Chapter 1 Why Study Money, Banking, and Financial Markets?

© 2004 Pearson Addison-Wesley. All rights reserved 1-2 Why Study Financial Markets? 1.Channel funds from savers to investors, thereby promoting economic efficiency 2.Affect personal wealth and behavior of business firms Why Study Banking and Financial Institutions? 1.Financial Intermediation Helps get funds from savers to investors 2.Banks and Money Supply Crucial role in creation of money 3.Financial Innovation Why Study Money and Monetary Policy? 1.Influence on business cycles, inflation, and interest rates

© 2004 Pearson Addison-Wesley. All rights reserved 1-3 Bond Market

© 2004 Pearson Addison-Wesley. All rights reserved 1-4 The Bond Market A security 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. There are many interest rates.

© 2004 Pearson Addison-Wesley. All rights reserved 1-5 The Stock Market A common 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. Both the bond market and the stock market are important factors in business investment decisions.

© 2004 Pearson Addison-Wesley. All rights reserved 1-6 Stock Market

© 2004 Pearson Addison-Wesley. All rights reserved 1-7 The Foreign Exchange Market The foreign exchange market is where the conversion of currency between countries take place. The foreign exchange rate is the price of one country’s currency in terms of another’s. A change in the exchange rate has a direct effect on American consumers because it affects the cost of imports.

© 2004 Pearson Addison-Wesley. All rights reserved 1-8 Foreign Exchange Market

© 2004 Pearson Addison-Wesley. All rights reserved 1-9 Structure of the Financial System The financial system comprises banks, insurance companies, mutual funds, finance companies, and investment banks. The financial intermediaries are institutions that borrow funds from people who have saved and in turn make loans to others Questions to be answered in Chapter 9.

© 2004 Pearson Addison-Wesley. All rights reserved 1-10 Banks and Other Financial Institution 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. Other financial institutions include insurance companies, finance companies, pension funds, mutual funds, and investment banks.

© 2004 Pearson Addison-Wesley. All rights reserved 1-11 Questions to Address How financial institutions make profits? (9) Why bank regulation takes the current form? (10) How the competitive environment has changed for banking industry and other financial institutions? How the financial institutions manage risk? (13) How the financial system change over time? (10)

© 2004 Pearson Addison-Wesley. All rights reserved 1-12 Money and Business Cycles Money is store of value, unit of account and medium of exchange. Business cycles are the upward and downward movements of aggregate output produced in the economy. Data: Every recent recession has been preceded by a decline in the rate of money growth. Theory: transmission mechanism (22-28)

© 2004 Pearson Addison-Wesley. All rights reserved 1-13 Money and Business Cycles

© 2004 Pearson Addison-Wesley. All rights reserved 1-14 Money and Inflation The inflation rate is defined as the growth rate of the aggregate price level. What explains inflation? Data: Inflation seems tied with increases in the money supply across time and countries. Theory: Money’s role in creating inflation (27).

© 2004 Pearson Addison-Wesley. All rights reserved 1-15 Money and the Price Level

© 2004 Pearson Addison-Wesley. All rights reserved 1-16 Money Growth and Inflation

© 2004 Pearson Addison-Wesley. All rights reserved 1-17 Other Interesting Issues Money and Interest Rates (5) Conduct of Monetary Policy (14-18, 21) Fiscal Policy and Monetary Policy (8,21,27)

© 2004 Pearson Addison-Wesley. All rights reserved 1-18 Money Growth and Interest Rates

© 2004 Pearson Addison-Wesley. All rights reserved 1-19 Fiscal Policy and Monetary Policy

1-20 How We Study Money and Banking Basic Analytic Framework 1.Simplified approach to the demand for assets 2.Concept of equilibrium 3.Basic supply and demand approach to understand behavior in financial markets 4.Search for profits 5.Transactions cost and asymmetric information approach to financial structure 6.Aggregate supply and demand analysis Features 1.Case studies 2.Applications 3.Special-interest boxes 4.Following the Financial News boxes 5.Reading the Wall Street Journal 6.Web Exercises and URLs

© 2004 Pearson Addison-Wesley. All rights reserved 1-21 Appendix: Definitions Aggregate Output Gross Domestic Product (GDP) = Value of all final goods and services produced in domestic economy during year Aggregate Income Total income of factors of production (land, capital, labor) during year Distinction Between Nominal and Real Nominal = values measured using current prices Real = quantities, measured with constant prices Aggregate Price Level nominal GDP GDP Deflator = real GDP $10 trillion GDP Deflator = = 1.11 $9 trillion Consumer Price Index (CPI) price of “basket” of goods and services

© 2004 Pearson Addison-Wesley. All rights reserved 1-22 Appendix: Definitions Growth Rates and the Inflation Rate