mishkinch01.ppt

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Chapter 1

Why Study Money,

Banking, andFinancial Markets?


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To examine how financial markets such as bond,stock and foreign exchange markets work

To examine how financial institutions such asbanks, 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 whichfunds are transferred from people andFirms who have an excess of available

funds to people and Firms who have aneed of funds


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The Bond Market and InterestRates

A security (financial instrument) is aclaim on the issuers future income orassets.

A bond is a debt security that promises tomake payments periodically for aspecified period of time.

An interest rate is the cost of borrowingor the price paid for the rental of funds.


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Figure 1 Interest Rates on SelectedBonds, 19502011

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


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The Stock Market

Common stock represents a share ofownership in a corporation

A share of stock is a claim on the residual

earnings and assets of the corporation


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Why Study Financial Institutionsand Banking?

Financial Intermediaries: institutions thatborrow funds from people who have savedand make loans to other people:

Banks: accept deposits and make loans

Other Financial Institutions: insurancecompanies, finance companies, pension funds,mutual funds and investment companies

Financial Innovation: the development ofnew financial products and services

Can be an important force for good by makingthe financial system more efficient



Figure 2 Stock Prices as Measured bythe Dow Jones Industrial Average,19502011

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



Financial Crises

Financial crises are major disruptions infinancial markets that are characterized bysharp declines in asset prices and thefailures of many financial and nonfinancial

firms.


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Why Study Money and MonetaryPolicy?

Evidence suggests that money plays animportant role in generating business cycles

Recessions (unemployment) and expansions

affect all of us

Monetary Theory ties changes in the moneysupply to changes in aggregate economic

activity and the price level


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Money, Business Cycles andInflation

The aggregate price level is the averageprice of goods and services in an economy

A continual rise in the price level (inflation)

affects all economic players

Data shows a connection between themoney supply and the price level


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Figure 3 Money Growth (M2 AnnualRate) and the Business Cycle in theUnited States 19502011

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


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Figure 4 Aggregate Price Level andthe Money Supply in the United States,19502011

Sources: Based on www.stls.frb.org/fred/data/gdp/gdpdef;www.federalreserve.gov/releases/h6/hist/h6hist10.txt.


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Figure 5 Average Inflation Rate VersusAverage Rate of Money Growth forSelected Countries, 2000-2010

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


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Money and Interest Rates

Interest rates are the price of money

Prior to 1980, the rate of money growthand 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 AnnualRate) and Interest Rates (Long-TermU.S. Treasury Bonds), 19502011

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


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Fiscal Policy and Monetary Policy

Monetary policy is the management of the moneysupply and interest rates

Conducted in the U.S. by the Federal Reserve System(Fed)

Fiscal policy deals with government spendingand taxation

Budget deficit is the excess of expenditures overrevenues 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 Surplusor Deficit as a Percentage of GrossDomestic Product, 19502010

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


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The Foreign Exchange Market

The foreign exchange market is wherefunds are converted from one currency intoanother

The foreign exchange rate is the price ofone currency in terms of another currency

The foreign exchange market determines

the foreign exchange rate


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Figure 8 Exchange Rate of theU.S. Dollar, 19702011

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


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The International FinancialSystem

Financial markets have become increasinglyintegrated throughout the world.

The international financial system hastremendous impact on domestic economies:

How a countrys choice of exchange rate policyaffect its monetary policy?

How capital controls impact domestic financialsystems and therefore the performance of the

economy? Which should be the role of internationalfinancial institutions like the IMF?


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How We Will Study Money,Banking, and Financial Markets

A simplified approach to the demand forassets

The concept of equilibrium

Basic supply and demand to explainbehavior in financial markets

The search for profits

An approach to financial structure based on

transaction costs and asymmetricinformation

Aggregate supply and demand analysis


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Figure 9 Federal Reserve BoardWebsite

Source: www.federalreserve.gov/releases/H15.

i l d h


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Figure 10 Excel Spreadsheetwith Interest-Rate Data

Fi 11 E l G h f


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Figure 11 Excel Graph ofInterest-Rate Data


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Supplementary Notes

Bonds Inflation

US National Debt Clock

US Debt Clock.org
http://www.thestandard.com.hk/news_detail.asp?pp_cat=30&art_id=106110&sid=30658991&con_type=1http://www.e-allmoney.com/inflation/images/zimbabwe_inflation.jpeghttp://www.brillig.com/debt_clockhttp://www.usdebtclock.org/http://www.usdebtclock.org/http://www.brillig.com/debt_clockhttp://www.e-allmoney.com/inflation/images/zimbabwe_inflation.jpeghttp://www.thestandard.com.hk/news_detail.asp?pp_cat=30&art_id=106110&sid=30658991&con_type=1


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Aggregate Outputand Aggregate Income

Aggregate Output

Gross Domestic Product (GDP) = market value ofall final goods and services produced in thedomestic 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

GDP Deflator =nominal GDP

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 InflationRate

t t-1

t-1

A growth rate is the percentage change in a variable

x - xGrowth rate = (100)

x

$9.5 trillion - $9 trillionGDP growth rate = (100) = 5.6%

$9 trillion

113 - 111Inflation rate = (100) = 1.8%

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