Money and Banking. Semester 1/2016

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1 Money and Banking Semester 1/2016

2 Score Allocation Quizzes 10% Mid-Term Exam 30% Final Exam 30% Individual and Group Reports 20% Class Participation 10% >>> Total 100%

3 Classroom Disciplines I expect regular attendance & punctuality. Extra credit only available to those in attendance when it is offered. Behave in a polite manner Pay respect to instructor and class participants Cheating on an exam means a failing grade in the course. Copied or very identical homework will receive a zero.

4 Chapter 1 Money and Banking: An Overview

5 Chapter 1: Money and Banking: An Overview Financial markets is the markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Well-functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets are one reason that many countries in the world remain desperately poor.

6 Chapter 1: Money and Banking: An Overview A security (also called a financial instrument) is a claim on the issuer s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make payments periodically for a specified period of time. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year).

7 Chapter 1: Money and Banking: An Overview A bond is a debt instrument issued by a corporation, government, or government agency. A bond s indenture is an agreement to make a stream of interest payments at specified future dates, and also to return the principal at maturity. Bondholders are lenders; stockholders are owners. Interest rates (or yields) are determined by market forces of supply and demand.

8 Chapter 1: Money and Banking: An Overview The Stock Market : A common stock (typically just called a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Shares are claims of ownership in individual corporations. A company s stock share price reflects the opinion of the market about the corporation's continually changing prospects.

9 Chapter 1: Money and Banking: An Overview For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin into the currency of the country they are going to. The foreign exchange market is where this conversion takes place, and so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one country s currency in terms of another s, is determined.

10 Chapter 1: Money and Banking: An Overview Appreciation is an increase in the value of one nation s currency relative to another nation s currency. Depreciation is the opposite. Appreciation causes: higher prices to foreign buyers of exports, lower prices to domestic consumers of imports, and a trade deficit (or a reduction in the trade surplus). Depreciation causes: lower prices to foreign buyers of exports, higher prices to domestic consumers of imports a trade surplus (or a reduction in the trade deficit.)

11 Chapter 1: Money and Banking: An Overview Financial Intermediaries is an institutions that borrow funds from people who have saved and in turn make loans to others. Banks are financial institutions that accept various types of deposits and use the funds attracted primarily to grant loans. In recent years, other financial institutions such as insurance companies, finance companies, pension funds, mutual funds, and investment banks have been growing at the expense of banks, and so we need to study them as well.

12 Chapter 1: Money and Banking: An Overview Money, also referred to as the money supply, is defined as anything that is generally accepted in payment for goods or services or in the repayment of debts. currency and coins in circulation, checking accounts in depository institutions, and other items, such as Certificates of Deposit (CDs), when measured more broadly. Money is linked to changes in economic variables that affect all of us and are important to the health of the economy.

13 Chapter 1: Money and Banking: An Overview The average price of goods and services in an economy is called the aggregate price level, or, more simply, the price level. Inflation, a continual increase in the price level, affects individuals, businesses, and the government. Inflation is generally regarded as an important problem to be solved and has often been a primary concern of politicians and policymakers. To solve the inflation problem, we need to know something about its causes.

14 Chapter 1: Money and Banking: An Overview There is a positive association between inflation and the growth rate of the money supply: The countries with the highest inflation rates are also the ones with the highest money growth rates. Milton Friedman, a Nobel laureate in economics, to make the famous statement, Inflation is always and everywhere a monetary phenomenon.

15 Chapter 1: Money and Banking: An Overview Because money can affect many economic variables that are important to the well-being of our economy, politicians and policymakers throughout the world care about the conduct of monetary policy, the management of money and interest rates. The organization responsible for the conduct of a nation s monetary policy is the central bank which responsible for the trend or long-run behavior of the money supply. In the United States, the central bank is the Federal Reserve System (the Fed). What is about Thailand?

16 Chapter 1: Money and Banking: An Overview Fiscal policy involves decisions about government spending and taxation. A budget deficit is the excess of government expenditures over tax revenues for a particular time period, typically a year, A budget surplus arises when tax revenues exceed government expenditures.

17 Chapter 1: Money and Banking: An Overview National Output (as calculated by the gross domestic product, or GDP, a measure of aggregate output). The gross domestic product (GDP), is the market value of all final goods and services produced in a country during the course of the year. excludes two sets of items; Purchases of goods that have been produced in the past Purchases of stocks or bonds Intermediate goods, which are used up in producing final goods and services

18 Chapter 1: Money and Banking: An Overview Aggregate income, the total income of factors of production (land, labor, and capital) from producing goods and services in the economy during the course of the year, is best thought of as being equal to aggregate output. Because the payments for final goods and services must eventually flow back to the owners of the factors of production as income, income payments must equal payments for final goods and services.

19 Chapter 1: Money and Banking: An Overview When the total value of final goods and services is calculated using current prices, the resulting GDP measure is referred to as nominal GDP. The word nominal indicates that values are measured using current prices. If all prices doubled but actual production of goods and services remained the same, nominal GDP would double even though people would not enjoy the benefits of twice as many goods and services. As a result, nominal variables can be misleading measures of economic well-being.

20 Chapter 1: Money and Banking: An Overview When the money supply increases more rapidly than the output of goods and services, inflation occurs. Inflation targeting occurs when a central bank announces an explicit inflation range it pledges to maintain and enforces policies consistent with that goal. Deflation is a continuing decline in prices and is more damaging to a nation's economic health than inflation.

21 Chapter 1: Money and Banking: An Overview Aggregate Price Level: as a measure of average prices in the economy 1. The first is the GDP deflator, which is defined as nominal GDP divided by real GDP. if 2004 nominal GDP is $10 trillion but 2004 real GDP in1996 prices is $9 trillion Typically, measures of the price level are presented in the form of a price index, which expresses the price level for the base year.

22 Chapter 1: Money and Banking: An Overview 2. Another popular measure of the aggregate price level is the PCE deflator, which is similar to the GDP deflator and is defined as nominal personal consumption expenditures (PCE) divided by real PCE. 3. The measure of the aggregate price level that is most frequently reported in the press is the consumer price index (CPI). The CPI is measured by pricing a basket list of goods and services bought by a typical urban household.

23 Chapter 1: Money and Banking: An Overview A growth rate is defined as the percentage change in a variable. growth rate x t x x t 1 t The inflation rate is defined as the growth rate of the aggregate price level. if the GDP deflator rose from 111 in 2004 to 113 in 2005, the inflation rate using the GDP deflator would be 1.8%: if real GDP grew from $9 trillion in 2004 to $9.5 trillion in 2005, then the GDP growth rate for 2005 would be 5.6%:

24 Chapter 3 Time Value of Money

25 The Interest Rate Topic Coverage: Simple Interest Rate Compound Interest Rate Amortizing a Loan Compounding Interest More Than Once per Year

26 Principles Used in this Chapter: The Time Value of Money A Dollar Received Today Is Worth More Than a Dollar Received in The Future. Point out the importance of interest rates, which will serve a variety of functions, including discounting/compounding rates and representing opportunity costs.

27 Types of Interest: Simple Interest - Interest paid (earned) on only the original amount, or principal, borrowed (lent). Compound Interest - Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent). When interest paid on an investment during the first period is added to the principal; then, during the second period, interest is earned on the new sum.

28 Future Value (FV): What is the Future Value (FV) of the deposit? FV = P 0 + SI = $1,000 + $140 = $1,140 Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

29 Present Value (PV): What is the Present Value (PV) of the previous problem? The Present Value is simply the $1,000 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

30 Future Value Single Deposit (Graphic) Assume that you deposit $1,000 at a compound interest rate of 7% for 2 years % $1,000 FV 2

31 General Future Value Formula FV 1 = P 0 (1+i) 1 FV 2 = P 0 (1+i) 2 General Future Value Formula: FV n = P 0 (1+i) n or FV n = P 0 (FVIF i,n ) -- See Table I Period 6% 7% 8%

32 Calculation based on general formula: FV n = P 0 (1+i) n FV 5 = $10,000 ( ) 5 = $16, Calculation based on Table I: FV 5 = $10,000 (FVIF 10%, 5 ) = $10,000 (1.611) = $16,110 [Due to Rounding]

33 General Present Value Formula PV 0 = FV 1 / (1+i) 1 PV 0 = FV 2 / (1+i) 2 General Present Value Formula: PV 0 = FV n / (1+i) n or PV 0 = FV n (PVIF i,n ) -- See Table II

34 Using Present Value Tables PV 2 = $1,000 (PVIF 7%,2 ) = $1,000 (.873) = $873 [Due to Rounding] Period 6% 7% 8%

35 Calculation based on general formula: PV 0 = FV n / (1+i) n PV 0 = $10,000 / ( ) 5 = $6, Calculation based on Table I: PV 0 = $10,000 (PVIF 10%, 5 ) = $10,000 (.621) = $6, [Due to Rounding]

36 Types of Annuities: An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods. Ordinary Annuity: Payments or receipts occur at the end of each period. Annuity Due: Payments or receipts occur at the beginning of each period.

37 Examples of Annuities Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

38 Overview of an Ordinary Annuity--FVA Cash flows occur at the end of the period n n+1 R = Periodic Cash Flow i%... R R R FVA n FVA n = R(1+i) n-1 + R(1+i) n R(1+i) 1 + R(1+i) 0

39 Valuation Using Table III: FVA n = R (FVIFA i%,n ) FVA 3 = $1,000 (FVIFA 7%,3 ) = $1,000 (3.215) = $3,215 Period 6% 7% 8%

40 Overview of an Annuity Due -- FVAD Cash flows occur at the beginning of the period n-1 n i%... R R R R R FVAD n FVAD n = R(1+i) n + R(1+i) n R(1+i) 2 + R(1+i) 1 = FVA n (1+i)

41 Valuation Using Table III: FVAD n = R (FVIFA i%,n )(1+i) FVAD 3 = $1,000 (FVIFA 7%,3 )(1.07) = $1,000 (3.215)(1.07) = $3,440 Period 6% 7% 8%

42 Overview of an Ordinary Annuity -- FVAD Cash flows occur at the end of the period n n+1 PVA n i%... R R R R = Periodic Cash Flow PVA n = R/(1+i) 1 + R/(1+i) R/(1+i) n

43 Valuation Using Table III PVA n = R (PVIFA i%,n ) PVA 3 = $1,000 (PVIFA 7%,3 ) = $1,000 (2.624) = $2,624 Period 6% 7% 8%

44 Overview of an Annuity Due -- PVAD Cash flows occur at the beginning of the period n-1 n i%... R R R R PVAD n R: Periodic Cash Flow PVAD n = R/(1+i) 0 + R/(1+i) R/(1+i) n-1 = PVA n (1+i)

45 Valuation Using Table III: PVAD n = R (PVIFA i%,n )(1+i) PVAD 3 = $1,000 (PVIFA 7%,3 )(1.07) = $1,000 (2.624)(1.07) = $2,808 Period 6% 7% 8%

46 Piece At A Time: $ $ $ $ $ % $600 $600 $400 $400 $100 $ = PV 0 of the Mixed Flow

47 Group At A Time: Example $1, Plus $ Plus $62.10 $400 $400 $400 $ $200 $200 PV 0 equals $ $100

48 Frequency of Compounding: General Formula: FV n = PV 0 (1 + [i/m]) mn n: Number of Years m: Compounding Periods per Year i: Annual Interest Rate FV n,m : FV at the end of Year n PV 0 : PV of the Cash Flow today

49 Impact of Frequency: Julie Miller has $1,000 to invest for 2 Years at an annual interest rate of 12%. Annual FV 2 = 1,000(1+ [.12/1]) (1)(2) = 1, Semi-Annual FV 2 = 1,000(1+ [.12/2]) (2)(2) = 1,262.48

50 Impact of Frequency: Julie Miller has $1,000 to invest for 2 Years at an annual interest rate of 12%. Quarterly FV 2 = 1,000(1+ [.12/4]) (4)(2) = 1, Monthly FV 2 = 1,000(1+ [.12/12]) (12)(2) = 1, Daily FV 2 = 1,000(1+[.12/365]) (365)(2) = 1,271.20

51 Effective Annual Interest Rate: Effective Annual Interest Rate The actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number of compounding periods per year. EAR= (1 + [ i / m ] ) m - 1

52 Perpetuities: Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. PV of Perpetuity Formula PV PMT i PV = present value of the perpetuity PMT = periodic cash payment (constant dollar amount provided by the of perpetuity) i = interest rate (annuity interest or discount rate)

53 Steps to Amortizing a Loan: 1. Calculate the payment per period. 2. Determine the interest in Period t. (Loan Balance at t-1) x (i% / m) 3. Compute principal payment in Period t. (Payment - Interest from Step 2) 4. Determine ending balance in Period t. (Balance - principal payment from Step 3) 5. Start again at Step 2 and repeat.