15. Principles of Economics (Brief Edition)_2e (16)

Chapter 16: Money, Prices, and the. Financial . Describe the role of financial . Differentiate between bonds and stocks and show. why their prices are inversely related to interest. . Explain how the financial system improves the. allocation of saving to productive . Discuss the three functions of money and how the. money supply is . Analyze how the lending behavior of commercial. banks affects the money . Explain how the central bank controls the money. supply and its relation to inflation in the long run. McGraw­Hill/Irwin Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved. Banking System.• Financial intermediaries are firms that extend. credit to borrowers using funds raised from. savers. – Thousands of commercial banks accept deposits. from individuals and businesses and make loans. – Banks and other intermediaries specialize in. evaluating the quality of borrowers. • Principle of Comparative Advantage. • Banks have a lower cost of evaluating opportunities. than an individual would. • Banks pool the saving of many individuals to make. large loans. 16­2 Banking System.• Banks gather information about potential investments. – Evaluate the options. – Direct saving. – Service provided to depositors.• Banks provide access to credit for small businesses and. homeowners. – May be the only source of credit for some investments.• When banks make loans, they earn interest which, in turn,. is paid to the banks depositors.• Having bank deposits makes payments easier. – Checks, ATMs, debit card.• Checks and debit cards are safer than cash.• Banks provide a record of your transactions 16­3 Bonds.• A bond is a legal promise to repay a debt.• Each bond specifies. – Principal amount, the amount originally lent. – Maturation date, the date when the principal amount will be. repaid. • The term of a bond is the length of time from issue to maturation. – Coupon payments, the periodic interest payments to the. bondholder. – Coupon rate, the interest rate that is applied to the principal to. determine the coupon payments.• Corporations and governments issue bonds.• The coupon rate depends on. – The bonds term: 30 days to 30 years; longer term, higher coupon rate. – The issuers credit risk: the higher risk, higher coupon rate. – Tax treatment for the coupon payments: lower taxes, lower coupon. rates. • Municipal bonds are free from federal taxes. 16­4 Bond Market.• Bonds can be sold before their maturation date. – Market value at any time is the price of the bond. – Price depends on the relationship between the. coupon rate and the interest rate in financial. markets.• A two-year government bond with principal $1,000 is. sold for $1,000, 1/1/12. – Coupon rate is 5%. – $50 will be paid 1/1/13. – $1,050 will be paid 1/1/14.• Bonds price on 1/1/10 depends on the prevailing. interest rate. 16­5Stocks.• A share of stock is a claim to partial ownership of a firm. – Receive dividends, a periodic payment determined by. management. – Receive capital gains if the price of the stock increases.• Prices are determined in the stock market. – Reflect supply and demand. Risk Premium.• Risk premium is the rate of return investors require to. hold risky assets minus the rate of return on safe assets.• Risk aversion increases the return required of a risky stock. and lowers the selling price 16­6 Bond Markets and Stock. Mark