ECON F312:

Money, Banking and Financial

Markets
I Semester 2020-21
BITS Pilani
Recapitulation of the Last
Class on 19th August, 2020
• Introduction to the course
• Business news and relationship with various concepts
• Nature and scope of the course
• Learning objectives
• Knowledge to be gained from the course
• Overview of the course
• Course contents and modules
• Evaluation scheme

BITS Pilani, Pilani Campus

Overview of the Course

• Monetary System, Banking System and Financial

System as a whole plays a vital role in the national
economy.
• The total quantity of money and the rate at which that
quantity grows overtime have important implications for
the inflation interest rates, stock prices and economy’s
overall growth.
• Central Bank of the country plays an important role to
regulate the quantity of money and oversee the health of
the banking system and entire financial system with the
help of monetary policy and its instruments.
• At this point, we have a little knowledge about the
functioning of all the systems.
BITS Pilani, Pilani Campus
Course Content in brief and
modules
Module I: Financial System: Financial Markets, Rational Expectation
Hypothesis, Understanding interest rates, Behavior of interest
rates, Risk and Term structure, Efficient Market Hypothesis,
Module II: Monetary System: Money, Money market, Monetary
policy, Central Bank, Conduct of monetary policy: goals and
targets, Monetary transmission mechanism
Module III: Banking System: Banking, The banking firm, Banking and
management of financial institutions, Banking industry; structure
and competition, Economic analysis of banking regulation, Indian
Banking
Module IV: Management of Financial Institutions: International
Financial system and risk management in Financial institutions,
hedging with financial derivatives and Risk management in
Foreign exchange markets.
BITS Pilani, Pilani Campus
 Part – I : Introduction
Chapter 1: Why Study Financial
Markets and Institutions?
BITS Pilani
Chapter 1: Why Study Financial
Markets and Institutions?
Chapter Outline:
 Why Study Financial Markets?
– Debt Market and Interest rates
– The Stock Market
– The Foreign Exchange market
 Why Study Financial Institutions?
– Structure and role of the Financial Intermediaries
– Financial Crisis and the role of FIs
 Central Bank and the Conduct of Monetary Policy

BITS Pilani, Pilani Campus

Why Study Financial Markets?

 Financial markets, such as bond and stock

markets, are crucial in our economy. Part II and V focuses
on Financial Markets.
 These markets channel funds from savers to investors,
thereby promoting economic growth.
 Financial market affects personal wealth, the behavior of
business firms, and economy as a whole
 Hence, well functioning financial markets, such as the
bond market, stock market, and foreign exchange market,
are key factors in producing high economic growth.
 We will briefly examine each of these markets, key
statistics, and how we will study them throughout this
course.

BITS Pilani, Pilani Campus

 Why Study Financial Markets?
Debt Markets & Interest Rates
• A security (financial instrument) is a claim on the issuers
future income or assets.
• Debt markets, or bond markets, allow governments,
corporations, and individuals to borrow to finance their
activities.
• In this market, borrowers issue a security, called a bond,
that promises the timely payment of interest and
principal over some specific time horizon.
• The interest rate is the cost of borrowing.

BITS Pilani, Pilani Campus

 Why Study Financial Markets?
Debt Markets & Interest Rates
• Interest rates are important on a number of levels.
• On personal level, high interest rate could deter you from
buying a car, property, house or durable assets.
• It could encourage you to save more in the expectation
of more earnings.
• High interest could discourage the economic business
and low interest rate encourage the business
• Hence interest rate have impact on both investment and
savings and hence economic growth.
• Because changes in the interest rate have important
effect on decisions made by individuals, financial
institutions, business and hence it has impact on over all
economy, it is important to explain fluctuations.

BITS Pilani, Pilani Campus

Fluctuations in the interest
rate in India
 If we look at the fluctuations of one specific short term
interest rate in India, we could find that…
 The interest rate on 91-day treasury bills peaks at 12.5%
in 1995-96 and this fall to 4.5% in 2003-04.
 It increases to above 7% in 2007-08 then it decreased to
3.5% in 2009-10.
 Again it increased to 8.9% in 2013-14 and it remained
above 8% in 2014-15.
 This rate is one of the many interest rate in the market.
 In the following slide, we have different interest rates
over last 32 years.

BITS Pilani, Pilani Campus

Trends of Interest rates in India

BITS Pilani, Pilani Campus

 Why Study Financial Markets?
Debt Markets & Interest Rates
• The above figure shows that different interest rates have
tendency to move together.
• Economists frequently lump interest rates together and
refer to “the” interest rate. It is also noticed that interest
rate has a co-movement among them. Why?
• The figure also shows interest rates on different assets
can differ substantially. Why?
• In Chapter 2 we will study the role of debt market in the
economy. In Chapters 3 to 5 we will examine the causes
of correlation and deviation among different interest
rates.

BITS Pilani, Pilani Campus

Relationship between interest
rate and economic growth

25

20 Interest rate and Economic growth

15

10

0
3
91 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 07 0 8 0 9 1 0 1 1 1 2 2 -1
9 0- 9 1- 9 2- 9 3- 9 4- 9 5- 9 6- 9 7- 9 8- 9 9- 0 0- 0 1- 0 2- 0 3- 0 4- 0 5- 0 6- 0 7- 0 8- 0 9- 1 0- 1 1- 01
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 2

CALL Money Rate GDP growth (annual %)

BITS Pilani, Pilani Campus

Interest rate and Economics
Growth
 From the above figures, it is found that interest rate and
economic growth are inversely related in the long run.
 This implied the supply leading hypothesis of financial
development and economic growth.
 This is the basis for RBI to reduce interest rates
continuously through its monetary policy stance.
 This is the reason why RBI has been decreasing repo
rate continuously from 8% in 2014 to 4 % in 2020.
 Question arises whether, economic growth has
responded to the cut in repo rate?
 One of the important empirical quest is to find this
relationship in the Indian economy over the years.

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus
Why Study Financial Markets?

The Stock Market

 The stock market is the market where common stock (or
just stock), representing ownership in a company, are
traded.
 Companies initially sell stock (in the primary market) to
raise money. But after the initial offerings, the stock is
traded among investors in the secondary market.
 Secondary market has the credibility of making the stock
marketable and liquid.
 Of all the active markets, the stock market receives the
most attention from the media.
 Today stock market is most volatile market in the
economy.

BITS Pilani, Pilani Campus

Why Study Financial Markets?

The Stock Market

 The Statistics of the Indian stock market shows that it is
extremely volatile.
 A bull market in 2003 culminated to in a peak by January
2007 when Benchmark BSE Sensex rose to a record of
21,206 from 4500 in 2003.
 However, Sensex fell sharply by 50% in early 2008 due
to financial crisis and US recession.
 Again in 2010, it again crossed 20,000 mark, followed by
another dip in 2011.
 Between Jan 2013 and 2015 Sensex crossed 29000
mark.

BITS Pilani, Pilani Campus

Why Study Financial Markets?

The Stock Market

 With further volatility in the stock market it crossed 38,000
mark by 2018.
 These considerable fluctuations in the stock price affect
the size of the people’s wealth and as a result, may affect
the willingness to spend and invest.
 The stock market is also important factor in business
investment decision.
 Price of the share affect amount of fund that can be raised
by selling newly issued stocks to finance investment.
 More is the price more is fund raised and more equipment
can be added. (Business Valuations)

BITS Pilani, Pilani Campus

Stock Prices as measured by
BSE Sensex (1986 to 2020)

BITS Pilani, Pilani Campus

Stock Prices as measured by
BSE Sensex (last 5 years)

41,945

27,590

BITS Pilani, Pilani Campus

Stock price and relationship
with Economic Growth
 BSE Sensex was as high as 41,900 in January 2020 and
fall to 27,590 in April, 2020
 The Sensex is revived to 38,400 in 18th August 2020.
 What about the economic growth?
 What about the economic theory?
 What its predicts?
 There are supply leading hypothesis and demand
following hypothesis in the literature.
 Which one is true and what point of time?
 This is also one empirical quest area of financial
economics.

BITS Pilani, Pilani Campus

80000.00

70000.00

60000.00

50000.00

40000.00

30000.00

20000.00

10000.00

0.00
1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2
0 -9 1 -9 2 -9 3 -9 4 -9 5 -9 6 -9 7 -9 8 -9 9 -0 0 -0 1 -0 2 -0 3 -0 4 -0 5 -0 6 -0 7 -0 8 -0 9 -1 0 -1 1 -1
9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20

MARKET CAPITALISATION - BSE GDP at Const.

BITS Pilani, Pilani Campus

Financial Development and
Growth
 Stock market growth also plays an important role in
economic growth of the country.
 It is clear from the graph that with the growth in market
capitalization, economic growth also increased.
 This also supports the supply leading hypothesis of
Financial Development and Economic Growth against
the demand following hypothesis.

BITS Pilani, Pilani Campus