Chapter 1 – Why Study Money, Banking and Financial Markets
Why study financial markets?
- Reduces transaction costs, asymmetric information: financial markets are markets in
which funds are transferred from people and firms who have an excess of available funds to
people and firms who have a shortage
-Channelling funds for productive use, risk-sharing: financial markets are crucial to
promoting greater economic efficiency
-Economies of scale, liquidity services, economies of scope: well-functioning financial
markets are a key factor in promoting development and producing high economic growth
- The financial cycle is identified using credit, house prices and equity prices as indicators,
and estimated using traditional turning-point analysis, frequency-based filters and an
unobserved components model-based approach
- Activities in financial markets have a direct effect on personal wealth, the behaviour of
businesses and consumers and the cyclical performance of the economy
The bond market and interest rates
-Security (financial instrument): a claim on the issuer’s future income or assets
-Bond: debt security that promises to make payments periodically for a specified period
-Interest rate: cost of borrowing or the price paid for the rental of funds
The stock market
-Common stock represents a share of ownership in a corporation
-Share of stock is a claim on the residual earnings and assets of the corporation
Why study financial institutions and banking?
1. Financial intermediaries: institutions that borrow funds from people who have saved
and in turn make loans to people who need funds. Banks- accept deposits and make
loans. Systematic banking crises are rarely single-country events. Other financial
institutions are insurance companies, finance companies, pension funds, mutual funds
and investment companies
2. Financial innovation: the development of new financial products or services. Can be
an important force for good by making the financial system more efficient. The
improvement of information technology leads to the ability to deliver financial
services electronically (E-finance)
3. Financial crises: major disruptions in financial markets that are characterised by
sharp declines in asset prices and the failures of many financial and non-financial
firms
,Why study money and monetary policy?
-Money: anything that is generally accepted as payment for goods or services or in the
repayment of debts
-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 continuous rise in the price level, inflation, affects all economic players
-Data shows a connection between the money supply and the price level
Money and interest rates
-Interest rates are the opportunity cost of money
-Prior to 1980, the rate of money growth and the interest rate on long term 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
Fiscal policy
-Deals with government spending and taxation
-Budget deficit: excess of expenditure over revenues for a particular year
-Budget surplus: excess of revenues over expenditures for a particular year
-Any deficit must be financed by borrowing
Monetary policy
-The management of the money supply and interest rates
-Federal Reserve system in U.S.
-South African Reserve Bank in SA
The foreign exchange market
-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
,Why study international finance?
-Financial markets have become increasingly integrated throughout the world
-The international financial system has tremendous impact on domestic economies:
• How a country’s choice of exchange rate policy affects its monetary policy
• How capital controls impact domestic financial systems and therefore the
performance of the economy
• What should be the role of international financial institutions like the IMF
Money, banking, financial markets and your career
-Understanding monetary policy may help you predict when interest rates will rise or fall,
help you make decisions about whether its better to borrow now or to wait until later, know
how banks and other financial institutions are managed which may help you get a better deal
when you need to borrow from them and may enable you to make better investment
decisions, whether for yourself or for the company you work for
How will we study money, banking and financial markets?
-A simplified approach to the demand for assets
-The concept of equilibrium
-Basic supply and demand to explain behaviour in financial markets
-The search for profits
-An approach to financial structure based on transaction costs and asymmetric information
-Aggregate supply and demand analysis
, Chapter 2 - Overview of The Financial System
Function of financial markets
-Performs the essential function of channelling funds from economic players that have saved
surplus funds to those that have a shortage of funds
-Direct finance: borrowers borrow funds directly from lenders in financial markets by selling
them securities
-Promotes economic efficiency by producing and efficient allocation of capital, which
increases production
-Directly improves the well-being of consumers by allowing them to time purchases better
Structure of financial markets
-Debt instruments (contractual agreement): maturity refers to the remaining time until the
expiration date
-Equities (claims to net income and assets): residual claimant; dividends refers to the
periodic payment to shareholders
-Primary market: not well known to the public; investment banks underwrite securities in
primary markets
-Secondary market: previously issued securities will be sold in the secondary market;
brokers and dealers work in secondary markets
-Exchanges: NYSE, Chicago Board of Trade
-Over-the-counter markets (OTC): Foreign exchange, Federal funds
-Money markets: deal in short-term debt instruments; short terms to maturity, least price
fluctuations and least risky investment
Why study financial markets?
- Reduces transaction costs, asymmetric information: financial markets are markets in
which funds are transferred from people and firms who have an excess of available funds to
people and firms who have a shortage
-Channelling funds for productive use, risk-sharing: financial markets are crucial to
promoting greater economic efficiency
-Economies of scale, liquidity services, economies of scope: well-functioning financial
markets are a key factor in promoting development and producing high economic growth
- The financial cycle is identified using credit, house prices and equity prices as indicators,
and estimated using traditional turning-point analysis, frequency-based filters and an
unobserved components model-based approach
- Activities in financial markets have a direct effect on personal wealth, the behaviour of
businesses and consumers and the cyclical performance of the economy
The bond market and interest rates
-Security (financial instrument): a claim on the issuer’s future income or assets
-Bond: debt security that promises to make payments periodically for a specified period
-Interest rate: cost of borrowing or the price paid for the rental of funds
The stock market
-Common stock represents a share of ownership in a corporation
-Share of stock is a claim on the residual earnings and assets of the corporation
Why study financial institutions and banking?
1. Financial intermediaries: institutions that borrow funds from people who have saved
and in turn make loans to people who need funds. Banks- accept deposits and make
loans. Systematic banking crises are rarely single-country events. Other financial
institutions are insurance companies, finance companies, pension funds, mutual funds
and investment companies
2. Financial innovation: the development of new financial products or services. Can be
an important force for good by making the financial system more efficient. The
improvement of information technology leads to the ability to deliver financial
services electronically (E-finance)
3. Financial crises: major disruptions in financial markets that are characterised by
sharp declines in asset prices and the failures of many financial and non-financial
firms
,Why study money and monetary policy?
-Money: anything that is generally accepted as payment for goods or services or in the
repayment of debts
-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 continuous rise in the price level, inflation, affects all economic players
-Data shows a connection between the money supply and the price level
Money and interest rates
-Interest rates are the opportunity cost of money
-Prior to 1980, the rate of money growth and the interest rate on long term 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
Fiscal policy
-Deals with government spending and taxation
-Budget deficit: excess of expenditure over revenues for a particular year
-Budget surplus: excess of revenues over expenditures for a particular year
-Any deficit must be financed by borrowing
Monetary policy
-The management of the money supply and interest rates
-Federal Reserve system in U.S.
-South African Reserve Bank in SA
The foreign exchange market
-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
,Why study international finance?
-Financial markets have become increasingly integrated throughout the world
-The international financial system has tremendous impact on domestic economies:
• How a country’s choice of exchange rate policy affects its monetary policy
• How capital controls impact domestic financial systems and therefore the
performance of the economy
• What should be the role of international financial institutions like the IMF
Money, banking, financial markets and your career
-Understanding monetary policy may help you predict when interest rates will rise or fall,
help you make decisions about whether its better to borrow now or to wait until later, know
how banks and other financial institutions are managed which may help you get a better deal
when you need to borrow from them and may enable you to make better investment
decisions, whether for yourself or for the company you work for
How will we study money, banking and financial markets?
-A simplified approach to the demand for assets
-The concept of equilibrium
-Basic supply and demand to explain behaviour in financial markets
-The search for profits
-An approach to financial structure based on transaction costs and asymmetric information
-Aggregate supply and demand analysis
, Chapter 2 - Overview of The Financial System
Function of financial markets
-Performs the essential function of channelling funds from economic players that have saved
surplus funds to those that have a shortage of funds
-Direct finance: borrowers borrow funds directly from lenders in financial markets by selling
them securities
-Promotes economic efficiency by producing and efficient allocation of capital, which
increases production
-Directly improves the well-being of consumers by allowing them to time purchases better
Structure of financial markets
-Debt instruments (contractual agreement): maturity refers to the remaining time until the
expiration date
-Equities (claims to net income and assets): residual claimant; dividends refers to the
periodic payment to shareholders
-Primary market: not well known to the public; investment banks underwrite securities in
primary markets
-Secondary market: previously issued securities will be sold in the secondary market;
brokers and dealers work in secondary markets
-Exchanges: NYSE, Chicago Board of Trade
-Over-the-counter markets (OTC): Foreign exchange, Federal funds
-Money markets: deal in short-term debt instruments; short terms to maturity, least price
fluctuations and least risky investment
