Why Study Money, Banking, and Financial Markets

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• Chapter 1
• Why Study Money, Banking, and Financial Markets
• To examine how financial markets such as bond,
  stock and foreign exchange markets work
• To examine how financial institutions such as
  banks and insurance companies work
• To examine the role of money in the economy

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Financial Markets

• Markets in which funds are transferred from
  people who have an excess of available funds to
  people who have a shortage of funds

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The Bond Market and Interest Rates

• A security (financial instrument) is a claim on
  the issuers future income or assets
• 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

gtgo to interest rate chart
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The Stock Market

• Common stock represents a share of ownership in a
  corporation
• A share of stock is a claim on the earnings and
  assets of the corporation

gtgo to djia chart
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The Foreign Exchange Market

• The foreign exchange market is where funds are
  converted from one currency into another
• The foreign exchange rate is the price of one
  currency in terms of another currency
• The foreign exchange market determines the
  foreign exchange rate

gtgo to foreign exchange chart
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Banking and Financial Institutions

• Financial Intermediariesinstitutions that borrow
  funds from people who have saved and make loans
  to other people
• Banksinstitutions that accept deposits and make
  loans
• Other Financial Institutionsinsurance companies,
  finance companies, pension funds, mutual funds
  and investment banks
• Financial Innovationin particular, the advent of
  the information age and e-finance

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Money and Business Cycles

• Evidence suggests that money plays an important
  role in generating business cycles
• Recessions (unemployment) and booms (inflation)
  affect all of us
• Monetary Theory ties changes in the money supply
  to changes in aggregate economic activity and the
  price level

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Money and Inflation

• The aggregate price level is the average price
  of goods and services in an economy
• A continual rise in the price level (inflation)
  affects all economic players
• Data shows a connection between the money supply
  and the price level

gtgo to price level and M2
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Money and Interest Rates

• Interest rates are the price of money
• Prior to 1980, the rate of money growth and the
  interest rate on long-term Treasure bonds were
  closely tied
• Since then, the relationship is less clear but
  still an important determinant of interest rates

gtM2 growth and interest rates chart
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Monetary and Fiscal Policy

• Monetary policy is the management of the money
  supply and interest rates
• Conducted in the U.S. by the Federal Reserve Bank
  (Fed)
• Fiscal policy is government spending and
  taxation
• Budget deficit is the excess of expenditures over
  revenues for a particular year
• Budget surplus is the excess of revenues over
  expenditures for a particular year
• Any deficit must be financed by borrowing

gtsurplus/deficit chart
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How We Will Study Money, Banking, and Financial
Markets

• A simplified approach to the demand for assets
• Basic supply and demand to explain behavior in
  financial markets
• The concept of equilibrium
• The search for profits
• An approach to financial structure based on
  transaction costs and asymmetric information
• Aggregate supply and demand analysis

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Basics of Macro Model

• Aggregate Output
• Gross Domestic Product (GDP) market value of
  all final goods and services produced in the
  domestic economy during a particular year
• Aggregate Income
• Total income of the factors of production (land,
  capital, labor) during a particular year
• Distinction Between Nominal and Real
• Nominal values measured using current prices
• Real quantities measured with constant prices

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Aggregate Price Level
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Growth Rates and the Inflation Rate
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Chapter 2, financial systemfinancial markets

• Perform the essential function of channeling
  funds from economic players that have saved
  surplus funds to those that have a shortage of
  funds
• Promotes economic efficiency by producing an
  efficient allocation of capital, which increases
  production
• Directly improve the well-being of consumers by
  allowing them to time purchases better

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Circular Flow - Simple Model
Households offer their productive services to
businesses in exchange for pay in the form of
wages, rent, and interest and owners receive
profits
Resource Income

Productive Services
Businesses
Households
Income recipients use their money to buy goods
and services produced by business
Goods and Services

Spending for Goods and Services
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Circular Flow saving and investment
Resource Income

Productive Services
Businesses
Households
Savings (leakage)
Goods and Services
Investment (injection)
Spending for Goods and Services (Consumption)
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Structure of Financial Markets

• Debt and Equity Markets
• Primary and Secondary Markets
• Investment Banks underwrite securities in primary
  markets
• Brokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets
• Money and Capital Markets
• Money markets deal in short-term debt instruments
• Capital markets deal in longer-term debt and
  equity instruments

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MONEY MARKET INSTRUMENTS (short-terms debts
maturity of lt 1 year)

• COMMERCIAL PAPER-- similar to bonds formal,
  short-term IOUs promising that a certain sum of
  money plus interest will be paid back on demand.
  Usually issued by large corporations, as an
  alternative to borrowing money from a bank (at a
  higher interest rate).  
• Negotiable bank CD's (resellable, redeemable
  early these tend to be very large CD's) 
• U.S. Treasury bills (T-bills)-- short-term IOU's
  to finance the government's deficits
• REPURCHASE AGREEMENTS (REPOS) -- short-term
  loans, usually from corporations to banks, with
  T-bills serving as collateral. An important
  source of bank funds since 1969. 
• EURODOLLARS-- U.S. dollars deposited abroad.
  American banks often borrow Eurodollars, either
  from their own foreign branches or from other
  banks, when they need cash. 
• FEDERAL FUNDS -- overnight loans between banks of
  their Federal Reserve deposits. These loans are
  usually made so that the borrowing bank can meet
  its reserve requirements at the Fed. The federal
  funds rate is a key target of Fed policymakers. 
• BANKER'S ACCEPTANCES-- formal IOUs issued by a
  firm and guaranteed by a bank, in case of default
  by the firm. These are used mostly in the course
  of international trade and have been around for
  centuries. 

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CAPITAL MARKET INSTRUMENTS (equities,
long-term debts with maturity of gt 1 year)

• STOCKS-- shares of ownership in a company
  typically includes right to a periodic share of
  profits (dividends), plus rights to a share of
  the company's physical assets if the company
  fails. The stock market is by far the largest
  capital market. 
• MORTGAGES-- loans to households, to finance
  purchases of homes or land. The largest debt
  market in the U.S. Can be held indirectly as an
  asset, thru Real Estate Investment Trusts
  (REITs). 
• CORPORATE BONDS-- long-term bonds issued by
  corporations. They typically pay interest twice a
  year, and pay off the principal at a specified
  maturity date. Convertible bonds are corporate
  bonds that may be converted into stock at any
  time. 
• U.S. TREASURY BONDS-- to finance government
  deficits. The most widely traded bonds in the
  U.S., their trading volume normally exceeds 100
  billion daily. 
• U.S. Government AGENCY BONDS -- issued by the
  likes of Ginnie Mae (GNMA, the Govt. National
  Mortgage Assn.) and the Tennessee Valley
  Authority. 
• STATE LOCAL GOVERNMENT BONDS (municipal bonds)
  -- issued by state local governments to pay for
  long-term projects not covered by current tax
  dollars. Sold mainly to commercial banks, mutual
  funds, and wealthy individuals. Completely
  tax-exempt. 
• CONSUMER BANK COMMERCIAL LOANS. Usually have no
  secondary (resale) markets.

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Internationalization of Financial Markets

• Foreign Bondssold in a foreign country and
  denominated in that countrys currency
• Eurobondbond denominated in a currency other
  than that of the country in which it is sold
• Eurocurrenciesforeign currencies deposited in
  banks outside the home country
• EurodollarsU.S. dollars deposited in foreign
  banks outside the U.S. or in foreign branches of
  U.S. banks
• World Stock Markets

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Function of Financial Intermediaries Indirect
Finance

• Lower transaction costs
• Economies of scale
• Liquidity services
• Reduce Risk
• Risk Sharing (Asset Transformation)
• Diversification
• Asymmetric Information
• Adverse Selection (before the transaction)more
  likely to select risky borrower
• Moral Hazard (after the transaction)less likely
  borrower will repay loan

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Regulation of the Financial System

• To increase the information available to
  investors
• Reduce adverse selection and moral hazard
  problems
• Reduce insider trading
• To ensure the soundness of financial
  intermediaries
• Restrictions on entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates

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Chapter 3Meaning of Money

• Money (money supply) anything that is generally
  accepted in payment for goods or services or in
  the repayment of debts a stock concept
• Wealththe total collection of pieces of property
  that serve to store value (stock)
• Incomeflow of earnings per unit of time

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Functions of Money

• Medium of Exchangepromotes economic efficiency
  by minimizing the time spent in exchanging goods
  and services, characteristics
• Must be easily standardized
• Must be widely accepted
• Must be divisible
• Must be easy to carry
• Must not deteriorate quickly
• Unit of Accountused to measure value in the
  economy
• Store of Valueused to save purchasing power
  most liquid of all assets but loses value during
  inflation

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Evolution of the Payments System

• Commodity Money
• Paper money
• Fiat Money
• Checks
• Electronic Payment
• E-Money

gtgo to current measures
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How Reliable are the Money Data?

• Revisions are issued because
• Small depository institutions report infrequently
• Adjustments must be made for seasonal variation
• We probably should not pay much attention to
  short-run movements in the money supply numbers,
  but should be concerned only with longer-run
  movements

gtM2 growth 2005