The Economics of Money, Banking, and

Financial Markets
Twelfth Edition

Chapter 1
Why Study Money, Banking,
and Financial Markets?

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Preview
• Examine how financial markets work
– bond markets
– stock market

• Role of financial institutions in the economy

– commercial banks and investment banks
– asset management and insurance companies

• Role of money in the economy

– identifying links between monetary policy and the
business cycle (expansions, recessions).

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 Financial Markets and Institutions
• … help transfer funds from economic agents (i.e.,
households, firms, government, foreigners) who have an
excess of available funds to other agents who need funds to
finance expenditures

– HHs financing housing purchases (mortgages)

– Firms financing capital expenditures (corporate bonds,

stock issuance, bank loans)

– Governments financing budget deficits (Treasury

bills/bonds, Eurobonds)

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Flow of Funds Through the Financial System

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Functions of Financial System
• Channel funds from savers to borrowers
– more efficient allocation of capital

• Ease exchange of goods and services by providing means

of payment
– or provide the liquidity to convert financial assets to the medium of
exchange with low cost

• Provide insurance, diversification, risk management,

consumption smoothing benefits
– “Life-cycle”: borrow early in life, pay off mortgage and save for
retirement in middle age, dis-save when old.

• Provide information (esp. in secondary markets)

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The Bond Market and Interest Rates
• A bond is a debt security that promises to make payments
periodically for a specified period of time.
– Treasury bills, government bonds
– Corporate bonds

• Interest rate is the (implied) compensation received by the

lender for the “rental of funds,” or equivalently, the cost of
funding for the borrower.

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Interest Rates on Selected Bonds, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/BAA

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The Stock Market
• Stocks/shares/equity represent ownership in a company.

• Some corporations sell shares to the public to raise funds

and finance their activities
– Publicly-traded corporations vs. privately-held
– Secondary markets for stocks (stock exchanges)

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Dow Jones Industrial Average, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA

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S&P 500 index, 2012-2021

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Mutual funds and ETFs
• Buying and selling
individual stocks can be
costly and risky.

• Diversify risk through

mutual funds or exchange
traded funds (ETFs)
• Actively-managed funds
versus “passive” funds
that track a given index

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1-11
Financial Institutions and Banking
• Financial intermediaries:
– Banks (depository institutions): accept deposits and make loans
– Other financial institutions: insurance companies, finance
companies, pension funds, mutual funds and investment
companies

• Financial innovation: the development of new financial

products and services
– ATMs, e-finance, mortgage-backed securities (MBS) etc.

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Financial Crises
• Major disruptions in financial markets that are
characterized by sharp declines in asset prices and the
failures of many financial and nonfinancial firms.
– E.g., Financial crisis of 2007-08

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Banking crises are common across the world

Source: Laeven and Valencia (2010) Banking Crisis Database of IMF

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 Money and Monetary Policy
• Money plays an important role in facilitating transactions
– Medium of exchange role
• The amount of money/liquidity available in the economy
affects interest rates and asset prices, and is a crucial
determinant of business cycles (expansions/recessions).
• Monetary theory ties changes in the money supply to
changes in aggregate economic activity and to inflation
(changes in the overall price level).

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Average Inflation Rate Versus Average Rate of Money
Growth for Selected Countries, 2006–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/

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Aggregate Price Level and the Money Supply in
the United States, 1960–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GDPDEF

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 Low inflation (or deflation) during recent
recessions despite large monetary stimulus
Money and Interest Rates
Short-term
• Liquidity effect: increase in money supply reduces the
“price” of obtaining funds, thereby lowering short-term
interest rates

Long-term
• Fisher effect: higher money supply (growth) may raise
inflationary expectations and inflation, and thereby increase
interest rates in the long run

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Money Growth (M2 Annual Rate) and Interest Rates
(Long-Term U.S. Treasury Bonds), 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/M2SL

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Central Banks
• The Federal Reserve and other central banks control the
availability of money and credit to ensure low inflation, high
growth and stability of the financial system.

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Federal Reserve Board in Washington DC
and the 12 regional Federal Reserve Banks

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Expansionary monetary policy during recessions
Fed’s latest
projections
“Dot plot”
Quantitative Easing following the financial crisis of 2007-8
and the coronavirus pandemic
 18-
30

Can interest rates be negative?

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Fiscal Policy
• Monetary policy refers to the management of the money
supply and interest rates
– conducted by central banks (e.g., the Federal Reserve)

• Fiscal policy refers to the management of government

spending and taxation
– Budget deficit is the excess of gov. expenditures over its revenues
for a particular year
 Budget surplus is the excess of gov. revenues over its
expenditures for a particular year
– Budget deficits must be financed by new borrowing (which adds to
government debt)

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Federal Government Budget Surplus or Deficit as a Percentage of
Gross Domestic Product

Source: Economic Report of the President, Table B79 at http://www.gpoaccess.gov/eop/tables09.html

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Federal Debt projected to grow even higher in
the next 30 years
Deficits projected to increase over time
Foreign Exchange Market
• Markets where funds are converted from one currency into
another

• The foreign exchange rate is the price of one currency in

terms of another currency.

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USD appreciated at the start of the coronavirus crisis,
but has depreciated since.
 Appendix 1:
Defining Aggregate Output, Income, the Price Level, and
the Inflation Rate

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 Real vs. Nominal GDP
 GDP is the market value of all final goods and
services produced in a given period in a country.

 Nominal GDP measures these values using current

prices.
 Real GDP measures these values using the prices of
a base year.

CHAPTER 2 The Data of Macroeconomics 38

 Real GDP controls for inflation
 Changes in nominal GDP can be due to:
 changes in prices
 changes in quantities of output produced

 Changes in real GDP captures changes in quantity of

output since real GDP is constructed using constant
base-year prices.

CHAPTER 2 The Data of Macroeconomics 39

NOW YOU TRY
Real and nominal GDP

2015 2016 2017

P Q P Q P Q

good A $30 900 $31 1,000 $36 1,050

good B $100 192 $102 200 $100 205

 Compute nominal GDP in each year.

 Compute real GDP in each year using 2015 as
the base year.
40
NOW YOU TRY
Answers

Nominal GDP multiply Ps & Qs from same year

2015: $46,200 = $30 × 900 + $100 × 192
2016: $51,400
2017: $58,300

Real GDP multiply each year’s Qs by 2015 Ps

2015: $46,200
2016: $50,000
2017: $52,000 = $30 × 1050 + $100 × 205

41
Aggregate Price Level
• The aggregate price level is a measure of average prices
in the economy.

• Three measures of the aggregate price level are

commonly used:
– The GDP deflator
– The PCE deflator
– The Consumer Price Index (CPI)

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Calculating the Real Growth Rate and the
Inflation rate
• Growth rate of Real GDP
RGDPt − RGDPt −1
gt = %∆Yt =
RGDPt −1

• Inflation rate (using GDP Deflator)

Pt − Pt −1
π t = %∆Pt =
Pt −1
Business Cycle Fluctuations
The GDP deflator, CPI, and PCE deflator