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Economics of the Financial System (Aug 2021 - Week 10 - 13), image, image,…
Economics of the Financial System (Aug 2021 - Week 10 - 13)
1) FV, PV and ir
Valuing Monetary Payments
In the future (Future Value)
Compound r
Simple r
Rule of 72
given r%
Number of years to double income/investment
Now (Present Value)
*Interest Rates, r (inverse relationship)
Future Value, FV
= Discounting Future Value
TIme, n
Applying PV (to stream of returns)
Optional (Just for fun)
Internal rate of return
Example #2: Loan = $225
(paid over 3 year $100/yr;
paid over 2 years $125/yr)
Example #1: Machine that cost $1 mn
(generates $150,000 a year) for 10 years
Activity #1(a)
Retire 65 (today: 45)
with $1.5 mn
r=1%:
Find:
PV of $1.5 mn (25 years from today)? Ans: $554,567
r=3%:
Find:
PV of $1.5 mn (25 years from today)? Ans: $78,050
Activity #1(a)
Retire = 65 (live = 85)
Annuity = $50K p.a. (for 25 years)
r=7%:
Find:
How much save? Ans: $529,701
r=2%:
Find:
How much save? Ans: $817,572
Bond valuation: Valuing the
Coupon Payments
Principal + Coupon Payments
Principal Payment
2) Bond Market (BM)
Fair Value of Bond = Sum of .....
PV of Principal
PV of coupon payments
Market price of Bond
Demand for Bond-C rises (Shifts in DD)
Real interest rates (nominal r less inflation)
Expectations of interest rates falls (Bond-C pays higher coupon cf newly-issued bonds)
Expectations of inflation fall (PV of Bond-C will be higher)
Expectation of Bond Performance > Equity performance
Expansionary Monetary policy (OM purchase of T-securities)
Demand for T-bills increase
Price of T-bills increase
Yield of T-bill falls
Banks' reserves increase
FFR falls
Proportional increase in Money Supply (market r falls)
Credit rating for Bond-C improves
Impact: Bond-C will be more attractive / Bond demand increase
Supply of Bonds rises (Shifts in SS)
Contractionary Monetary Policy (OM sales of T-securities)
Supply of T-bills rise
Price of T-bills falls
Yield of T-bills rise
Bank reserves to fall
Proportional fall in Money supply (market r rises)
FFR rises
Government Budget
Budget Surplus
Government buys back bonds
Bond SS shifts left
Budget Deficit
Government borrowing (New issuance)
Bond supply shifts right
Crowding-out private sector bond borrowing
Expectations of inflation rise (cheaper for firms to borrow)
Credit rating deteriorates (existing holders of Bond sell)
Improvements in business conditions (encourage firms to raise funds in Bond market)
Impact: Factors that cause Bond Supply to increase
3) Money Market (MM)
Money demand
Transactions = f(income)
Precautionary = f(income)
Speculative = f (interest rates)
Liquidity vs Yield
Downward sloping DD for money
Low r - More Liquidity / Less Yield
High r - Less Liquidity / More Yield
Money Supply
Fractional Reserve Banking
Vertical line
Liquidity Trap
Low r
High savings rate
Rendering MP ineffective
MM and BM equilibrium
Money (More liquid; Lower r)
Bond (Less liquid; Higher r)
Activity #1: Bond-3%
(Market r) > (Coupon 3%)
(Market r) < (Coupon 3%)
Bond price falls / Bond price rise until YTM = Market r
4) Monetary Policy and the Bond Market
Conventional MP Tools
Reserve Requirement Ratio (0% effective 26 Mar 2020); set by Fed
Discount rate, or Cash rate = Rates that Fed charges commercial banks
FFR (Fed funds rate) = Rates that commercial banks charge each other Interbank market
Target FFR (Set by FOMC) = 0 to 0.25% (16 Mar 2020)
Effective FFR (Median weighted average data reported by banks)
Unsecured borrowings
IOR (Interest on Reserves) = Rates that Fed pays commercial banks on reserves
Interest on Required Reserves (IORR)
Interest on Excess Reserves (IOER)
Set by Fed
Case
Scenario (b): Expansionary MP
Scenario (a) Contractionary MP
Activity #2: Expansionary MP (Equilibrium in MM and BM)
Unconventional MP
Tools
Quantitative Easing
Forward Guidance
Negative Interest Rate Policy (NIRP)
Zero Interest Rate Policy (ZIRP)
Cases
Activity #3a; #3b: US Recessions (1990, 2001, 2008, 2020) - QE & ZIRP
Activity #4(a), #4(b): Japan (1990's; 2016) - QE, ZIRP; & NIRP
(i) Liquidity Trap (a new normal?)
Fed Funds Market (Market for Bank Reserves)
Target: Fed Funds Rate (FFR) Interbank Lending
Min: IOER (Fed pays banks who have surplus reserves)
Max: Fed Discount Rate (Fed charges banks who needs more reserves)
Effective Market FFR
Reserve Demand Curve (Downward sloping)
Reserve Supply Curve
Fed OM purchase (increase Bank Reserves)
Fed OM sales (decrease Bank Reserves)
Unwinding the QE
See STUDENT WORKSHEET
