University at Albany

State University of New York

Economics 350: Money and Banking

Lecture Notes

Fall 2015
John Bailey Jones
 Sources

1. Abel, Andrew B., and Ben S. Bernanke, 1998, Macroeconomics, 4th ed., Reading, MA:
Addison-Wesley.

2. Aliber, Robert Z., James S. Duesenberry and Thomas Mayer, 1984, Money, Banking
and the Economy, 2nd ed., New York: W.W. Norton & Company.

3. Baumol, William A., and Alan S. Blinder, 1997, Macroeconomics: Principles and
Policy, 7th ed., Orlando: Harcourt Brace & Company.

4. Board of Governors of the Federal Reserve System, 1994, The Federal Reserve System:
Purposes and Functions, Washington, D.C.: Board of Governors of the Federal
Reserve System.

5. Chicago Board of Trade, 1994, CBOT Financial Instruments Guide.

6. Financial Crisis Inquiry Commission, 2010, Staff Reports

(http://www.fcic.gov/reports/).

7. Dornbusch, Rudiger Stanley Fischer and Richard Startz, 1998, Macroeconomics, 7th
ed., Boston: Irwin/McGraw-Hill.

8. Federal Reserve Bank of Chicago, 1994, Modern Money Mechanics.

9. Hester, Donald, 1997, lecture notes for Economics 330, University of Wisconsin-
Madison, fall semester. (Compiled by Meredith Crowley.)

10. Mankiw, N. Gregory, 1998, Principles of Macroeconomics, Orlando, FL: The Dryden
Press.

11. Mishkin, Frederic S., 1998, The Economics of Money, Banking and Financial Markets,
5th ed., Reading, MA: Addison-Wesley.

12. Mishkin, Frederic S., 2007 & 2013, The Economics of Money, Banking and Financial
Markets, Business School Edition, Reading, MA: Addison-Wesley.

13. Ritter, Lawrence S., William L. Silber and Gregory F. Udell, 2000, Principles of
Money, Banking and Financial Markets, 10th ed., Reading, MA: Addison-Wesley.

14. Stern, Gary H., 2000, “Using Market Data to Manage Risk,” The Region (Federal
Reserve Bank of Minneapolis), 14 (March).

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Topic 0: Overview of Course

1. Introduction: Topics 1-2

A. Money: what it is and what it does

B. Financial markets: what is traded, why it is traded, and who trades it

2. Principles of Finance: Topics 3-7

A. Interest rates/bond prices and how to calculate them

B. How bond prices/interest rates are set in the marketplace

C. Financial derivatives: how they work and what they do

3. Financial Institutions: Topics 8-11

A. Basic principles of bank management

B. The evolution of commercial banks, their regulation, and their non-bank

competitors

4. Monetary Policy and Central Banking: Topics 12-16

A. How the money supply is set, and how central banks control it

B. The Federal Reserve’s goals and tactics

C. Financial crises and central banks

5. Monetary Theory: Topics 17-18

A. How the money supply affects aggregate output and prices

B. Whether the Federal Reserve can (or should) intervene in the economy

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Topic 1: Introduction to Money
Mishkin, Chapter 3

1. Money and its Functions

A. Money: any asset widely accepted as payment for goods and services or in the
repayment of debt

B. 3 Functions of Money
i. Medium of exchange: facilitates trade
ii. Unit of account
iii. Store of value (wealth): extremely liquid, but subject to inflation risk

C. Evolution of the payments system

i. Autarky
ii. Barter
iii. Commodity money
iv. Paper currency: full-bodied and fiat
v. Checks
vi. Electronic money
vii. Monetary Collapse

2. Measuring Money: The Federal Reserve’s Monetary Aggregates

A. M1 and M2: M2 is more general

B. M1 =
Total: 7/2015
($billions)
Currency 1,299.9
+ Travelers checks 2.7
+ Demand deposits (“classic” no-interest checking accts) 1,226.7
+ Other checkable deposits 506.4
Total 3,035.6

C. M2 =
M1 3,035.6
+ Small denomination (< $100,000) time deposits 466.2
(Certificates of Deposit or CDs)
+ Money market mutual fund shares (retail owners) 618.8
+ Savings deposits and money market deposit accounts
(MMMFs offered by banks) 7,938.5
Total 12,059.2

D. Comment: the different measures move together, but far from exactly.

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Topic 2: Overview of Financial Markets
Mishkin, Chapter 2

1. Main Function

A. Transfer funds from lenders to borrowers: improves allocation of resources

B. Direct finance: borrowers sell securities to lenders

C. Indirect finance: funds go through a financial intermediary

2. Four Ways of Characterizing Financial Markets

A. Debt vs. equity

i. Debt: a security with a specified payment schedule
ii. Equity: a claim to a share of a firm’s income (net of debt payments) and net
worth

B. Primary vs. secondary

i. Primary: new securities
ii. Secondary: resale of existing securities

C. Exchange vs. over-the-counter

i. Exchange: trade in a central location
ii. Over-the-counter: dealers in many locations

D. Money vs. capital markets

i. Money markets: maturity of one year or less
ii. Capital markets: maturity of more than one year

3. Financial Intermediaries

A. Financial intermediary: an institution that borrows funds from one group of people
in order to lend them to another

B. Function: utilize economies of scale in:

i. Contracting
ii. Diversification
iii. Creating liquidity
iv. Handling asymmetric information

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 C. Adverse selection:
i. When the people most undesirable to the other party are the ones mostly likely
to seek to transact with him/her
ii. Problem with asymmetric information before transaction is made
iii. Handled with screening

D. Moral hazard:
i. Risk that one party in a transaction will engage in an action harmful to the other
party
ii. Problem with asymmetric information after transaction is made
iii. Handled with monitoring

E. Types of financial intermediaries

i. Depository: includes commercial banks, S&Ls, credit unions
ii. Contractual savings: includes insurance companies and pension plans
iii. Investment: includes mutual funds and finance companies

4. Regulation

A. Goals
i. Transparent and efficient operation
ii. Preventing financial panics

B. Regulating direct markets

i. Disclosure
ii. Insider trading prohibited
iii. Other screening and monitoring

C. Regulating financial intermediaries

i. Screening: chartering
ii. Monitoring: reporting and management restrictions
iii. Deposit insurance
iv. Limiting competition
v. Reserve requirements

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Topic 3: Understanding Interest Rates
Mishkin, Chapter 4

1. Present Value

A. One-period loan
i. i = interest rate
ii. Future Payment = (1 + i)⋅[Present Value of Loan]: FP = (1 + i)PV
iii. Discounting: PV = FP/(1 + i); compensation for foregone interest

B. More generally: if FP is received n periods ahead (with constant rate i):

PV = FP/(1 + i)n

2. Yield to Maturity

A. Interest rate that equates the present value of a series of payments to a security’s
market price. Most common definition of “interest rate.”

B. Suppose security pays FP1 one period later, FP2 2 periods later, etc. Then
i. PV(d) = FP1/(1 + d) + FP2/(1 + d)2 + FP3/(1 + d)3 + … + FPn/(1 + d)n
ii. For d > -1, PV(d) ↓ in d
iii. i = Y-T-M = value of d that sets PV(d) = P = market price.
Present Value ($)

Market Price = P

PV(d)

i = Y-T-M Discount Rate (d)

iv. Negative relationship between a security’s price and its Y-T-M

3. Pricing/Yield Formulae

A. Simple Loan: Y-T-M = “interest rate”

B. Fixed Payments Loan

i. Pay FP after each of n periods
ii. LV = FP/(1 + i) + FP/(1 + i)2 + FP/(1 + i)3 + … + FP/(1 + i)n

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 iii. Given LV, FP and n, i found with table or calculator. Given i, FP and n, LV
found similarly.

C. Coupon Bond
i. F = face value = amount repaid at end of final period
ii. c = coupon rate
iii. cF = C = coupon payment = interest payment made at end of each period
iv. PB = cF/(1 + i) + cF/(1 + i)2 + cF/(1 + i)3 + … + cF/(1 + i)n + F/(1 + i)n
v. Given PB, c, F and n, use table to find i. Given i, c, F and n, find PB.
vi. When F = PB, i = c

D. Consol
i. Coupon bond with no maturity date
ii. PC = C/i ⇒ i = C/PC.
iii. C = cF = “coupon payment”

E. Discount Bond
i. No interest payments: repay F at the end of n periods
ii. PD = F/(1 + i)n ⇒ i = (F/PD)1/n – 1

4. Rate of Return

A. 1-period rate of return = ret = C/P1 + [P2 - P1] /P1 = ic + g

i. ic = current yield: C = total payments of any sort over upcoming periods
ii. g is the rate of capital gain
iii. Negative relationship between current price (P1) and ret

B. Lifetime ret = Y-T-M if one holds the security until it matures

i. g irrelevant once security matures

C. Interest rate risk: the uncertainty in an security’s total return induced by changes in
the market Y-T-M
i. As market i changes, so does a security’s price ⇒ capital gains or losses
ii. Long-term securities have more interest rate risk
iii. Avoid risk by matching holding period and maturity

5. Nominal vs. Real Interest Rates (and Rates of Return)

A. Nominal interest rates: calculated with money (nominal) quantities

B. Real interest rates: calculated with purchasing power (real) quantities

C. Real interest rates usually more relevant

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D. Fisher equation: i ≈ r + πe, where i is the nominal rate, r is the real rate, and πe is
expected inflation.

E. Same logic applies for rates of return

F. Indexed bonds
i. Nominal payments adjusted for inflation: i = r + π
ii. Direct indicator of real interest rates
iii. No inflation risk

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 Monthly Payment Necessary To Amortize a $1,000 Loan*

Annual ----------------------------------------------------Term (Years)-----------------------------------------------------

Interest 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Rate (%) **
8.00 $9.56 $9.25 $8.98 $8.75 $8.55 $8.36 $8.20 $8.06 $7.93 $7.82 $7.72 $7.63 $7.54 $7.47 $7.40 $7.34
8.50 9.85 9.54 9.28 9.05 8.85 8.68 8.52 8.38 8.26 8.15 8.05 7.96 7.88 7.81 7.75 7.69
9.00 10.14 9.85 9.59 9.36 9.17 9.00 8.85 8.71 8.59 8.49 8.39 8.31 8.23 8.16 8.10 8.05
9.50 10.44 10.15 9.90 9.68 9.49 9.32 9.17 9.04 8.93 8.83 8.74 8.66 8.58 8.52 8.46 8.41
10.00 10.75 10.46 10.21 10.00 9.81 9.65 9.51 9.38 9.27 9.17 9.09 9.01 8.94 8.88 8.82 8.78
10

10.50 11.05 10.77 10.53 10.32 10.14 9.98 9.85 9.73 9.62 9.52 9.44 9.37 9.30 9.25 9.19 9.15
11.00 11.37 11.09 10.85 10.65 10.47 10.32 10.19 10.07 9.97 9.88 9.80 9.73 9.67 9.61 9.57 9.52
11.50 11.68 11.41 11.18 10.98 10.81 10.66 10.54 10.42 10.33 10.24 10.16 10.10 10.04 9.99 9.94 9.90
12.00 12.00 11.74 11.51 11.32 11.15 11.01 10.89 10.78 10.69 10.60 10.53 10.47 10.41 10.37 10.32 10.29

For example, for a 20-year loan with a 10 percent interest rate, the monthly payment would be $9.65 a
* month.
** Interest rate expressed as 12x monthly rate; for example, an "annual" rate of 12.00% reflects a monthly rate
N
of 1.00%. The payments tabulated above thus satisfy LV = FPx(1/i)x[1 -1/(1+i) ], where LV is the loan's
value ($1,000), FP is the monthly payment, i is the monthly interest rate and N is the number of months.
 10.00 Bond Values per $1,000 of Face Value for a 10% Coupon Bond*

---------------------------------------------------------------Years to Maturity----------------------------------------------------------------
Annual 1 2 3 4 5 6 7 8 9 10 15 20 30
Yield (%) **
10.00 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
10.25 997.7 995.6 993.7 992.0 990.4 989.0 987.7 986.6 985.5 984.6 981.1 978.9 976.8
10.50 995.4 991.2 987.4 984.0 980.9 978.2 975.6 973.4 971.3 969.5 962.6 958.5 954.6
10.75 993.1 986.8 981.2 976.1 971.6 967.5 963.8 960.4 957.4 954.7 944.7 938.8 933.2
11.00 990.8 982.5 975.0 968.3 962.3 956.9 952.1 947.7 943.8 940.2 927.3 919.8 912.8
11.25 988.5 978.2 968.9 960.6 953.2 946.5 940.5 935.2 930.4 926.1 910.4 901.3 893.1
11.50 986.2 973.9 962.8 953.0 944.1 936.3 929.2 922.9 917.2 912.2 893.9 883.5 874.1
11

11.75 983.9 969.6 956.8 945.4 935.2 926.1 918.0 910.8 904.4 898.6 877.9 866.2 855.9
12.00 981.7 965.3 950.8 937.9 926.4 916.2 907.1 898.9 891.7 885.3 862.4 849.5 838.4
12.25 979.4 961.1 944.9 930.5 917.7 906.3 896.2 887.3 879.3 872.3 847.2 833.4 821.5
12.50 977.2 956.9 939.0 923.1 909.1 896.6 885.6 875.8 867.2 859.5 832.4 817.7 805.3
12.75 974.9 952.8 933.2 915.9 900.6 887.1 875.1 864.6 855.2 847.0 818.1 802.5 789.6

* For example, a 20-year bond with a yield of 12 percent has a market value of $849.5.
Interest rate expressed as 2x biannual rate; for example, an "annual" rate of 12.00% reflects a biannual rate of
** 6.00%.
The bond values tabulated above thus satisfy PB = [c/i + (1-c/i)/(1+i)N]xFV, where PB is the bond's market value,
FV is the bond's face value ($1,000), c is the half-year coupon rate (5%), i is the half-year interest rate
and N is the number of half-years.
 In-Class Problems 1
Interest Rate and Return Formulae

1. Use the table in your lecture notes to answer the following questions.

A. Suppose you have borrowed $1,700. If you repay this loan in a series of constant
monthly payments over 23 years, what will be the monthly payment that gives your
lender an (approximate) annual yield of 12 percent?

B. Suppose that you have won $1,000,000 in the lottery. You have 3 payment choices:
(1) the $1,000,000 today; (2) $10,900 at the end of each month for the next 20
years; (3) $10,600 at the end of each month for the next 25 years. If your
(approximate) annual discount rate is 12 percent, which option has the highest
present value?

2. When necessary, use the table in your lecture notes to answer the following questions.

A. Find the (approximate) annual yield to maturity on the following 10-percent coupon
bonds: (1) a bond maturing in 8 years, with a face value of $100 and a market value
of $93.52; (2) a bond maturing in 6 years, with a face value of $500 and a market
value of $453.15.

B. What is the yield to maturity on a coupon bond, maturing in 17 years, with an

annual coupon rate of 8.75 percent, a face value of $250,000 and a market value of
$250,000?

C. Find the market value of the following 10-percent coupon bonds: (1) a bond
maturing in 5 years, with a face value of $100 and an (approximate) annual yield of
12.25 percent; (2) a bond maturing in 9 years, with a face value of $750 and an
(approximate) annual yield of 10.75 percent.

D. Which 10-percent coupon bond would generate the highest annual yield: (1) a bond
maturing in 8 years, with a face value of $100 and a market value of 96.04; (2) a
bond maturing in 6 years, with a face value of $100 and a market value of $97; (3) a
bond maturing in 10 years, with a face value of $100 and a market value of $95.

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3. Use the formulae in your notes to answer the following questions.

A. Suppose you own an apartment that produces a perpetual rent of $12,000 every
year. (Pretend the rents are year-end.) If you bought this apartment for $300,000,
what will be its annual yield to maturity?

B. What is the annual yield to maturity of a discount bond, maturing in three years,
with a face value of $1,000 and a market value of $804.96?

C. What is the market value of a discount bond, maturing in 4 years, with a face value
of $5,000 and an annual yield of 5 percent?

4. Consider a consol with a coupon rate of 5 percent and a face value of $1,000.

A. Suppose that at the beginning of year 1, when the market’s yield to maturity for
consols is 6.25 percent per year, you buy the consol at price P1. What will P1 be?

B. Now suppose that at the beginning of year 2 the market yield to maturity is 4.0
percent per year. What will the new price, P2, be?

C. What is the annual rate of return that you would earn by holding the consol from
the beginning of year 1 to the beginning of year 2? (Assume that the coupon
payment is made at the end of year 1/beginning of year 2.)

5. Consider a discount bond with a face value of $1000 and a maturity date of January 1,
2000.

A. Suppose that on January 1, 1990, when the market’s yield to maturity on this bond
is 5 percent per year, you purchase the bond at price P1. What will P1 be?

B. Now suppose that on January 1, 1991, the market’s yield to maturity on this bond is
4 percent per year. What will the new price, P2, be? (Warning: what is the bond’s
maturity now?)

C. What is the annual rate of return that you would earn by holding this discount bond
from January 1, 1990 through January 1, 1991?

D. Suppose that on January 1, 1991, the market’s yield to maturity on this bond is 6
percent instead. Without redoing your calculations, explain whether your rate of
return is higher or lower than in part (C).

E. Suppose that on January 1, 1990, you want to buy a discount bond that had no
interest rate risk over the upcoming year. What would be the maturity of the bond
that you would buy?

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