Chapter 1

Why Study
Money, Banking,
and Financial
Markets?

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 Students Learning Objectives

• Understand the reasons for studying

financial markets including:
– Financial institutions and banking
– Money and monetary policy
– International finance

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 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

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 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
– Promotes economic efficiency
– Channels funds to people who need them
– Promotes economic growth

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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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 Importance of Interest Rates

• High interest rates:

– increases costs for borrowers
– encourages more savings
– affects investment decisions for businesses
– See Figure 1: types of interest rates

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 FIGURE 1 Interest Rates on
Selected Bonds, 1950–2008

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

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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 earnings and
assets of the corporation
• Issue of stocks is a way to raise funds
• Stock markets are volatile – see Figure 2
• Are important in business decisions as prices of
shares affects the amount of funds that can be
raised by selling newly issued stock to finance
investment spending

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

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

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 Financial Institutions and
Banking
• Financial institutions include:
– Banks
– Insurance companies
– Mutual funds
– Finance companies
– Investment banks

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 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 Innovation: in particular, the
advent of the information age and e-finance

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 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.
• August 2007: USA hit by worst financial
crisis
• Reason: defaults in subprime residential
mortgages led to major losses in financial
institutions
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 Money and Business Cycles

• Evidence suggests that money plays an important

role in generating business cycles
– Business cycle: upward and downward
movement of aggregate output
• Recessions (unemployment) and expansions affect
all of us
– Decline in money growth rate leads to decline in
output
• Monetary Theory ties changes in the money supply
to changes in aggregate economic activity and the
price level
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 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

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 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.

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 What explains inflation?

• Inflation is tied to increases in money supply

• See Figure 5
• Positive association between inflation and
growth in money supply

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

Source: International Financial Statistics.

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 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.

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

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

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 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)
– In Oman: Central Bank of Oman

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 Monetary and Fiscal Policy
• 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 8 Exchange Rate of the
U.S. Dollar, 1970–2008

Source: Federal Reserve:

www.federalreserve.gov/releases/H10/summary/indexbc_m.txt/.

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 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

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 FIGURE 3 Money Growth (M2 Annual Rate)
and the Business Cycle in the United States,
1950–2008

Note: Shaded areas represent recessions.

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

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 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?
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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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 END

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