Summary ECS 3701 STUDY NOTES 2022 (All Units)

ECS 3701 STUDY NOTES 2022 (All Units) This document contains a complete and an all-inclusive guide to ECS3701 - Monetary Economics. WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS Why study financial markets? Securities - a claim on the issuer’s future income or assets that is sold by a borrower to a lender. Securities may also be referred to as financial instruments. Financial instruments may be divided into two main categories: money market instruments (e.g. Negotiable Certificate of Deposit (NCDs), Commercial Papers; Retirement Annuity (RAs) and Bankers Acceptance (Bas)) and capital market instruments (e.g. bonds and shares). Bonds - a specific type of security, namely a debt security that promises to make payments periodically for a specified period of time. Interest rate - cost of borrowing or the price paid for the rental of funds. “The” interest rate is made up of a number of different interest rates that exist in an economy. E.g. mortgage, car loan etc Bond Market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and it is where interest rates are determined. Stock Market is the market in which claims on the earnings of corporations (shares of stocks) are traded. In SA we refer to the trading of shares rather than stocks. Stock (share) - equity: a financial instruments representing part ownership of a corporate entity. Sometimes referred to as common stock as compared to the more specialized type of share, e.g. preference shares. Issuing shares is a way in which a company can raise funds. Importance of stock /stock market: the price (value) of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. The higher the price of a firm’s shares the more money can be raised to buy, e.g. machinery and equipment to increase production. Also, as per the study guide: the stock market creates a facility for financial investors to invest their surplus funds and for firms to facilitate real investment. Why study financial institutions and banking? Structure of the Financial System: The financial system is complex, comprising many different types of private sector financial institutions (banks, insurance companies, mutual funds, finance companies, investment banks) all of which are heavily regulated by Government. 4 ECS 3701 Lecture Notes Nicolas Souvaris Financial Intermediaries - institutions that borrow funds from people (surplus units) who have saved and in turn make loans to others (deficit units). Financial Innovation - shows how creative thinking on the part of financial institutions can lead to higher profits. To keep in touch with what is happening within the financial systems of the world it is necessary to study the changes that innovation has brought about. One example is the way in which dramatic improvements in information technology have brought about new means of delivering financial services electronically (e-finance). Why study money and monetary policy? Definition of money: money is defined as anything that is generally accepted in payment for goods and services (in terms of its function as a medium of exchange). In this course, the term money generally refers to the money supply. Importance of Money: money is linked to changes in economic variables and is important to the health of the economy. Money plays an important role in generating business cycles: empirical data indicates that, in the USA, the rate of growth in money supply has declined before every recession; however, not every decline in money growth is followed by a recession. Inflation is believed to be caused by continuing increases in money supply. Money plays an important role in interest rate fluctuations. Aggregate Output: gross domestic product (GDP) = the market (total) value of all final goods and services produced in a country during the course of a year. Aggregate Income: total income received for the use of factors of production (land, labour and capital) used to produce all the goods and services in the economy during the course of the year. Business Cycles: the upward and downward movement of aggregate output produced in the economy. Aggregate price level: the average price of goods and services in an economy. Three commonly used measures are the GDP deflator (nominal GDP divided by real GDP), the consumer price index (CPI) and the personal consumption expenditure deflator (PCE). Inflation: a continual increase in the aggregate price level in an economy. The price level and money supply generally rise together. 5 ECS 3701 Lecture Notes Nicolas Souvaris Monetary Policy: the management of money and interest rates by the central monetary authorities. Because money can affect many economic variables in the economy, politicians and policymakers care about the conduct of monetary policy. Real versus Nominal GDP: nominal GDP indicates that current prices are used to measure GDP. Real GDP is nominal GDP adjusted to remove inflation and using constant prices from an identified base year. Don’t forget to study Appendix 1 at the end of the chapter! Typical Examination questions 1.1 Explain briefly and in general terms what is the meaning of a security and how it facilitates direct lending and borrowing. (5) 1.2 Explain briefly what is a common stock, what purpose it serves and how it affects business investment decisions. (4) 1.3 List two ways in which the quantity of money may affect the economy. (2) 1.4 Explain the difference between nominal and real GDP and the purpose for which each should be used. (4) 1.5 List and define three commonly used measures of the aggregate price level. (6) True or false review questions Money: 1. Monetary economics primarily teaches students how to make money quickly and effortlessly. 2. A decrease in the interest rate normally increases the money stock in the economy. 3. Because money is complex, it is difficult to demonstrate the real advantages of money within the economy. 4. The use of money introduces sources of instability in the economy. 5. When interest rates rise, then all households are worse off. Securities: 6. A security is a financial instrument. In simple terms it is a "piece of paper" which is sold by the issuer to investors in exchange for funds. The security promises to repay these funds (plus interest) over the term of the security by means of a number of (one or more) future payments to the holder of the security. 7. A security is issued mostly by firms and government that wish to borrow money. 8. The issuer of a security promises to make future payments to the holder (purchaser) of the security. 9. The purchaser of a security provides cash to the issuer of a security. 10. The purchaser of a security is the lender (provider of funds). 11. The issuer of a security is the borrower of funds. 12. The holder (purchaser) of the security receives future payment/s from the issuer of the security. 6 ECS 3701 Lecture Notes Nicolas Souvaris 13. Securities can be traded on the financial market. When holder A of a security sells the security in the financial market at the going market price to B then B pays cash to A and B receives the remaining payments of the security. 7 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 2: AN OVERVIEW OF THE FINANCIAL SYSTEM Function of financial markets. Functions and advantages of financial markets in general: they allow funds to flow from people who lack productive investment opportunities but have surplus funds, to people who have such opportunities but do not have the funds to make it happen Direct financing: borrowers borrow funds directly from lenders in the financial markets by selling them securities. Remember that both borrowers and/or lenders can be households, businesses, government and foreigners. Indirect financing: this refers to the activities of financial intermediaries such as commercial banks in facilitating and reconciling the different requirements of borrowers and lenders via the process of financial asset transformation. [Example: banks accept deposits from savers and lend that money out to borrowers.] Financial markets are critical for producing an efficient allocation of capital. Structure of financial markets How does a debt instrument work? A debt instrument is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payment) until a specified date when the final payment is made (maturity date). Maturity of a debt instrument: number of years (term) until the instruments expires or becomes paid up. It is short-term if it is less than a year and longterm if it is ten years or longer with the intermediate-term being between one and ten years. In South Africa however, any financial instrument with a lifespan that is longer than a year is referred to as long-term and is traded in the capital market. An equity instrument: is a claim to share in the income and net assets of a business. It is more commonly known as a stock or share. An advantage of such an instrument is that the holder owns part of the business. You essentially own a part of the business and are therefore awarded the right to vote on important issues to the firm as well as elect the directors. You will also benefit from an increase in the firms profitability or asset value. A disadvantage is that the holder is a residual claimant. This means that the business must pay its debt holders before it pays its equity holders. Such an instrument has no maturity date. The structure of the different financial markets relates to the type of functions and the type of financial instruments that are found in each of them.  Debt and Equity markets: Debt market is that market in which debt instruments are traded, while an equity market is a market in which equity instruments are traded, e.g. stock exchange. 8 ECS 3701 Lecture Notes Nicolas Souvaris  Primary and Secondary markets: Primary market is the market in which financial instruments are issued, while the secondary market is the market in which financial instruments are traded. o An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities and guarantees a price for a corporations securities and then sells them to the public.  Exchanges and OTC Markets: Secondary markets can be organised in two ways:  Exchanges: a place specifically designed for the meeting of buyers and sellers of securities.  Over-the-counter-markets: 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 buy (e.g. US bond market).