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

Chapter 1
Why Study Money,

Banking, and
Financial Markets?
Preview
• To examine how financial markets such as bond,

stock and foreign exchange markets work
• To examine how financial institutions such as
banks, investment and insurance companies work
• To examine the role of money in the economy
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Why Study Financial Markets?
• Financial markets are markets in which

funds are transferred from people and
Firms who have an excess of available
funds to people and Firms who have a
need of funds

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.
• An interest rate is the cost of borrowing
or the price paid for the rental of funds.

Figure 1 Interest Rates on Selected
Bonds, 1950–2011
Sources: Based on Federal Reserve Bulletin;

www.federalreserve.gov/releases/H15/data.htm.

The Stock Market
• Common stock represents a share of

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

Why Study 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 companies
• Financial Innovation: the development of
new financial products and services
– Can be an important force for good by making
the financial system more efficient

Figure 2 Stock Prices as Measured by
the Dow Jones Industrial Average,
1950–2011
Source: Based on Dow Jones Indexes: http://nance.yahoo.com/?u.

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.

Why Study Money and Monetary
Policy?
• 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

Money, Business Cycles 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 3 Money Growth (M2 Annual
Rate) and the Business Cycle in the
United States 1950–2011
Source: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

Figure 4 Aggregate Price Level and
the Money Supply in the United
States, 1950–2011
Sources: Based on www.stls.frb.org/fred/data/gdp/gdpdef;


Figure 5 Average Inflation Rate
Versus Average Rate of Money
Growth for Selected Countries, 2000-
2010
Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

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 Treasury
bonds were closely tied
• Since then, the relationship is less clear but
the rate of money growth is still an
important determinant of interest rates

Figure 6 Money Growth (M2 Annual
Rate) and Interest Rates (Long-Term
U.S. Treasury Bonds), 1950–2011
Sources: Based on Federal Reserve Bulletin, p. A4, Table 1.10;


Fiscal Policy and Monetary 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, 1950–2010
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, 1970–2011
Source: Federal Reserve; www.federalreserve.gov/releases/H10/summary/indexbc_m.txt/.

The International Financial
System
• 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
Source: www.federalreserve.gov/releases/H15.

Figure 10 Excel Spreadsheet
with Interest-Rate Data

Figure 11 Excel Graph of
Interest-Rate Data

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Chapter 1

Why Study Money,

• To examine how financial markets such as bond,

1-2 © 2013 Pearson Education, Inc. All rights reserved.

• Financial markets are markets in which

1-3 © 2013 Pearson Education, Inc. All rights reserved.

• A security (financial instrument) is a

1-4 © 2013 Pearson Education, Inc. All rights reserved.

Sources: Based on Federal Reserve Bulletin;

1-5 © 2013 Pearson Education, Inc. All rights reserved.

• Common stock represents a share of

1-6 © 2013 Pearson Education, Inc. All rights reserved.

1-7 © 2013 Pearson Education, Inc. All rights reserved.

Source: Based on Dow Jones Indexes: http://nance.yahoo.com/?u.

1-8 © 2013 Pearson Education, Inc. All rights reserved.

• Financial crises are major disruptions in

1-9 © 2013 Pearson Education, Inc. All rights reserved.

1-10 © 2013 Pearson Education, Inc. All rights reserved.

• The aggregate price level is the average

1-11 © 2013 Pearson Education, Inc. All rights reserved.

Source: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

1-12 © 2013 Pearson Education, Inc. All rights reserved.

Sources: Based on www.stls.frb.org/fred/data/gdp/gdpdef;

1-13 © 2013 Pearson Education, Inc. All rights reserved.

Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

1-14 © 2013 Pearson Education, Inc. All rights reserved.

• Interest rates are the price of money

1-15 © 2013 Pearson Education, Inc. All rights reserved.

Sources: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

1-16 © 2013 Pearson Education, Inc. All rights reserved.

• Monetary policy is the management of the money

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1-18 © 2013 Pearson Education, Inc. All rights reserved.

• The foreign exchange market is where

1-19 © 2013 Pearson Education, Inc. All rights reserved.

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

1-20 © 2013 Pearson Education, Inc. All rights reserved.

1-21 © 2013 Pearson Education, Inc. All rights reserved.

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1-23 © 2013 Pearson Education, Inc. All rights reserved.

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1-25 © 2013 Pearson Education, Inc. All rights reserved.

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