Chapter 1: Introduction

Contents

1.1. Why Study Money, Banking and

Financial markets

1.2. An overview of the financial system

1.3. What is Money

1.1. Why Study Money, Banking, and
Financial Markets
1.1. Why Study Money, Banking, and
Financial Markets
To examine how financial markets
such as bond, stock and foreign exchange
markets work
To examine how
Click tofinancial
add text 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 (but do not have productive
investment opportunities) to people who have a shortage of
funds (and investment opportunities)

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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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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

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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 Bấm để thêm nội dung

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Banking and Financial Institutions
Financial Intermediaries—institutions that borrow
funds from people who have saved and make
loans to other people
Banks—institutions that 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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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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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

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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
Treasure bonds were closely tied
Since then, the relationship is less clear
but still an important determinant of
interest rates

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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
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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 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 1-17
1.2. An overview of the financial
system
Function of Financial Markets
Perform the essential function of channeling
funds from economic players that have
saved surplus funds to those that have a shortage
of funds
Promotes economic efficiency by producing
an efficient allocation of capital, which increases
production
Directly improve the well-being of consumers by
allowing them to time purchases better

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Structure of Financial Markets
 Debt and Equity Markets
 Primary and Secondary Markets
 Investment Banks underwrite securities in primary markets
 Brokers and dealers work in secondary markets
 Exchanges and Over-the-Counter (OTC) Markets
 Money and Capital Markets
 Money markets deal in short-term debt instruments
 Capital markets deal in longer-term debt and
equity instruments

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Primary vs. Secondary Markets

PRIMARY SECONDARY
New Issue of Trading Previously
Securities Issued Securities

No New Funds for

Exchange of Funds Issuer
for Financial Claim

Funds for Borrower; Provides Liquidity for

an IOU for Lender Seller
 Financial Markets

Newly issued Previously issued

securities securities

Issuer Investor A Investor B

Funds Funds

Primary market Secondary market

Liquidity

a. Liquidity is the degree to which

securities can easily be liquidated (sold)
without a loss of value.
b. If a security is illiquid, investors may not
be able to find a willing buyer for it in
the secondary market and may have to
sell the security at a large discount just
to attract a buyer.
 Money vs. Capital Markets

Money Capital
Short-Term, < 1 Year Long-Term, >1Yr
High Quality Issuers Range of Issuer Quality
Debt Only Debt and Equity
Primary Market Secondary Market
Focus Focus
Liquidity Market--Low Financing Investment--
Returns Higher Returns
Organized vs. Over-the-Counter
Markets
Organized OTC
Visible Wired Network of
Marketplace Dealers
Members Trade No Central, Physical
Securities Listed Location
New York Stock All Securities
Exchange Traded off the
Exchanges
Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and
denominated in that country’s currency
Eurobond—bond denominated in a currency other
than that of the country in which it is sold
Eurocurrencies—foreign currencies deposited in
banks outside the home country
Eurodollars—U.S. dollars deposited in foreign
banks outside the U.S. or in foreign branches of
U.S. banks

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 Money Market Securities
The more popular money market securities
are:
Treasury bills (T-bills)
Commercial paper
Negotiable certificates of deposit
Repurchase agreements
Federal funds
 Money Market Securities
Treasury bills (T-bills): Short-term debt
instruments issued by the Treasury to meet
the short-term funding needs of the
government
Negotiable certificates of deposit:
Certificates sold by banks to depositors that
pay annual interest of a given amount and at
maturity pay back the original purchase price.
NCD funds cannot be withdrawn before
maturity but they can be sold in the
secondary market.
 Money Market Securities
Commercial paper: Short-term debt
instruments issued by large banks and well-
known corporations.
Repurchase agreements (repos):
Effectively short-term loans, in which one
party sells securities to another with an
agreement to repurchase the securities at a
specified date and price.
Federal funds: Very short-term interbank
lending and borrowing
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 Capital Market Securities
Capital market securities are:
Stocks
Mortgages
Corporate bonds
Treasury bonds
Government agency securities
Municipal bonds (State and local
government bonds)
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Function of Financial Intermediaries:
Indirect Finance
Lower transaction costs
 Economies of scale
 Liquidity services
Reduce Risk
 Risk Sharing (Asset Transformation)
 Diversification
Asymmetric Information
 Adverse Selection (before the transaction)—more
likely to select risky borrower
 Moral Hazard (after the transaction)—less likely
borrower will repay loan
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 Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard
problems
Reduce insider trading
To ensure the soundness of financial
intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates 2-37
1.3. What is money?
Assets

Money
Stock
Bond
Commodities: gold
Land
Real estate

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Meaning of Money
Money (money supply)—anything that is
generally accepted in payment for goods
or services or in the repayment of debts; a
stock concept
Wealth—the total collection of pieces of
property that serve to store value
Income—flow of earnings per unit
of time

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Functions of Money
Medium of Exchange—promotes economic efficiency
minimizing the time spent in exchanging goods
and services
 Must be easily standardized
 Must be widely accepted
 Must be divisible
 Must be easy to carry
 Must not deteriorate quickly
Unit of Account—used to measure value in
the economy: in barter system, # of “price”= n(n-1)/2
With money, # of price = n
Store of Value—used to save purchasing power; mos
liquid of all assets but loses value during inflation
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Evolution of the Payments System
Commodity Money
Fiat Money
Checks
Electronic Payment
E-Money

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Empirical Measure of Money supply
Money is used in final settlement of a debt
and as a ready store of value
narrow monetary aggregates: close to
monetary policy
broad monetary aggregates: less link to
monetary policy

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 How Reliable are the Money Data?
Revisions are issued because:
Small depository institutions report infrequently
Adjustments must be made for seasonal
variation
We probably should not pay much attention
to short-run movements in the money
supply numbers, but should be concerned
only with longer-run movements

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