Econ 303: Money and Banking

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Econ 303 Money and Banking

• Fall 2007 Giandomenico Sarolli

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Information

• Syllabus
• Textbook ?
• WSJ and Economist
• Calculators and Excel
• Tests and Memos
• Office Hours
• (3x5 index card)
• Name, Year, Hometown, birthday, why study MB,
  Favorite sports team, Fun Fact , Fed Funds on
  12/11

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Why Study Money, Banking, and Financial Markets?

• To examine how financial markets such as bond,
  stock and foreign exchange markets work
• To examine how financial institutions such as
  banks and insurance companies work
• To examine the role of money in the economy

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Bonds and Interest Rates
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The Bond Market and Interest Rates

• A security (financial instrument) is a claim on
  the issuers future income or assets
• A bond is a debt security that promises to make
  payments periodically for a specified period of
  time
• An interest rate is the cost of borrowing or the
  price paid for the rental of funds
• Q1 What happened in the late 1970s?

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US Stock Market
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The Stock Market

• Common stock represents a share of ownership in a
  corporation
• A share of stock is a claim on the earnings and
  assets of the corporation
• Q1 How is a stock valued?
• Q2 What is the Dow Jones Industrial Avg?
• Q3 What is the difference between Real and
  Nominal?

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US Exchange Rate
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The Foreign Exchange Market

• The foreign exchange market is 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
• Q1 What is Purchasing Power Parity and what does
  that have to do with hamburgers?

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Banking and Financial Institutions

• Financial Intermediariesinstitutions that borrow
  funds from people who have saved and make loans
  to other people
• Banksinstitutions that accept deposits and make
  loans
• Other Financial Institutionsinsurance companies,
  finance companies, pension funds, mutual funds
  and investment banks
• Financial Innovationin particular, the advent of
  the information age and e-finance

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Money and Business Cycles

• Evidence suggests that money plays an important
  role in generating business cycles
• Recessions (unemployment) and booms (inflation)
  affect all of us
• Monetary Theory ties changes in the money supply
  to changes in aggregate economic activity and the
  price level

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Money Supply
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Money and Prices
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Money and Inflation
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Money and Inflation

• The aggregate price level is the average price
  of goods and services in an economy
• A continual rise in the price level (inflation)
  affects all economic players
• Data shows a connection between the money supply
  and the price level
• Q1 What is a regression? Plot a regression line
  on the cross country data about inflation.

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Money and Interest Rates

• Interest rates are the price of money
• Prior to 1980, the rate of money growth and the
  interest rate on long-term Treasure bonds were
  closely tied
• Since then, the relationship is less clear but
  still an important determinant of interest rates
• Q1 When the US had a large budget surplus, there
  was no more need to issue long term T-Bonds,
  given their importance for financial firms what
  could they do to replace the lost bonds?

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US Budgets
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Monetary and Fiscal Policy

• Monetary policy is the management of the money
  supply and interest rates
• Conducted in the U.S. by the Federal Reserve Bank
  (Fed)
• Fiscal policy is government spending and
  taxation
• Budget deficit is the excess of expenditures over
  revenues for a particular year
• Budget surplus is the excess of revenues over
  expenditures for a particular year
• Any deficit must be financed by borrowing

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An Overview of the Financial System
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Purpose of the Financial System

• Provides channels to transfer funds from savers
  to borrowers.
• Savers are suppliers of funds.
• Borrowers are demanders of funds.
• Financial markets issue claims on borrowers
  directly to savers.
• Financial intermediaries act as go-betweens by
  holding a portfolio of assets and issuing claims
  to savers.

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Moving Funds Through the Financial System
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Key Services Provided by the Financial System
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Key Services Provided by the Financial System

• Risk sharing by allowing savers to hold many
  assets
• Liquidity, which is the ease with which an asset
  can be exchanged for money
• Information about borrowers and returns on
  financial assets

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Financial Markets

• Primary markets are those in which newly issued
  claims are sold to initial buyers.
• Secondary markets are those in which previously
  issued claims are resold.
• Risk-sharing, liquidity, and information services
  are provided in secondary markets.

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Types of Secondary Financial Markets

• Maturity money and capital markets
• Trading places auction and over-the-counter
  markets
• Settlement cash or derivative

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Financial Intermediaries Tasks

• Match savers and borrowers
• Provide risk-sharing, liquidity, and information
  services

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Competition and Change

• Financial innovation results from change.
• Ease of communicating information has allowed for
  greater financial integration.

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Goals of Financial Regulation

• Provision of information
• Maintenance of financial stability
• Controlling the money supply
• Encouraging particular activities (like home
  ownership)
• Regulation affects the ability of financial
  markets and institutions to provide risk-sharing,
  liquidity, and information services, as seen in
  Table 3.1

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Regulation of Financial Institutions and Markets
in the United States
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MONEY
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Meeting the Needs of Exchange

• 3 methods to gain the efficiency benefits of
  specialization include barter, government
  allocation, and money
• Money can help people benefit from specialization
  without incurring the high trading costs of
  barter or the misallocations of government
  allocation

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Methods of Exchange
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Functions of Money

• Medium of exchange
• Unit of account
• Store of value
• Standard of deferred payment

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Criteria for Medium of Exchange

• Acceptable to most traders
• Standardized quality
• Durable
• Valuable relative to its weight
• Divisible

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Payments Systems

• Commodity money
• Physical goods (precious metals) by which trade
  was accomplished
• Fiat money
• Money authorized by a central bank is the
  definitive money and doesnt have to be exchanged
  for gold or commodity money
• Checks
• Promises to pay definitive money on demand, drawn
  on money deposited in a financial institution
• Electronic funds
• Computerized payment-clearing

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NEW UVA MONEY!

• Create a new form of currency at UVA!

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Measuring the Money Supply

• To understand moneys role as an economic
  variable, we need to measure it.
• Definitions of the money supply are based o the
  assets included as money and depend on how
  substitutable different assets are for money.
• Liquidity refers to the cost at which an asset
  can be converted into definitive money.

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Monetary Aggregates

• The Federal Reserve has developed 3 definitions
  of money that include assets broader than
  currency, called monetary aggregates
• M1
• M2
• Broader monetary aggregates

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Measuring Monetary Aggregates, February 2006
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Selecting Monetary Aggregates

• M2 currently considered best.
• Aggregates move broadly together over long time
  periods.
• Some significant differences in monetary
  aggregate movements have occurred during certain
  periods
• The different monetary aggregates give a
  different picture of movements in the money
  supply over time.

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Growth Rates of M1 and M2, 1960-2006