Summary Summarised NOtes ECS3701

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. ECS3701 – Monetary Economics - 2014 H. Crassas Page 2 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. ECS3701 – Monetary Economics - 2014 H. Crassas Page 3 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.