Money & Banking

1. Learning Unit #1
Overview of Money and Banking

2. Objectives of Learning Unit
• Importance of Financial System
• Three Financial Markets
• Financial Institutions
• Money in Economy
• Economic Data of the U.S. Economy
• Review of Macroeconomics

3. Financial System
• Some people do not have a productive use of
funds, while others have a productive use of funds.
• Financial system channels funds from savers
(people who have an excess funds) to investors
(people who have a shortage of funds).
• Financial system promotes economic efficiency by
allocating limited resources efficiently in
economy.

4. Financial System and Economy
Well-functioning financial system promotes
• Economic growth
• Stable prices
• High employment
• Accumulation of wealth

5. Financial Instruments
• In financial system, when lenders provide funds to
borrowers, borrowers provide financial
instruments to lenders.
• Financial Instrument (a.k.a. Security, IOU): A
claim on the issuer’s (borrower’s) future income
or assets.
• Value of financial instruments is determined by
borrowers and lenders in financial markets.

6. Three Financial Markets
• Bond Market
• Stock Market
• Foreign Exchange Market

7. Bond Market
• Bond: A debt instrument that promises to make
payments periodically for a specified period of time.
– Ex. U.S. Treasury Bonds
• Governments issue bonds to finance budget deficits,
while large corporations issue bonds to finance
large investment projects.
• Bond market determines interest rates.

8. Interest Rates
• Interest rate: Cost of borrowing funds.
• Interest rates affect economic activities by
affecting individual’s willingness to spend.
– High interest rates encourage savers to save more (lend
more) and spend less.
– High interest rates discourage borrowers to borrow
more and spend more.
– High interest rates means high costs for corporations to
undertake investment projects.

9. Interest Rates in Action
• There are many different interest rates.
– Different financial instruments have different interest
rates.
– Each interest rate is determined in each bond market.
• Interest rates change over time.
– Interest rates tend to move together.

10. Figure 1:
Interest Rates on Selected Bonds, 1950-2011

11. Stock Market
• Stock: a share of ownership in a corporation.
– It is a claim on the earnings and assets of the corporation.
• Stock prices affect the economy by
– Affecting the amount of funds that corporations can raise
by selling newly issued stock to finance their business
investment projects.
– Affecting the size of people’s wealth and their
willingness to spend.
• Stock prices are extremely volatile.

12. Figure 2:
Stock Price as Measured by the Dow Jones Industrial
Average, 1950-2011

13. Foreign Exchange Market
• Foreign exchange market: one country’s currency
is exchanged with other country’s currency.
– It allows funds to move across borders from
country which have an excess funds to another
which have a shortage of funds.
• Foreign exchange rate: the price of one country’s
currency in terms of another’s.

14. Foreign Exchange Rate
• Foreign exchange rate affects the price of foreign
goods in the U.S. and the price of U.S. goods in
foreign countries.
– An increase in value of the U.S. dollar makes prices of
foreign-made goods cheaper for U.S. consumers and
affects American firms competing with foreign goods.
– An increase in value of the U.S. dollar makes prices of
American-made goods more expensive to foreign
consumers and affects exports of American firms.
• Foreign exchange rates change over time.

15. Figure 8:
Exchange Rate of the U.S. Dollar, 1970-2011

16. Financial Institutions
• Financial institutions help and complement
financial markets to channel funds from savers to
investors.
– Ex. Investment banks, security dealers
• Financial intermediaries borrow funds from people
who have saved and in turn make loans to others.
– Ex. Banks accept deposits and make loans.
– Ex. Insurance companies, pension funds, mutual funds

17. Financial Crisis
• Financial crises are major disruptions in financial
markets that are characterized by sharp declines in
asset prices and the failures of many financial and
nonfinancial firms.
• Starting in August 2007, the U.S. economy was hit
by the worst financial crisis since the Great
Depression in 1930s.
– Ex. Failure of Lehman Brothers, AIG, and Wachovia Bank
• Recessions and depressions were often preceded by
financial crises.

18. Financial Innovation
• Financial innovation: Financial institutions
introduce new financial services.
• Financial innovation makes the financial system
more efficient.
̶ Ex. Online banking/trading, e-finance
• Financial innovation can lead to devastating
financial crises.
̶ Ex. Collapse of CDSs (Credit Default Swaps) lead to
failures of AIG.

19. Monetary Policy
• Money: anything that is generally accepted in
payment for goods or services or in the repayment
of debts.
• Money supply: the quantity of money in an
economy.
• Monetary policy: the management of money and
interest rates by the central bank
• Federal Reserve System (a.k.a. the Fed) is the
central bank of the U.S.

20. Money and Economy
Money can affect many economic variables by
affecting individual consumers and businesses.
• Production of goods and services in an economy:
Business cycle
• Prices of goods and services in an economy:
Inflation
• Interest rates, stock prices, and foreign exchange
rates

21. Money and Business Cycle
• Aggregate output: total production of goods and
services in an economy.
• Business cycle: the upward (expansion) and
downward (recession) movement of aggregate
output through time.
• Unemployment rate: a percentage of unemployed
workers in the total labor force.
– Unemployment rate increases during a recession and
declines during an expansion.

22. Figure 3:
Money Growth and Business Cycle, 1950-2011

23. Money and Inflation
• Aggregate price level: the average price of goods
and services in an economy.
• Inflation: a continual increase in the price level.
• A positive association of a continuing increase in
the money supply (money growth) and a
continuing increase in the price level (inflation).

24. Figure 4:
Aggregate Price Level and the Money Supply,
1950-2011

25. Figure 5:
Average Inflation Rate vs. Average Rate of Money
Growth, 2000-2010

26. Money and Interest Rates
• 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

27. Figure 6:
Money Growth and Interest Rates, 1950-2011

28. Fiscal Policy
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
− Ex. U.S. Treasury bonds

29. Figure 7:
Government Budget Surplus or Deficit as a
Percentage of GDP, 1950-2010

30. How We 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. Transactions cost and asymmetric information
approach to financial structure

31. How Money & Banking relates to
Other Courses
• Microeconomics – demand and supply model
• Macroeconomics – monetary policy
• Finance – present value & asset pricing
model
• Accounting – Balance sheet & T-account

32. Appendix:
Measuring the Economy
Two important measurements of an economy
• Aggregate output: total amount of goods and
services produced in the economy.
• Price level: a measure of average prices of goods
and services

33. Aggregate Output
• Gross Domestic Product (GDP): the market value
of all final goods and services produced in a
country during a year (or a quarter).
• Aggregate income: total income in an economy
during a particular year
• Aggregate output = Aggregate income
– When produced is what spent and what earned in a
whole economy.

34. Nominal and Real Values
Because prices change over time, economic
variables are measured in either nominal or
real.
• Nominal: values measured using current prices
• Real: quantities measured with constant prices

35. Nominal and Real GDP
• Nominal GDP: the value of the final goods and
services produced in a given year valued at the prices
that prevailed in that same year (current price).
• Real GDP: the value of the final goods and services
produced in a given year when valued at constant
prices (constant price).

36. Nominal vs. Real GDP
• The (nominal) GDP changes from one year to next
when
– the quantities of goods and services produced change or
the prices of goods and services produced change.
• Real GDP is intended to measure only changes in
quantities of goods and services produced from
one year to next by correcting the (nominal) GDP
for the price changes.

37. Price Level
Two commonly used measurements of the price
level of an economy:
• GDP deflator: A change in prices of all goods
and services (included in GDP) in an economy.
• Consumer Price Index (CPI): An average of
prices paid by urban consumers for a fixed
market basket of consumption goods and
services (typically purchased by urban
consumers).

38. GDP Deflator
100
GDPalRe
GDPalminNo
DeflatorGDP ×=
GDP deflator is measured as a ratio of nominal
GDP to Real GDP as in an index number:

39. GDP Deflator in 2011
Nominal GDP in 2011 = $15,094 trillion
Real GDP in 2011 = $13,315 trillion
GDP Deflator in 2011 = $15,094/$13,314 x 100
= 113.4

40. Growth Rate
Growth rate is a percentage change in a variable.
100
X
XX
rateGrowth
1t
1tt
×
−
=
−
−
A growth rate of variable X from year t-1 to
year t is calculated as

41. Money Growth
Money growth rate is a percentage change in
money supply in an economy.
100
SupplyMoney
SupplyMoneySupplyMoney
rateGrowthMoney
1t
1tt
×
−
=
−
−
A growth rate of money supply from year t-1 to
year t is calculated as

42. Economic Growth
Economic growth is measured as a growth rate in
real GDP of an economy.
100
GDPalRe
GDPalReGDPalRe
rateGrowthGDPalRe
1t
1tt
×
−
=
−
−
• When a real GDP growth rate is positive, an economy is
expanding (an expansion stage of business cycle).
• When a real GDP growth rate is negative, an economy is
contracting (a recession stage of business cycle).
A growth rate of real GDP from year t-1 to year:

43. Economic Growth from 2010 to 20111
Real GDP in 2010 = $13,088 trillion
Real GDP in 2011 = $13,315 trillion
Real GDP Growth Rate from 2010 to 2011
= ($13,314 - $13,088)/$13,088 x 100
= 1.7%

44. Inflation
Inflation rate is a percentage change in the price level.
100
LevelicePr
LevelicePrLevelicePr
RateInflation
1t
1tt
×
−
=
−
−
• Inflation: an inflation rate is positive (the price level is rising).
• Deflation: an inflation rate is negative (the price level is falling).
An inflation rate from year t-1 to year is
calculated as

45. Inflation from 2010 to 20111
CPI in January 2010 = 218.085
CPI in January 2011 = 224.937
Inflation Rate from January 2010 to January 2011
= (224.937 – 218.085)/218.085 x 100
= 3.1%

46. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University