1. Economics 330 – Money and Banking T and Th from 9:30am to 10:45am Text: Mishkin, Frederic: The Economics of Money, Banking, and Financial Markets, Addison-Wesley, Business School Edition, 4 th, 3 rd or 2 nd edition.

2. Who am I ? Dr. John Neri Office Hours: T and Th from 3:30pm to 4:30pm. Office: Morrill Hall, Room 1102B

3. Who you are: (238 students) as of 1/22/16 Accounting – 8 Info Sys – 4 Computer Science – 4 LTSC - 70 Sup MGMT - 8 Economics – 89 Foreign Exch - 6 Finance – 30 G & P – 6 Intl. Bus - 1 Marketing – 6 BioSci Chem - 2

4. Course Webpage http://www.terpconnect.umd.edu/~jneri/Econ330 NOTE: upper-case E

5. 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 Operation Twist MBS Money Market Capital Market Sub-prime Mortgage Shadow Banking System MMMF Large Scale Asset Purchase Term Structure Financial Intermediary

6. What is this?

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

8. Why Study Money, Banking & Financial Markets To understand how financial markets work - Obviously, there are many financial markets – stocks, bonds, foreign exchange. - We focus primarily on bond and credit markets To examine how financial institutions work - Many types of financial institutions – banks, investment banks, insurance companies, pension funds - We focus primarily on commercial banks To examine the role of money in the economy  How the Federal Reserve System works

9. Five Parts of the Financial System 1.Money An asset used to pay for purchases, repay of debt, pay taxes - medium of exchange - a store of wealth - a unit of account

10. Five Parts of the Financial System 2.Financial Instruments Contracts used to transfer wealth from people who have an excess of available funds (savers/lenders/investors) to people who have a shortage of funds (borrowers/entrepreneurs) Also, contracts to transfer risk to those best equipped to bear it.

11. Five Parts of the Financial System 3. Financial Markets Allow us to buy and sell financial instruments quickly and cheaply. Funds are transferred from people who have an excess of available funds to people who have a shortage of funds 4. Financial Institutions. Firms that provide access to financial markets

12. Five Parts of the Financial System 5. Central Banks  monitor and stabilize the economy,  monitor financial institutions.

13. 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

14. 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.

15. 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.

16. 2. CHANNEL FUNDS FROM SAVERS TO BORROWERS Why is this important? A) Allows those without funds to exploit profitable investment opportunities. Examples: Commercial loans to growing businesses; Venture capital; Student loans (investment in human capital); investment in physical capital and new products/processes crucial to economic growth.

17. 2. CHANNEL FUNDS FROM SAVERS TO BORROWERS B) Financial System allows the timing of income and expenditures to be decoupled. - Household earning potential starts low, grows rapidly until the mid 50s, then declines with age. Financial system allows households to borrow when young to prop up consumption (mortgages, car loans), repay and then accumulate wealth during middle age, then live off wealth during retirement.

18. TIMING OF INCOME AND EXPENDITURES DECOUPLED Consumption Income Dissaving Saving Dissaving $ Time Retirement Begins

19. 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

20. Risk Sharing Example 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. Options ?

21. 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

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

24. The Stock Market Common stock represents a share of ownership in a corporation  An equity security (financial instrument) that is a claim on the residual earnings and assets of the corporation  Residual claim Firms can issue new shares to finance investment spending

25. Mishkin Figure 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2014

26. Shiller: Real Terms. Note the behavior of price relative to earnings. Mishkin starts at 1950.

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

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

30. 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

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

32. 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

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

34. Examples of Hyperinflation: 1980s and Early 1990s

35. M2 Money Growth and Inflation - US

36. Money and Interest Rates Prior to 1980, the rate of money growth and 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

37. FIGURE 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2008

38. Mankiw Inflation and Nominal Interest Rates

39. Inflation and Nominal Interest rates