goes -&
Ta$ge(%ng Mone' G$o/(# %n a Lo/=In,0a(%on En3%$on&en(
,n the long r-n> inflation is tied to oney gro=th"
,n a high:inflation environent oderate variations in the gro=th of velocity are a ere
annoyance"
The only sol-tion to inflation in a high inflation environent is to red-ce oney gro=th"
,n a lo=:inflation environent> the a5ility to -se oney gro=th as a &olicy g-ide de&ends on the
sta5ility of the velocity of oney"
T=o criteria for the -se of oney gro=th as a direct onetary &olicy target?
1 sta5le link 5et=een the onetary 5ase and the 4-antity of oney
1 &redicta5le relationshi& 5et=een the 4-antity of oney and inflation
These allo= &olicyakers to Predict the i&act of changes in the central 5ankHs 5alance sheet on
the 4-antity of oney
Translate changes in oney gro=th into changes in inflation"
O.(7.( an1 In,0a(%on %n (#e Long .n
Po(en(%a0 O.(7.(
Potential o-t&-t is =hat the econoy is ca&a5le of &rod-cing =hen its reso-rces are -sed at noral
rates"
Potential o-t&-t is not a fixed level> 5eca-se the ao-nt of la5or and ca&ital in an econoy can
gro=> and i&roved technology can increase the efficiency of the &rod-ction &rocess
Cnex&ected events can &-sh c-rrent o-t&-t a=ay fro &otential o-t&-t> creating an o-t&-t ga&
,n the long r-n> c-rrent o-t&-t e4-als &otential o-t&-t"
Long=.n In,0a(%on
,n the long r-n> since c-rrent o-t&-t e4-als &otential o-t&-t> real gro=th -st e4-al gro=th in
&otential o-t&-t"
,gnoring changes in velocity> in the long r-n> inflation e4-als oney gro=th in-s gro=th in
&otential o-t&-t"
123
Tho-gh central 5anks foc-s on controlling short ter noinal interest rates> they kee& an eye on
oney gro=th
@hen they try to adR-st level of reserves in 5anking syste to aintain interest rate> it affects
oney gro=th" @hich in t-rn deterines inflation
Mone' G$o/(#2 In,0a(%on2 an1 Agg$ega(e De&an1
1ggregate deand tells -s ho= s&ending 7deand8 5y ho-seholds> firs> the governent> and
foreigners changes as inflation goes -& and do=n"
The level of aggregate deand is tied to onetary &olicy thro-gh the e4-ation of exchange
7M0LP38 5eca-se the ao-nt of oney in the econoy liits the a5ility to ake &ayents"
Rearranging the e4-ation of exchange
P
#V
$
ad
=
@here 3
ad
L aggregate deand>
M L the 4-antity of oney>
0 L the velocity of oney> and
P L the &rice level"
Fro this ex&ression it is clear that an increase in the &rice level red-ces the &-rchasing &o=er of
oney> =hich eans less &-rchases are ade> &-shing do=n aggregate deand

Inflation
-
P
-oney .ro/th
Unchaned
and less than
inflation
5elocity
Unchaned
(reate
De"and

6
ad

124
Lesson 4A
MONEY GO;T"2 IN!LATION2 AND AGGEGATE DEMAND
To shift the foc-s to inflation> =e need to look at changes in the &rice level"
S-&&ose that inflation exceeds oney gro=th 7=ith velocity held constant8" Real oney 5alances
=ill fall and so =ill aggregate deand
!%g.$e: T#e Agg$ega(e De&an1 C.$3e
1t higher level of inflation> real oney 5alances fall> res-lting in a lo=er level of aggregate
deand"
Beca-se real oney 5alances fall at higher levels of inflation> res-lting in a lo=er level of aggregate
deand> the aggregate deand c-rve is do=n=ard slo&ing"
%hanges in the interest rate also &rovide a echanis for aggregate deand to slo&e do=n
Mone(a$' Po0%-' an1 (#e ea0 In(e$es( a(e
%entral 5ankers control short:ter noinal interest rates 5y controlling the arket for reserves"
B-t the econoic decisions of ho-seholds and firs de&end on the real interest rateN
To alter the co-rse of the econoy> central 5anks -st infl-ence the real interest rate as =ell
,n the short r-n> 5eca-se inflation is slo= to res&ond> =hen onetary &olicyakers change the
noinal interest rate they change the real interest rate"
The real interest rate> then> is the lever thro-gh =hich onetary &olicyakers infl-ence the real
econoy"
,n changing real interest rates> they infl-ence aggregate deand"
Agg$ega(e De&an1 an1 (#e ea0 In(e$es( a(e
1ggregate deand is divided into fo-r co&onents?
%ons-&tion>
,nvestent>
Governent &-rchases>
9et ex&orts
1ggregate Govt"Hs 9et ;eand L %ons-&tion T ,nvestent T P-rchases T 2x&orts
3ad L % T , T G T 9G
,t is hel&f-l to think of aggregate deand as having t=o &arts> one that is sensitive to real interest
rate changes and one that is not
,nvestent is the ost i&ortant of the co&onents of aggregate deand that are sensitive to
changes in the real interest rate"
1n investent can 5e &rofita5le only if its internal rate of ret-rn exceeds the cost of 5orro=ing
125
_utput 5B6
In.lation 56
?ggegate Deman3 Cuve
%ons-&tion and net ex&orts also res&ond to the real interest rateN
%ons-&tion decisions often rely on 5orro=ing> and the alternative to cons-&tion is saving
7higher rates ean ore saving8"
1s for net ex&orts> =hen the real interest rate in a co-ntry rises> her financial assets 5ecoe
attractive to foreigners> ca-sing local c-rrency to a&&reciate> =hich in t-rn eans ore i&orts and
fe=er ex&orts 7lo=er net ex&orts8
@hile changes in real interest rate ay have an i&act on the governentHs 5-dget 5y raising the
cost of 5orro=ing> the effect is likely to 5e sall and ignora5le"
Th-s> considering cons-&tion> investent> and net ex&orts> an increase in the real interest rate
red-ces aggregate deand 7the effect on the 4th co&onent> governent s&ending> is sall
eno-gh to 5e ignored8"
I&7a-( o, $%se %n (#e ea0 %n(e$es( $a(e on Co&7onen(s o, Agg$ega(e De&an1
Co&7onen(s o,
Agg$ega(e De&an1
E,,e-( o, a $%se %n (#e $ea0 %n(e$es(
$a(e
I&7a-( on -o&7onen(
o, Agg$ega(e De&an1
%ons-&tion (C) Re=ard to saving rises %ons-&tion falls
,nvestent (I) %ost of financing rises ,nvestent falls
9et 2x&orts (NX) ;eand for doestic assets rises>
ca-sing a c-rrency a&&reciation> raising
the &rice of ex&orts and red-cing the
cost of i&orts
2x&orts fallN i&orts risesN
net ex&orts fall
Agg$ega(e De&an1 >Y
a1
9 C2 I an1 NX a00 ,a00 Agg$ega(e 1e&an1 ,a00s
T#e Long=.n ea0 In(e$es( a(e
There -st 5e soe level of the real interest rate at =hich aggregate deand e4-als &otential
o-t&-tN this is the long:r-n real interest rate"
The long:r-n real interest rate e4-ates aggregate deand =ith &otential o-t&-t"
The rate =ill change if a co&onent of aggregate deand that is not sensitive to the real interest
rate goes -& 7or do=n8 or if &otential o-t&-t changes"
For exa&le> an increase in governent &-rchases 7all else held constant8 =ill raise aggregate
deand at every level of the real interest rate"
To reain in e4-ili5ri-> one of the interest:sensitive co&onents of aggregate deand -st fall>
and for that to ha&&en> the long:r-n real interest rate -st rise"
The sae =o-ld 5e tr-e for increases in other co&onents of aggregate deand that are not
interest sensitive"
1 change in &otential o-t&-t has an inverse effect on the long:r-n real interest rateN
@hen &otential o-t&-t rises> aggregate deand -st rise =ith it> =hich re4-ires a decrease in the
real interest rate
In,0a(%on2 (#e ea0 In(e$es( a(e2 an1 (#e Mone(a$' Po0%-' ea-(%on C.$3e
Policyakers set their short:r-n noinal interest rate targets in res&onse to econoic conditions in
general and inflation in &artic-lar"
@hen c-rrent inflation is high or c-rrent o-t&-t is r-nning a5ove &otential o-t&-t> central 5ankers
=ill raise noinal interest ratesN =hen c-rrent inflation is lo= or c-rrent o-t&-t is =ell 5elo=
&otential> they =ill lo=er interest rates
@hile they state their &olicies in ters of noinal rates they do so kno=ing that changes in the
noinal interest rate =ill event-ally translate into changes in the real interest rate> and it is those
changes that infl-ence the econoic decisions of firs and ho-seholds
2x&erts agree that any 7coherent8 onetary &olicy can 5e =ritten as an inflation target &l-s a
res&onse to s-&&ly shocks
126
Lesson 41
DEIVING T"E MONETAY POLICY EACTION CUVE
To ens-re that deviations of inflation fro the target are only te&orary> onetary
&olicyakers res&ond to change in inflation 5y changing the real interest rate in the sae
direction"
The onetary &olicy reaction c-rve is set so that =hen c-rrent inflation e4-als target inflation>
the real interest rate e4-als the long:r-n real interest rate"
The slo&e of the c-rve de&ends on &olicyakersH o5RectivesN
@hen central 5ankers decide ho= aggressively to &-rs-e their inflation target> and ho= =illing
they are to tolerate te&orary changes in inflation> they deterine the slo&e of the c-rve
!%g.$e: T#e Mone(a$' Po0%-' ea-(%on C.$3e
A. T#e Mone(a$' Po0%-' ea-(%on C.$3e
Monetary &olicy akers react to changes in c-rrent inflation 5y changing the real interest rate" ,ncreases
in c-rrent inflation lead the to raise the real interest rate> =hile decreases lead the to lo=er it" The
onetary &olicy reaction c-rve is located so that the central 5ankHs target inflation is consistent =ith the
long:r-n real interest rate> =hich e4-ates aggregate deand =ith &otential o-t&-t"
B. Mo3e&en(s a0ong (#e Mone(a$' Po0%-' ea-(%on C.$3e
The long r-n real interest rate in an econoy is ro-ghly $"+J and the central 5ankHs i&licit inflation target
is a&&roxiately $J" The onetary &olicy reaction c-rve i&lies that a 1Jage &oint increase in inflation
calls for a half Jage &oint increase in the real interest rate::: a oveent along the onetary &olicy
reaction c-rve" That eans that an increase in inflation fro $ to ' J calls for an increase in the real
interest rate fro $"+ to ' J"
127
Moneta& "olic&
#eaction Cuve
#eal inteest
ate 56
In.lation 56 =aget In.lation
5
=
6
2ong #un #eal
Inteest #ate 5`6
S#%,(%ng (#e Mone(a$' Po0%-' ea-(%on C.$3e
Policyakers =ho are aggressive in kee&ing c-rrent inflation near target =ill have a stee& c-rve>
eaning that a sall change in inflation =ill 5e et =ith a large change in the real interest rate
1 relatively flat c-rve eans that central 5ankers are less concerned than they ight 5e =ith
kee&ing c-rrent inflation near target over the short ter"
The onetary &olicy reaction c-rve is set so that =hen c-rrent inflation e4-als target inflation>
the
Real interest rate e4-als the long:r-n real interest rate"
r L rY =hen L
T
"
@hen &olicyakers adR-st the real interest rate they are either oving along a fixed onetary
&olicy reaction c-rve or shifting the c-rve"
1 oveent along the c-rve is a reaction to a change in c-rrent inflationN a shift in the c-rve
re&resents a change in the level of the real interest rate at every level of inflation"

!%g.$e A: Mone(a$' Po0%-' ea-(%on C.$3e
128
Moneta& "olic&
#eaction Cuve
In.lation 56
#eal inteest ate
56
2ong #un #eal
Inteest #ate
5`'2( 5@6
3@
=aget
In.lation 5
=
'2@6
3@
inceases .om 2(5@
to 3@
Inceases .om
2@ to 3@
Moneta& polic& eaction
cuve o. a cental Ean!
t*at is aggessive in
!eeping cuent in.lation
close to its taget in t*e
s*ot un
In.lation 56 =aget In.lation 5
=
6
#eal Inteest
ate 56
2ong #un #eal Inteest
#ate 5`6
!%g.$e B: Mone(a$' Po0%-' ea-(%on C.$3e
,f either target inflation or the long:r-n real interest rate change> then the entire c-rve =ill shift
@ith a higher inflation target> the central 5ank =ill set a lo=er c-rrent real interest rate at every
level of c-rrent inflation> shifting the onetary &olicy reaction c-rve to the right 7a red-ction
=o-ld have the o&&osite effect8"
!%g.$e A: An %n-$ease %n (#e Cen($a0 Ban+Ms In,0a(%on Ta$ge(
1n increase in the central 5ankHs inflation target fro an initial level of
o
to the ne=
level of
1
shifts the onetary &olicy reaction c-rve to the right> lo=ering the real
interest rate at every level of c-rrent inflation"
The long:r-n real interest rate is deterined 5y the str-ct-re of the econoyN
,f it =ere to rise as a res-lt of an increase in governent &-rchases 7or soe other co&onent
of aggregate deand that is not sensitive to the real interest rate8 then the onetary &olicy
reaction c-rve =o-ld shift left
129
0e1 =aget
In.lation 516
_l3
0e1
In.lation 56
#eal Inteest #ate
56
2ong #un #eal
Inteest #ate 5`6
Initial =aget
In.lation 5o6
Moneta& "olic&
#eaction Cuve o. a
cental Ean! t*at is
less concene3 aEout
!eeping cuent
in.lation nea its taget
in t*e s*ot un
In.lation 56
=aget
In.lation 5
=
6
#eal Inteest
ate 5 6
2ong un eal
inteest ate 5`6
!%g.$e B: An %n-$ease %n (#e Long=$.n $ea0 %n(e$es( $a(e
1n increase in the econoyHs long r-n real interest rate fro r
o
to r
1
shifts the onetary &olicy reaction c-rve to the left> raising the real
interest rate at every level of c-rrent inflation
1ny shift in the onetary &olicy reaction c-rve can 5e characteriIed as either a change in target
inflation or a shift in the long:r-n real interest rate
T#e Mone(a$' Po0%-' ea-(%on C.$3e
;#a( %s %(< The relationshi& 5et=een c-rrent inflation and the real interest rate set 5y
onetary &olicy akers
;#a( 1e(e$&%nes %(s
0o-a(%on<
;ra=n so that> =hen c-rrent inflation e4-als target inflation> &olicyakers
=ill set the real interest rate e4-al to the long r-n real interest rate
;#a( 1e(e$&%nes %(s s0o7e< PolicyakerHs attit-de to=ard inflation" The ore aggressive &olicyakers
are in kee&ing c-rrent inflation close to target level> and the less tolerant
they are of te&orary changes in inflation> the stee&er the slo&es
;#en 1oes %( s#%,(< ,n res&onse to changes in either the long r-n real interest rate or the central
5ankHs inflation target" 1n increase in the long r-n real interest rate shifts
the c-rve to the left" 1n increase in the inflation target shifts the c-rve to
the right"
T#e Agg$ega(e De&an1 C.$3e
@hen c-rrent inflation rises
Monetary &olicyakers raise the real interest rate> oving -&=ard along the onetary &olicy
reaction c-rve
The higher real interest rate red-ces cons-&tion> investent> and net ex&orts ca-sing
aggregate deand 7o-t&-t8 to fall"
130
0e1
_l3
In.lation 56
#eal inteest ate 56
0e1 2ong un eal
inteest ate 516
Initial 2ong #un
eal inteest ate 5o6
=aget In.lation 5
=
6
T#e 0%n+ *e(/een C.$$en( In,0a(%on an1 Agg$ega(e De&an1
@hen c-rrent inflation rises > &olicy akers react 5y raising the real interest rate> =hich red-ces
cons-&tion> investent> and net ex&orts" The res-lt is a red-ction in aggregate deand"
%hanges in c-rrent inflation ove the econoy along a do=n=ard:slo&ing aggregate deand c-rve
This is in addition to the effect of higher inflation on real oney 5alances noted earlier
The slo&e of the aggregate deand c-rve tells -s ho= sensitive c-rrent o-t&-t is to a given change in
c-rrent inflation"
The aggregate deand c-rve =ill 5e relatively
Flat if c-rrent o-t&-t is very sensitive to inflation 7a change in c-rrent inflation ca-ses a large
oveent in c-rrent o-t&-t8
Stee& if c-rrent o-t&-t is not very sensitive to inflation
!%g.$e A: ;#en (#e &one(a$' 7o0%-' $ea-(%on -.$3e %s s(ee72 (#e -en($a0 *an+ %s agg$ess%3e %n
+ee7%ng -.$$en( %n,0a(%on nea$ %(s (a$ge( 0e3e0V (#e agg$ess%3e 1e&an1 -.$3e %s ,0a(.
!%g.$e B: ;#en (#e &one(a$' 7o0%-' $ea-(%on -.$3e %s ,0a(2 (#e -en($a0 *an+ %s 0ess -on-e$ne1 a*o.(
+ee7%ng -.$$en( %n,0a(%on nea$ %(s (a$ge( 0e3e0V (#e agg$ega(e 1e&an1 -.$3e %s s(ee7.
131
Current
Inflation -onetary Policy reacts
by tihtenin
,eal Interest
,ate
Consu"ption7
In)est"ent. 8et
exports all fall
(reate
De"and
Flat ?ggegate Deman3
_utput 5B6
In.lation 56
Steep ?ggegate Deman3
In.lation 56
_utput 5B6
Three factors infl-ence the sensitivity of c-rrent o-t&-t to inflation?
The strength of the effect of inflation on real oney 5alances>
The extent to =hich onetary &olicyakers react to a change in c-rrent inflation>
The siIe of the res&onse of aggregate deand to changes in the interest rate
The second factor relates to the slo&e of the onetary &olicy reaction c-rve
,f &olicyakers react aggressively to a oveent of c-rrent inflation a=ay fro its target
level =ith a large change in the real interest rate> the onetary &olicy reaction c-rve =ill 5e
stee& and the aggregate deand c-rve is flat
,f &olicyakers res&ond ore ca-tio-sly> the onetary &olicy reaction c-rve is flat and the
aggregate deand c-rve is stee&
The slo&e of the aggregate deand c-rve de&ends in &art on the &references of the central
5ankN
Fo= aggressive &olicyakers are in res&onding to deviations of inflation fro the target
level
132
Lesson 44
T"E AGGEGATE DEMAND CUVE
The slo&e of the aggregate deand c-rve tells -s ho= sensitive c-rrent o-t&-t is to a given change
in c-rrent inflation"
The aggregate deand c-rve =ill 5e relatively
Flat if c-rrent o-t&-t is very sensitive to inflation 7a change in c-rrent inflation ca-ses a large
oveent in c-rrent o-t&-t8
Stee& if c-rrent o-t&-t is not very sensitive to inflation
Three factors infl-ence the sensitivity of c-rrent o-t&-t to inflation?
The strength of the effect of inflation on real oney 5alances>
The extent to =hich onetary &olicyakers react to a change in c-rrent inflation>
The siIe of the res&onse of aggregate deand to changes in the interest rate
The second factor relates to the slo&e of the onetary &olicy reaction c-rve
,f &olicyakers react aggressively to a oveent of c-rrent inflation a=ay fro its target level =ith
a large change in the real interest rate> the onetary &olicy reaction c-rve =ill 5e stee& and the
aggregate deand c-rve is flat
,f &olicyakers res&ond ore ca-tio-sly> the onetary &olicy reaction c-rve is flat and the
aggregate deand c-rve is stee&
The slo&e of the aggregate deand c-rve de&ends in &art on the &references of the central 5ankN
ho= aggressive &olicyakers are in res&onding to deviations of inflation fro the target level
T#e$e a$e (/o $easons /#' (#e agg$ega(e 1e&an1 -.$3e s0o7es 1o/n:
First> 5eca-se higher inflation red-ces real oney 5alances 7th-s red-cing &-rchases8>
Second> 5eca-se higher inflation ind-ces &olicyakers to raise the real interest rate> de&ressing
vario-s co&onents of aggregate deand
Rising inflation also red-ces =ealth> =hich lo=ers cons-&tion and drives do=n aggregate
deand"
,n addition> as inflation rises the -ncertainty a5o-t inflation rises> =hich akes e4-ities a ore risky
investent and dro&s their val-e> also red-cing =ealth
1nother reason is that inflation can have a greater i&act on the &oor than it does on the =ealthy>
redistri5-ting incoe to those =ho are 5etter off
Peo&le ay also save ore as a res-lt of the increased risk associated =ith inflation"
1lso> rising inflation akes foreign goods chea&er in relation to doestic goods> driving i&orts
-& and net ex&orts do=n"
S#%,(%ng (#e Agg$ega(e De&an1 C.$3e
,n o-r derivation of the aggregate deand c-rve> =e held constant 5oth the location of the
onetary &olicy reaction c-rve and those co&onents of aggregate deand that do not res&ond to
the real interest rate"
%hanges in any of those co&onents> as =ell as changes in the location of the onetary &olicy
reaction c-rve> =ill shift the aggregate deand c-rve"
Shifts in the Monetary Policy Reaction %-rve
@henever the onetary &olicy reaction c-rve shifts> the aggregate deand c-rve =ill shift as =ell
%hanges in the long:r-n real interest rate> =hich is a conse4-ence of the str-ct-re of the econoy>
=ill also shift aggregate deand
133
!%g.$e: S#%,(%ng (#e Agg$ega(e De&an1 C.$3e >ADC9
,ncreases in aggregate ;eand arising fro a change in onetary &olicy> s-ch as a higher inflation target>
=ill shift the aggregate deand c-rve to the right" ,ncreases in interest rate intensive co&onents of
aggregate deand> s-ch as governent &-rchases> =ill also shift the aggregate deand c-rve to the right"
2ither a fall in target inflation or a rise in the long:r-n real interest rate =ill shift the onetary
&olicy reaction c-rve to the left and the aggregate deand c-rve to the left"
C#anges %n (#e Co&7onen(s o, Agg$ega(e De&an1
1ny change in a co&onent of aggregate deand that is ca-sed 5y a factor other than a change in
the real interest rate =ill shift the aggregate deand c-rve"
@hen firs 5ecoe ore o&tiistic a5o-t the f-t-re> or cons-er confidence increases>
investent or cons-&tion =ill increase and aggregate deand =ill shift to the right"
C#anges %n (#e Co&7onen(s o, Agg$ega(e De&an1
,ncreases in governent &-rchases =ill increase aggregate deand> as =ill decreases in taxes"
,ncreases in net ex&orts that are -nrelated to changes in real interest rates =ill shift the aggregate
deand c-rve to the right
C#anges (#a( s#%,( (#e Co&7onen(s o, Agg$ega(e De&an1 (o (#e $%g#(:
1n increase in cons-&tion that is -nrelated to a change in the real interest rate"
1n increase in investent that is -nrelated to a change in the real interest rate"
1n increase in governent &-rchases
1 decrease in taxes
1n increase in net ex&orts that is -nrelated to a change in the real interest rate
Beca-se shifts in the onetary &olicy reaction c-rve can shift the aggregate deand c-rve> it is
&ossi5le that onetary &olicy can ca-se recessions"
,f &olicyakers can ca-se recessions> they can &ro5a5ly avoid the as =ell 5y ne-traliIing shifts in
aggregate deand that arise fro other so-rces"
The analysis -& to this &oint has ass-ed that inflation does not change over tieN 5-t in reality
,nflation and o-t&-t are Rointly deterined> and onetary &olicy &lays a role in the short:r-n
Moveents of 5oth"
134
0e1 ?DC
_l3 ?DC
_utput 5B6
In.lation 56
Lesson 45
T"E AGGEGATE SUPPLY CUVE
The aggregate s-&&ly c-rve tells -s =here on the aggregate deand c-rve the econoy =ill end -&>
ex&laining the relationshi& 5et=een inflation and real o-t&-t in the &rocess"
The short r-n aggregate s-&&ly c-rve tells -s =here the econoy =ill settle at any &artic-lar tie
6ong r-n c-rve tells -s the levels of inflation and o-t&-t the econoy is oving to=ard"
,nflation &ersistence
,nflation tends to change slo=lyN =hen it is lo= one year it tends to 5e lo= the next year> and =hen
it is high it tends to stay high" This is called inflation &ersistence
,f inflation reains steady over shorter &eriods> =hile real o-t&-t adR-sts> then the short:r-n
aggregate s-&&ly c-rve -st 5e flat at the c-rrent level of inflation
!%g.$e: In,0a(%on S(a(%s(%-s o, Pa+%s(an
Inflation statistics of Pakistan
0
2
4
6
8
10
12
14
1
9
9
1
-
1
9
9
2
1
9
9
2
-
1
9
9
3
1
9
9
3
-
1
9
9
4
1
9
9
4
-
1
9
9
5
1
9
9
5
-
1
9
9
6
1
9
9
6
-
1
9
9
7
1
9
9
7
-
1
9
9
8
1
9
9
8
-
1
9
9
9
1
9
9
9
-
2
0
0
0
2
0
0
0
-
2
0
0
1
2
0
0
1
-
2
0
0
2
2
0
0
2
-
2
0
0
3
2
0
0
3
-
2
0
0
4
2
0
0
4
-
2
0
0
5
2
0
0
5
-
2
0
0
6
In,0a(%on %s 7e$s%s(en( ,o$ (/o $easons
First> =hen &eo&le ex&ect inflation to contin-e> they adR-st their &rices and =ages accordingly"
!%g.$e: In,0a(%on %n (#e E.$o A$ea2 1DD1=4AA4
This fig-re sho=s the 1$:onth change in the haroniIed
index of cons-er &rices for the 1$ co-ntries of the e-ro area"
135
0
1992 1994 1996 1998 2000 2002 2004
1
2
3
4
5
6
1
2
-
m
o
n
t
*

@
a
g
e

c
*
a
n
g
e

5
@
6
@hen &eo&le ex&ect inflation in the near f-t-re they raise =ages and &rices in a =ay that ca-ses
the inflation they ex&ect to occ-r"
Therefore> c-rrent inflation is at least &artially deterined 5y ex&ected inflation
In,0a(%on %s 7e$s%s(en( ,o$ (/o $easons
Second> not all =age and &rice decisions are ade at the sae tie"
Price and =age adR-stents are staggered> and this slo=s do=n the adR-stent &rocess ca-sing
&ersistence in inflation
The fact that inflation is &ersistent eans that it is fixed in the short r-n> so the short:r-n
aggregate s-&&ly c-rve is horiIontal at the c-rrent level of inflation"
!%g.$e: S#o$( .n Agg$ega(e S.770' C.$3e
,nflation &ersistence eans the short r-n aggregate s-&&ly c-rve is horiIontal"
Firs si&ly do not adR-st the rate of their &rice increases in the short r-nN instead> they adR-st
the 4-antities they &rod-ce and sell"
)ver &eriods of several years or ore> inflation does change> shifting the short:r-n aggregate
s-&&ly c-rve -& or do=n
S#%,(s %n (#e S#o$(=.n Agg$ega(e S.770' C.$3e
There are t=o reasons =hy the short r-n aggregate s-&&ly c-rve can shift
;eviations of c-rrent o-t&-t fro &otential o-t&-t> ca-sing changes in inflation
%hanges in external factors driving &rod-ction costs
O.(7.( Ga7s
@hen c-rrent o-t&-t e4-als &otential o-t&-t so that there is no o-t&-t ga&> the short:r-n
aggregate s-&&ly c-rve reains sta5le
B-t =hen c-rrent o-t&-t rises a5ove or falls 5elo= &otential o-t&-t> so that an o-t&-t ga&
develo&s> inflation =ill rise or fall"
136
S*ot #un ?ggegate Suppl& Cuve 5S#?S6
Cuent
In.lation
_utput 5B6
In.lation 56
!%g.$e: S#%,(s %n (#e S#o$( .n Agg$ega(e S.770' C.$3e
es7onse (o an O.(7.( Ga7
@hen c-rrent o-t&-t rises a5ove &otential o-t&-t> creating an ex&ansionary
o-t&-t ga&> the short r-n aggregate s-&&ly c-rve shifts -&=ard" @hen
c-rrent o-t&-t falls 5elo= &otential o-t&-t> creating a recessionary o-t&-t
ga&> the short r-n aggregate s-&&ly c-rve shifts do=n=ard"
@hen c-rrent o-t&-t is 5elo= &otential o-t&-t> &art of the econoyHs ca&acity is idle> and firs
tend to raise their &rices and =ages less than they did =hen c-rrent o-t&-t e4-aled &otential
o-t&-t"
@hen c-rrent o-t&-t exceeds &otential o-t&-t> the o&&osite ha&&ensN firs increase their &rices
and =ages ore than they =o-ld if they =ere o&erating at noral levels
Th-s =hen c-rrent o-t&-t deviates fro &otential o-t&-t> inflation adR-sts> and the effect takes
tie to 5e felt"
2conoists have differing vie=s on ho= 4-ickly inflation reacts and the short:r-n aggregate s-&&ly
c-rve shifts"
Those =ho 5elieve in flexi5le &rices think it ha&&ens 4-ickly>
@hile those =ho e&hasiIe that any &rice and =age decisions involve long:ter contracts think
the adR-stent is sl-ggish"
In,0a(%on S#o-+s
1n inflation shock is a change in the cost of &rod-cing o-t&-t and ca-ses the short:r-n aggregate
s-&&ly c-rve to shift"
This can 5e the res-lt of changes in the cost of ra= aterials or la5or> or 7as is ost coon8 a
change in the &rice of energy"
1 &ositive inflation shock ca-ses the short:r-n aggregate s-&&ly c-rve to shift -&=ard> ca-sing
inflation to rise
137
S#?S
a*en cuent output is
aEove t*an t*e potential
output9 t*e S#?S s*i.ts
up
a*en cuent output
is Eelo1 t*e potential
output9 t*e S#?S
s*i.ts 3o1n
_utput 5B6 "otential _utput
Cuent
In.lation
In.lation 56
!%g.$e: S#%,(s %n (#e S#o$(=.n Agg$ega(e S.770' C.$3e
es7onse (o an %n,0a(%on s#o-+
1 rise in la5or costs> the &rices of ra= aterials or ex&ected f-t-re level of inflation creates an inflation
shock that shifts the SR1S -&=ard> ca-sing inflation to rise"
T#e Long=.n Agg$ega(e S.770' C.$3e
,n the long r-n the econoy oves to the &oint =here c-rrent o-t&-t e4-als &otential o-t&-t>
=hile inflation is deterined 5y oney gro=th
The long:r-n aggregate s-&&ly c-rve is vertical at the &oint =here c-rrent o-t&-t e4-als &otential
o-t&-t"
!%g.$e: T#e Long .n an1 S#o$( .n Agg$ega(e S.770' C.$3es
The long r-n aggregate s-&&ly c-rve is vertical at the &oint =here c-rrent o-t&-t
e4-als the &otential o-t&-t"
%hanges in ex&ected inflation o&erate like cost shocks> shifting the short:r-n aggregate s-&&ly
c-rve -& and do=n"
For the econoy to reain in long:r-n e4-ili5ri-> then> in addition to c-rrent o-t&-t e4-aling
&otential o-t&-t> c-rrent inflation -st e4-al ex&ected inflation
1t any &oint along the long:r-n aggregate s-&&ly c-rve> c-rrent o-t&-t e4-als &otential o-t&-t and
c-rrent inflation e4-als ex&ected inflation
Potential o-t&-t is constantly rising as a res-lt of investent and technological i&roveents 7the
so-rces of econoic gro=th8> =hich increase the noral o-t&-t level"
%hanges in the econoyHs &rod-ctive ca&acity =ill shift the long:r-n aggregate s-&&ly c-rveN
increases =ill shift it right and decreases =ill shift it left"
138
?n incease in t*e cost o.
po3uction s*i.ts t*e S#?S up
"ositive In.lation S*oc!
_utput 5B6
In.lation 56
2#?S
S#?S
In.lation 56
_utput 5B6
"otential _utput
Cuent
In.lation
Lesson 44
EKUILIBIUM AND T"E DETEMINATION O! OUTPUT AND IN!LATION
S#o$(=.n E8.%0%*$%.&
Short:r-n e4-ili5ri- is deterined 5y the intersection of the aggregate deand c-rve =ith the
short:r-n aggregate s-&&ly c-rve"
!%g.$e: S#o$( .n E8.%0%*$%.& o, O.(7.( an1 In,0a(%on
,nflation and act-al o-t&-t are deterined 5y the intersection of the SR1S c-rve =ith the 1;%
A1Q.s(&en( (o Long=.n E8.%0%*$%.&
@hen c-rrent o-t&-t exceeds &otential> the res-lting ex&ansionary ga& exerts -&=ard &ress-re on
inflation> shifting the short:r-n aggregate s-&&ly c-rve -&=ard> a &rocess that contin-es -ntil
o-t&-t ret-rns to &otentialN at this &oint inflation sto&s changing"
,f c-rrent o-t&-t is lo=er than &otential o-t&-t> the res-lting recessionary ga& &laces do=n=ard
&ress-re on inflation> ca-sing the short:r-n aggregate s-&&ly c-rve to shift do=n=ard> and once
again the &rocess contin-es -ntil c-rrent o-t&-t ret-rns to &otential
139
?DC
S#?S
_utput 5B6
In.lation 56
?ctual _utput
Cuent
In.lation
S*ot un :VuiliEium
S#?S
2#?S
?DC
In.lation 56
Cuent
In.lation
"otential
_utput
Cuent
_utput
:Apansiona
& _utput
$ap
_utput 5B6
1
2
This sho=s that the econoy does indeed have a self:correcting echanis and that the anner in
=hich the short:r-n aggregate s-&&ly c-rve shifts in res&onse to o-t&-t ga&s reinforces o-r
concl-sion that the long:r-n aggregate s-&&ly c-rve is vertical
,n long:r-n e4-ili5ri-> c-rrent o-t&-t e4-als &otential o-t&-t and c-rrent inflation is steady and
e4-al to target inflation> =hich e4-als ex&ected inflation
T#e I&7a-( o, S#%,(s %n Agg$ega(e De&an1 on O.(7.( an1 In,0a(%on
S-&&ose aggregate deand shifted right as a res-lt of an increase in governent &-rchases"
1t first> c-rrent o-t&-t rises 5-t inflation does not change"
B-t the higher level of o-t&-t creates an ex&ansionary ga& and the short:r-n aggregate s-&&ly c-rve
starts to shift -&=ard and inflation rises

S#o$(=.n E8.%0%*$%.& In,0a(%on an1 O.(7.( !o00o/%ng an In-$ease %n Agg$ega(e De&an1
1. S(a$( a( Long=.n E8.%0%*$%.&
3 L Potential )-t&-t
L Target ,nflation
4. Agg$ega(e De&an1 S#%,(s %g#(
)riginal 1; shifts to 9e= 1;
3 M Potential )-t&-t
,nflation ,s Cnchanged
140
0e1 ?D
_iginal ?D
2#?S
"otential
_utput
Cuent
_utput
=aget In.lation 5
=
6
_utput 5B6
In.lation 56
2 S#?S
2#?S
S#?S
?DC
#ecessiona&
$ap
"otential
_utput
Cuent
_utput
Cuent
In.lation
In.lation 56
1
2
_utput 5B6
Short:r-n e4-ili5ri- oves fro &oint 1 to &oint $
Figher inflation oves &olicyakers along their reaction c-rve> leading the to raise the real
interest rate and oving the econoy -&=ard along the ne= aggregate deand c-rve" )-t&-t
then 5egins to fall 5ack to=ard its long:r-n e4-ili5ri- level"
The econoy =ill settle at the &oint at =hich the ne= aggregate deand c-rve crosses the long:r-n
aggregate s-&&ly c-rve and c-rrent o-t&-t again e4-als &otential o-t&-t

A1Q.s(&en( o, S#o$(=.n E8.%0%*$%.& In,0a(%on an1 O.(7.( !o00o/%ng an In-$ease %n Agg$ega(e
De&an1
A1Q.s(&en(:
1t the Short:R-n 24-ili5ri- &oint $?
3 M Potential )-t&-t
SR1S 5egins to shift -&
)-t&-t 5egins to fall
,nflation 5egins to rise as econoy oves along 9e= 1;
@ith no &olicy res&onse> econoy oves to &oint '> =here %-rrent inflation MTarget inflation
,f central 5ankers si&ly sit and =atch as the aggregate deand c-rve shifts to the right> inflation
=ill rise
So long as onetary &olicyakers reain coitted to their original inflation target> they =ill need
to do soething to get the econoy 5ack to the &oint =here it 5eganS&oint D1E
1n increase in governent &-rchases raises the long-ter real interest rate"
Policyakers =ill co&ensate 5y shifting their onetary &olicy reaction c-rve to the left> increasing
the real interest rate at every level of inflation
@hen the onetary &olicy reaction c-rve shifts> the aggregate deand c-rve shifts =ith it"
The aggregate deand c-rve =ill shift to the left> 5ringing the econoy 5ack to long:r-n
e4-ili5ri-"
1n increase in aggregate deand ca-ses a te&orary increase in 5oth o-t&-t and inflation"
1 decline in aggregate deand ca-ses a te&orary decline in 5oth o-t&-t and inflation
This disc-ssion i&lies that =henever =e see a &eranent increase in inflation> it -st 5e the res-lt
of onetary &olicy"
That is> if inflation goes -& or do=n and reains at its ne= level> the only ex&lanation is that central
5anker -st 5e allo=ing it to ha&&en"
They have changed their inflation target> =hether or not they ackno=ledge the change ex&licitly"
T#e I&7a-( o, In,0a(%on S#o-+s on O.(7.( an1 In,0a(%on
1n inflation shock shifts the short:r-n aggregate s-&&ly c-rve 7s-ch as an oil &rice increase8
141
2#?S
S#?S
0e1 ?DC
"otential
_utput
_utput 5B6
=aget
In.lation 5
=
6
In.lation 56
2
3
1 &ositive shock oves it to a higher level> and the res-lt is higher inflation and lo=er o-t&-t> a
sit-ation called DstagflationE"
!%g.$e: T#e E,,e-(s o, a Pos%(%3e In,0a(%on S#o-+ on S#o$(=.n E8.%0%*$%.&
1 &ositive inflation shock shifts the short:r-n aggregate s-&&ly c-rve -&=ard> oving short
r-n e4-ili5ri- fro &oint 1 to &oint $" ,nflation rises and o-t&-t falls"
B-t the decline in o-t&-t exerts do=n=ard &ress-re on inflation> ca-sing the short:r-n aggregate
s-&&ly c-rve to shift do=n
,nflation falls and o-t&-t rises -ntil the econoy ret-rns to the &oint =here c-rrent o-t&-t e4-als
&otential o-t&-t and inflation e4-als the central 5ankHs target"
1n inflation shock has no affect on the econoyHs long:r-n e4-ili5ri- &ointN only a change in
Potential o-t&-t or a change in the central 5ankHs inflation target can acco&lish that"
142
2#?S
0e1 S#?S
_l3 S#?S
Cuent
_utput
"otential
_utput
_utput 5B6
=aget In.lation 5
=
6
In.lation 56
2
1
?DC
Lesson 46
S"I!TS IN POTENTIAL OUTPUT AND EAL BUSINESS CYCLE T"EOY
%hanges in &otential o-t&-t shift the long:r-n aggregate s-&&ly c-rve
1t first the shift has no i&act on the short:r-n aggregate s-&&ly c-rve> so inflation and o-t&-t
reain sta5le
B-t =ith tie> the increase in &otential o-t&-t =ill ean that c-rrent o-t&-t is no= 5elo= &otential
o-t&-t> creating a recessionary o-t&-t ga&> =hich &-ts do=n=ard &ress-re on inflation> shifting the
short:r-n aggregate s-&&ly c-rve do=n=ard
!%g.$e: T#e E,,e-(s o, an %n-$ease %n 7o(en(%a0 O.(7.( on In,0a(%on an1 O.(7.(
1n increase in &otential o-t&-t shifts the 6R1S c-rve to the right" ,n the short r-n> c-rrent o-t&-t reains
-nchanged" B-t since c-rrent o-t&-t is no= 5elo= &otential o-t&-t> the res-lting recessionary ga& &laces
do=n=ard &ress-re on inflation and o-t&-t event-ally 5egin to rise"
@hat ha&&ens next de&ends on =hat &olicyakers doN they can?
Take advantage of the do=n=ard &ress-re on inflation to red-ce their inflation target
,nitiate actions that ens-re that inflation does not fall"
,n either case> notice that the higher level of &otential o-t&-t eans a lo=er long:ter real interest
rate"
B-siness cycle fl-ct-ations can therefore 5e ex&lained in ters of shifts in aggregate deand that
change its &oint of intersection =ith a flat short:r-n aggregate s-&&ly c-rve
1n alternative ex&lanation for 5-siness cycle fl-ct-ations foc-ses on shifts in &otential o-t&-t> a
vie= called real 5-siness cycle theory"
ea0 *.s%ness -'-0e (#eo$'
Real 5-siness cycle theory starts =ith the ass-&tion that &rices and =ages are flexi5le> so that
inflation adR-sts ra&idly 7the short:r-n aggregate s-&&ly c-rve shifts 4-ickly in res&onse to
deviations of c-rrent o-t&-t fro &otential o-t&-t8"
This ass-&tion i&lies that the short:r-n aggregate s-&&ly c-rve is irrelevant? e4-ili5ri- o-t&-t
and inflation are deterined 5y the &oint on the aggregate deand c-rve =here c-rrent o-t&-t
e4-als &otential o-t&-t
1ny shift in the aggregate deand c-rve> regardless of its so-rce> =ill change inflation 5-t not
o-t&-t
143
0e1 2#?S _l3 2#?S
S#?S
?D
=aget In.lation
5
=
6
_l3 "otential
_utput
0e1
"otential
_utput
_utput 5B6
In.lation 56
S*ot un
eVuiliEium is
unc*ange3
Real 5-siness cycle theorists ex&lain recessions and 5oos 5y looking at fl-ct-ations in &otential
o-t&-t> foc-sing on changes in &rod-ctivity and their i&act on G;P
T#e I&7a-( o, a S#%,( %n Agg$ega(e De&an1 an1 Agg$ega(e S.770' on O.(7.( an1 In,0a(%on
In-$ease %n Agg$ega(e
De&an1
Pos%(%3e In,0a(%on
S#o-+
In-$ease %n Po(en(%a0
O.(7.(
So.$-e %ons-er %onfidence -&
B-siness )&tiis -&
Govt" P-rchases -&
Taxes ;o=n
2xchange Rate
;e&reciates
6a5or %osts -&
Ra= Material Prices -&
2x&ected ,nflation -&
%a&ital in Prod-ction -&
6a5or in Prod-ction -&
Prod-ctivity -&
S#o$(=.n
E,,e-(s
3 ,ncreases
,s -nchanged
3 falls
rises
3 -nchanged
Cnchanged
Pa(# o,
A1Q.s(&en(
1" 2x&ansionary o-t&-t ga&
&-ts -&=ard &ress-re on
inflation
$" 1s ,nflation 5egins to
rise> o-t&-t 5egins to fall
1" Recessionary o-t&-t
ga& &-ts do=n=ard
&ress-re on inflation
$" 1s ,nflation 5egins to
fall> o-t&-t 5egins to
rise
1" Recessionary o-t&-t ga&
&-ts do=n=ard &ress-re on
inflation
$" 1s ,nflation 5egins to fall>
o-t&-t 5egins to rise
Long=.n
E,,e-(s
3 L original &otential
o-t&-t
L target 7ay change8
3 L original &otential
o-t&-t
L target 7ay
change8
3 L ne= &otential o-t&-t
L target 7ay change8
E,,e-(s o,
Mone(a$'
Po0%-'
,nflation =ill rise
te&orarily -nless the
central 5ank changes its
inflation target"
,nflation =ill rise
te&orarily -nless the
central 5ank changes its
inflation target"
,nflation =ill fall te&orarily
-nless the central 5ank
changes its inflation target"
S(a*%0%Fa(%on Po0%-'
Mone(a$' Po0%-'
Policyakers can shift the aggregate deand c-rve 5y shifting their onetary &olicy reaction c-rve>
5-t they cannot shift the short:r-n aggregate s-&&ly c-rve
They can ne-traliIe oveents in aggregate deand> 5-t they cannot eliinate the effects of an
inflation shock
S#%,(s %n Agg$ega(e De&an1
,f ho-seholds and 5-sinesses 5ecoe ore &essiistic> driving do=n aggregate deand> the
econoy oves into a recession as the ne= short:r-n e4-ili5ri- &oint is at a c-rrent o-t&-t less
than &otential o-t&-t"
Policyakers =ill concl-de that the long:r-n real interest rate has gone do=n and =ill shift their
onetary &olicy reaction c-rve to the right> red-cing the level of the real interest rate at every level
of inflation
This shifts the aggregate deand c-rve 5ack to its initial &osition
!%g.$e: S(a*%0%F%ng a s#%,( %n Agg$ega(e De&an1
Follo=ing a dro& in cons-er or 5-siness confidence> 1;% shifts to the left" to sta5iliIe the econoy> the
central 5ank can ease the &olicy> shifting the onetary &olicy reaction c-rve to the right" This red-ces the
real interest rate at every level of inflation and shifts the aggregate deand c-rve 5ack to =here it started"
Their action leaves c-rrent o-t&-t and inflation -nchanged"
144
,n the a5sence of a &olicy res&onse> o-t&-t =o-ld fallN instead> o-t&-t reains steady along =ith
inflation"
Policyakers have ne-traliIed the shift in aggregate deand> kee&ing c-rrent o-t&-t e4-al to
&otential o-t&-t and c-rrent inflation e4-al to target inflation"
In,0a(%on S#o-+s an1 (#e Po0%-' T$a1eo,,
For &olicyakers> an inflation shock is an entirely different story"
1 &ositive inflation shock drives do=n o-t&-t and drives -& inflation"
Policyakers can shift the onetary &olicy reaction c-rve and so shift the aggregate deand c-rve>
relying on the econoyHs nat-ral res&onse to an o-t&-t ga& to 5ring inflation 5ack to target
The central 5ank can res&ond aggressively to kee& %-rrent ,nflation near Target
B-t this tool cannot 5e -sed to 5ring the econoy 5ack to its original long:r-n e4-ili5ri- &oint>
5eca-se onetary &olicy can shift the aggregate deand c-rve 5-t not the short:r-n aggregate
s-&&ly c-rve
Fo=ever> onetary &olicyakers can choose the slo&e of their onetary &olicy reaction c-rve and
so affect the slo&e of the aggregate deand c-rve> and in this =ay onetary &olicyakers can
choose the extent to =hich inflation shocks translate into changes in o-t&-t or changes in inflation
By reacting aggressively to inflation shocks> &olicyakers force c-rrent inflation 5ack to target
4-ickly> 5-t at a cost of s-5stantial decreases in o-t&-t
The central 5ank can res&ond ca-tio-sly to MiniiIe ;eviations of %-rrent )-t&-t fro Potential
)-t&-t
@hen choosing ho= aggressively to res&ond to inflation shocks> central 5ankers decide ho= to
cond-ct sta5iliIation &olicyN they can sta5iliIe o-t&-t or inflation> 5-t not 5oth
O77o$(.n%(%es C$ea(e1 *' In-$ease1 P$o1.-(%3%('
@hen &rod-ctivity rises> &otential o-t&-t increases" This shifts the long:r-n aggregate s-&&ly c-rve
to the right> event-ally creating a recessionary ga&> =hich exerts do=n=ard &ress-re on inflation"
This gives &olicyakers the o&&ort-nity to g-ide the econoy to a ne=> lo=er inflation target
=itho-t ind-cing a recession
145
0e1 S#?S
_l3 S#?S
Flat ?DC
=aget In.lation
5
=
6
In.lation 56
Cuent
_utput
"otential
_utput
_utput 5B6
0e1 s*ot un
:VuiliEium
0e1 S#?S
_l3 S#?S
Steep ?D
0e1 s*ot un
eVuiliEium
2#?S
=aget In.lation 5
=
6
In.lation 56
_utput 5B6
Cuent
_utput
"otential
_utput
Since the increase in &otential o-t&-t lo=ers the long:r-n real interest rate> rather than red-cing
their inflation target> &olicyakers can shift their onetary &olicy reaction c-rve to the right>
shifting aggregate deand to the right"
This =ill increase c-rrent o-t&-t 4-ickly> leaving inflation -nchanged at the target level
!%s-a0 Po0%-'
The &eo&le =ho control the governentHs tax and ex&endit-re &olicies can sta5iliIe o-t&-t and
inflation too"
Fiscal &olicy can 5e -sed R-st like onetary &olicy to ne-traliIe shocks to aggregate deand and
sta5iliIe o-t&-t and inflation"
Fiscal &olicy has t=o defects? it =orks slo=ly and it is alost i&ossi5le to i&leent effectively
Most recessions are short> data is availa5le only =ith a lag> and it takes tie for %ongress to &ass
legislation"
2conoics collides =ith &olitics =here fiscal sti-l-s is concerned as &oliticians design sti-l-s
&ackages 5ased ore on &olitical calc-lation than econoic logic"
Cnder ost circ-stances> then> sta5iliIation &olicy sho-ld 5e left to the central 5ankersN fiscal
&olicy does have a role 5-t only after onetary &olicy has r-n its co-rse
TF2 29;
146

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