Money and financial institutions
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Money and Financial Institutions. Mike & Ryan. Bonds. Bonds: certificate that promises to pay some money in the future Future money can be paid in two ways Maturity Value (Par Value, Face Value) Coupon (most coupon bonds pay semi-annually)

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Money and Financial Institutions

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Money and financial institutions

Money and Financial Institutions

Mike & Ryan



  • Bonds: certificate that promises to pay some money in the future

  • Future money can be paid in two ways

    • Maturity Value (Par Value, Face Value)

    • Coupon (most coupon bonds pay semi-annually)

  • Yield or yield to maturity=interest rate paid on a bond

  • $90.91 matures to $100 equivalent to earning 10%

  • Inverse relationship with prices and yields

    • i.e. high price, low yield

    • Seesaw

Government bonds

Government Bonds

  • 3 Types

    • T-Bills

      • Zero coupon bond

      • Maturity = 1-12 months

    • T-Notes

      • Semi-annual coupons

      • 2-10 years

    • T-Bonds

      • Semi-annual coupons

      • 20-30 years

Income risk

Income Risk

  • Income risk is the risk that changing interest rates will reduce the income from portfolio

  • Income Risk higher for short term assets

  • CUs face income risk when rates change

  • Because CUs have longer term assets and shorter term liabilities, income risk occurs when interest rates rise.

Capital risk

Capital Risk

  • Higher for longer term assets

  • Higher interest rates reduce the market value of assets and reduce the market value of equity capital

Money and financial institutions


  • Defined as cash outside of banks plus checking deposits, plus travelers checks

    • Cash outside of banks=cash not in vault, not in federal reserve, not in banking system

Structure of federal reserve system

Structure of Federal Reserve system

  • 12 District banks each with president

  • Board of Governors with chair and 6 other governors

  • Combine = FOMC (Federal Open Market Committee)

    • FOMC= All 7 governors plus 5 district bank presidents

  • Chair serves 4 year term NOT synchronous with president term, CAN be reappointed

  • Governors serve 14 year terms

  • FOMC meets every 6 weeks, 1951 Fed Treasury accord made Fed independent

Loanable funds model

Loanable funds Model

  • Supply meets Demand = Equilibrium

    • “market clearing rate”

  • Rise in loan demand will push interest rates UP

  • Rise in loan supply will push interest rates DOWN

Money multiplier

Money Multiplier

  • Real world multiplier is around 2 or 3 due to leakages

    • Leakage = currency in system, required reserves, excess reserves

  • Reserve Requirements

    • Has an inverse relationship with money supply

      • Lower reserves = higher money supply

  • Discount Rate

    • Lower discount rate=more discount loans=more bank reserves=more bank deposits=money supply raises

    • Higher discount rate=less discount loans=less reserves=less bank deposits=money supply decreases

  • Discount rate typically non-factor as volume of loans is low

Fomc open market operations

FOMC Open Market Operations

  • Open market purchase = money supply increases, loans rise

  • Open market sale=money supply decreases, loans fall

  • Fed target rate=Federal Funds rate

    • Uses open market operations to maintain Fed Target Rate

Money and financial institutions

  • Short term rates move together because short term assets are close substitutes.

  • If Fed funds rate goes above target, Fed will buy bonds until rate lowers. Opposite if rate is below target.

  • Expectations theory

    • Long term rates=expected average short term rates over the life of the bond

      • 3yr bond yield is 8%, people expect 1yr bonds to average 8% of the next 3 years

Money and financial institutions

  • When market expects short term rates to be high in the long run, then long term rates will be high. Opposite for low short term rates

  • Adjusted conclusions to theory

    • When long term rates is higher than normal relative to short term rates, people expect short term rates to rise. Opposite for when lower than normal.

    • When there is a normal gap between short term and long term rates, then people expect rates to stay the same.

Money and financial institutions

  • Income we earn is spread between short term and long term rates

    • Larger spread tends to push up CU income

  • Can Fed control long term rates?

    • Can influence but NOT control

  • Fed established dual mandate

    • Maximum employment, stabile prices (inflation)

  • Taylor Rule

    • Fed Funds rate is a positive function of inflation minus unemployment

    • When inflation is high relative to unemployment, Fed increases short term rates

    • When unemployment is higher, Fed sets short term rates low

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