11 Unit 1 Why Study Money, Banking, and Financial Markets?

22 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

33 Main Topics What is money? Who controls the money supply? Why is money important? Why is inflation a problem? How do banks make money (profits)? Why are banks important? How does the government regulate banks and why? Financial Markets and financial instruments What is monetary policy? How does the Fed conduct monetary policy? How are interest rates determined?

44 Money Money is the stock of items widely used to make payment for goods and services. Money, or the money supply, includes: currency and coins in circulation, checking accounts in depository institutions, and other items, such as Certificates of Deposit (CDs), when measured more broadly.

55 Figure 1-1

66 What Determines The Money Supply? The central bank is responsible for the trend or long-run behavior of the money supply. Banks and non-bank public also play important roles in determining the aggregate money supply. In the United States, the central bank is the Federal Reserve System (the Fed). The Fed conducts monetary policy. Monetary Policy refers to the management of money supply and interest rates.

77 Money, Inflation, and Deflation When the money supply increases more rapidly than the output of goods and services, inflation occurs. Why is Inflation a problem? Deflation is a continuing decline in prices and is more damaging to a nation's economic health than inflation. Why is deflation a problem? Inflation targeting occurs when a central bank announces an explicit inflation range it pledges to maintain and enforces policies consistent with that goal.

88 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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13 Key Financial Markets The stock market The bond market The foreign exchange (ForEx) market Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds

14 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 Bondholders are lenders; stockholders are owners. An interest rate (or yield) is the cost of borrowing or the price paid for the rental of funds and are determined by market forces of supply and demand.

15 Facts about interest rates There are many different interest rates. Interest rates tend to move together. Sometimes we ignore the differences among interest rates and focus on the interest rate level. The interest rate level is determined in the bond market or loanable funds market. There are intimate relationships among different interest rates.

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17 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 A companys stock share price reflects the opinion of the market about the company's economic value, which ultimately depends on its future profitability. Major indexes reflect changing sentiment about the nation's economic prospects. Dow-Jones Industrials Average (DJIA) Standard and Poor's 500 Average (S&P 500)

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20 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

21 Foreign Exchange and Trade Appreciation is an increase in the value of one nations currency relative to another nations currency. Depreciation is the opposite. Appreciation causes: higher prices to foreign buyers of exports, lower prices to domestic consumers of imports, and a trade deficit (or a reduction in the trade surplus). Depreciation causes: lower prices to foreign buyers of exports, higher prices to domestic consumers of imports, and a trade surplus (or a reduction in the trade deficit.)

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23 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

24 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

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26 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

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