Introduction – Money,

Banking and Financial

Markets
READING: MISHKIN CHAPTER 1
Overview – The role of financial markets
◦A well-functioning financial systems channels savings to
investors helping an economy to grow.
◦A malfunctioning financial system can damage an
economy.
◦The collapse of the stock market and banking system
caused the Great Depression.
◦A financial crisis beginning in 2007 plunged the U.S.
economy into a recession, doubling the unemployment
rate.

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Financial Markets and Interest rates
◦ Financial markets are comprised of the people and firms that
trade financial assets.
◦ Two types of financial assets:
◦ Currencies
◦ Securities
◦ Bonds
◦ Stocks
◦An interest rate is the cost of borrowing or the price paid
for the rental of funds

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Bonds
oA bond is a debt security or fixed-income security.
◦ A bond is a security that promises fixed payments at future
dates.
◦ The coupon payment is interest paid at specified intervals for
the use of the borrowed funds.
◦ The face value is the principal paid when a bond matures.
◦ Maturity is the life of a bond: the time between the original
sale and payment of the face value.

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Interest Rates on Selected Bonds, 1950–2017

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

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 Stocks
Stock or equity is an ownership share in a corporation.
◦Stockholders share a corporation’s profits.
◦Profits are uncertain, so a stock’s return is uncertain.
Stockholders vote on corporate policies.
Bondholders have no vote on corporate policies.

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

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

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 Economic Functions of Financial Markets
To match savers and investors:
◦ Savers have surplus funds to lend.
◦ Investors borrow to increase productive capacity of economy.
To share risk or diversification:
◦ Diversification involves holding a variety of different assets to reduce
risk.
Financial innovation: the development of new financial products and
services
◦ Can be an important force for good by making the financial system
more efficient
◦ E-finance: the ability to deliver financial services electronically

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 Banks
A bank is a financial institution or financial intermediary.
Banks raise funds by accepting deposits.
Banks use the funds to make loans to businesses and
individuals.
◦Bank loans are private loans – negotiated between one
lender and one borrower.

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 Types of Banks

Savings and Loan Associations accept deposits and

primarily make mortgage loans.
Commercial banks accept deposits, make loans for a
variety of purposes and some also deal in securities
markets.
Investment banks are not really banks. They help
companies raise funds by issuing new securities.

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The Financial System and Economic Growth

◦Economic growth means increases in real GDP, standards

of living, and productivity.
◦A well-developed financial system increases economic
growth.
◦Economic growth is growth of real gross domestic
product (real GDP).

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 Saving and Growth
Countries that save more invest more and have higher
standards of living in the long run.
Underdeveloped financial systems make it difficult for
investors to raise funds.
Deposit insurance encourages savers to channel funds
through banks.

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Financial Development and Economic
Growth
Studies find that strong financial systems increase growth.
◦ Stock market capitalization, the value of all corporate stock
as a percentage of GDP, increases as country income
increases.
◦ Total bank loans as a percentage of GDP are also high in high
income countries.

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Financial Development and Economic Growth, 1996-2007
(A) Stock Market Capitalization (B) Bank Loans
Percent 100 Percent 100
of GDP of GDP
90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
Low Lower Upper High Low Lower Upper High
income middle middle income income middle middle income
(Nigeria, income income (Germany, income income
Pakistan) (India, (Mexico, United
Indonesia) Turkey) States)

This figure compares financial development in four group of countries, from the quarter with the lowest real GDP per capita
to the quarter with the highest. Examples of countries in each group appear in parentheses in Panel (A). Richer countries
have higher levels of stock market capitalization ad bank loans than poorer countries.
Source of data: World Bank

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Financial Crises
A financial crisis is a major disruption of the financial
system.
◦A financial crisis often involves a sharp drop in asset
prices and failures of financial institutions.
◦Financial crises often reduce output and increase
unemployment.

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The 2007 Financial Crisis
Many defaults on subprime mortgages.
Stock prices fell 55% from 2007 to 2009.
The economy suffered a severe recession.
Unemployment rose from under 5% to over 10%.

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 Policy Responses
The government became partial owner in many of the
largest banks.
The Federal Reserve expanded the money supply
massively through loans to financial institutions.
The Fed pushed short-term interest rates to close to
zero.

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Money and Monetary Policy
Evidence suggests that money, defined as anything that
is generally accepted as payment for goods or services
or in the repayment of debts, plays an important role in
generating business cycles.
Recessions (unemployment) and expansions affect all of
us.
Monetary theory ties changes in the money supply or
changes in policy interest rates to changes in aggregate
economic activity and the price level.
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Money, Business Cycles, and Inflation
A continual rise in the price level (inflation) affects all
economic players
Data show a connection between the money supply and the
price level
The aggregate price level is the average price of goods and
services in an economy

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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

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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

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Average Inflation Rate Versus Average Money Growth Rate for Selected Countries,
2006–2016

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

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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 Treasury bonds were closely tied
Since then, the relationship is less clear, but the rate of
money growth is still an important determinant of interest
rates

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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

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Fiscal Policy and Monetary Policy
Monetary policy is the management of the money supply and interest
rates
◦ Conducted in the United States by the Federal Reserve System (Fed)
Fiscal policy deals with 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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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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The Foreign Exchange Market
The foreign exchange market: 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.

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International Finance

Financial markets have become increasingly integrated

throughout the world.
The international financial system has tremendous impact on
domestic economies:
◦ How a country’s choice of exchange rate policy affect its
monetary policy?
◦ How capital controls impact domestic financial systems and
therefore the performance of the economy?
◦ Which should be the role of international financial institutions
like the IMF?
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Exchange Rate of the U.S. Dollar, 1973–2017

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

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 Measuring Output and the Price Level
Nominal Gross Domestic Product (Nominal GDP) – the
total value of all goods and services produced in the
economy in a given period (usually one year)
Aggregate income, the total income of factors of
production (land, labor, and capital) from producing
goods and services in the economy during the course
of the year, is equal to aggregate output.
Aggregate price level – a weighted average of the
prices of goods and services

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Real Versus Nominal Magnitudes (1 of 2)
When the total value of final goods and services is calculated using
current prices, the resulting GDP measure is referred to as nominal
GDP. The word nominal indicates that values are measured using
current prices.
A more reliable measure of economic production expresses values in
terms of prices for an arbitrary base year, currently 2012. GDP
measured with constant prices is referred to as real GDP, the word
real indicating that values are measured in terms of fixed prices.

real GDP = nominal GDP x 100

aggregate price level

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 Measuring Output and the Price Level
Consumer price index – an average of prices paid by
consumers
Personal Consumption Expenditure Deflator (PCE) -
price index for personal consumption expenditure in
GDP
GDP deflator – the average of prices for all goods and
services produced in the economy
The aggregate price level is an average of all prices in
the economy.

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 Inflation Rate
The inflation rate – the percentage change in prices over a
period of time, typically one year.

𝑃𝑡 − 𝑃𝑡−1
Inflation rate =
𝑃𝑡−1

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