ECS3701 – Monetary Economics - 2014
Monetary Economic – ECS3701
CHAPTER 1 - WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS.
WHY STUDY FINANCIAL MARKETS
Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a proper use to people who do. Well functioning financial markets
are a key to producing high economic growth and have direct effects on personal wealth, behavior on business
consumers and the cyclical performance of the economy.
The Bond Market and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets. The bond market is
important because it enables corporations and governments to borrow to finance their activities and because it is
where interest rates are determined.
A bond is a debt that promises to make payments periodically for a specific period of time.
An interest rate is the cost of borrowing or the price paid for the rental of funds. Interest rates are important
because:
1. Higher rates could deter one from borrowing to buy a house or car.
2. Conversely, higher rates could encourage one to save money as cost of borrowing is higher.
3. They impact the general health of the economy as they affect consumers and business’s willingness to
spend, save or make investment decisions.
The Stock Market
A common stock represents a share of ownership in a corporation. It is a security claim on the earnings and assets
of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their
activities.
‘The market’ is a place where people can get rich – or poor – quickly.
The stock market is important as the price of the shares affects the amount of funds that can be raised be selling
newly issued stock to finance spending, a higher price means more funds.
WHY STUDY FINANCIAL INSTITUTIONS AND BANKING?
Banks and other financial institutions are what makes financial markets work, without them, financial markets
would not be able to move funds from people who save to people have productive investment opportunities.
Structure of the Financial System
The financial system is complex comprising of many different institutions such as banks, insurance companies,
mutual funds, finance companies and investment banks. Financial intermediaries borrow money from people who
have saved and in turn make loans to others. The cost being the interest rate.
Financial Crisis
A financial crisis is a major disruption in the financial markets that are characterized by sharp declines in assets
prices and the failures of many financial and nonfinancial firms. Defaults in subprime residential mortgages led to
major losses in the financial institutions producing two of the largest banks to fails, Bear Sterns and Lehman
Brothers causing the worst crises since the financial depression, starting in August 2007.
H. Crassas Page 1
,ECS3701 – Monetary Economics - 2014
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. These include commercial banks, savings and
loans associations, mutual savings banks & credit unions. Banks are the most interacted financial intermediaries
but other financial institutions such as insurance companies, finance companies, pension funds, mutual funds
have been growing at the expense of banks.
Financial Innovation
Financial Innovation is the development of new financial products and services is important as it makes the
financial system more efficient. It can also have a ‘dark side’ and lead to a financial crisis. Financial innovation
shows us how creative thinking can lead to profits or result in financial disasters. It provides clues how the
financial system may change over time.
WHY STUDY MONEY AND MONETARY POLICY?
Money or money supply is defines as anything that is generally accepted in payment for goods or services or in
the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important
to the health of the economy.
Money and Business Cycles
Why do economies undergo such pronounced fluctuations? Evidence shows money plays an important role in
generating business cycles, the upward and downward movement of aggregate output (the total production of
goods and services), produced in the economy. When output is raising unemployment decreases, when output is
falling, unemployment increases.
Recessions are periods of declining aggregate output we see that the rate of money growth has declined before
almost every recession indicating that changes in money might be the driving force behind business cycle
fluctuations but not every decline in money growth is followed by a recession.
Money and Inflation
The average price of goods and services in an economy is called the aggregate price level, or simply the price level.
Inflation is a continual increase in the price level and effect individuals, businesses and government.
What explains inflation? Data seems to indicate that a continuing increase in the money supply may be an
important factor of increasing inflation.
Evidence has found that the countries with the highest average inflation rate also have the highest interest rates.
Money and Interest Rates
Money also plays an important role in interest rate fluctuations. We analyze the relationship between money and
interest rates in Chapter 5.
Conduct of Monetary Policy.
The conduct of monetary policy is the management of money and interest rates. The central bank is responsible
for a nation’s monetary policy. In SA we have the South African Reserve Bank. The US has the Federal Reserve
System.
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,ECS3701 – Monetary Economics - 2014
Fiscal Policy and Monetary Policy
Fiscal policy involves decisions about government appending and taxation. A budget deficit is the excess of
government expenditure over tax revenues for a particular time period. A budget surplus is when tax revenues
exceed government expenditure. The government must finance any deficit by borrowing. We explore if budget
deficits are a good thing and why deficit may result in higher rate of money growth, higher inflation and higher
interest rates.
APPENDIX TO CH 1: DEFINING AGGREGATE OUTPUT, INCOME, THE PRICE LEVEL AND THE INFLATION RATE.
AGGREGATE OUTPUT AND INCOME
Gross domestic product: The most common measure of aggregate output is the market value of all final goods
and services produced in a country during the course of the year. It excludes two sets of items:
1. Purchases of goods that have been produced in the past.
2. Purchases of stocks or bonds.
Aggregate income: is the total income of the factors of production (land, labour, capital) from producing goods
and services in the economy during the year.
REAL VERSUS NOMINAL MAGNITUDES
Nominal GDP – When the total value of goods and services are calculated using current prices. Nominal indicates
values measured at current prices.
Real GDP – Expresses values of economic production in terms of prices for an arbitrary base year. Real GDP
measures the quantities of goods and services and do not change because the prices have changed.
AGGREGATE PRICE LEVEL
Three measures of aggregate price level are encountered in economic data:
1. GDP Deflator – Typically measures of the price level are presented in the form of a price index, which
expresses the price level for the base year as 100. It is defined as the nominal GDP divided by the real GDP.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
2. PCE Deflator – Similar to GDP deflator and is defined as nominal Persons Consumption Expenditures (PCE)
divided by real PCE.
3. Consumer Price Index (CPI) – is measured by pricing a ‘basket’ of goods and services bought through a
typical household. The CPI is als expressed as a price index with the base year equal to 100.
GROWTH RATES AND THE INFLATION RATE
The media often talk about the economy’s growth rate and the growth rate of real GDP. A growth rate is defined
as the percentage change in variable, i.e.
𝑋𝑡 −𝑋𝑡−1
𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑥 = 𝑥 100
𝑋𝑡−1
Where t indicates today and t-1 a year earlier.
The inflation rate is defined as the growth rate of the aggregate price level.
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,ECS3701 – Monetary Economics - 2014
CHAPTER 2 – AN OVERVIEW OF THE FINANCIAL SYSTEM
FUNCTION OF FINANCIAL MARKETS
In direct finance, borrowers borrow funds
directly from lenders in financial markets by
selling the securities which are claims on the
borrowers future income or assets.
Securities are assets for the person who buys
them but liabilities for the individual or firms
that sells/issues them.
Financial markets allow funds to move from
people who lack productive investment
opportunities to people who have these
opportunities.
They are crucial for the efficient allocation of
capital, which contribute to higher production
and efficiency.
STRUCTURE OF FINANCIAL MARKETS
Debt and equity markets
One can obtain funds in two ways, the most common method is to issue a debt instrument such as a bond or a
mortgage which is a contractual agreement by the borrower o pay the holder of the instrument a fixed amount
over a certain period of time.
The maturity of a debt instrument is the number of years until the instruments expiration date. A debt instrument
is short-term if it is less than a year, and long-term if it is more than 10 years. 1 – 10 year debt instruments are said
to be intermediate-term instruments.
The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the
net income and assets of a business. Equities make payments in term of dividends to their holders and known as
long-term securities as they have no maturity.
Primary and Secondary Markets
A primary market is a financial market in which new issues of a security, such as a bond or stock, are sold to initial
buyers by the corporation borrowing the funds.
A secondary market is a financial market in which securities that have previously been issued can be resold.
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, it guarantees a price for corporation’s securities and then
sells them to the public. Examples include; stock exchanges, forex markets, futures markets and options markets.
Brokers are agents of investors who match buyers with sellers of securities, dealer’s link buyers and sellers by
buying and selling securities as stated prices.
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,ECS3701 – Monetary Economics - 2014
Exchanges and Over-the-Counter Markets
Secondary markets can be organized in two ways. One method is to organize exchanges where buyers and sellers
meet in one central location to conduct trades.
The other method is to have an over-the-counter (OTC) market, in which dealers as different locations who have
an inventory of securities stand ready to buy and sell securities over the counter to anyone who is willing to
accept the prices.
Money and Capital Markets
The money market is a financial market in which only short-term debt instruments are traded. They are more
widely traded and so tend to be more liquid. Short term instruments also have smaller fluctuations making them
safer instruments.
The capital markets is the market is the market in which longer-term debt and equity instruments are traded.
FINANCIAL MARKET INSTRUMENTS
Money Market Instruments
Because of their short-term to maturity, they undergo the least price fluctuations and so are least risky.
US Treasury Bills – Instruments of the US government issued in one, three and six month maturities to finance
the federal government. They pay a set amount at maturity and have no interest but issued at a discount
value.
Negotiable Bank Certificates of Deposits – Certificates of Deposits is a debt instrument sold by a bank to
depositors that pays annual interest if a given amount at maturity pays back the original purchase price.
Negotiable CD’s are those sold in secondary markets.
Commercial Paper - is a short-term debt instrument issued by large banks and well-know corporations.
Repurchase agreements – Are effectively short-term loans for which treasury bills serve as collateral.
Federal (Fed) Funds – these are typically overnight loans between banks of their deposits at the Federal
Reserve. These loans are made by banks to other banks as the bank may not have enough deposits at the Fed
to meet amounts required by regulators.
FINANCIAL MARKET INSTRUMENTS
These are debt instruments are debt and equity instruments with maturities greater than one year. They have far
wider price fluctuations than the money market instruments and are considered fairly risky.
Stocks – Are equity claims on the net income and assets of a corporation.
Mortgages and Mortgage-Backed Securities – Mortgages are loans to households or firms to purchase land,
housing or other real structures that can be used as collateral for the loans. Mortgage-backed Securities are
bond-like debt instruments backed by a bundle of individual mortgages, whose interest and principle
payments are collectively paid to the holders of the security.
Corporate Bonds – These are long-term bond issued to corporations with very strong credit ratings. It sells the
holder an interest payment twice a year and pays off the face value when the bond matures. Convertible
Bonds allows the holder to convert the value into shares of a stock at maturity date.
US Government Securities – Issued by the US Government to finance the deficit of the federal government.
They are the third most liquid traded security.
US Government Agency Securities – Long-terms bonds issued by government agencies to finance items such
as mortgages, farm loans or power generating.
State and Local Government Bonds – Also called municipal bonds issued by state and local to finance
expenditure on schools, roads and other programs.
Consumer and Bank Commercial Loans – Loans to consumers also by finance companies.
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,ECS3701 – Monetary Economics - 2014
FUNCTIONS OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE
This involves a financial intermediary as they stand between the lend-savers and he borrower-spenders and helps
transfer funds from one to the other. The process is called financial intermediation and is the primary route for
moving funds from lenders to borrowers.
Transaction Costs - Are the time and money spent in carrying out financial transactions. Financial
intermediaries reduce the transaction costs as they have the expertise and can take advantage of economies
of scale. The low cost allows financial intermediaries to provide customers with liquid services, i.e. services
that make it easier to conduct transactions.
Risk Sharing – Financial intermediaries create and sell assets with risk characteristics that people are
comfortable with. Low transactions allow for risk to be shared at low cost, enabling profit to be earned on the
spread between returns. Risk sharing is also known as asset transformation as they are turned into safer
assets. Diversification entails investing in a collection of assets with the result that risk is lower than a single
asset.
Asymmetrical Information: Adverse selection and Moral Hazard – Adverse selection is when one party does
not know enough about the other party to make accurate decisions. Lack of information creates problems on
two fronts:
1. Adverse Selection – created by asymmetric selection before the transaction occurs. It occurs when the
potential borrows who are most likely to produce an undesirable outcome (bad credit risks) are the ones
who most actively seek out loans and thus are likely to be selected causing lenders not to make any loans.
2. Moral Hazard - created by asymmetric selection after the transaction occurs. It is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral) from a lenders point of view as the loan
is less likely to be paid back.
Financial intermediaries are better equipped to than individuals to screen out the bad credit risks from the
good ones reducing the losses resulting from adverse selection.
Economies of Scope and Conflicts of interest – Financial intermediaries provide multiple financial services
achieving economies of scope, i.e. they can lower the cost of information production for each service by
applying one information resource to may different services. This can also cause conflicts of interest in that a
person or institution has multiple objectives and may have a conflict between the objectives. The competing
interest of the services may lead to an individual or firm to conceal or disseminate misleading information.
To conclude: Financial intermediaries play an important role in that the:
1. Provide liquidity services
2. Promote risk sharing
3. Solve information problems
4. Channel funds form lender-savers to borrower-spenders.
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,ECS3701 – Monetary Economics - 2014
TYPES OF FINANCIAL INTERMEDIARIES
Financial intermediaries fall into three categories:
1. Depository institutions
2. Contractual saving institutions
3. Investment intermediaries
Depository institutions
Also referred to as banks that accept deposits from individuals and companies and then make loans. They are
involved in the creation of deposits. These include commercial banks and thrift institutions (thrifts), savings and
loan associations, mutual savings banks and credit unions.
Commercial banks – Financial intermediaries that raise fund by issuing checkable deposits, savings deposits
and time deposits and use these funds to make loans.
Savings and loan associations (S & L’s) and Mutual Savings Banks – Obtain funds through savings deposits,
time and checkable deposits and were restricted and mostly made residential mortgage loans, this has
changed/loosened recently
Credit Unions – Typically very small cooperative lending institutions organized around a particular group. They
acquire funds from deposits called shares and primarily make consumer loans.
Contractual Saving Institutions
These are insurance companies and pension funds that acquire funds at periodic intervals on a contractual basis.
They can predict how much they will have to pay out they do not worry as much as depository institutions.
Liquidity of assets is not important and mostly invests in long-term securities such as corporate bonds.
Life Insurance Companies – Insure people against financial hazards following a death and sell annuities. They
acquire funds from premiums and used mainly to buy corporate bonds and mortgages.
Fire and Casualty Insurance companies – Insure their policyholders against fire, theft and accidents. Acquire
funds through premiums and buy more liquid securities such as municipal bonds.
Pension Funds and Government Retirement Funds – Provide retirement income in the form of annuities to
covered employees. Funds are acquired by employees and employers. The largest assets are corporate bonds
and stocks.
Investment Intermediaries
Finance companies – Raise funds by selling commercial paper (short-term debt instrument) and by issuing
stocks and bonds. They lend funds to consumers to buy furniture, cars and home improvements
Mutual Funds – Acquire funds by selling shares to many individuals and use the proceeds to purchase
diversified portfolios of stocks and bonds. They allow shareholders to pool funds to take advantage of lower
transaction costs. And allow for more diversified portfolios.
Money Market Mutual Funds – They sells shares to acquire funds and use the funds to by money market
instruments that are both safe and liquid. The interest on the assets is paid to shareholders. Shareholder scan
write checks against the value of their shareholdings.
Investment Banks – An intermediary that helps corporations issue securities. It advises which type of
securities to issue (stocks or bonds) and then helps sell or underwrite the securities by buying them at a
predetermined price and selling them to the market. They also act as deal makers through mergers and
acquisitions.
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,ECS3701 – Monetary Economics - 2014
REGULATION OF THE FINANCIAL SYSTEM
The government regulates for two main reasons:
1. Increasing information available to investors - Government regulation can reduce adverse selection and
moral hazard problems and enhance the efficiency of the markets by increasing the amount of information
available to investors
2. To ensure the soundness of the financial system – Asymmetric information can lead to collapse of
financial intermediaries, referred to as a financial panic. If providers of funds feel the institutions holding
their funds are not sound, they may pull their funds creating financial panic that can cause large losses and
damage to the economy. Government has implemented six regulations to prevent this:
i. Restrictions of entry
ii. Disclosure – Reporting requirements are extremely stringent
iii. Restrictions on Assets and Activities – Limit the risky activates that may be undertaken.
iv. Deposit Insurance – Government can issue peoples deposits if the banks fail.
v. Limits on Competition
vi. Restrictions on Interest Rates
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,ECS3701 – Monetary Economics - 2014
CHAPTER 3 – WHAT IS MONEY?
MEANING OF MONEY
Economists define money as anything that is generally accepted as payment for goods and services or in the
repayment of debts. When people talk about money, they are referring to currency.
Economist’s distinction between money in the form of currency , demand deposits and other items that are used
to make purchases and wealth.
Wealth includes not only money but also assets such as stocks, bonds, land, furniture, cars, houses etc. Money is
also referred to as income. Income is a flow of earning per unit of time. Money by contrast is a stock, it is certain
at a point of time
FUNCTIONS OF MONEY
There are three primary functions of money;
1. Medium of exchange
2. Unit of account
3. Store of value
Medium of Exchange
Money in the form of currency or checks is a medium of exchange; it is used to pay for goods and services. It
promotes economic efficiency by minimizing time spent exchanging goods and services.
In a barter economy, time spent trying to exchange goods and services are called transaction costs. In a barter
economy these are high as one has to satisfy ‘a double coincidence of wants’. This is avoided with money.
Money promotes efficiency by eliminating time spent exchanging goods and services and allowing people to
specialization and the division of labour.
For a commodity to function effectively as money, it needs to be;
1. Easily standardized, making it simple to ascertain value.
2. It must be widely accepted
3. It must be divisible so it is easy to make change
4. It must be easy to carry
5. It must not deteriorate quickly
Unit of Account
This is used to measure the value in an economy. We measure the value of goods and services in terms of money
resulting in lower transaction costs by reducing the number of prices that need to be considers. The benefits of
this function increase as the economy becomes more complex.
Store of Value
It is a repository of purchasing power over time. It is used to save purchasing power from the time income is
received to the time it is spent. Money is liquid referring to the relative speed and ease to which it can be used
into a medium of exchange and does not have transaction costs associated with like homes or land that have
transaction costs.
Money is has a draw back during inflation and especially hyperinflation (>50%)
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, ECS3701 – Monetary Economics - 2014
EVOLUTION OF THE PAYMENTS SYSTEM
Commodity Money – Money made up of precious metal or another valuable commodity is called commodity
money. It functioned as a medium of exchange from ancient times to a few hundred years ago. This form of
money is heavy and hard to transport.
Fiat Money – The next development in paper system was paper currency. Initially it was guaranteed that is was
convertible into a precious metal but evolved into fiat money, i.e. paper money decreed by governments as legal
tender but not convertible into precious metals. Paper has the advantage of being easy to transport, accepted as a
medium of exchange, and can be difficult to counterfeit.
Checks – A check is an instruction to your bank to transfer money to a recipient. They allow transactions to take
place without the need to carry large amounts of money and can be of any value upto the amount in the account.
Problems are that it takes time to get checks from one place to another and the processing of checks can be slow
and is expensive.
Electronic Payment – The process of paying bills and making purches electronically. Allows for speed and
immediate access.
E-Money – This is money that only exits in electronic form. The first form of e-money was the debit card. There
are also store-value cards or a smart card that can load cash like a prepaid phone card. Another form is e-cash
which is used on the internet to purchase goods.
Definition of money
The functions of money (medium of exchange, unit of account, store of value) explain why money is useful and
why it facilitates exchange. It does not, however, explain exactly how money should be defined.
For practical reasons, economists have decided to define money as Currency (notes and coins) plus Deposits
(positive balances held in bank accounts): M=C+D. This definition focuses on money as a liquid asset.
This definition is not perfect. We should include certain forms of credit within the definition of money. But not all
forms of credit are counted as money. These come in two forms. The first form of credit which facilitates
exchange is credit cards held by consumers. The credit provided only has to be settled in a month's time. It may
appear that the amount of available credit must be counted as money since it facilitates exchange and provides
access to real purchasing power. The second important form of credit not counted as money is trade credit. Trade
credit is when firms sell their products to the trade sector, on condition that payment for the goods is made at a
future date, say in three months’ time.
But because these forms of credit do not lead to an increase in cash or deposits, the money stock (M=C+D) is not
affected by any of the two.
The reason why these two forms of credit are not included within the practical definition of money is because of
practical difficulties of measuring these forms of credit. Thus, for reasons of simplicity, money is practically
defined as Currency held plus Deposits (positive balances) only (M=C+D). The amount of currency in circulation is
known since only the central bank issues currency. Because deposits are always held at banks, banks know the
exact amount of deposits held by the non-bank (private) sector.
The provision of trade credit, for example, may lead to indirect increases in money supply. Assume a firm provides
trade credit to the value of R50 million to be paid in three months’ time. The provision of trade credit itself does
H. Crassas Page 10
Monetary Economic – ECS3701
CHAPTER 1 - WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS.
WHY STUDY FINANCIAL MARKETS
Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a proper use to people who do. Well functioning financial markets
are a key to producing high economic growth and have direct effects on personal wealth, behavior on business
consumers and the cyclical performance of the economy.
The Bond Market and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets. The bond market is
important because it enables corporations and governments to borrow to finance their activities and because it is
where interest rates are determined.
A bond is a debt that promises to make payments periodically for a specific period of time.
An interest rate is the cost of borrowing or the price paid for the rental of funds. Interest rates are important
because:
1. Higher rates could deter one from borrowing to buy a house or car.
2. Conversely, higher rates could encourage one to save money as cost of borrowing is higher.
3. They impact the general health of the economy as they affect consumers and business’s willingness to
spend, save or make investment decisions.
The Stock Market
A common stock represents a share of ownership in a corporation. It is a security claim on the earnings and assets
of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their
activities.
‘The market’ is a place where people can get rich – or poor – quickly.
The stock market is important as the price of the shares affects the amount of funds that can be raised be selling
newly issued stock to finance spending, a higher price means more funds.
WHY STUDY FINANCIAL INSTITUTIONS AND BANKING?
Banks and other financial institutions are what makes financial markets work, without them, financial markets
would not be able to move funds from people who save to people have productive investment opportunities.
Structure of the Financial System
The financial system is complex comprising of many different institutions such as banks, insurance companies,
mutual funds, finance companies and investment banks. Financial intermediaries borrow money from people who
have saved and in turn make loans to others. The cost being the interest rate.
Financial Crisis
A financial crisis is a major disruption in the financial markets that are characterized by sharp declines in assets
prices and the failures of many financial and nonfinancial firms. Defaults in subprime residential mortgages led to
major losses in the financial institutions producing two of the largest banks to fails, Bear Sterns and Lehman
Brothers causing the worst crises since the financial depression, starting in August 2007.
H. Crassas Page 1
,ECS3701 – Monetary Economics - 2014
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. These include commercial banks, savings and
loans associations, mutual savings banks & credit unions. Banks are the most interacted financial intermediaries
but other financial institutions such as insurance companies, finance companies, pension funds, mutual funds
have been growing at the expense of banks.
Financial Innovation
Financial Innovation is the development of new financial products and services is important as it makes the
financial system more efficient. It can also have a ‘dark side’ and lead to a financial crisis. Financial innovation
shows us how creative thinking can lead to profits or result in financial disasters. It provides clues how the
financial system may change over time.
WHY STUDY MONEY AND MONETARY POLICY?
Money or money supply is defines as anything that is generally accepted in payment for goods or services or in
the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important
to the health of the economy.
Money and Business Cycles
Why do economies undergo such pronounced fluctuations? Evidence shows money plays an important role in
generating business cycles, the upward and downward movement of aggregate output (the total production of
goods and services), produced in the economy. When output is raising unemployment decreases, when output is
falling, unemployment increases.
Recessions are periods of declining aggregate output we see that the rate of money growth has declined before
almost every recession indicating that changes in money might be the driving force behind business cycle
fluctuations but not every decline in money growth is followed by a recession.
Money and Inflation
The average price of goods and services in an economy is called the aggregate price level, or simply the price level.
Inflation is a continual increase in the price level and effect individuals, businesses and government.
What explains inflation? Data seems to indicate that a continuing increase in the money supply may be an
important factor of increasing inflation.
Evidence has found that the countries with the highest average inflation rate also have the highest interest rates.
Money and Interest Rates
Money also plays an important role in interest rate fluctuations. We analyze the relationship between money and
interest rates in Chapter 5.
Conduct of Monetary Policy.
The conduct of monetary policy is the management of money and interest rates. The central bank is responsible
for a nation’s monetary policy. In SA we have the South African Reserve Bank. The US has the Federal Reserve
System.
H. Crassas Page 2
,ECS3701 – Monetary Economics - 2014
Fiscal Policy and Monetary Policy
Fiscal policy involves decisions about government appending and taxation. A budget deficit is the excess of
government expenditure over tax revenues for a particular time period. A budget surplus is when tax revenues
exceed government expenditure. The government must finance any deficit by borrowing. We explore if budget
deficits are a good thing and why deficit may result in higher rate of money growth, higher inflation and higher
interest rates.
APPENDIX TO CH 1: DEFINING AGGREGATE OUTPUT, INCOME, THE PRICE LEVEL AND THE INFLATION RATE.
AGGREGATE OUTPUT AND INCOME
Gross domestic product: The most common measure of aggregate output is the market value of all final goods
and services produced in a country during the course of the year. It excludes two sets of items:
1. Purchases of goods that have been produced in the past.
2. Purchases of stocks or bonds.
Aggregate income: is the total income of the factors of production (land, labour, capital) from producing goods
and services in the economy during the year.
REAL VERSUS NOMINAL MAGNITUDES
Nominal GDP – When the total value of goods and services are calculated using current prices. Nominal indicates
values measured at current prices.
Real GDP – Expresses values of economic production in terms of prices for an arbitrary base year. Real GDP
measures the quantities of goods and services and do not change because the prices have changed.
AGGREGATE PRICE LEVEL
Three measures of aggregate price level are encountered in economic data:
1. GDP Deflator – Typically measures of the price level are presented in the form of a price index, which
expresses the price level for the base year as 100. It is defined as the nominal GDP divided by the real GDP.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
2. PCE Deflator – Similar to GDP deflator and is defined as nominal Persons Consumption Expenditures (PCE)
divided by real PCE.
3. Consumer Price Index (CPI) – is measured by pricing a ‘basket’ of goods and services bought through a
typical household. The CPI is als expressed as a price index with the base year equal to 100.
GROWTH RATES AND THE INFLATION RATE
The media often talk about the economy’s growth rate and the growth rate of real GDP. A growth rate is defined
as the percentage change in variable, i.e.
𝑋𝑡 −𝑋𝑡−1
𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑥 = 𝑥 100
𝑋𝑡−1
Where t indicates today and t-1 a year earlier.
The inflation rate is defined as the growth rate of the aggregate price level.
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CHAPTER 2 – AN OVERVIEW OF THE FINANCIAL SYSTEM
FUNCTION OF FINANCIAL MARKETS
In direct finance, borrowers borrow funds
directly from lenders in financial markets by
selling the securities which are claims on the
borrowers future income or assets.
Securities are assets for the person who buys
them but liabilities for the individual or firms
that sells/issues them.
Financial markets allow funds to move from
people who lack productive investment
opportunities to people who have these
opportunities.
They are crucial for the efficient allocation of
capital, which contribute to higher production
and efficiency.
STRUCTURE OF FINANCIAL MARKETS
Debt and equity markets
One can obtain funds in two ways, the most common method is to issue a debt instrument such as a bond or a
mortgage which is a contractual agreement by the borrower o pay the holder of the instrument a fixed amount
over a certain period of time.
The maturity of a debt instrument is the number of years until the instruments expiration date. A debt instrument
is short-term if it is less than a year, and long-term if it is more than 10 years. 1 – 10 year debt instruments are said
to be intermediate-term instruments.
The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the
net income and assets of a business. Equities make payments in term of dividends to their holders and known as
long-term securities as they have no maturity.
Primary and Secondary Markets
A primary market is a financial market in which new issues of a security, such as a bond or stock, are sold to initial
buyers by the corporation borrowing the funds.
A secondary market is a financial market in which securities that have previously been issued can be resold.
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, it guarantees a price for corporation’s securities and then
sells them to the public. Examples include; stock exchanges, forex markets, futures markets and options markets.
Brokers are agents of investors who match buyers with sellers of securities, dealer’s link buyers and sellers by
buying and selling securities as stated prices.
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Exchanges and Over-the-Counter Markets
Secondary markets can be organized in two ways. One method is to organize exchanges where buyers and sellers
meet in one central location to conduct trades.
The other method is to have an over-the-counter (OTC) market, in which dealers as different locations who have
an inventory of securities stand ready to buy and sell securities over the counter to anyone who is willing to
accept the prices.
Money and Capital Markets
The money market is a financial market in which only short-term debt instruments are traded. They are more
widely traded and so tend to be more liquid. Short term instruments also have smaller fluctuations making them
safer instruments.
The capital markets is the market is the market in which longer-term debt and equity instruments are traded.
FINANCIAL MARKET INSTRUMENTS
Money Market Instruments
Because of their short-term to maturity, they undergo the least price fluctuations and so are least risky.
US Treasury Bills – Instruments of the US government issued in one, three and six month maturities to finance
the federal government. They pay a set amount at maturity and have no interest but issued at a discount
value.
Negotiable Bank Certificates of Deposits – Certificates of Deposits is a debt instrument sold by a bank to
depositors that pays annual interest if a given amount at maturity pays back the original purchase price.
Negotiable CD’s are those sold in secondary markets.
Commercial Paper - is a short-term debt instrument issued by large banks and well-know corporations.
Repurchase agreements – Are effectively short-term loans for which treasury bills serve as collateral.
Federal (Fed) Funds – these are typically overnight loans between banks of their deposits at the Federal
Reserve. These loans are made by banks to other banks as the bank may not have enough deposits at the Fed
to meet amounts required by regulators.
FINANCIAL MARKET INSTRUMENTS
These are debt instruments are debt and equity instruments with maturities greater than one year. They have far
wider price fluctuations than the money market instruments and are considered fairly risky.
Stocks – Are equity claims on the net income and assets of a corporation.
Mortgages and Mortgage-Backed Securities – Mortgages are loans to households or firms to purchase land,
housing or other real structures that can be used as collateral for the loans. Mortgage-backed Securities are
bond-like debt instruments backed by a bundle of individual mortgages, whose interest and principle
payments are collectively paid to the holders of the security.
Corporate Bonds – These are long-term bond issued to corporations with very strong credit ratings. It sells the
holder an interest payment twice a year and pays off the face value when the bond matures. Convertible
Bonds allows the holder to convert the value into shares of a stock at maturity date.
US Government Securities – Issued by the US Government to finance the deficit of the federal government.
They are the third most liquid traded security.
US Government Agency Securities – Long-terms bonds issued by government agencies to finance items such
as mortgages, farm loans or power generating.
State and Local Government Bonds – Also called municipal bonds issued by state and local to finance
expenditure on schools, roads and other programs.
Consumer and Bank Commercial Loans – Loans to consumers also by finance companies.
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FUNCTIONS OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE
This involves a financial intermediary as they stand between the lend-savers and he borrower-spenders and helps
transfer funds from one to the other. The process is called financial intermediation and is the primary route for
moving funds from lenders to borrowers.
Transaction Costs - Are the time and money spent in carrying out financial transactions. Financial
intermediaries reduce the transaction costs as they have the expertise and can take advantage of economies
of scale. The low cost allows financial intermediaries to provide customers with liquid services, i.e. services
that make it easier to conduct transactions.
Risk Sharing – Financial intermediaries create and sell assets with risk characteristics that people are
comfortable with. Low transactions allow for risk to be shared at low cost, enabling profit to be earned on the
spread between returns. Risk sharing is also known as asset transformation as they are turned into safer
assets. Diversification entails investing in a collection of assets with the result that risk is lower than a single
asset.
Asymmetrical Information: Adverse selection and Moral Hazard – Adverse selection is when one party does
not know enough about the other party to make accurate decisions. Lack of information creates problems on
two fronts:
1. Adverse Selection – created by asymmetric selection before the transaction occurs. It occurs when the
potential borrows who are most likely to produce an undesirable outcome (bad credit risks) are the ones
who most actively seek out loans and thus are likely to be selected causing lenders not to make any loans.
2. Moral Hazard - created by asymmetric selection after the transaction occurs. It is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral) from a lenders point of view as the loan
is less likely to be paid back.
Financial intermediaries are better equipped to than individuals to screen out the bad credit risks from the
good ones reducing the losses resulting from adverse selection.
Economies of Scope and Conflicts of interest – Financial intermediaries provide multiple financial services
achieving economies of scope, i.e. they can lower the cost of information production for each service by
applying one information resource to may different services. This can also cause conflicts of interest in that a
person or institution has multiple objectives and may have a conflict between the objectives. The competing
interest of the services may lead to an individual or firm to conceal or disseminate misleading information.
To conclude: Financial intermediaries play an important role in that the:
1. Provide liquidity services
2. Promote risk sharing
3. Solve information problems
4. Channel funds form lender-savers to borrower-spenders.
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TYPES OF FINANCIAL INTERMEDIARIES
Financial intermediaries fall into three categories:
1. Depository institutions
2. Contractual saving institutions
3. Investment intermediaries
Depository institutions
Also referred to as banks that accept deposits from individuals and companies and then make loans. They are
involved in the creation of deposits. These include commercial banks and thrift institutions (thrifts), savings and
loan associations, mutual savings banks and credit unions.
Commercial banks – Financial intermediaries that raise fund by issuing checkable deposits, savings deposits
and time deposits and use these funds to make loans.
Savings and loan associations (S & L’s) and Mutual Savings Banks – Obtain funds through savings deposits,
time and checkable deposits and were restricted and mostly made residential mortgage loans, this has
changed/loosened recently
Credit Unions – Typically very small cooperative lending institutions organized around a particular group. They
acquire funds from deposits called shares and primarily make consumer loans.
Contractual Saving Institutions
These are insurance companies and pension funds that acquire funds at periodic intervals on a contractual basis.
They can predict how much they will have to pay out they do not worry as much as depository institutions.
Liquidity of assets is not important and mostly invests in long-term securities such as corporate bonds.
Life Insurance Companies – Insure people against financial hazards following a death and sell annuities. They
acquire funds from premiums and used mainly to buy corporate bonds and mortgages.
Fire and Casualty Insurance companies – Insure their policyholders against fire, theft and accidents. Acquire
funds through premiums and buy more liquid securities such as municipal bonds.
Pension Funds and Government Retirement Funds – Provide retirement income in the form of annuities to
covered employees. Funds are acquired by employees and employers. The largest assets are corporate bonds
and stocks.
Investment Intermediaries
Finance companies – Raise funds by selling commercial paper (short-term debt instrument) and by issuing
stocks and bonds. They lend funds to consumers to buy furniture, cars and home improvements
Mutual Funds – Acquire funds by selling shares to many individuals and use the proceeds to purchase
diversified portfolios of stocks and bonds. They allow shareholders to pool funds to take advantage of lower
transaction costs. And allow for more diversified portfolios.
Money Market Mutual Funds – They sells shares to acquire funds and use the funds to by money market
instruments that are both safe and liquid. The interest on the assets is paid to shareholders. Shareholder scan
write checks against the value of their shareholdings.
Investment Banks – An intermediary that helps corporations issue securities. It advises which type of
securities to issue (stocks or bonds) and then helps sell or underwrite the securities by buying them at a
predetermined price and selling them to the market. They also act as deal makers through mergers and
acquisitions.
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REGULATION OF THE FINANCIAL SYSTEM
The government regulates for two main reasons:
1. Increasing information available to investors - Government regulation can reduce adverse selection and
moral hazard problems and enhance the efficiency of the markets by increasing the amount of information
available to investors
2. To ensure the soundness of the financial system – Asymmetric information can lead to collapse of
financial intermediaries, referred to as a financial panic. If providers of funds feel the institutions holding
their funds are not sound, they may pull their funds creating financial panic that can cause large losses and
damage to the economy. Government has implemented six regulations to prevent this:
i. Restrictions of entry
ii. Disclosure – Reporting requirements are extremely stringent
iii. Restrictions on Assets and Activities – Limit the risky activates that may be undertaken.
iv. Deposit Insurance – Government can issue peoples deposits if the banks fail.
v. Limits on Competition
vi. Restrictions on Interest Rates
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CHAPTER 3 – WHAT IS MONEY?
MEANING OF MONEY
Economists define money as anything that is generally accepted as payment for goods and services or in the
repayment of debts. When people talk about money, they are referring to currency.
Economist’s distinction between money in the form of currency , demand deposits and other items that are used
to make purchases and wealth.
Wealth includes not only money but also assets such as stocks, bonds, land, furniture, cars, houses etc. Money is
also referred to as income. Income is a flow of earning per unit of time. Money by contrast is a stock, it is certain
at a point of time
FUNCTIONS OF MONEY
There are three primary functions of money;
1. Medium of exchange
2. Unit of account
3. Store of value
Medium of Exchange
Money in the form of currency or checks is a medium of exchange; it is used to pay for goods and services. It
promotes economic efficiency by minimizing time spent exchanging goods and services.
In a barter economy, time spent trying to exchange goods and services are called transaction costs. In a barter
economy these are high as one has to satisfy ‘a double coincidence of wants’. This is avoided with money.
Money promotes efficiency by eliminating time spent exchanging goods and services and allowing people to
specialization and the division of labour.
For a commodity to function effectively as money, it needs to be;
1. Easily standardized, making it simple to ascertain value.
2. It must be widely accepted
3. It must be divisible so it is easy to make change
4. It must be easy to carry
5. It must not deteriorate quickly
Unit of Account
This is used to measure the value in an economy. We measure the value of goods and services in terms of money
resulting in lower transaction costs by reducing the number of prices that need to be considers. The benefits of
this function increase as the economy becomes more complex.
Store of Value
It is a repository of purchasing power over time. It is used to save purchasing power from the time income is
received to the time it is spent. Money is liquid referring to the relative speed and ease to which it can be used
into a medium of exchange and does not have transaction costs associated with like homes or land that have
transaction costs.
Money is has a draw back during inflation and especially hyperinflation (>50%)
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EVOLUTION OF THE PAYMENTS SYSTEM
Commodity Money – Money made up of precious metal or another valuable commodity is called commodity
money. It functioned as a medium of exchange from ancient times to a few hundred years ago. This form of
money is heavy and hard to transport.
Fiat Money – The next development in paper system was paper currency. Initially it was guaranteed that is was
convertible into a precious metal but evolved into fiat money, i.e. paper money decreed by governments as legal
tender but not convertible into precious metals. Paper has the advantage of being easy to transport, accepted as a
medium of exchange, and can be difficult to counterfeit.
Checks – A check is an instruction to your bank to transfer money to a recipient. They allow transactions to take
place without the need to carry large amounts of money and can be of any value upto the amount in the account.
Problems are that it takes time to get checks from one place to another and the processing of checks can be slow
and is expensive.
Electronic Payment – The process of paying bills and making purches electronically. Allows for speed and
immediate access.
E-Money – This is money that only exits in electronic form. The first form of e-money was the debit card. There
are also store-value cards or a smart card that can load cash like a prepaid phone card. Another form is e-cash
which is used on the internet to purchase goods.
Definition of money
The functions of money (medium of exchange, unit of account, store of value) explain why money is useful and
why it facilitates exchange. It does not, however, explain exactly how money should be defined.
For practical reasons, economists have decided to define money as Currency (notes and coins) plus Deposits
(positive balances held in bank accounts): M=C+D. This definition focuses on money as a liquid asset.
This definition is not perfect. We should include certain forms of credit within the definition of money. But not all
forms of credit are counted as money. These come in two forms. The first form of credit which facilitates
exchange is credit cards held by consumers. The credit provided only has to be settled in a month's time. It may
appear that the amount of available credit must be counted as money since it facilitates exchange and provides
access to real purchasing power. The second important form of credit not counted as money is trade credit. Trade
credit is when firms sell their products to the trade sector, on condition that payment for the goods is made at a
future date, say in three months’ time.
But because these forms of credit do not lead to an increase in cash or deposits, the money stock (M=C+D) is not
affected by any of the two.
The reason why these two forms of credit are not included within the practical definition of money is because of
practical difficulties of measuring these forms of credit. Thus, for reasons of simplicity, money is practically
defined as Currency held plus Deposits (positive balances) only (M=C+D). The amount of currency in circulation is
known since only the central bank issues currency. Because deposits are always held at banks, banks know the
exact amount of deposits held by the non-bank (private) sector.
The provision of trade credit, for example, may lead to indirect increases in money supply. Assume a firm provides
trade credit to the value of R50 million to be paid in three months’ time. The provision of trade credit itself does
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