Chapter 1: Money, Banking, and influences business investment

decisions and consumer spending

Financial Markets patterns.
29 Feb, 2024
7. Economic Cycles: Financial
market activities can influence the
a- financial markets: cyclical performance of economies,
impacting factors such as inflation,
1. Purpose: Financial markets employment, and overall economic
facilitate the transfer of funds from stability.
individuals with surplus funds to
those with a shortage, enabling Understanding and effectively
efficient allocation of capital. managing financial markets are
essential for individuals, businesses,
2. Types: Financial markets include and policymakers to navigate
bond markets, stock markets, money economic challenges and
markets, and derivatives markets, opportunities.
each serving different purposes and
instruments.
b-The bond market and interest rates:
1. Security and Bonds: A security is a
3. Economic Efficiency: Well- financial claim on the future income or
functioning financial markets assets of an issuer. Bonds are debt securities
promote economic efficiency by that promise periodic payments for a
directing funds to productive uses, specified time.
stimulating economic growth.

4. Global Impact: Financial markets 2. Importance of the Bond Market: The bond
play a critical role in global market is crucial for economic activity as it
economic development. Poorly enables corporations and governments to
borrow funds for financing activities.
performing markets can contribute to Additionally, it serves as the primary
persistent poverty in many countries. determinant of interest rates.

5. Personal Wealth: Activities in

financial markets directly impact 3. Interest Rates: Interest rates represent the
personal wealth, influencing cost of borrowing or the price paid for the
investment returns, savings, and use of funds, typically expressed as a
retirement planning. percentage. Various types of interest rates
exist, including mortgage rates, car loan
6. Business and Consumer Behavior: rates, and rates on different bonds.
The functioning of financial markets
affects the behavior of businesses
and consumers. Access to capital
4. Impact of Interest Rates: High interest decisions, and assessing investment
rates can deter individuals from making opportunities.
large purchases like homes or cars due to
8. Interest rates across various bonds are
increased financing costs. Conversely, they
often consolidated into a single concept,
may encourage saving as individuals can
simplifying analysis of interest rate trends
earn more interest income. At a broader
on a macroeconomic scale.
level, interest rates influence consumer
spending, saving behavior, and business 9. Despite this simplification, it's vital to
investment decisions. acknowledge significant variations in
interest rates among different bond types,
reflecting diverse market conditions, risk
5. Economic Impact: Fluctuations in interest levels, and issuer characteristics.
rates affect individuals, financial
institutions, businesses, and the overall
economy. For instance, high-interest rates 10. Figure 1 likely illustrates these
may lead corporations to postpone substantial differences in interest rates
investment in projects that create jobs. among various bonds, highlighting the non-
uniformity of interest rates across bond
categories.
6. Historical Fluctuations: Over the past 35
years, significant fluctuations in interest
rates have occurred. For example, the
interest rate on three-month Treasury bills
peaked at over 16% in 1981, fell to 3% in
the early 1990s, rose again in the late 1990s,
fell to below 1% in 2004, rose to 5% by
2007, and decreased to close to zero from
11. Recognizing this variability is crucial for
2008 to 2014.
investors, policymakers, and economists,
guiding decisions related to asset allocation,
risk management, and economic policy.
7. Differences in Interest Rates: Interest
rates on various types of bonds can differ
substantially. For instance, the interest rate
12. Given the complexity of financial
on three-month Treasury bills fluctuates
markets, understanding the nuances of
more than other rates and tends to be lower
interest rate dynamics among bond types
on average. On the other hand, the interest
enhances analytical precision and decision-
rate on Baa (medium-quality) corporate
making effectiveness.
bonds is typically higher and exhibits
fluctuations over time. c- Stock Market:
Understanding the dynamics of the bond 1. Stock Ownership: Common stock
market and interest rates is essential for represents ownership in a corporation,
analyzing economic trends, making financial providing shareholders with claims on the
company's earnings and assets. Corporations Understanding the dynamics of the stock
issue stock to raise funds for their activities. market is crucial for investors, businesses,
and policymakers as it affects wealth
2. Significance of the Stock Market: The
accumulation, consumer behavior, and
stock market is the primary venue for
investment decisions, ultimately impacting
trading shares of stock, making it the most
economic activity.
closely watched financial market in many
countries. Major fluctuations in stock prices d-The financial system:
often make headline news due to their
widespread impact. 1. Complexity of the Financial System: The
financial system encompasses various
3. Volatility: Stock prices exhibit high private sector institutions such as banks,
volatility, meaning they can experience insurance companies, mutual funds, finance
significant fluctuations over short periods. companies, and investment banks. These
Events like "Black Monday" in 1987, with a institutions play a critical role in channeling
22% drop in the Dow Jones Industrial funds from savers to borrowers.
Average, illustrate the market's volatility.
4. Historical Trends: The stock market has
seen periods of both growth ("bull markets") 2. Role of Financial Intermediaries:
and decline ("bear markets"). For example, Financial intermediaries, including banks,
from the 1980s to 2000, there was a serve as intermediaries between savers and
significant rise in stock prices, followed by a borrowers. They collect funds from savers
sharp decline after the collapse of the high- and lend them to borrowers, facilitating the
tech bubble in 2000. Subsequent bull flow of capital in the economy.
markets and declines have occurred,
impacting investors' wealth and spending
behavior. 3. Importance of Financial Intermediaries:
Financial intermediaries are crucial for the
5. Wealth Effects: Fluctuations in stock smooth functioning of financial markets.
prices affect the size of individuals' wealth, They extend credit to borrowers based on
influencing their willingness to spend. When their assessment of creditworthiness,
stock prices rise, people may feel wealthier manage risk through diversification, and
and spend more, while declines can lead to provide liquidity to the market.
reduced spending.

4. Regulation of Financial Intermediaries:

6. Impact on Business Investment: Stock Financial intermediaries are heavily
prices also influence business investment regulated by the government due to their
decisions. Higher stock prices allow firms to systemic importance and potential impact on
raise more funds by selling newly issued the economy. Regulation aims to ensure
stock, enabling them to finance investment financial stability, protect investors, and
in production facilities and equipment. mitigate risks associated with financial
activities.
 Understanding the structure of the financial
system, the role of financial intermediaries,
5. Banking Institutions: Banks, including
and the impact of financial innovation and
commercial banks, savings and loan
crises is crucial for policymakers, investors,
associations, mutual savings banks, and
and individuals to navigate the complexities
credit unions, are primary financial
of the modern economy.
intermediaries that accept deposits and make
loans. They play a central role in the
financial system by providing various
financial services to individuals and e-money and its role in the economy:
businesses.

1. Definition of Money: Money, or the

6. Diversification of Financial Institutions: money supply, refers to anything generally
While banks are significant players in the accepted as a medium of exchange for
financial system, other institutions such as goods, services, or debt repayment. It
insurance companies, finance companies, encompasses currency, demand deposits,
pension funds, mutual funds, and investment and other liquid assets.
banks also play important roles. These
institutions have experienced growth and
diversification, impacting the overall 2. Link between Money and Economic
structure of the financial system. Variables: Changes in the money supply
affect economic variables that impact
7. Financial Innovation: Financial individuals and the overall health of the
innovation involves the development of new economy. These variables include aggregate
financial products and services. Advances in output (the total production of goods and
information technology have led to e- services), unemployment rates, inflation,
finance and new financial instruments. and interest rates.
Financial innovation can enhance
profitability but may also introduce risks and 3. Money and Business Cycles: Fluctuations
contribute to financial crises. in the money supply are closely associated
with business cycle movements, including
8. Financial Crises: Financial crises are periods of economic expansion and
major disruptions in financial markets contraction. Changes in the rate of money
characterized by sharp declines in asset growth can influence the direction and
prices and the failure of financial severity of business cycles, affecting
institutions. They have occurred throughout employment opportunities and economic
history and are often followed by severe activity.
economic downturns. Understanding the
causes and consequences of financial crises
is essential for mitigating their impact and 4. Money and Inflation: There is a positive
promoting financial stability. correlation between the money supply and
the aggregate price level, indicating that
increases in the money supply often lead to
inflation. Milton Friedman famously stated f-international finance:
that "inflation is always and everywhere a
monetary phenomenon," suggesting that 1. Globalization of Financial Markets:
changes in the money supply are a primary Financial markets have become increasingly
driver of inflationary pressures. integrated worldwide, with companies and
financial institutions operating across
borders. This globalization trend has
5. Monetary Policy: The conduct of accelerated in recent years, leading to
monetary policy, which involves managing greater interconnectedness in the global
money and interest rates, is crucial for financial system.
maintaining economic stability. Central 2. International Operations of Financial
banks, such as the Federal Reserve System Institutions: Major financial institutions,
in the United States, play a key role in such as JP Morgan Chase, Citigroup, UBS,
formulating and implementing monetary and Deutschebank, have expanded their
policy to influence economic variables like operations internationally. They operate in
inflation and employment. multiple countries and participate in various
financial markets around the world.

6. Interest Rates: Money also influences 3. The Foreign Exchange Market (Forex):
interest-rate fluctuations. Changes in the The foreign exchange market is where
money supply can impact interest rates, currencies are traded, facilitating the
affecting borrowing and lending activities conversion of one currency into another. It
by businesses and consumers. plays a crucial role in enabling the transfer
of funds between countries and determines
exchange rates, which represent the price of
one currency in terms of another.
4. Exchange Rate Fluctuations: Exchange
7. Fiscal Policy: Fiscal policy, involving
rates exhibit significant fluctuations over
government spending and taxation
time. These fluctuations impact consumers,
decisions, interacts with monetary policy.
businesses, and the overall economy.
Budget deficits, where government
Changes in exchange rates affect the cost of
expenditures exceed tax revenues, can lead
imports and exports, influencing consumer
to higher money growth rates, inflation, and
purchasing power, business profitability, and
interest rates.
trade dynamics.
5. Impact on Consumers and Businesses: A
Understanding the role of money in the weaker domestic currency makes imports
economy, its interaction with other more expensive, leading to higher prices for
economic variables, and the implications for foreign goods and potentially reducing
monetary and fiscal policy is essential for consumer purchasing power. Conversely, a
policymakers, economists, and individuals stronger domestic currency makes exports
to navigate economic challenges and more expensive for foreign buyers, affecting
promote stability and growth.
the competitiveness of domestic products in - Key components of an efficient financial
international markets. system include:
1. Financial Institutions
6. Economic Consequences: Fluctuations in 2. Financial Markets
exchange rates have significant economic
3. Financial Instruments
consequences. They affect trade balances,
corporate earnings, employment levels, and - These components work together within
overall economic growth. Understanding the financial system to facilitate the flow of
exchange rate dynamics is essential for funds, as depicted in Figure 1.1.
policymakers, businesses, and investors to
make informed decisions in the global
economy.
7. Study of Exchange Rate Determination:
Chapter 18 explores how exchange rates are
determined in the foreign exchange market.
It examines the factors influencing exchange
rate movements and the mechanisms
through which currencies are bought and
sold in international currency markets. - Financial markets serve as the
platforms for conducting financial
transactions and other monetary
activities. {where financial
Studying international finance provides
transactions are conducted?}
insights into the complexities of the global
financial system, the dynamics of exchange
rate movements, and the implications for
economic activity and policy decisions on - Financial instruments represent the
both domestic and international levels. commodities traded within these
markets. {what commodities are
Financial Economies traded?}

a. financial Economies:
- Economics deals with the allocation of - Financial institutions are the key
scarce resources, while financial economics participants in financial markets,
focuses specifically on managing financial acting as the main traders. {who is
resources and conducting monetary the main trader?}
activities within a financial system.
- A financial system facilitates the exchange - Financial economics encompasses
of funds among lenders, investors, and the study of the financial system,
borrowers. which also includes financial
services and money to be efficient.
 - New investments boost total output
(GDP) and foster economic growth.
- Financial services involve activities
provided by asset management and
- The circular flow of expenditures
liability management companies, as
and incomes illustrates how different
well as other financial services firms,
sectors interact to generate a
facilitating efficient fund acquisition
country's GDP.
and deployment, assisting in
financing decisions, and managing
- Potential injections into the
risk exposures in financial markets.
economy can come from abroad
through foreign savings, entering via
two channels:
- Money is any medium accepted for a. Indirect channel: foreign savings
payment of goods, services, or debt are attracted by financial markets
repayment, serving as a medium of and then injected into the economy
exchange and a store of value. (Foreign Indirect Investments).
b. Direct channel: foreign savings
B. financial system: enter the economy as investments
(Foreign Direct Investment).
- The financial system facilitates the
transfer of funds and exchange of - The circular flow diagram of
financial instruments among expenditures and income provides
borrowers, lenders, and investors in insights into the economy's
the economy. performance, indicating:
a. The efficiency of financial markets
- Funds move from surplus units to and the economy as a whole.
deficit units through two routes: b. Efficient economies can attract not
market-based finance, where funds only domestic savings but also
are directly traded in financial foreign savings from outside the
markets, and indirect finance, which economy.
involves financial intermediaries.

C. Types of Financial Markets

& Financial Instruments:
a- Foreign Exchange Market
{FX}:
- USD is the key player, followed by
In the financial system:
the Euro, GBP Sterling, Yen, and
a. Surplus units receive interest or
finally CHF. All of them are traded
returns on their savings.
against the US Dollar. They all
b. Deficit units utilize funds for
operate in two main markets: the
investment opportunities, leading to
spot market and the derivative
profit generation.
market. The spot market is
considered the highest risk market,
for instance, When trading Euro, for
example, to USD, where 1 Euro
equals $1.07542, each digit after the
decimal point is referred to as a
"pid.". The second market is
derivatives, which includes forward
contracts, future contracts, and
options, further divided into put or
call options. Options involve foreign
currency and stock market
operations, while the ……..
contracts operate on commodities.
The maximum duration for
derivatives is typically one year.