chapter 1

Copyright © 2010 Pearson Education. All rights reserved.

Chapter 1

Why Study Money, Banking, and Financial Markets?

Copyright © 2010 Pearson Education. All rights reserved.1-2

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


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

• 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 poor


The Bond Market and Interest Rates

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

• A bond is a debt security that promises to make payments periodically for a specified period of time

• The bond market is important to economic activities because it enables corporations and government to borrow to finance their activities.

• An interest rate is the cost of borrowing or the price paid for the rental of funds. There are many interest rates in the economy- mortgage interest rates, car loan interest rates, and interest rates om many types of bonds.


Importance of interest rates

• On personal level, interest rates affect the individual decisions for example, higher interest rates encourage savings and discourage consumption.

• On general level, interest rates have an impact on the overall health of the economy, for example, higher interest rates lead to decrease investment which may affect the economic growth


FIGURE 1 Interest Rates on Selected Bonds, 1950–2008

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.


The Stock Market

• Common stock(typically just called 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.

• The stock market is the market in which stocks or shares are traded.

• The stock market affect the business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price of stock means that it can raise a large amount of funds, which it can used to buy production facilities and equipment.


FIGURE 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2008

Source: Dow Jones Indexes: http://finance.yahoo.com/?u.


Financial Institutions and Banking

• Financial Intermediaries: institutions that borrow funds from people who have saved and make loans to other people:

– Banks: accept deposits and make loans

– Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks


Financial Crises

• Financial crises are major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms.

• Staring in August 2007, the United States economy was hit by the worst financial crisis since the Great Depression. Producing not only bank failure but also to down turning in economic growth.


Financial Innovation

• Nowadays people interact with an automatic teller machine (ATM) to draw cash and get account balance.

• Then financial services could be delivered electronically, in what it has become known as e-finance.

• Financial innovation lead to increase the profits of financial institutions.


Money and Business Cycles

• Evidence suggests that money plays an important role in generating business cycles

• Recessions (unemployment) and expansions affect all of us

• Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level


WHY STUDY MONEY AND MONETARY POLICY?


Money

• Money, also referred to as Money Supply, is defined as anything that is generally accepted in payment for goods or services or in the repayments of debt

• The final two parts of the book examine the role of money in the economy


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


FIGURE 4 Aggregate Price Level and the Money Supply in the United States, 1950–2008

Sources: www.stls.frb.org/fred/data/gdp/gdpdef ; www.federalreserve.gov/releases/h6/hist/h6hist10.txt.


FIGURE 5 Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007

Source: International Financial Statistics.


FIGURE 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2008

Sources: Federal Reserve Bulletin, p. A4, Table 1.10; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.


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 System

(Fed)

• Fiscal policy deals with 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


FIGURE 7 Government Budget Surplus or Deficit as a Percentage of Gross Domestic Product, 1950–2008

Source: www.gpoaccess.gov/usbudget/fy06/sheets/hist01z2.xls.


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


FIGURE 8 Exchange Rate of the U.S. Dollar, 1970–2008

Source: Federal Reserve: www.federalreserve.gov/releases/H10/summary/indexbc_m.txt/.


International Finance

• Financial markets have become increasingly integrated throughout the world.

• The international financial system has tremendous impact on domestic economies:– How a country’s choice of exchange rate policy

affect its monetary policy?– How capital controls impact domestic financial

systems and therefore the performance of the economy?

– Which should be the role of international financial institutions like the IMF?


How We Will Study Money, Banking, and Financial Markets

• A simplified approach to the demand for assets

• The concept of equilibrium• Basic supply and demand to explain

behavior in financial markets• The search for profits• An approach to financial structure based on

transaction costs and asymmetric information

• Aggregate supply and demand analysis


FIGURE 9 Federal Reserve Board Website


FIGURE 10 Excel Spreadsheet with Interest-Rate Data


FIGURE 11 Excel Graph of Interest-Rate Data


Aggregate Output and Aggregate Income

• 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


Real vs. nominal GDP

Nominal GDP• Represents the total

money value of final goods and services produced in a given year, where the values are expressed in terms of the market prices of each year

Real GDP• Real GDP (Q)

removes price changes from nominal GDP and calculates GDP in terms of the quantities of goods and services


Real vs. nominal GDP

• Nominal GDP is calculated by valuing all outputs at current prices, it is called “money GDP”, or “GDP in current dollars”. But nominal GDP rises when prices rise and falls when prices fall

• There is an alternative measure that correct for inflation by valuing goods and services produced in different years at the same set of prices, that is called real GDP

• Real GDP or “GDP in constant dollar”, is calculated by valuing outputs of different years at constant prices

• Therefore, real GDP is a far better measure than nominal GDP because it is corrected for inflation


Real vs. nominal GDP, Example

years Output (quantity

Q)units

Prices of output

(P) $

Nominal GDP = Q×P

$

Real GDP(year

1995 is base

year) $

1995 1000 10 10000 10000

1996 1000 20 20000 10000

1997 1000 50 50000 10000

Comment:•When price level increases, the nominal GDP becomes higher.•But this is misleading measure, because real quantity of output does not change. •Real GDP reflect the real change in output, because it is corrected from the price changes.•Then, real GDP is better than nominal GDP


Aggregate Price Level

• Aggregate price level is a measure of average prices in the economy

• Price index is a measure of average level of prices, which is the a weighted average of the price of a basket of goods and services

• There are different kinds of price indexes, but we will study the following two index:

1.Consumer price index [CPI2.GDP price index (GDP deflator)


CPI & GDP deflator

1. Consumer price index [CPI], is a measure of the average price paid by urban consumers for a market basket of consumer goods and services

2. GDP deflator is another, widely used price index, which is the price of all goods and services produced in the country (consumption, investment, government purchases, and net exports) rather than consumption goods only in case of constructing CPI


Economic growth rate

• The growth rate of real GDP (economic growth) is the percentage change of real GDP in two consecutive years.


Economic growth rate, example

• Using the following data, calculate the growth rate of real GDP

years Real GDP Growth rate

1981 100 ----------

1982 150

1983 180


Inflation rate

• Annual Inflation rate is the percentage change in price index [CPI] of two consecutive years

• An example, if the CPI= 130 in year 2001, and CPI= 192 in year 2002, calculate the annual inflation rate?

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