TOPIC 1 INTRODUCTION TO MONEY AND THE FINANCIAL SYSTEM

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-2 Chapter Preview 1.Financial System-Real Economy Connections 2.Components of Financial System: Markets & Institutions 3.Money and Monetary System 4.Economic Approach

Why Study Money and Banking? Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-3  Knowledge about money and banking is very important: Need to understand economic/financial situation, its implications to economy, and provide solutions  Financial markets (such as bonds, stocks, foreign exchange) and financial institutions (such as banks and insurance companies) involve huge amounts of funds: they affect consumers, businesses and the economy  Interest rates are being determined in the bond market. Several implications on the economic units

4 Interest Rates (Malaysia)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-5 Financial System and the Economy  Financial system -A network of markets and institutions to bring savers and borrowers together -Provides for efficient flow of funds from saving to investment by bringing savers and borrowers together via financial markets and financial institutions.  Savers and borrowers -Surplus units vs deficit units -Potential savers and borrowers are households, businesses, and governments  Financial instruments - Assets & liabilities

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-6

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-7 Financial Markets  Markets in which funds flowed from savers (those having excess of funds) to investors (those who are in short of funds), thereby promoting economic efficiency  Well functioning financial markets, such as the bond market, stock market, and foreign exchange market, are key factors in producing high economic growth  Affects personal wealth and behavior of business firms, thus, the economic cycle  We are going to study various financial markets: Money, debt, stock and foreign exchange markets

Debt Markets and Interest Rates A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make payments periodically for a specified period of time. Debt markets, also often referred to generically as the bond market, are especially important to economic activity because they enable corporations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-8

Debt Markets and Interest Rates An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). There are many interest rates in the economy— mortgage interest rates, car loan rates, and interest rates on many different types of bonds. Interest rates are important on a number of levels. On a personal level, high interest rates could deter you from buying a house or a car. On a more general level, interest rates have an impact on the overall health of the economy because they affect also businesses’ investment decisions. High interest rates, for example, might cause a corporation to postpone building a new plant that would provide more jobs. Changes in interest rates have important effects on individuals, financial institutions, businesses, and the overall economy, Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-9

Stock Market A common stock (typically just called a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The stock market, in which claims on the earnings of corporations (shares of stock) are traded, that’s why it is often called simply “the market.” Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-10

Stock Market A big swing in the prices of shares in the stock market. “Big killing,” and big loss. It is a place where people can get rich—or poor—quickly. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-11

Stock Market The stock market is also an important factor in business investment decisions: -the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. -a higher price for a firm’s shares means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-12

Foreign Exchange Market For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the country they are going to (say, euros). The foreign exchange market is where this conversion takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one country’s currency in terms of another’s, is determined. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-13

Bond Market and Interest Rates Figure 1.1 Interest Rates on Selected Bonds, 1950–2001

15 Foreign Exchange Market

16 Foreign Exchange Market

Structure of the Financial System The financial system is complex, comprising many different types of private- sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks—all of which are heavily regulated by the government. If you wanted to make a loan to IBM or General Motors, for example, you would not go directly to the president of the company and offer a loan. Instead, you would lend to such companies indirectly through financial intermediaries, institutions such as commercial banks, savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies that borrow funds from people who have saved and in turn make loans to others. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-17

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Financial Institutions  Intermediaries between borrowers and savers  Some examples  Loans from financial institutions account for the majority of funds borrowers raise, rather than the stock and bonds markets (Figure 1.1)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 1.1 Sources of Funds for Nonfinancial Businesses: Markets Versus Institutions

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Money  Defined as anything that people are willing to accept in payment for goods & services or to pay off debts.  Money supply: total quantity of money in the economy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Money and Monetary System  Central Banks –Role of central banks –Collects data on various measures of the money supply –Responsible for the conduct of monetary policy  Monetary policy –The management of the money supply and its links to prices, interest rates, and other economic variables –Monetary policy affects interest rates, inflation, and business cycles, all of which have a major impact on financial markets and institutions, we study how monetary policy is conducted by central banks  Monetary theory –Explores the relationships linking changes in the money supply to changes in economic activity and prices

Banks and Other Financial Institutions Banks are financial institutions that accept deposits and make loans. Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. Most Americans keep a large proportion of their financial wealth in banks in the form of checking accounts, savings accounts, or other types of bank deposits. Because banks are the largest financial intermediaries in our economy. However, banks are not the only important financial institutions. Indeed, in recent years, other financial institutions such as insurance companies, finance companies, pension funds, mutual funds, and investment banks have been growing at the expense of banks. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-22