ECOS2004 NOTES
WEEK 1 (CH 1): WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS?
EXAMINE HOW FINANCIAL MARKETS SUCH AS BOND MARKETS ARE CONNECTED TO
THE AGGREGATE ECONOMY
DEFINITIONS
• A security (financial instrument) is a claim on the issuer’s future income or assets
• A bond is a debt security that promises to make payments periodically for a specified period of time. Principal is
returned to lender at maturity.
• An interest rate is the cost of borrowing or the price of credit (the price paid for the rental of funds).
INTEREST RATES ON 10-YEAR US GOVERNMENT BONDS, 1962–2019
POLICY INTEREST RATES: MAJOR ADVANCED ECONOMIES
INTEREST RATES: AUSTRALIA
1
,HOUSING RATES AND THE CASH RATE
THE STOCK MARKET
• Common stock (equity) represents a share of ownership in a corporation.
• A share of stock is a claim on the net earnings and assets of the corporation.
STOCK PRICES AS MEASURED BY THE DOW JONES INDUSTRIAL AVERAGE, 1950–2014
EXAMINE HOW FINANCIAL INSTITUTIONS, ESPECIALLY BANKS, PLAY A ROLE IN THE
BEHAVIOUR OF THE ECONOMY
• Financial intermediaries: institutions that borrow funds from people (households and firms) who have saved and that in
turn make loans to other people.
o Banks: accept deposits and make loans
o Other financial institutions: pension funds, mutual funds and investment companies
• Financial innovation: the development of new financial products and services
o Can be an important force for good by making the financial system more efficient
• Financial crises: major disruptions in financial markets that are characterized by sharp declines in asset prices and the
failures (or government rescues) of many financial and nonfinancial firms.
• History shows that financial events and monetary policy can play an important role in macroeconomic outcomes:
o Inflation
o Business cycles
• Monetary theory ties monetary policy actions to changes in aggregate economic activity and the price level
• The causation flows in both directions
IDENTIFY THE BASIC LINKS AMONG MONETARY POLICY, THE BUSINESS CYCLE, AND
ECONOMIC VARIABLES
MONEY, BUSINESS CYCLES, AND INFLATION
• The aggregate price level is the average price (a weighted index of prices) of goods and services in an economy
• Inflation is a continual rise in the price level
• History has generally shown a connection between the money supply and the price level, but the link is complex
• We will be studying tradition and modern views as to how this link works
2
,AGGREGATE PRICE LEVEL AND THE MONEY SUPPLY IN THE UNITED STATES, 1950–2014
AVERAGE INFLATION RATE VERSUS AVERAGE RATE OF MONETARY GROWTH,
SELECTED COUNTRIES, 2003−2013
• Imprecise relationship between money supply and inflation
GROWTH OF MONETARY AND CREDIT AGGREGATES IN AUSTRALIA
• Credit and broad money are correlated
QUANTITY OF MONEY: DEFINITIONS (AUSTRALIA)
• Currency = notes and coin in circulation
• M3 = currency + bank deposits help by the public
• Broad money = M3 + deposits with non-bank financial institutions (NBFIs)
3
, MONEY AND INTEREST RATES
• Traditional monetary theory postulates that central banks conduct policy by controlling the money supply
• Central bank policy setters no longer think in those terms
• Their actions set the short-term policy interest rate
• Money and credit growth are endogenous responses to these actions and to broader economic conditions
• In Australia this has been explicit in policy statements since 1990
EXAMINE THE ROLE OF MONETARY AND FINANCIAL POLICY IN THE ECONOMY
FISCAL POLICY AND MONETARY POLICY
• Monetary policy is the management of interest rates and the central bank balance sheet
o Conducted in the U.S. by the Federal Reserve System (Fed); by RBA in Australia
• Fiscal policy deals with government spending and taxation
o Budget deficit is the excess of expenditures over revenues for a particular year
o Budget surplus is the excess of revenues over expenditures for a particular year
o Any deficit must be financed by borrowing or money creation (typically finance through bonds)
o Budgeted deficit for 2018/19 was $14.5bn (= 0.8 percent of GDP)
BUDGET BALANCE AND GOVERNMENT DEBT: AUSTRALIA
THE FOREIGN EXCHANGE MARKET
• The foreign exchange market: where funds are converted from one currency into another
o Currently 78c
• The foreign exchange rate is the price of one currency in terms of another currency
• In a floating rate system, the market determines the foreign exchange rate
EXPLAIN THE IMPORTANCE OF EXCHANGE RATES IN THE GLOBAL ECONOMY AND IN
POLICY DECISIONS
AUSTRALIAN DOLLAR EXCHANGE RATES
• Trade-weighted Index – weighted average of movement of all currencies
4
WEEK 1 (CH 1): WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS?
EXAMINE HOW FINANCIAL MARKETS SUCH AS BOND MARKETS ARE CONNECTED TO
THE AGGREGATE ECONOMY
DEFINITIONS
• A security (financial instrument) is a claim on the issuer’s future income or assets
• A bond is a debt security that promises to make payments periodically for a specified period of time. Principal is
returned to lender at maturity.
• An interest rate is the cost of borrowing or the price of credit (the price paid for the rental of funds).
INTEREST RATES ON 10-YEAR US GOVERNMENT BONDS, 1962–2019
POLICY INTEREST RATES: MAJOR ADVANCED ECONOMIES
INTEREST RATES: AUSTRALIA
1
,HOUSING RATES AND THE CASH RATE
THE STOCK MARKET
• Common stock (equity) represents a share of ownership in a corporation.
• A share of stock is a claim on the net earnings and assets of the corporation.
STOCK PRICES AS MEASURED BY THE DOW JONES INDUSTRIAL AVERAGE, 1950–2014
EXAMINE HOW FINANCIAL INSTITUTIONS, ESPECIALLY BANKS, PLAY A ROLE IN THE
BEHAVIOUR OF THE ECONOMY
• Financial intermediaries: institutions that borrow funds from people (households and firms) who have saved and that in
turn make loans to other people.
o Banks: accept deposits and make loans
o Other financial institutions: pension funds, mutual funds and investment companies
• Financial innovation: the development of new financial products and services
o Can be an important force for good by making the financial system more efficient
• Financial crises: major disruptions in financial markets that are characterized by sharp declines in asset prices and the
failures (or government rescues) of many financial and nonfinancial firms.
• History shows that financial events and monetary policy can play an important role in macroeconomic outcomes:
o Inflation
o Business cycles
• Monetary theory ties monetary policy actions to changes in aggregate economic activity and the price level
• The causation flows in both directions
IDENTIFY THE BASIC LINKS AMONG MONETARY POLICY, THE BUSINESS CYCLE, AND
ECONOMIC VARIABLES
MONEY, BUSINESS CYCLES, AND INFLATION
• The aggregate price level is the average price (a weighted index of prices) of goods and services in an economy
• Inflation is a continual rise in the price level
• History has generally shown a connection between the money supply and the price level, but the link is complex
• We will be studying tradition and modern views as to how this link works
2
,AGGREGATE PRICE LEVEL AND THE MONEY SUPPLY IN THE UNITED STATES, 1950–2014
AVERAGE INFLATION RATE VERSUS AVERAGE RATE OF MONETARY GROWTH,
SELECTED COUNTRIES, 2003−2013
• Imprecise relationship between money supply and inflation
GROWTH OF MONETARY AND CREDIT AGGREGATES IN AUSTRALIA
• Credit and broad money are correlated
QUANTITY OF MONEY: DEFINITIONS (AUSTRALIA)
• Currency = notes and coin in circulation
• M3 = currency + bank deposits help by the public
• Broad money = M3 + deposits with non-bank financial institutions (NBFIs)
3
, MONEY AND INTEREST RATES
• Traditional monetary theory postulates that central banks conduct policy by controlling the money supply
• Central bank policy setters no longer think in those terms
• Their actions set the short-term policy interest rate
• Money and credit growth are endogenous responses to these actions and to broader economic conditions
• In Australia this has been explicit in policy statements since 1990
EXAMINE THE ROLE OF MONETARY AND FINANCIAL POLICY IN THE ECONOMY
FISCAL POLICY AND MONETARY POLICY
• Monetary policy is the management of interest rates and the central bank balance sheet
o Conducted in the U.S. by the Federal Reserve System (Fed); by RBA in Australia
• Fiscal policy deals with government spending and taxation
o Budget deficit is the excess of expenditures over revenues for a particular year
o Budget surplus is the excess of revenues over expenditures for a particular year
o Any deficit must be financed by borrowing or money creation (typically finance through bonds)
o Budgeted deficit for 2018/19 was $14.5bn (= 0.8 percent of GDP)
BUDGET BALANCE AND GOVERNMENT DEBT: AUSTRALIA
THE FOREIGN EXCHANGE MARKET
• The foreign exchange market: where funds are converted from one currency into another
o Currently 78c
• The foreign exchange rate is the price of one currency in terms of another currency
• In a floating rate system, the market determines the foreign exchange rate
EXPLAIN THE IMPORTANCE OF EXCHANGE RATES IN THE GLOBAL ECONOMY AND IN
POLICY DECISIONS
AUSTRALIAN DOLLAR EXCHANGE RATES
• Trade-weighted Index – weighted average of movement of all currencies
4
