Money

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Money Banking

• Week 3
• History of Money cont.,
• Interest Rates

2

• So can you technically trade in U.S. dollar
  bills for gold?
• Is our money even really backed by gold any more?

3
Whats a dollar?

• Most people associate the noun "dollar" with the
  Federal Reserve Note ("FRN") "dollar bill,
  engraved with the portrait of President George
  Washington. This association is mistaken.

4

• No statute defines - or ever has defined - the
  "one dollar" FRN as the "dollar, or even as a
  species of "dollar. Moreover, the United States
  Code provides that FRNs "shall be redeemed in
  lawful money on demand at the Treasury Department
  of the United States or at any Federal
  Reserve bank.4 Thus, FRNs are not themselves
  "lawful money" - otherwise, they would not be
  "redeemable in lawful money. And if FRNs are not
  even "lawful money, it is inconceivable that
  they are somehow "dollars, the very units in
  which all "United States money is expressed.
• --- Edwin Vieira, Jr.

5
When did the U.S. go off the gold standard?

• Short answer 1914.
• Long answer The gold standard broke down during
  World War I as major belligerents resorted to
  inflationary finance and was briefly reinstated
  from 1925 to 1931 as the Gold Exchange Standard.
  Under this standard countries could hold gold or
  dollars or pounds as reserves, except for the
  United States and the United Kingdom, which held
  reserves only in gold. This version broke down in
  1931 following Britain's departure from gold in
  the face of massive gold and capital outflows. In
  1933 President Roosevelt nationalized gold owned
  by private citizens and abrogated contracts in
  which payment was specified in gold.
• -- Michael Bordo in the Concise Encyclopedia of
  Economics

6
Dated 5 April, 1933 Presidential Executive
Order 6102 I, Franklin D. Roosevelt, President of
the United States of America, do declare that
said national emergency still continues to exist
and pursuant to said section to do hereby
prohibit the hoarding gold coin, gold bullion,
and gold certificates within the continental
United States by individuals, partnerships,
associations and corporations and hereby
prescribe the following regulations for carrying
out the purposes of the order
7
All persons are hereby required to deliver on or
before May 1, 1933, to a Federal Reserve bank or
a branch or agency thereof or to any member bank
of the Federal Reserve System all gold coin, gold
bullion, and gold certificates now owned by them
or coming into their ownership on or before April
28, 1933.
8
Until otherwise ordered any person becoming the
owner of any gold coin, gold bullion, and gold
certificates after April 28, 1933, shall within
three days after receipt thereof, deliver the
same in the manner prescribed in Section 2 .
Upon receipt of gold coin, gold bullion, or gold
certificates delivered to it in accordance with
Section 2 or 3, the Federal reserve bank or
member bank will pay thereof an equivalent amount
of any other form of coin or currency coined or
issued under the laws of the Unites States.
9
Gold Standard

• Advantages
• Inflationary finance is impossible.
• Economic stability and less government spending.

• Disadvantages
• An inelastic supply of money.
• Deflation (falling prices).
• Although its not clear that deflation is harmful
  if it comes about through scarce money.

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Present Value

• What is a future cash flow (FV ) worth now?

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Rule of the Cash Flow Timeline

• Cash flows at the same date can be added
  together, but cash flows at different dates
  cannot be added together.

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Four Types of Credit Market Instruments

• 1. Simple loan

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2. Fixed Payment, or Amortized, Loan

• Examples car loans, mortgages

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3. Coupon Bond

• Most bonds with maturities greater than a year
  are of this form.
• Coupons bonds issued by
• Federal government (Treasurys)
• State and local governments (munis)
• Corporations (corporates)

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(No Transcript)
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Special Type of Coupon Bond Consol or Perpetuity

• Fixed coupon received forever.

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4. Discount, or Zero Coupon, Bond

• Identical in cash flow structure to a simple
  loan. The difference is that theres an active
  secondary market for zero coupon bonds.

18
Draw cash flow diagrams for the four types of
credit instruments.
Take the perspective of the lender. Simple
loan Annuity/Amortized loan Coupon bond Zero
coupon bond
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Present value quick review

• Three pieces of information are needed
• Future cash flow(s).
• The number of periods between now and the receipt
  of the cash flow(s).
• The periodic rate of discountin each period what
  rate of return do you want on this investment.
• Example An investment will pay 50 in six
  months, 100 in one year.
• I need a 6 annual rate.
• PV 50/1.03 100/(1.03)2
• 48.54 94.26
• 142.80
• Id be willing to pay 142.80 for the investment.

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Using a table

• The PV table gives the discount factor for a
  given rate of discount and number of periods.
• Multiply the discount factor by the cash flow to
  get the answer.
• Another table can be used to get PV of an
  annuity, multiply PMT by the appropriate factor.

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Bond Page of the Newspaper
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Rate Maturity Mo/Yr Bid Asked Chg Asked Yield
13 1/4 May 14 14301 14302 14 3.22
Semi annual coupon on 1 mil of face
value? 66,250.00 Number of coupons
remaining? M05 M14 19 Asked price of 1 mil
of face value? 1,430,625
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Pricing a coupon bond

• Suppose I need a 4 rate of return.
• How much would I be willing to pay for 1 million
  of face value of the bond on the previous slide?
• Calculate the PV of face value (FV1mil, n19, i
  .02)
• Calculate the PV of coupons using annuity table.
  (PMT 66,250, n19, i .02)
• Add two parts together.

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Yield to Maturity

• The rate of discount that equates the present
  value of future cash flows with the price of the
  credit instrument.

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Relationship Between Price and Yield to Maturity
.
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Calculate the yield to maturity on a consol that
pays 100 a year and is priced at 2,500.

• Recall formula for present value of a consol

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Approximation for YTM Current Yield
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Fisher Equation

• The nominal (actual) interest rate equals the
  real rate plus the expected inflation rate.

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TIPS (Treasury Inflation Protection Securities)

• Originally issued in 1997.
• Interest and principal payments are adjusted for
  inflation.
• In times of high inflation the amount paid to
  investors rises.
• Return on TIPS provides information on expected
  inflation.

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U.S. Real and Nominal Interest Rates