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Chapter 1
Why Study
Money, Banking,
and Financial
Markets?
19-1
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• 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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Learning Objectives
• Recognize the importance of financial
markets in the economy.
• Describe how financial intermediation and
financial innovation affect banking and the
economy.
• Identify the basic links among monetary
policy, the business cycle, and economic
variables.
• Explain the importance of exchange rates in
a global 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
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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.
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Figure 1 Interest Rates on Selected
Bonds, 1950–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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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 residual
earnings and assets of the corporation.
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Figure 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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Why Study Financial Institutions
and Banking?
• Financial intermediaries: institutions that
borrow funds from people who have saved and in
turn 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
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Why Study Financial Institutions
and Banking?
• 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.
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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.
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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
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Figure 3 Money Growth (M2 Annual Rate) and the
Business Cycle in the United States 1950–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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Figure 4 Aggregate Price Level and the Money
Supply in the United States, 1950–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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Figure 5 Average Inflation Rate Versus Average Rate
of Money Growth, Selected Countries, 2003-2013
Source: International Financial Statistics. http://www.imf.org/external/data.htm
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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 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
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Figure 6 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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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
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Figure 7 Government Budget Surplus or Deficit
as a Percentage of Gross Domestic Product,
1950–2013
Source: Economic Report of the President, Table B79 at http://www.gpoaccess.gov/eop/tables09.html
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US Debt Clock.org
The Foreign Exchange Market
• The foreign exchange market: 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.
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Figure 8 Exchange Rate of the U.S.
Dollar, 1970–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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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?
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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
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Appendix 1:
Defining Aggregate Output, Income, the
Price Level, and the Inflation Rate
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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
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Aggregate Price Level
Aggregate price level is a measure of average prices
in the economy
One measure of the price level is the GDP Deflator
nominal GDP
GDP Deflator =
real GDP
Another measure is the Consumer Price Index (CPI)
The CPI is a measure of the average change over time in the
prices paid by urban consumers for a market basket of goods
and services
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Growth Rates and the Inflation Rate
A growth rate is the percentage change in a variable
x t - x t-1
Growth rate =
(100)
x t-1
$9.5 trillion - $9 trillion
GDP growth rate =
(100) = 5.6%
$9 trillion
113 - 111
Inflation rate =
(100) = 1.8%
111
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Chapter 1: Q1
Markets in which funds are transferred from those
who have excess funds available to those who
have a shortage of funds are called
A)fund-available markets.
B)derivative exchange markets.
C)commodity markets.
D)financial markets.
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Chapter 1: Q7
Banks are important to the study of money and the
economy because they
A)channel funds from investors to savers.
B)create inflation.
C)have been a source of rapid financial innovation.
D)are the only important financial institutions in
the U.S. economy.
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Chapter 1: Q10
___________ theory relates the quantity of money
and monetary policy to changes in aggregate
economic activity and inflation.
A)Financial
B)Systemic
C)Monetary
D)Fiscal
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Chapter 1:Q11
Which of the following is a true statement?
A)The aggregate price level is measured as the rate
of change in the inflation rate.
B)The inflation rate is measured as the rate of
change in the federal government budget deficit.
C)The average price of goods and services in an
economy is called the aggregate price level.
D)Money or the money supply is defined as
Federal Reserve notes.
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Chapter 1: Q12
Countries that experience very high rates of
inflation may also have
A)balanced budget.
B)rapid growing money supplies.
C)constant money supplies.
D)falling money supplies.
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