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Chapter 1: An Introduction to Money and Banking
Features of Market Economies
1. Use of money as a medium of exchange
2. Use of financial markets and financial intermediaries to reallocate
funds from
savers to investors.
3. Use of government policies to stabilize the economy: inflation, output,
interest rate,
and others.
Course Objectives:
1. How does the use of money promote economic efficiency?
2. How do financial markets allocate financial resources among various
activities?
3. How do financial intermediaries facilitate borrowing and lending?
4. What are the distinguishing features of private banks and the Central
Bank?
5. What are the principles of bank management?
6. What are the distinguishing features of private banks and the Central
Bank.
7. How do private banks create money?
8. How does the central bank control the stock of money?
9. What is monetary policy, its objectives, and its instruments?
10. What is monetary theory and its uses?
Introduction
1. Money and the Economy
2. Financial Intermediaries and the economy
3. Financial Markets and the Economy
What is Money?
Collection of financial assets that serves as a medium of exchange, store
of wealth,
and unit of account.
Importance
1. As a medium of exchange, facilitates trade, eliminates "double
coincidence of wants".
2. As a unit of account, reduces information costs.
3. As a store of wealth, it is the most liquid asset.
4. Strong relation with other economic variables.
a. Money and Price Level: Positive and strong relation.
b. Money Growth and Inflation: Positive and strong relation.
Milton Friedman, "inflation is always and everywhere a monetary
Phenomenon."
c. Money and Business Cycles:
Business Cycles: ups and downs in production around the normal level.
- Money growth and business cycles are positively and strongly correlated.
- Recessions are usually preceded by a decline in money growth.
d. Money Growth and Interest Rates
The relation seems to be negative in the short-run but positive in the
long-run.
e. Money Growth and Budget Deficits:
Budget deficit: excess of government spending over tax revenues.
Is financed by sale of treasury securities (borrowing). Thus no direct
relation between
deficits and money stock.
However, borrowing increases interest rates.
If the FED controls interest rates, it must increase the supply of
money (monetizing
the deficit).
Thus budget deficits might lead to increases in money supply, and inflation.
Budget Deficits and Monetary Policy
FINANCIAL INTERMEDIARIES (Banks)
Importance: Play three roles
INTERMEDIATION: stand between lenders and borrowers: offer deposits
to lenders
and use the funds to make loans or purchase other assets.
MONEY SUPPLY CREATION: Bank deposits are part of money supply. Thus,
banks
create money by creating new deposits.
FINANCIAL INNOVATION: Banks create new types of financial assets. Examples
are NOW and ATS accounts, CD’s, money market deposit accounts,...
FINANCIAL MARKETS:
Help allocate financial resources efficiently by transferring funds
from savers to investors.
Three markets
THE BOND MARKET:.
Where corporate and government IOUs are traded.
The interest rate on IOU’s is determined in the bond market
Bond Market
THE STOCK MARKET:.
where claims on the earnings and ownership of corporations are traded.
stock market determines the price of stocks and the value of corporations.
Stock Market and the Economy:
1. Stocks are part of people's wealth. Thus changes in stock prices affect
people's wealth
and their spending and saving behavior.
2. Businesses obtain investment funds by selling stocks. A fall in stock
prices reduces
corporations’ ability to obtain funds by selling stocks.
THE FOREIGN EXCHANGE MARKET:
Market for a foreign currency.
Exchange rate: price of one currency (dollar) in terms of another currency
(Yen).
Exchange rates are determined in the foreign exchange market.
Exchange Rate and the Economy
A change in the exchange rate affects exports, imports, trade balance,
and output.
EXAMPLE: A $ appreciation causes a rise in export prices, which reduces
exports,
and a fall in import prices, which increases in imports. The outcome
is trade deficit.
Foreign Exchange Market
How to Study Money and Banking
Basic Analytic Framework
1. Simplified approach to the demand for assets
2. Concept of equilibrium
3. Basic supply and demand approach to understand behavior in financial
markets
4. Search for profits
5. Transactions cost and asymmetric information approach to financial
structure
6. Aggregate supply and demand analysis
Features
1. Case studies
2. Applications
3. Special-interest boxes
4. Following the Financial News boxes
5. Reading the Wall Street Journal
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