Chap 1: Why Study Money, Banking and Financial
Markets in terms of another’s
*Provides answers to different financial phenomenon by
examining how financial markets and financial
institutions work and by exploring the role of money in
the economy
Why Study Financial Markets
Financial Markets – markets in which funds are
transferred from people who have an excess of available
funds to people who have a shortage.
 Resource allocation must be efficient
and optimal
 A key factor in producing high economic
growth
 Affect personal wealth
 Impacts the business cycle
Types of Fin Markets
Bond Market - Also called the debt market or credit
market. It is a financial market in which the participants
are provided with the issuance and trading of debt
securities.
INTEREST RATE- is the cost of borrowing or the
price paid for the rental of funds. Important on a
personal level as high interest rates could deter you from
buying a house or a car but can encourage you to save
and vice versa. On a general level, they affect businesses’
investment decisions like expansion and job layoffs.
Security (also called a “financial instrument”) -
Claim on the issuer’s future income or assets (assets are
any financial claim or piece of property that is subject to
ownership
Bond - Debt security that provides payments at
specified future dates
Stock market – where shares of stock is traded
- Important factor in business
investment decisions because share
prices affects the amount of funds that
can be raised by selling newly issued
stock to finance investment spending
Stocks/Common Stocks - Claim on the earnings
and assets of the corporation; Share of
ownership in a corporation; Very volatile
A place people can get rich/poor quickly
Foreign Exchange Market - A market in which
participants are able to buy, sell, exchange and speculate
on currencies. Affects the price of imports and exports as
well as its effect on domestic goods.
Forex Rate - The price of one country’s currency
Why Study Banking and Financial Institutions
FINANCIAL INSTITUTIONS OR FINANCIAL
INTERMEDIATIES - Establishment that conducts
financial transaction such as
investments, loans, and deposits.
- Institutions that borrow funds from
people who have saved and in turn
make loans to others
Banks and other Fin institutions
Banks - financial institutions that accept deposits and
make loans including 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
Financial Innovation – Innovations in providing financial
services to customers emphasizing improvements in
information technology leading to new means of
delivering financial services electronically, otherwise
known as e-finance.
Why Study Money and Monetary Policy
Money - also referred to as the money supply, is defined
as anything that is generally
accepted in payment for goods or services or in the
repayment of debts. It affects the three economic
variables affecting the health of the economy
Money and Business Cycles - Money plays an important
role in generating business cycles. It is then linked to
aggregate output and unemployment rate
Business Cycle - the upward and downward
movement of aggregate output produced in the economy.
Recessions represents period of declining aggregate
output and increasing unemployment rate.

Money and Inflation – a continuing increase in the money
supply might be an important factor in causing the
continuing increase in the price level that we call inflation.
there is also a positive association between inflation and
the growth rate of the money supply
Aggregate price level - the average price of goods and
services in an economy
Money and Interest Rates - Money plays an important
role in interest-rate fluctuations, which is concern to
businesses and consumers
Monetary Policy - the management of money and interest
rates
Central Bank – The organization responsible for the
conduct of a nation’s monetary policy (Bangko Sentral ng
Pilipinas
Fiscal Policy – involves decisions about government
spending and taxation (managing budget deficit and
budget surplus or difference between tax revenues and
government expenditures) Deficit is financed by
borrowing, and surplus results to lower govt debts
GDP – a measure of aggregate output produced by the
economy
Chap 2: An Overview of the Financial System
Function of Financial Markets
*Fin markets perform the essential economic function of
channeling funds from households, firms, and
governments that have saved surplus funds by spending
less than their income to those that have a shortage of
funds because they wish to spend more than their income.
Lender-saver - those who have saved and are lending
funds
Borrower-spenders – those who must borrow funds to
finance their spending
*1. Allows transfers of funds from person or business
without investment opportunities to one who has them (a
carpenter who has a skill but no capital to fund resources,
and a person who saves enough money but don’t have
time to find an exact person who could use the money for
a corresponding interest)
2. critical for producing an efficient allocation of capital,
which contributes to higher production and efficiency for
the overall economy
3. Well-functioning financial markets also directly improve
the well-being of consumers by allowing them to time
their purchases better (provide funds immediately w/o
having them wait by just saving their money)
Segment of Financial Market
DIRECT FINANCE- Borrowers borrow directly from lenders
in financial markets by selling financial instruments
INDIRECT FINANCE- Borrowers borrow indirectly from
lenders via financial intermediaries by issuing financial
instruments which are claims on the borrower’s future
income or assets. Securities are assets for the holder and
liabilities for the issuer.
Structure of Financial Markets
Debt Market - Issuing a debt instrument, such as a bond or
a mortgage
- contractual obligation to pay the holder
fixed payments at specified dates (e.g.,
mortgages, bonds, car loans, student
loans)
- Short-term- if its maturity is less than a
year
- Long-term- if its maturity is ten years or
longer.
- Intermediate-term- with a maturity
between one and ten years.
Equity Market – issuing equities, such as common stock
- sale of ownership share (owners are
residual claimants, or creditors must be
paid first before equity holders).
- Owners of stock may receive dividends
- advantage of holding equities is that
equity holders benefit directly from any
increases in the corporation’s profitability
or asset value because equities confer
ownership rights on the equity holders
Primary Market - Is a financial market in which new issues
of a security, such as a bond or a stock, are sold to initial
buyers by corporation or government agency borrowing
the funds (helped by an investment bank which
underwrites the securities for sale to the public)
Secondary Market - Is a financial market in which
securities that have been previously issued can be resold
(brokers are agents or investors who match buyers with
sellers of securities; dealers link buyers and sellers by
buying and selling securities at stated prices)
2 Important Functions of Secondary Market
- They make it easier and quicker to sell
financial instruments to raise cash
(Increase liquidity of financial assets)
- They determine the price of the security
that the issuing firm sells in the primary
market
Two ways to organize Secondary Markets
- Exchanges Market, where buyers and
sellers of securities meet in one central
location to conduct trades (
- OTC (Over-the-counter) Market, dealers at
different locations who have an inventory
of securities stand ready to buy and sell
securities “over the counter” to anyone
who comes to them and is willing to
accept their prices
Money Market – financial market in which only short-term
debt instruments (less than one year) are traded like:
- Treasury bills, short-term debt
instruments with one-, three- and six-
month maturities issued to finance a
government
- Certificates of Deposit, is a debt
instrument sold by a bank to depositors
- Commercial Paper, is a short-term debt
instrument issued by large banks and
well-known corporations
- Banker’s Acceptances, these instruments
are created in the course of carrying out
international trade and have been in use
for hundreds of years
- Repurchase Agreements, are effectively
short-term loans for which Treasury bills
serve as collateral, an asset that the
lender receives if the borrower does not
pay back the loan
- Federal (Fed) Fund, these instruments are
typically overnight loans between banks
of their deposits at the Federal Reserve
Capital Market – market in which long-term debt (one year
or more) and equity instruments are traded (like Stocks,
Mortgages, Corporate Bonds)
Function of Financial Intermediaries - Funds can move
from lenders to borrowers by involving a financial
intermediary that stands between the lender-savers and
the borrower-spenders and helps transfer funds from one
to the other ( like a bank issuing a liability to the public,
the proceeds will be used to acquire an asset by making
loans or buying bonds)
Financial Intermediation – the process of indirect finance
using financial intermediaries and is the primary route for
moving funds from lenders to borrowers
*Financial intermediaries play an important role in the
economy because they provide liquidity services, promote
risk sharing, and solve information problems
Transaction Costs - The time and money spent in carrying amount he borrowed to
out financial transaction. Can be reduced because the opportunities that can ensure a
large size of these intermediaries allows them to return of capital on your part, so
take advantage of economies of scale, the reduction in you will decide not to lend the
transaction costs per dollar of transactions as the size money
(scale) of transactions increases (like hiring one lawyer to
make legal costs cheaper). Results to provision of liquidity *The problems created by adverse selection and moral
services or services that make it easier for customers to hazard are an important impediment to well-functioning
conduct transactions (like easy to pay bills from banks) financial markets. Again, financial intermediaries can
alleviate these problems by lending these funds to a
Risk Sharing - Can help reduce the exposure of investors trustworthy intermediaries
to risk (uncertainty about the returns
investors will earn on assets); like offering Financial Intermediaries
assets with less risk and acquiring assets
with far more risk (asset transformation)
- Financial intermediaries also promote risk
sharing by helping individuals to diversify
(investing in a portfolio) and thereby
lower the amount of risk to which they
are exposed

Asymmetric Information - One party often does not know

enough about the other party to
make accurate decisions
(borrower has better information
about risks and rewards than the
lender does
 Adverse selection is the problem
created by asymmetric
information before the Depository Institutions - financial intermediaries that
transaction occurs. It happens accept deposits from individuals and institutions and make
when the potential borrowers loans
who are the most likely to
Contractual Savings Institutions - financial intermediaries
produce an undesirable (adverse)
that acquire funds at periodic intervals on a contractual
outcome—the bad credit risks—
basis (liquidity of assets is not important as payment
are the ones who most actively
benefits can be predicted with reasonable accuracy)
seek out a loan and are thus most
likely to be selected (like those Investment Intermediaries – (no discussion)
who are offered a high return
investment will seek out and be Two Main Reasons for Regulation (Financial sector is one
granted a loan more than those of the most heavily regulated sectors of the economy)
who are more careful in selecting
their investments) 1. Increase information to investors
 Moral hazard is the problem A. Decreases adverse selection and moral hazard
created by asymmetric problems
information after the transaction B. SEC forces corporations to disclose information
occurs. It is the risk (hazard) that 2. Ensuring the soundness of financial intermediaries
the borrower might engage in To protect the public and the economy from
financial panic, the government has implemented
activities that are undesirable
6 types of regulation
(immoral) from the lender’s point
Restrictions on Entry
of view, because they make it Disclosure
less likely that the loan will be Restrictions on Asset and Activities
paid back (like you believe that a Deposit Insurance
person will not spend the Limits on Competition
 Restriction on Interest Rates
Chap 3: What is Money
*Money (also referred to as the money supply) is anything
that is generally accepted in payment for goods or services
or in the repayment of debts.
 To define money merely as currency is much too
narrow for economists. Because checks are also
accepted as payment for purchases and savings
that can be easily converted to cash, checking
account deposits are considered money as well
(Money is broader than currency)
 Money constitutes currency, demand deposits,
and other items that are used to make purchases
while wealth is the total collection of pieces of
property that serve to store value (Wealth is
broader than money)
 Income is a flow of earnings per unit of time.
Money, by contrast, is a stock or a certain amount
at a given point in time (Money not same to
income)
Functions of Money
Medium of Exchange - used to pay for goods and services.
The use of money as a medium of exchange promotes
economic efficiency by minimizing the time spent in
exchanging goods and services (compare with barter
system. It also allows people to specialize in what they do
best, and a lubricant allowing the economy to run more
smoothly by lowering transaction costs.
Transaction cost - the time spent trying to
exchange goods or services
Double coincidence of wants - they have to find
someone who has a good or service they want and who
also wants the good or service they have to offer
For a commodity to function effectively as money,
it has to meet several criteria:
It must be easily standardized.
It must be widely accepted.
It must be divisible
It must be easy to carry
It must not deteriorate quickly
Unit of account - used to measure value in the economy
(value of goods and services). Using money as a unit of
account reduces transaction costs in an economy by
reducing the number of prices that need to be considered
(important as economy becomes complex)
Store of value - a repository of purchasing power over
time. It is used to save purchasing power from the time
income is received until the time it is spent
- Any asset can be used to store wealth but people hold
money because is the most liquid asset of all because
it is the medium of exchange; it does not have to be
converted into anything else in order to make
purchases (liquidity refers to the relative ease and
speed with which an asset can be converted into a
medium of exchange
- How good a store of value money is depends on the
price level, because its value is fixed in terms of the
price level (price level doubles, value of money will
drop by half, and vice versa)
Evolution of the Payments System
Payments System - the method of conducting transactions
in the economy
Barter System
Commodity Money - Money made up of precious metals
or another valuable commodity. The problem with a
payments system based exclusively on precious metals is
that such a form of money is very heavy and is hard to
transport from one place to another
Fiat Money - Paper currency decreed by government as
legal tender but not convertible to coins or precious
metals. Much lighter but it can be accepted as a medium
of exchange only if there is some trust in the authorities
who issue it and if printing has reached a sufficiently
advanced stage that counterfeiting is extremely difficult.
Drawbacks include being easily stolen and can be
expensive to transport in large amounts because of their
bulk.
Checks - an instruction from you to your bank to transfer
money from your account to someone else’s account
when she deposits the check. The use of checks thus
reduces the transportation costs associated with the
payments system and improves economic efficiency. Also,
they can be written for any amount up to the balance in
the account, making transactions for large amounts much
easier. But it takes time to get checks from one place to
another, and it usually takes several business days before a
bank will allow you to make use of the funds from a check
you have deposited. All the paper shuffling required to
process checks is also costly.
Electronic Payment - Banks provide Website at which you
just log in, make a few clicks and thereby transmit your
payments electronically. Here, paying bills becomes
(almost) a pleasure, requiring little effort.
E-money - Electronic payments technology can not only
substitute for checks, but can substitute for cash, as well,
by money that exists only in electronic form
- Debit card - enable consumers to purchase goods and
services by electronically transferring funds directly
from their bank accounts to a merchant’s account.
- Stored-value card - payments card with a monetary
value stored on the card
- E-cash – used on the Internet to purchase goods or
services
Measuring Money
If people find it more convenient for purchases paid
through cash or checks, more money is used to conduct
the transactions generated by the same level of nominal
income
Institutional and Technological features of the economy
would affect velocity only slowly over time, so velocity
would normally be reasonably constant in the short run

Monetary Aggregates – measure of money or the money
supply (done by the BSP which is the authority responsible
for the monetary policy
M1 - Consists of currency in circulation and peso demand
deposits
M2 - Consists of M1 plus peso savings and time deposits
M3 - Consists of M2 plus peso deposit substitutes, such as
promissory notes and commercial papers
M4 - Consists of M3 plus transferable and other deposits in
foreign currency
*Quantity Theory of Money states that nominal income is
determined solely by movements in the quantity of money
Additional presumption is that wages and prices were
completely flexible, they believed that the level of
aggregate output Y produced in the economy during
normal times would remain at the full-employment level,
so Y in the equation of exchange could also be treated as
reasonably constant in the short run.
Therefore, movements in the price level result solely from
changes in the quantity of money

Chap 22: The Demand and Supply For Money

Quantity Theory of Money - a theory of how the nominal Fisher suggest that the demand for money is purely a
value of aggregate income is determined which in turn
function of income
determine the demand for money (classical theory which
suggested interest rates have no effect on money demand) The demand for money is determined by:
1. level of transaction generated by the level of
Velocity of Money and The Equation of Exchange nominal income PY.
M = the money supply
P = price level
2. the institutions in the economy that affects the
Y = aggregate output (income) way people conduct transactions and thus
P  Y  aggregate nominal income (nominal GDP) determine velocity.
V = velocity of money (average number of times per year that a dollar is spent)

V
PY Is Velocity Constant?
M
Equation of Exchange
M V  P  Y

Velocity is determined by institutions in an economy that

affect the way individuals conduct transactions

If people use charge accounts and credit cards, less money

is required to conduct the transactions generated by
nominal income

*Even in the short run, velocity fluctuates too much to
be viewed as a constant. Velocity declines sharply
during severe economic contractions (this was not
recognized because no data is available before)
Keynes’s Liquidity Preference Theory
L.P.T. – a theory of money demand that emphasized the
importance of interest rates. Focuses on why do
individuals hold money.
Motives behind demand for money
Transactions motive - The amount of money that you
require to survive. As everyday transactions were
proportional to income, the transaction motive is also
proportional to income
Precautionary motive - the amount of money required
in case of an emergency. It is believed that the amount
of precautionary money balances people want to hold is
determined primarily by the level of transactions that
they expect to make in the future and that these
transactions are proportional to income, so the
precautionary motive is also proportional to income.
Speculative motive - The amount of money required for
investment opportunities and/ or luxury items (Money
considered as a source of wealth). As interest rates
become higher, bond prices fall, making people invest
less and just store their wealth. Opposite occurs when
interest rates are lowered. Thus money demand is
negatively related to the level of interest rates
Further Developments in the Keynesian Approach
- Transactions demand - Transactions component of
the demand for money is negatively related to the
level of interest rates (As interest rates increase,
the amount of cash held for transactions purposes
will decline, which in turn means that velocity will
increase as interest rates increase)
- Precautionary demand - Precautionary demand for
money is negatively related to interest rates (As
interest rates rise, the opportunity cost of holding
precautionary balances rises, and so the holdings of
these money balances fall)
- Speculative Demand - Keynes’s analysis therefore
implies that practically no one holds a diversified
portfolio of bonds and money simultaneously as a
store of wealth. James Tobin developed a model of
the speculative demand for money that attempted
to avoid this criticism of Keynes’s analysis.
Specifically, Tobin assumed that most people are
risk-averse—that they would be willing to hold an
asset with a lower expected return if it is less risky
What if there are assets that have no risk but earn a
higher return? Will there be any speculative demand for
money?
- No, because an individual will always be better off
holding such an asset rather than money. The
resulting portfolio will enjoy a higher expected return
yet has no higher risk.
- Tobin’s Analysis was an important development in
our understanding of how people should choose
among assets
Change in Demand For money
- Income effect - Income would affect demand for
money because:
(a) As the economy expands and income rises,
wealth increases and people will want to hold
more money as a store of value
(b) As the economy expands and rises, people
will want to carry out more transactions using
money hence; they will want to hold more money.
- Price-level effect - When the price level rises, the
value of a nominal sum of money is eroded and in
order to be able to buy the same quantity of goods/
services as before, people will have to hold a larger
nominal quantity of money
Supply of Money
*An assumption that the Central Bank (BSP) controls the
money supply through its monetary policies
How the Government Alter Money Supply
*We need to understand what cause the demand and
supply to change. Change means to shift. Contractionary
monetary policy never usually happens.
- The supply curve for money is thus a vertical line
(because its determined by the BSP). Money market
equilibrium occurs at the interest rate at which the
quantity of money demanded equals the quantity of
money supplied.
- All other things unchanged, a shift in money demand
or supply will lead to a change in the equilibrium
interest rate and therefore to changes in the level of
real GDP and the price level
- We assume that the supply of money is determined
by the Fed. The supply curve for money is thus a
vertical line. Money market equilibrium occurs at the
interest rate at which the quantity of money
demanded equals the quantity of money supplied.
- All other things unchanged, a shift in money demand
or supply will lead to a change in the equilibrium
interest rate and therefore to changes in the level of
real GDP and the price level
- An increase in money supply shifts the supply curve to
the right, and ceteris paribus, causes a decline in
interest rates (Liquidity Effect)