ECON0038: Economics of Money &
Banking
IR = interest rate
CB = central bank
MS = money supply
FDIC = Federal Deposit Insurance Corporation Act 1991
Table of Contents
1 Introduction. Why Study Money & Banking? What is Money?................................................................3
1.1 What is Money? What can money do?.............................................................................................3
1.2 The Economy – the players:..............................................................................................................3
1.3 Features of financial markets:...........................................................................................................3
1.4 What are the roles of money?...........................................................................................................4
1.5 What might cause money to not always fulfil its functions perfectly?..............................................4
1.6 Criteria for money to fulfil its functions well:....................................................................................5
1.7 Money Supply....................................................................................................................................5
1.8 Interest Rates and Money Supply......................................................................................................6
1.9 Different types of money...................................................................................................................7
1.10 Evolution of the Payments System..................................................................................................8
1.11 Measures of Monetary Aggregates.................................................................................................8
1.12 Banks’ Balance Sheet (not in MCQ).................................................................................................8
2 The Meaning of Interest Rates...............................................................................................................10
2.1 Present value of future cash flows:.................................................................................................10
2.2 Simple Present Value.......................................................................................................................10
2.3 Credit Market Instruments..............................................................................................................10
2.4 Distinctions:.....................................................................................................................................11
2.5 Fisher Equation:...............................................................................................................................12
2.6 Supply & Demand in the Money Market: the Liquidity Preference Framework..............................12
2.7 Money & Interest Rates:.................................................................................................................13
2.8 Higher Money Supply Growth = Lower Interest Rates?...................................................................14
3 Economic Analysis of Financial Structure...............................................................................................15
3.1 8 Basic Facts About the Global Financial System.............................................................................15
3.2 Data: sources of external funds for non-financial businesses:........................................................15
3.3 How Transaction Costs Affect Financial Intermediaries..................................................................16
3.4 Why Asymmetric information leads to Adverse Selection & Moral Hazard....................................16
3.5 Adverse Selection & Strategies to Reduce It...................................................................................16
, 3.6 Principal-Agent Problem Arising from Moral Hazard in Equity Contracts & Strategies to Reduce It
..............................................................................................................................................................17
3.7 How Moral Hazard Influences Financial Structure in Debt Markets:...............................................17
3.8 Summary:........................................................................................................................................18
3.9 Application:.....................................................................................................................................18
3.10 Securitisation.................................................................................................................................19
4 Economic Analysis of Banking and Financial Regulations.......................................................................20
4.1 Reasons for government safety net in financial markets................................................................20
4.2 Forms of government safety net in financial markets.....................................................................20
4.3 Drawbacks of the Government Safety Net......................................................................................20
4.4 Types of financial regulations..........................................................................................................20
5 Financial Crises.......................................................................................................................................25
5.1 Financial Crisis.................................................................................................................................25
5.2 3 Stages of a Financial Crisis............................................................................................................28
6 -Reading Week-......................................................................................................................................31
6.1 Week 1:...........................................................................................................................................31
6.2 Week 2:...........................................................................................................................................31
6.3 Week 3:...........................................................................................................................................31
6.4 Week 4:...........................................................................................................................................32
6.5 Week 5:...........................................................................................................................................33
6.6 Mock Quiz.......................................................................................................................................33
7 Tutorial 1 (Oliver Yimeng Zhang)............................................................................................................36
8 Tutorial 2 (Covered by Jinjin Lyu)...........................................................................................................38
9 Tutorial 3 (Oliver Yimeng Zhang)............................................................................................................39
10 Tutorial 4 (Oliver Yimeng Zhang)..........................................................................................................41
10.1 Referencing...................................................................................................................................41
10.2 Common Mistakes.........................................................................................................................41
10.3 To get above 80%:.........................................................................................................................41
10.4 Tutorial Questions.........................................................................................................................42
11 Tutorial 5 (Oliver Yimeng Zhang)..........................................................................................................42
,1 INTRODUCTION. WHY STUDY MONEY & BANKING? WHAT IS
MONEY?
1.1 WHAT IS MONEY? WHAT CAN MONEY DO?
Money: anything that is generally accepted as payment for goods or services (G+S), or in the
repayment of debts.
o Income is cash flow – not money.
o Wealth/assets are goods – not money.
Aggregate price level: the average price of G+S in an economy.
Inflation: continual rise in the price level.
Data shows a connection between money supply and the price level.
1.2 THE ECONOMY – THE PLAYERS:
1. Households provide labour, land, and capital to the market for factors.
2. Firms provide factor payments in exchange of FOPs (factors of production). This is income for
households.
3. Households use the income to purchase G+S (goods and services).
4. Firms provide the G+S to households in exchange for revenue.
5. If firms want to invest more than the cycle allows, financial markets step in; e.g., direct finance
from investors or loans.
6. Households save a proportion of their income.
7. Households are taxed a proportion of their income – received by the govt which can be invested
in financial markets.
1.3 FEATURES OF FINANCIAL MARKETS:
Any market that matches borrowers and lenders (intermediaries).
Borrower: anyone who is trading future income in exchange for current consumption.
Lender: anyone trading current consumption for future income.
a. Compensated by the interest rate paid on the loan.
Many different interest rates (IRs) in the economy. Reasons:
, i. Length of loans.
ii. Risk involved.
iii. Tax treatment of interest payments.
b. Generally, however, IRs move in the same direction but not identically.
c. 3 different IRs in the US:
i. T-bills (3-month Treasury Bills) – assumed to be risk-free due to short term.
ii. US Govt Long-Term Bonds – riskier than T-bills; less risky than corp. bonds.
iii. Corporate Bonds – most risky.
1.4 WHAT ARE THE ROLES OF MONEY?
Unit of Account – ability to define a price for a good in terms of money. Without money, we
would need to price each good in terms of many more prices.
1
o Number of prices: Number of independent prices= n(n−1) where n is the number
2
of goods being exchanged in the market.
Medium of Exchange
o Barter is generally inefficient – leads to the ‘double coincidence of wants’.
o We can make it more efficient by setting up a market.
Market: location- and time-specific trading of commodities.
o Some goods are perishable too.
o Number of possible exchanges can be reduced by using money by the amount:
1
reduction∈number of exchanges= n (n−1)
2
Store of Value
o Allows us to separate purchase and sales over time. Purchasing power is transferred
over time.
o Allows money to then store wealth, giving flexibility in financial transactions.
o Other storable commodities (non-perishable) can also store values, e.g. gold, houses,
art, etc.
o Money is perfectly liquid but loses value during inflation – other assets are less liquid.
Standard of Deferred Payment
o Ability to borrow and lend between periods; creates credit markets.
1.5 WHAT MIGHT CAUSE MONEY TO NOT ALWAYS FULFIL ITS FUNCTIONS PERFECTLY?
Inflation – examples:
o Hyperinflation (inflation >50% per month):
Store of value function deteriorates.
Examples:
1970s in Latin America, especially Venezuela.
1922-23 in Germany.
1945-46 in Hungary.
2007-08 in Zimbabwe.
1992-94 in Yugoslavia.
o Exchange rate depreciation, e.g. Japan in the 1990s.
Black Wednesday (early/mid-1990s): GBP depreciated in value after it departed
from the exchange rate mechanism. GBP was devalued by 15% in Sep-1992.
Banking
IR = interest rate
CB = central bank
MS = money supply
FDIC = Federal Deposit Insurance Corporation Act 1991
Table of Contents
1 Introduction. Why Study Money & Banking? What is Money?................................................................3
1.1 What is Money? What can money do?.............................................................................................3
1.2 The Economy – the players:..............................................................................................................3
1.3 Features of financial markets:...........................................................................................................3
1.4 What are the roles of money?...........................................................................................................4
1.5 What might cause money to not always fulfil its functions perfectly?..............................................4
1.6 Criteria for money to fulfil its functions well:....................................................................................5
1.7 Money Supply....................................................................................................................................5
1.8 Interest Rates and Money Supply......................................................................................................6
1.9 Different types of money...................................................................................................................7
1.10 Evolution of the Payments System..................................................................................................8
1.11 Measures of Monetary Aggregates.................................................................................................8
1.12 Banks’ Balance Sheet (not in MCQ).................................................................................................8
2 The Meaning of Interest Rates...............................................................................................................10
2.1 Present value of future cash flows:.................................................................................................10
2.2 Simple Present Value.......................................................................................................................10
2.3 Credit Market Instruments..............................................................................................................10
2.4 Distinctions:.....................................................................................................................................11
2.5 Fisher Equation:...............................................................................................................................12
2.6 Supply & Demand in the Money Market: the Liquidity Preference Framework..............................12
2.7 Money & Interest Rates:.................................................................................................................13
2.8 Higher Money Supply Growth = Lower Interest Rates?...................................................................14
3 Economic Analysis of Financial Structure...............................................................................................15
3.1 8 Basic Facts About the Global Financial System.............................................................................15
3.2 Data: sources of external funds for non-financial businesses:........................................................15
3.3 How Transaction Costs Affect Financial Intermediaries..................................................................16
3.4 Why Asymmetric information leads to Adverse Selection & Moral Hazard....................................16
3.5 Adverse Selection & Strategies to Reduce It...................................................................................16
, 3.6 Principal-Agent Problem Arising from Moral Hazard in Equity Contracts & Strategies to Reduce It
..............................................................................................................................................................17
3.7 How Moral Hazard Influences Financial Structure in Debt Markets:...............................................17
3.8 Summary:........................................................................................................................................18
3.9 Application:.....................................................................................................................................18
3.10 Securitisation.................................................................................................................................19
4 Economic Analysis of Banking and Financial Regulations.......................................................................20
4.1 Reasons for government safety net in financial markets................................................................20
4.2 Forms of government safety net in financial markets.....................................................................20
4.3 Drawbacks of the Government Safety Net......................................................................................20
4.4 Types of financial regulations..........................................................................................................20
5 Financial Crises.......................................................................................................................................25
5.1 Financial Crisis.................................................................................................................................25
5.2 3 Stages of a Financial Crisis............................................................................................................28
6 -Reading Week-......................................................................................................................................31
6.1 Week 1:...........................................................................................................................................31
6.2 Week 2:...........................................................................................................................................31
6.3 Week 3:...........................................................................................................................................31
6.4 Week 4:...........................................................................................................................................32
6.5 Week 5:...........................................................................................................................................33
6.6 Mock Quiz.......................................................................................................................................33
7 Tutorial 1 (Oliver Yimeng Zhang)............................................................................................................36
8 Tutorial 2 (Covered by Jinjin Lyu)...........................................................................................................38
9 Tutorial 3 (Oliver Yimeng Zhang)............................................................................................................39
10 Tutorial 4 (Oliver Yimeng Zhang)..........................................................................................................41
10.1 Referencing...................................................................................................................................41
10.2 Common Mistakes.........................................................................................................................41
10.3 To get above 80%:.........................................................................................................................41
10.4 Tutorial Questions.........................................................................................................................42
11 Tutorial 5 (Oliver Yimeng Zhang)..........................................................................................................42
,1 INTRODUCTION. WHY STUDY MONEY & BANKING? WHAT IS
MONEY?
1.1 WHAT IS MONEY? WHAT CAN MONEY DO?
Money: anything that is generally accepted as payment for goods or services (G+S), or in the
repayment of debts.
o Income is cash flow – not money.
o Wealth/assets are goods – not money.
Aggregate price level: the average price of G+S in an economy.
Inflation: continual rise in the price level.
Data shows a connection between money supply and the price level.
1.2 THE ECONOMY – THE PLAYERS:
1. Households provide labour, land, and capital to the market for factors.
2. Firms provide factor payments in exchange of FOPs (factors of production). This is income for
households.
3. Households use the income to purchase G+S (goods and services).
4. Firms provide the G+S to households in exchange for revenue.
5. If firms want to invest more than the cycle allows, financial markets step in; e.g., direct finance
from investors or loans.
6. Households save a proportion of their income.
7. Households are taxed a proportion of their income – received by the govt which can be invested
in financial markets.
1.3 FEATURES OF FINANCIAL MARKETS:
Any market that matches borrowers and lenders (intermediaries).
Borrower: anyone who is trading future income in exchange for current consumption.
Lender: anyone trading current consumption for future income.
a. Compensated by the interest rate paid on the loan.
Many different interest rates (IRs) in the economy. Reasons:
, i. Length of loans.
ii. Risk involved.
iii. Tax treatment of interest payments.
b. Generally, however, IRs move in the same direction but not identically.
c. 3 different IRs in the US:
i. T-bills (3-month Treasury Bills) – assumed to be risk-free due to short term.
ii. US Govt Long-Term Bonds – riskier than T-bills; less risky than corp. bonds.
iii. Corporate Bonds – most risky.
1.4 WHAT ARE THE ROLES OF MONEY?
Unit of Account – ability to define a price for a good in terms of money. Without money, we
would need to price each good in terms of many more prices.
1
o Number of prices: Number of independent prices= n(n−1) where n is the number
2
of goods being exchanged in the market.
Medium of Exchange
o Barter is generally inefficient – leads to the ‘double coincidence of wants’.
o We can make it more efficient by setting up a market.
Market: location- and time-specific trading of commodities.
o Some goods are perishable too.
o Number of possible exchanges can be reduced by using money by the amount:
1
reduction∈number of exchanges= n (n−1)
2
Store of Value
o Allows us to separate purchase and sales over time. Purchasing power is transferred
over time.
o Allows money to then store wealth, giving flexibility in financial transactions.
o Other storable commodities (non-perishable) can also store values, e.g. gold, houses,
art, etc.
o Money is perfectly liquid but loses value during inflation – other assets are less liquid.
Standard of Deferred Payment
o Ability to borrow and lend between periods; creates credit markets.
1.5 WHAT MIGHT CAUSE MONEY TO NOT ALWAYS FULFIL ITS FUNCTIONS PERFECTLY?
Inflation – examples:
o Hyperinflation (inflation >50% per month):
Store of value function deteriorates.
Examples:
1970s in Latin America, especially Venezuela.
1922-23 in Germany.
1945-46 in Hungary.
2007-08 in Zimbabwe.
1992-94 in Yugoslavia.
o Exchange rate depreciation, e.g. Japan in the 1990s.
Black Wednesday (early/mid-1990s): GBP depreciated in value after it departed
from the exchange rate mechanism. GBP was devalued by 15% in Sep-1992.
