CHAPTER 1

OVERVIEW OF THE STUDY

ON MONEY, BANKING AND
FINANCIAL MARKETS
Prepared by: Fauziana Fauzi @ Mat
Rawi
 Why study Financial Why Study Money
Why study the
Institutions & & Monetary Policy
Financial Markets?
Banking?
Debt Market Structure of the Money &
& Interest Financial Business
Rate System Cycles

Money &
The Stock Banks & Other
Inflation
Market Financial
Institutions
Money &
Interest Rates

Conduct of
Why Study Money, Banking & Monetary
Financial Markets? Policy

Fiscal Policy &

Monetary
Policy
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Why Study Financial
Markets?

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 Eg. of Financial
Markets

The Bond Market The Stock Market

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 Financial Markets – Markets in which funds are
transferred from people who have an excess of
available funds to people who have a shortage.

Crucial to promoting greater economic

efficiency by channeling funds from people who
do not have a productive use for them to those
who do.

Well-functioning financial markets are a key

factor in producing high economic growth, and
poorly-performing financial markets are one
reason that many countries in the world remain
desperately poor.

Activities in financial markets also have a direct

effect on personal wealth, the behavior of
businesses, and the cyclical performance of the
economy.

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Debt Market & Interest Rates

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 What is Interest Rates?
What is Debt Market?

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• A security (also called a financial instrument) is a claim on the issuer’s
future income or assets (any financial claim or piece of property that is
subject to ownership).
• A bond: A debt security that promises to make periodic payments for a
specific period.
• Debt market, also often generically referred to as bond market is
especially important to economic activity because they enables
corporations and governments to borrow money to finance their
activities and because it is where interest rates are determined.

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• Interest rate – Cost of borrowing/the price paid for the rental of funds
(usually expressed as a percentage of the rental).

• Types of interest rates – mortgage interest rates, car loan rates & interest
rates on many different types of bonds.

• The Importance of interest rates:

– Personal level: High-interest rates might deter you from buying a
house/a car because the cost of financing would be high.
– High interest rates might encourage saving because you can earn
more interest income.
– High interest rates might cause a corporation to postpone building a
new plant that would provide more jobs.

• Because changes in interest rates affect individuals, financial institutions,

businesses, and the overall economy, it is important to explain substantial
fluctuations in interest rates over the past 35 years.

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 Figure 1 Interest Rates on Selected Bonds,
1950–2017 Interest rates on several types of bonds can differ substantially

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/BAA
The Stock Market

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• A common stock represents a share of ownership in a
corporation.
• A security that is a claim on the earnings and assets of the
corporation.
• Issuing stock and selling it to the public is a way for
corporations to raise funds to finance their activities.
• A big swing in the prices of shares in the stock market is
always a major story on the evening news.
• People often speculate on where the market is heading and
get very excited when they can brag about their latest “big
killing’ but they become depressed when they suffer a big
loss.
• The attention the market receives can probably be best
explained by one simple fact: It is a place where people can
get rich or poor very quickly.

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• The stock market is also an important factor in business
investment decisions, because the price of shares affects the
amount of funds that can be raised by selling newly issued
stock to finance investment spending.
• A higher price for a firm’s share means that the firm can
raise a larger amount of funds, which it can then use to buy
production facilities and equipment.

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Figure 2 Stock Prices as Measured by the Dow
Jones Industrial Average, 1950–2017

Stock prices are extremely volatile

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA

 Why Study Financial Institutions and
Banking?
• Banks and other financial institutions are what make
financial markets work.
• Without them, financial markets would not be able to
move funds from people who save to people who have
productive investment opportunities.

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 Structure of the Financial System
• Complex, comprising many different types of private sector
financial institutions – banks, insurance companies, mutual funds,
finance companies, investment banks (heavily regulated by the
gov.)

• If an individual wanted to make a loan to IBM/General Motors, he

would lend to such a company indirectly through financial
intermediaries – institutions that borrow funds from people who
have saved and in turn make loans to people who need funds.

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 Banks and Other Financial Institutions
• Banks are financial institutions that accept deposits and make
loans.
• Term banks includes firms – commercial banks, savings and loan
associations, mutual savings bank and credit union.
• Banks are the financial intermediaries that the average person
interacts with most frequently.
• A person who needs a loan to buy a house/a car usually obtains it
from a local bank.
• Other financial institutions – insurance companies, finance
companies, pension funds, mutual funds and investment banks
have been growing at the expense of banks.

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 Why Study Money and Monetary Policy?
• Money = money supply.
– Anything that is generally accepted as
payment for goods and services or in the
repayment of debts.
– Linked to changes in economic variables that
affect all of us and are important to the
health of the economy.

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 Money and Business Cycle
• Money plays an important role in generating business cycles, the
upward and downward movement of aggregate output
produced in the economy.

• Business cycles affect all of us in immediate and important ways.

• When output is rising, it is easier to find a good job; when
output is falling, finding a job might be difficult.

• Figure 3: Rate of money growth declined before most recession,

indicating that changes in money growth might be a driving
forces behind business cycle fluctuations.

• However, declines in the rate of money growth are often not

followed by a recession.

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 Figure 3 Money Growth (M2 Annual Rate) and
the Business Cycle in the United States, 1950–
2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL

 The Business Cycle

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2

3
 BUSINESS CYCLE PATTERN
National Output

Long-
run
BOOM output
BOOM trend
line

Recovery

Recession Depression

Time (years)
 Money and Inflation
• Inflation – a continual increase in the price level, affects
individuals, businesses and the government.
• It is generally regarded as an important problem to be
solved and is often at the top of political and policy making
agendas.
• What explain inflation?
– Plots the money supply vs the price level.
– The price level and the money supply generally rise
together.
– Continuing increase in the money supply might be an
important factor in causing the continuing increase in
the price level that we call inflation.
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 Figure 4 Aggregate Price Level and the Money
Supply in the United States, 1960–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GDPDEF
• Figure 5: Show a positive association exists between inflation and
the growth rate of the money supply.

• The countries with the highest inflation rates are also the ones
with the highest money growth rates – Russia, Turkey.
• Japan and Euro area experienced low inflation rates and their
rates of money growth were low.

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 Figure 5: Average Inflation Rate Versus Average Rate
of Money Growth for Selected Countries, 2006–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/

Milton Friedman – Inflation is always and
everywhere a monetary phenomenon.

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 Money and Interest Rates
• Money plays an important role in interest-rate fluctuations,
which are of great concern to business and consumers.
• Figure 6: Shows changes in the interest rate on long-term
treasury bonds and the rate of money growth from 1950 to
2017.
• As the money growth rate rose in the 1960s and 1970s, the
long-term bond rate rose with it.

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 Figure 6 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/M2SL
 Conduct of Monetary Policy
• Because money affects many economic variables that are important
to the well-being of our economy, politicians and policy makers
throughout the world care about the conduct of monetary policy –
the management of money and interest rates.

• The organization responsible for the conduct of a nation’s monetary

policy is the central bank.

• The Malaysia’s Central Bank is Bank Negara Malaysia.

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 Fiscal Policy and Monetary Policy
• Fiscal policy involves decisions about government spending and
taxation.

• A budget deficit is an excess of government expenditures with

respect to tax revenues for a particular time period, typically a year.

• Budget surplus arises when tax revenues exceed government

expenditures.

• The government must finance any budget deficit by borrowing,

whereas a budget surplus leads to a lower government debt
burden.

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 Figure 7 Government Budget Surplus or Deficit as a
Percentage of Gross Domestic Product, 1950–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/FYFSGDA188Sl
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