Professor Yamin Ahmad, Money and Banking – ECON 354 ECON 354 Money and Banking Lecture 1 Syllabus...

Professor Yamin Ahmad, Money and Banking – ECON 354

ECON 354

Money and BankingMoney and Banking

• Lecture 1

Syllabus

Introduction to Financial Markets and Money

Real World Observations and Basic Definitions


Note: These notes are incomplete without having attended lectures

Resources Needed For This Class

• Aplia Website:http://econ.aplia.comUse course code: M363-5FTK-EX38

• Mishkin, Frederick S. (2010), The Economics of Money, Banking and Financial Markets, 9th Edition, Pearson8th edition is also fine if you have it.

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Success in an (Any!) Economics Course

To do well in Economics, you need to be able to do 3 things well (in conjunction):

1. Think Mathematically: Don’t be afraid of equations!

2. Think graphically!

3. Abstract Logic! (Often the hardest part)

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A Model of the Economy

• As in Principles of Macro, divide the economy into different sectors and see how those sectors interact:

“Agents” in the Economy

Markets where Agents Interact

Equilibrium

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The Agents in the System…

• There are four agents that we will focus on when constructing a model of the economy:Households

Firms

Government

“The Rest of the World” (ROW)

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Markets

• There are three markets that we typically focus on in macroeconomics:

The Factor Market

The Goods Market

The Financial Market (- we examine in detail in this course)

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The Economy

HOUSEHOLDS

FIRMS

GOVERNMENT

Overview of the Course

Financial Markets:

-Interest Rates-Risk

-Expectations

Financial Institutions

- Financial Intermediaries

Central Banking & Monetary Policy

REST OF THEWORLD

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• Money

• Monetary Theory and Monetary Policy

• Financial Markets and Financial Intermediaries

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Some Definitions• Money: Anything that is generally accepted in payment

for goods and services

• In the United States: M1 = Currency + Traveler's Checks + Demand Deposits +

Other Checkable Deposits

M2 = M1 + Small denomination time deposits & repurchase agreements + Savings Deposits and money market deposit accounts + retail Money Market mutual fund shares

• There also used to be a broader measure of money, M3 which was discontinued as of March 2006.

• See: http://www.federalreserve.gov/releases/h6/hist/ 1004/19/23



Role of Money

• Medium of exchange Form of transaction technology

• Unit of account

• Store of value Purchasing Power

Hence money helps to: Lower transaction costs Increase Liquidity in an economy

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• Money



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Monetary Theory and Policy

• Why study Monetary Theory and Policy?

Influence on business cycles, inflation, and interest rates.

How Central Bank (Fed) can have a big influence on the economy?.

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Money and Business Cycles

• Shaded areas represent Recessions• Note: Figure above shows a decline in money growth rate

prior to every recession (except the most recent one)! 1404/19/23



Money and the Price Level

• Note: Positive Relationship between Money and the Aggregate Price Level

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Money Growth and Inflation

• Note: Across different countries, positive correlation between avg. money growth rates and avg. inflation rates

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Money Growth and Interest Rates

• Positive correlation between money growth rates and interest rates in 1960’s & 1970’s

• Relationship breaks down in 1980’s1704/19/23


Surpluses and Deficits • Figure 10(a) shows the

changing surplus and deficit of the federal and provincial governments in the United States since 1971.

• Persistent federal deficit during the 1970s through 1990s.

• Surplus from 1998 to 2001

• More deficits following.

Source: Congressional Budget Office

1980’s expansion

1990’s expansion

2002 – 2007 expansion

2001 – 2002 Recession

1991 Recession1982

Recession

OPEC Recession

18Note: These notes are incomplete without having attended lectures04/19/23


Surpluses and Deficits

International Surplus and Deficit• If a nation imports more than it exports, it has an

international (trade) deficit.• If a nation exports more than it imports, it has an

international (trade) surplus.

• The current account deficit or surplus is the balance of exports minus imports plus net interest paid to and received from the rest of the world.



Surpluses and Deficits • Figure 10(b) shows

The U.S. current account balance since 1960.

• Persistent current account deficit since 1983

• The deficit has swollen during the past few years

OPEC Recession 1981-82

Recession

1991 Recession

2001 – 2002 Recession

1990’s Expansion

1980’s Expansion

2008 Recession

Source: Bureau of Economic Analysis 20Note: These notes are incomplete without having attended lectures04/19/23



Interaction of Monetary and Fiscal Policy

• Surpluses – good? Deficits – bad?

• Examine how fiscal irresponsibility can lead to the onset of financial crises.

• Why deficits might lead to a higher money growth rate, a higher rate of inflation and higher interest rates?.

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• Money



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• Why Study Financial Markets? Channel funds from savers to investors, thereby

promoting economic efficiencyAffect personal wealth and behavior of business firms

• Brief Introduction to:Bond MarketStock MarketForeign Exchange Market

Financial Markets

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Function of Financial Markets: Flow of Funds

• Allows transfers of funds from person or business without investment opportunities to one who has them.

• Improves economic efficiency.

Lender-Savers• Households• Firms• Government• Foreigners

FinancialMarkets

Borrowers-Spenders• Business-Firms• Government• Households• Foreigners

Direct Finance

Indirect Finance

FinancialIntermediaries

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Bond Market: 1953 - 2010

• Bonds, securities…. what are they?

• Bond Market (and Money Markets):

determines interest rates2504/19/23



Stock Market: 1950 - 2010

• Stocks: Share of ownership in a

corporation/firm.

• Stock Price volatility

• “Bull Market” vs. “Bear Market”

• Stock Price “Bubbles” Technology bubble in

1990’s?

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Foreign Exchange Market

• Foreign Exchange Market:

Transfer funds from one country to another

• Changes in Exchange rate:

Changes in relative prices2704/19/23



Some Basic Definitions

Debt Instrument:

1. Debt Instrument: Contractual agreement by borrower to pay holder of the instrument a fixed dollar amount at regular intervals (principal + interest), until a specified date Example: Car loan

2. The maturity of a debt instrument is the number of years (term) until the instrument expires

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Classifications of Financial Markets1. Primary Market

New security issues sold to initial buyers (often behind closed doors)

Investment banks typically underwrite securities (i.e. guarantees a price for the security and then sells it to the public)

2. Secondary Market Securities previously issued are bought and sold E.g.: NASDAQ, Futures, Options, Foreign Exchange Exchanges

o Trades conducted in central locations (e.g., New York Stock Exchange, NYSE; London Stock Exchange, LSE)

Over-the-Counter Marketso Dealers at different locations buy and sell

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Methods of Raising Private Sector Funds• Debt Markets

Short-term (maturity < 1 year): Money Market Intermediate-term (1year < maturity < 10 years) Long-term (maturity > 10 years)

• Equity Markets Common stocks: claims to share in assets and net income No maturity date; periodic payments known as dividends

• Capital Market: Intermediate + Long Term Debt + Equity

• Examples: Bonds, mortgages3004/19/23


Financial Market Instruments

What are the kinds of securities traded in financial markets?

• Money Market Instruments Because of short term to maturity, debt instruments traded in the

money market do not have much fluctuation in their prices, and hence are the least risky

• Capital Market Instruments Debt and equity instruments with maturities greater than a year;

these have much greater fluctuations in their prices (compared to money market instruments) and as such are considered more risky

Note: These notes are incomplete without having attended lectures3104/19/23


Examples: Money Market Instruments

• US Treasury Bills Issued by US govt, with 1, 3, and 6 month maturities. Pay a set amount at maturity, and have no interest

payments; effectively pay interest by selling at a discount.

• Negotiable Bank Certificates of Deposit CD’s are debt instruments sold by banks to depositors that

pays an annual interest of a given amount, and pays back the original purchase price at maturity

• Commercial Paper Short term debt instrument issued by large banks and well

known corporations (e.g. Microsoft, GM).



Examples: Money Market Instruments

• Repurchase AgreementsRepos are effectively short term loans (usually with a

maturity of less than 2 weeks) for which T-bills serve as collateral. The most important lenders in this market are usually large corporations.

• Federal (Fed) FundsThese are typically overnight loans of reserves

between banks, of their deposits at the Federal Reserve.



Table 1 Principal Money Market Instruments



Examples: Capital Market Instruments• Stocks

These are equity claims on net income and assets of a corporation. Issue of new stocks in any given year is typically quite small, although the

total value of stocks exceed that of any other type of security in the capital markets.

• Mortgages Mortgage market is the largest debt market in the US Residential mortgages are approximately 4 times the amount of commercial

and farm combined.

• Corporate Bonds Long term bonds issued by corporations with very strong credit ratings. Typical corporate bond sends the holder an interest payment twice a year

and pays off the face value when the bond matures. Some “convertible” corporate bonds allows the holder to convert them into a

specified number of shares of stock at any time up to the maturity date.



Examples: Capital Market Instruments• US Government Securities

These are long term debt instruments issued by the US Treasury to finance the deficits of the government.

• US Government Agency Securities Issued by various agencies such as Ginnie Mae, the Federal Farm Credit

Bank, etc, to finance such items as mortgages, farm loans or power generating equipment.

Many of the securities are guaranteed by the federal government.

• State and Local bonds Also called municipal bonds, which are long term debt instruments issued

by the state and local governments to finance expenditures on roads, schools, and other programs.

Interest payments from these bonds are exempt from federal income tax and generally from the state taxes issuing the bond.

• Consumer and Bank loansNote: These notes are incomplete without having attended lectures

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Table 2 Principal Capital Market Instruments




Internationalization of Financial MarketsInternational Bond Market• Foreign bonds: bonds sold in a foreign country and

denominated in that country’s currency.• Eurobonds:

Now larger than U.S. corporate bond market

World Stock Markets• U.S. stock markets are no longer always the largest:

Japan sometimes larger• E.g. Dow Jones Industrial Average (U.S.); Financial

Times Stock Exchange (FTSE - London); Nikkei (Tokyo)

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Common Confusions

• Eurobond: bond denominated in a currency other than that of the country in which it is sold E.g. Bond denominated in Sterling, sold in the U.S.

• Eurocurrencies: foreign currencies deposited in banks outside the home country E.g.: Eurodollar Market – U.S. dollars deposited in foreign banks

outside the U.S.

• Different to the Euro which is the national currency adopted in Europe after monetary union in 2002.

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Function of Financial Markets: Flow of Funds

Lender-Savers• Households• Firms• Government• Foreigners

FinancialMarkets

Borrowers-Spenders• Business-Firms• Government• Households• Foreigners

Direct Finance

Indirect Finance

FinancialIntermediaries

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Function of Financial IntermediariesFinancial Intermediaries:

1. Engage in process of indirect finance

2. More important source of finance than securities markets

3. Needed because of transactions costs and asymmetric information

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Role of Financial Intermediaries

1. Transaction Costs

2. Risk Sharing

3. Asymmetric Information

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Primary Assets and Liabilities of Financial IntermediariesType of Intermediary Primary Liabilities Primary Assets

Depository Institutions (banks)

Commercial Banks Deposits Business and consumer loans, mortgages, US Govt securities and municipal bonds

Savings and Loans Institutions Deposits Mortgages

Mutual Savings Banks Deposits Mortgages

Credit Unions Deposits Consumer Loans

Contractual Savings Institutions

Life Insurance Companies Premium from Policies Corporate bonds and mortgages

Fire and Casualty Insurance Companies Premium from Policies Municipal bonds, corporate bonds and stocks, US Govt securities

Pension Funds, Government Retirement Funds Employee and Employer Contributions

Corporate bonds and stock

Investment Intermediaries

Finance Companies Commercial paper, stock, bonds

Consumer and business loans

Mutual Funds Shares Stocks and bonds

Money Market Mutual Funds Shares Money market instruments



Financial Intermediaries and Value of Their AssetsValue of Assets (Billions of $)

Type of Intermediary 1970 1980 1990 2007 2010Q1

Depository Institutions (banks)

Commercial Banks 517 1481 3334 11809.5 14438

Savings and Loans Institutions and Mutual Savings Banks 250 792 1365 1815.0 1262.3

Credit Unions 18 67 215 758.7 892.4

Contractual Savings Institutions

Life Insurance Companies 201 464 1367 4952.5 4919.0

Fire and Casualty Insurance Companies 50 182 533 1381.0 1386.1

Pension Funds (Private) 112 504 1629 6410.6 5726.7

State and local Government Retirement Funds 60 197 737 3198.8 2793.9

Investment Intermediaries

Finance Companies 64 205 610 1911.2 1665.8

Mutual Funds 47 70 654 7829.0 7311.9

Money Market Mutual Funds 0 76 498 3033.1 2930.7Note: These notes are incomplete without having attended lectures

4404/19/23


Regulatory AgenciesRegulatory Agency Subject of Regulation Nature of RegulationSecurities and Exchange Commission (SEC)

Organized Exchanges and Financial Markets

Requires disclosure of information; restricts insider trading

Commodities Futures Trading Commission (CFTC)

Futures Markets Exchanges Regulates procedures for trading in futures markets

Office of the Comptroller of the Currency

Federally charted commercial banks

Charters and examines the books of federally chartered commercial banks and imposes restrictions on assets they can hold

National Credit Union Administration (NCUA)

Federally chartered credit unions

Charters and examines the books of federally chartered credit unions and imposes restrictions on assets they can hold

State banking and Insurance Commissions

State chartered depository institutions

Charters and examines the books of state chartered banks and insurance companies; imposes restrictions on assets they can hold and imposes restrictions on branching



Regulatory Agencies

Regulatory Agency Subject of Regulation Nature of RegulationFederal Deposit Insurance Corporation (FDIC)

Commercial banks, mutual savings banks, savings and loans associations

Provides insurance for each depositor. Currently it is set to $250000 per depositor, until 12/31/2013, whereas it will revert back to the pre-crisis level of $100000 per depositor; examines the books of insured banks and imposes restrictions on assets they can hold

Office of Thrift Supervision Savings and Loans Associations Examines the books of savings and loans associations and imposes restrictions on assets they can hold

Federal Reserve System All depository institutions Examines the books of commercial banks that are members of the system; sets reserve requirements for all banks



Regulatory Agencies

Regulatory Agency Subject of Regulation New PowersFederal Deposit Insurance Corporation (FDIC)

Commercial banks, mutual savings banks, savings and loans associations

Will be able to unwind giant financial firms in the same way it takes down banks.

Federal Reserve System All depository institutions Fed will have powers to crack down on interchange fees, which retailers pay to banks to cover the operational cost of transferring money. Fed can cap the fees

Consumer Financial Protection Bureau

Consumer loans and credit cards Establishes an independent Consumer Financial Protection Bureau housed inside the Federal Reserve. Fees paid by banks fund the agency, which would set rules to curb unfair practices in consumer loans and credit cards. It would not have power over auto dealers.

Government Accountability Office Federal Reserve (excluding FOMC and Monetary Policy)

Allows Congress to order the Government Accountability Office to review Fed activities, excluding monetary policy. Audits would be allowed two years after the Fed makes emergency loans and gives financial help to ailing financial firms.


• The new Dodd-Frank Banking reform bill that was passed during June 2010 gives the following agencies additional power:

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Banking and Financial Institutions

• Financial Intermediation Helps get funds from savers to investors through

bond/equity/foreign exchange markets

• Banks and Money Supply Crucial role in creation of money

• Financial Innovation

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Professor Yamin Ahmad, Money and Banking – ECON 354 ECON 354 Money and Banking Lecture 1 Syllabus...

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Transcript of Professor Yamin Ahmad, Money and Banking – ECON 354 ECON 354 Money and Banking Lecture 1 Syllabus...