Money and Banking

Chapter 1 : Why Study Money,

Banking, and Financial Markets?
Chapter 2 : An Overview of the
Financial System.

Money and Banking

Three Parts:
1. Financial System
2. Monetary theory and Policy
3. International Finance

Moving Funds Through the Financial System

The financial system transfers funds from savers to borrowers. Borrowers transfer
returns back to savers through the financial system. Savers and borrowers include
domestic and foreign households, businesses, and governments. Direct and Indirect
Finance

Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Exchange and Over the Counter
Markets
Money and Capital Markets

Financial Markets
Debt and Equity Markets
Source of Fund for a Firm
Bond-Agreement by the borrower to pay the holder of
the instrument fixed dollar amounts at regular intervals
( interest and principal payments) until a specified date
( the maturity date), when final payment is made.
Interest Rate.
Stock- A share of ownership in a corporation. It is a
claim on the earnings and assets of the corporation.
Periodic payments (dividends)
Difference between bond and stock.
Ownership
No maturity date
Residual claimant/share profitability

Financial Markets
Primary and Secondary Markets
New securities are issued in primary markets.
Secondary market- Previously issued securities
are sold (NY stock exchange and NASDAQ)
Investment Bank-Underwriters.
Brokers and Dealers.
Why corporations care about secondary markets?
Increased liquidity in secondary markets
make it easier to raise cash.
Secondary markets determine the price of the
security in the primary markets.

Financial Markets
Exchanges and Over the Counter Markets
Organized Exchanges-The New York Stock Exchange and
NASDAQ
Buyers and Sellers may not meet anymore.
US government bond market is an example of the OTC market.

Money and Capital Markets

Based on maturity of the instrument

Short term debt instruments are traded in money markets
Longer term debt instruments are traded in capital markets
Money market instruments are widely traded and more liquid.
Short term securities have smaller fluctuations in prices than
long term securities.

Moving Funds Through the Financial System

The financial system transfers funds from savers to borrowers. Borrowers transfer
returns back to savers through the financial system. Savers and borrowers include
domestic and foreign households, businesses, and governments.
Key Components of the Financial System

Financial
Intermediaries/Institutions
Depository Institutions
Contractual Savings Institutions
Investment Intermediaries

Financial
Intermediaries/Institutions
Depository Institutions-

accept deposits from

individuals and institutions and make loans. Money Supply

Commercial Banks-Checkable deposits, savings

deposits, and time deposits.

S&Ls and Mutual Savings Banks

- collect funds through deposits
- used to make mortgage loans.

Credit Unions-Cooperative lending institutions for a

particular group.

Financial
Intermediaries/Institutions
Contractual Savings Institutions -collects
premium at periodic intervals on a contractual basis. Have
better idea about how much money to hold and how much to
invest in long term securities.

Life Insurance Companies insurance against

financial hazards because of death. Invest in bonds
and mortgages.

Fire and Casualty Insurance Companies buys

more liquid assets because of major disasters.

Pension Funds Acquire funds from contributions

made by employers and employee. Provide retirement
income in the form of annuities to employees.

Financial
Intermediaries/Institutions
Investment Intermediaries
Finance Companies
raise funds by selling commercial paper and by issuing stocks
and bonds.
Sells consumer goods

Mutual Funds/Hedge Funds

Sell shares to investors, invest in a portfolio of financial
assets and charge fees
Reduce risk because of diversification and buy back
Fidelity Investment
Acquire funds by selling share to many individuals.
Value of the mutual funds stock determined by the value of
the holdings.
Hedge fund no more than 99 investors.

Financial
Intermediaries/Institutions
Investment Intermediaries
Money Market Mutual Funds
Sell shares to acquire funds but mainly invest in
money market instruments.
Can write checks against the value of
shareholdings.
Like checking with interest.

Investment banks
Do not take any deposits
Underwrite the securities of corporations
Goldman Sachs and Morgan Stanley.

Moving Funds Through the Financial System

The financial system transfers funds from savers to borrowers. Borrowers transfer
returns back to savers through the financial system. Savers and borrowers include
domestic and foreign households, businesses, and governments.
Key Components of the Financial System

Financial Market Instruments

Money Market Instruments
Capital Market Instruments

Financial Market Instruments

Money Market Instruments- Maturity less
than a year with less price fluctuations and so less risky
investments.

T-Bills
Issued by U.S. governments in 1, 3, and 6 month
maturities.
Sell at discount and pay only at maturities.
No possibility of default.

Certificate of Deposit
Issued by bank and pays annual interest rate and
principal at maturity.
Has secondary markets.

Financial Market Instruments

Money Market Instruments- Maturity less
than a year with less price fluctuations and so less risky
investments.

Commercial Paper
Issued by large banks and corporations.

Repurchase Agreements
Short term loans (maturity < 2 weeks) for which
T-bill works as collateral.

Federal funds
Overnight exchanges of deposits between banks.
Federal Funds Rate-High and Low

Financial Market Instruments

Capital Market Instruments- Maturity more
than a year with more price fluctuations and so more risky
investments.

Stocks
Equity claims on the net income and assets of a
corporation.

Mortgage Backed Security

The source of mortgage.
A debt instrument backed by mortgages.
Interests and principal collected from the
mortgages are paid to the holders of security.
Freddie Mac, Fannie Mae, and Ginnie Mae.

Financial Market Instruments

Capital Market Instruments- Maturity more
than a year with more price fluctuations and so more risky
investments.

Corporate Bonds
Issued by corporations with strong credit rating
and not very liquid.
Usually interest payment twice a year and pays
off the face value when bond matures.
Convertible bonds
Avoid interest payment
Size of the bond market is substantially smaller
than that of the stock market.

Financial Market Instruments

Capital Market Instruments- Maturity more
than a year with more price fluctuations and so more risky
investments.

Government Securities
Issued by the U. S. treasury to finance the deficit.
Most liquid among all capital market instruments.

State and Local Government Bonds

To finance expenditures on schools, roads etc.
Interest payment is exempt from income tax.
Institutions (commercial banks) and people with
high income tax bracket usually invest.

Financial Market Instruments

International Bond Market-

Growing

internationalization of financial markets.

Foreign bonds-traditional instruments in the

international Bond Market
Sold in a foreign country and are denominated in
that countrys currency.
A British firm sells their bond in the US and it is
denominated in the US dollars.

Eurobond - recent innovation

Denominated in a currency other than that of the
country in which it is sold.
Denominated in British Pound sold in New York.

Financial Market Instruments

International Bond Market-

Growing

internationalization of financial markets.

Eurocurrencies - variant of Eurobond

Foreign currencies deposited in a bank outside
the home country.
Eurodollars US dollars deposited in Canada.
Dont be confused with Euros.

What does financial system

do?
Financial Intermediaries lower Transaction
Costs
Economies of Scale

Liquidity services
Risk Sharing
Asset transformation-risky assets transformed into safer
assets
Create and sell assets that have low risk and use the
funds to purchase risky assets
Diversification-the returns of the assets in the portfolio do
not move together, with the overall risk is lower than for
individual assets.

Collection and communication of information

Regulation of the Financial

System
Increasing Information Available to Investors
The SEC requires corporations to disclose certain
information about their sales, assets, and earnings.

Ensuring the Soundness of Financial

Intermediaries
Collapse of financial intermediaries-financial panic.

Restrictions on Entry, Assets, Interest Rates, and

Activities
Federal Deposit Insurance
Limits on Competition

Money and Banking

Three Parts:
1. Financial System
2. Monetary theory and Policy
3. International Finance

Why Study Money and

Monetary Policy?
Money affects standard of living because it
affects other important macro variables.
Evidence suggests that money plays an
important role in generating business cycles
Recessions (unemployment) and expansions
affect all of us
Monetary Theory ties changes in the money
supply to changes in aggregate economic
activity and the price level

Money, Business Cycles

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

Figure 4 Aggregate Price Level and the

Money Supply in the United States, 1950
2011

Sources: Based on www.stls.frb.org/fred/data/gdp/gdpdef;

www.federalreserve.gov/releases/h6/hist/h6hist10.txt.

Figure 5 Average Inflation Rate Versus

Average Rate of Money Growth for
Selected Countries, 2000-2010

Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

Money and Interest Rates

Interest rates are the price of money
Prior to 1980, the rate of money
growth and the interest rate on longterm 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

Figure 6 Money Growth (M2 Annual Rate)

and Interest Rates (Long-Term U.S.
Treasury Bonds), 19502011

Sources: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

Figure 3 Money Growth (M2 Annual Rate)

and the Business Cycle in the United
States 19502011

Source: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

Monetary Policy: the Federal Reserve?

The Federal Reserve is the central bank of the United States; usually
referred to as the Fed.
Established by Congress in 1913 to deal with banking problems.
Original role: lender of last resort.

Key Components of the Financial System

What Does the Federal Reserve Do?

The Fed is responsible for monetary policy, which refers to the actions to
manage the money supply and interest rates to pursue macroeconomic
policy objectives.
The Fed is divided into 12 districts.
The main policymaking body is Federal Open Market Committee (FOMC).
Janet Yellen has been the chair of the Board of Governors since 2014.
The FOMC meets 8 times per year to make decisions on a target for the
federal funds rate.
The federal funds rate is the interest rate that banks charge each other on
short-term loans.

Key Components of the Financial System

Figure 1.2 The Federal Reserve System

The Federal Reserve System is divided into 12 districts, each of which has a District
Bank located in the city shown on the map.
Key Components of the Financial System

Fiscal Policy and Monetary

Policy
Monetary policy is the management of the money
supply and interest rates
Conducted in the U.S. by the Federal Reserve System
(Fed)

Fiscal policy deals with government spending

and taxation
Budget deficit is the excess of expenditures over
revenues for a particular year
Budget surplus is the excess of revenues over
expenditures for a particular year
Any deficit must be financed by borrowing

Money and Banking

Three Parts:
1. Financial System
2. Monetary theory and Policy
3. International Finance

International Finance: The Foreign

Exchange Market
The foreign exchange market is where funds are
converted from one currency into another
The foreign exchange rate is the price of one
currency in terms of another currency
The foreign exchange market determines the
foreign exchange rate

Figure 8 Exchange Rate

of the U.S. Dollar, 1970
2011

Source: Federal Reserve; www.federalreserve.gov/releases/H10/summary/indexbc_m.txt/.

International Finance: The

International Financial System
Financial markets have become increasingly
integrated throughout the world.
The international financial system has
tremendous impact on domestic
economies:
How a countrys choice of exchange rate policy
affect its monetary policy?
How capital controls impact domestic financial
systems and therefore the performance of the
economy?
Which should be the role of international
financial institutions like the IMF?