Economics 330 – Money and Banking M and W from 3:30pm to 4:45pm Text: Cecchetti and Schoenholtz: Money, Banking, and Financial Markets, McGraw Hill, 5th and 4th editions.

Who am I ? Dr. John Neri Office Hours: M and W from 10:30qm to 11:30am. Office: Morrill Hall, Room 1106

Who you are: 230 as of 8/15/17 Accounting – 8 Info Sys – 3 Computer Science – 4 IAP - 20 LTSC - 34 Sup MGMT - 1 Economics – 93 Foreign Exch - 7 Finance – 41 G & P – 2 Intl. Bus - 2 Marketing/Int. Bus/Mgnt – 11 Math - 1

Course Webpage http://www.terpconnect.umd.edu/~jneri/Econ330 Students using DSS, please see me within the first 2 weeks of class. NOTE: upper-case E

Can you define each of the following? Federal Reserve System FOMC Federal Funds Market Federal Funds Rate Discount Loan Discount Rate Open Market Operation Quantitative Easing QE 1, 2 and 3 Financial Intermediary Money Market Capital Market MMMF Large Scale Asset Purchase Term Structure

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https://www. c-span. org/video/ https://www.c-span.org/video/?430765-1/federal-reserve-chair-predicts-moderate-pace-economic-growth

Cecchetti - Chapter One An Introduction to Money and the Financial System

Six Parts of the Financial System Money Financial Instruments 3. Financial Markets Financial Institutions Regulatory Agencies Central Banks

Six Parts of the Financial System Money Facilitates transactions, used to buy stuff Store wealth. Money has changed over time from gold/silver coins to paper currency to electronic funds.

Six Parts of the Financial System Financial instruments Contracts used to transfer resources from savers to investors Loans, bonds, stocks (this is financial capital) Contracts used to transfer risk Insurance policies Derivative contracts

Six Parts of the Financial System Financial Markets make buying and selling financial instruments easy Went from being in coffee houses and taverns to well organized markets like the New York Stock Exchange. Now transactions are mostly handled by electronic markets. As the cost of processing financial transactions has fallen a broader array of financial instruments available.

Six Parts of the Financial System Financial Institutions Provide providing access to financial markets and gathering information Take a few minutes to list some FIs and describe what they do

Six Parts of the Financial System Government regulatory agencies Make sure the financial system operates safely and reliably. Government regulatory agencies were introduced by federal government after the Great Depression. Wide-ranging financial regulation: rules, supervision, examine banks – how the use funds and manage risk.

Six Parts of the Financial System Central banks Central banks control the availability of money and credit to promote low inflation, high growth and stability of financial system.

Cecchetti’s Five Core Principles of Money and Banking Time has value. Risk requires compensation. Information is the basis for decisions. Markets determine prices and allocation resources. Stability improves welfare.

Core Principle 1: Time has value Time affects the value of financial instruments. Interest is paid to compensate the lenders for the time the borrowers have their money. Chapter 4 develops an understanding of interest rates and how to use them.

Core Principle 2: Risk requires compensation In a world of uncertainty, individuals will accept risk only if they are compensated. In the financial world, compensation comes in the form of explicit payments: the higher the risk the bigger the payment.

Core Principle 3: Information is the basis for decisions The more important the decision, the more information we gather. Collection and processing of information is the foundation of the financial system.

Core Principle 4: Markets determine prices and allocate resources Markets are the core of the economic system. Markets channel resources and minimize the cost of gathering information and making transactions. In general, the better developed the financial markets, the faster the country will grow.

Core Principle 5: Stability improves welfare A stable economy reduces risk and improves everyone's welfare. Financial instability in the autumn of 2008 triggered the worse global downturn since the Great Depression. A stable economy grows faster than an unstable one. One of the main roles of central banks is stabilizing the economy.

Bottom Line: A well Functioning Financial System Promotes Economic Efficiency Facilitate Payments – currency, commercial bank checking accounts Channel Funds from Savers to Borrowers Enable Risk Sharing - Classic examples are insurance and forward markets

1. Facilitate Payments Cash transactions (Trade value for value). Could hold a lot of cash on hand to pay for things. Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs Make transactions easier.

2. CHANNEL FUNDS FROM SAVERS TO BORROWERS Lending is a form of trade ( Trade value for a promise) Give up purchasing power today in exchange for purchasing power in the future. Savers: have more funds than they currently need; would like to earn capital income Borrowers: need more funds than they currently have; willing and able to repay with interest in the future.

3. Risk Sharing The world is an uncertain place. The financial system allows trade in risk. Two principal forms of trade in risk are insurance and forward contracts. Trade value for a Promise

Take a few minutes to list some approaches to address this risk. Risk Sharing Example Consider the following: Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to replace lost income to provide for their family. Take a few minutes to list some approaches to address this risk. Self-insurance – save and accumulate a large amount of precautionary wealth in case you die. - No insurance: rely on charity, the state, or family for help. - Financial system offers a better alternative: life insurance. Everyone pays $1000 premium, and receives $1 million in case of death. In between, life insurance company can invest premiums and earn returns.

The Bond Market and Interest Rates A bond is a debt security that promises to make payments periodically for a specified period of time A security (a financial instrument) is a claim on the issuer’s future income or assets The interest rate is the cost of borrowing. Price paid for the rental of funds, expressed as a percentage. Pay $5.00 to rent $100 for one year - 5.0% interest 27

Interest Rates on Selected Bonds, 1950–2015 Three things this graph demonstrates?? 3-month Bill 10-year Treasury 10-year Corporate Baa 28

Financial Institutions and Banking Financial Intermediaries: institutions that “borrow funds from” (“issue liabilities to”) people who save and make loans to other people: Commercial Banks: accept deposits and make loans Other financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks 30

Commercial Banks Insurance Companies Loans deposits Bonds Stocks Insurance Policies Pension Funds Mutual Funds Retirement Plans Bonds Stocks Stocks Shares Money Market Mutual Funds Commercial paper T-Bills Shares/ “deposits”

Money and Economic Activity (Business Cycles) Evidence suggests that money plays an important role in generating business cycles Recessions and expansions in economic activity Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level 32

Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2008 Note: Shaded areas represent recessions. 33

  The aggregate price level is the average price of goods and services in an economy A continual rise in the price level is inflation - affects all economic players Data shows a connection between the growth in the money supply and the rate of inflation 34

Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007 Source: International Financial Statistics. 35

Examples of Hyperinflation:1980s and Early 1990s

M2 Money Growth and Inflation - US

Inflation and Nominal Interest Rates Mankiw

Inflation and Nominal Interest rates