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Summary ECS3701- Monetary economics exam notes 21
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ESC3701 Monetary Economics IIIESC3701 Monetary Economics III
Part 1
Chapter 1: Why study money, banking and financial markets.
→ A security or financial instrument is a claim on the issuer’s future income or assets (which is any
financial claim or piece of property that is subject to ownership).
→ A bond is a debt security that promises to make payments periodically for a specified period of
time.
→ An interest rate is the cost of borrowing or the price paid for the rental of funds.
→ Financial Crises is a major disruption in the financial markets characterised by a sharp decline in
asset prices and the failure of many financial and non-financial firms.
→ GDP (aggregate output) is the market value of all final goods and services produced in a country
during the course of the year, which excludes purchase of goods that have been produced in the
past and excludes purchase of stocks or bonds. Intermediate goods are not counted.
→ Aggregate income is the total income of factors of production from producing goods and services
per country per year. GDP = Aggregate Income.
→ When GDP is calculate with current prices it is called nominal GDP.
→ GDP measured with constant prices is referred to as real GDP. Therefore values only change if
actual production changed.
→ 3 Aggregate price levels, expressed as price index against base year 100.
nominal GDP
1) GDP deflator =
real GDP
nominal personal consumption expenditures
2) PCE deflator =
real personal consumption expenditures
3) Consumer Price Index measured by pricing a basket of goods and services brought by a
typical urban household.
→ To convert nominal to real divide by price index. Annualised basis is a basis converted to a year.
Meaning of a security and how it facilitates direct lending and borrowing
→ A security or financial instrument is a claim on the issuer’s future income or assets.
→ To facilitate direct lending securities are sold in financial markets where the lender-savers channel
funds to the borrower-spenders.
→ Common securities include bonds or stocks.
→ Securities are assets to the lender-savers and liabilities to the borrower-spenders.
→ Securities facilitate moving funds from people with an excess to the people who have profitable
opportunities.
→ SA the major instrument of monetary policy is the control of an interest rate called the repo rate. →
SARB – sets the repo rate.
→ The repo rate in South Africa is the equivalent of the federal funds rate in the USA.
→ The repo rate is a short-term interest rate which represents an interest rate paid by commercial
banks to the SARB to obtain reserve funding (i.e. borrowing money from the SARB), yet it impacts
on all interest rates in the economy. Thus changes in the repo rate impact the economy at large.
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, ESC3701 Monetary Economics III
Common stock, its purpose and how it affects business investment decisions.
→ A common stock represents a share of ownership in a company.
→ It is a security, and is a claim on the earnings and assets of the corporation.
→ Selling stock is way to raise funds for financing the companies activities.
→ It affects business decisions as higher stocks prices in the stock market mean that the company
will be able to raise more finance through selling stock at higher prices.
List two ways in which the quantity of money may affect the economy
1) Through the aggregate price level
2) Through interest rates.
Difference between nominal and real GDP and their uses
→ Nominal GDP is when the total value of final goods and services is calculated using current prices.
→ Real GDP is calculated with constant prices, given at a base year.
→ Nominal GDP can be misleading as an increase could be due to a rise in the price level or an
actual increase in final good and services.
→ An increase in Real GDP can only be from an increase in final goods and services and not and
increase in prices.
Chapter 2: Overview of financial system
→ Direct finance: borrowers borrow funds directly from financial markets by selling securities
→ Indirect finance: a financial intermediary borrows funds from lender-savers and then uses these
funds to make loans to borrower-spenders.
→ Financial markets are critical for producing an efficient allocation of capital which contributes to
higher production and efficiency for the economy as a whole.
→ Structure of financial markets
1) Debt and Equity Markets
→ Short-term less than a year. 1-10 years are intermediate. > 10 is long-term
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, ESC3701 Monetary Economics III
→ Firms or individuals can obtain funds through issuing debt instruments (bonds/mortgage) or
issue equities (stock)
→ A disadvantage of equities is the holder is a residual claimant, the firm must pay debt holders
first before its equity holders.
→ A advantage to holding equities is the direct benefit of increased firm profits versus the fixed
amounts of debt, because of ownership rights of equities.
→ Brokers are agents of investors who match buyers with sellers, dealers link buyers and sellers by
buying and selling at stated prices.
2) Primary and Secondary Markets
→ Primary market for initial issues of securities (Investment banks).
→ Secondary markets (JSE) make securities more liquid, also set benchmark prices for the
primary market.
3) Exchange and OTC markets
→ Secondary markets.
→ Exchanges, central location where buyers and sellers of securities conduct trades
→ OTC dealers at different locations sell securities to anyone willing to pay their prices. Similarly
competitive to exchanges due to technology.
4) Money and Capital Markets
→ Money market: short-term securities
→ Capital markets: 1 year or greater.1
Financial market instruments
→ Money market short-term debt instruments.
1) US Treasury Bills. Short-term, no interest payments, set payment at maturity, sold at a discount.
Most liquid and safest. Mainly held by banks.
2) Negotiable Bank Certificates of Deposit: a certificate of deposit (CD) is a debt instrument sold
by a bank to depositors that pays annual interest of a given amount and at maturity pays back
the original price. Negotiable CD’s are traded in secondary markets. Big source of funds for
banks.
3) Commercial Paper is a short-term debt instrument issued by large banks and well-know
corporations.
4) Repurchase agreements are effectively short-term loans less than 2 weeks for which Treasury
bills serve as collateral. Big source of funds for banks. Issued mainly by corporations.
5) Federal Funds, overnight loans between banks using their deposits at the Federal reserve.
→ Capital Market for longer term debt.(Riskier than money market)
1) Stocks. Largest security in capital market, Held by households and institutions.
2) Mortgages are loans to households or firms to purchase housing, land or real structures that
serve as collateral. Largest debt market in US.
→ Mortgage back security is a bond like instrument backed by a bundle of individual mortgages
whose interest and principle payments are collectively paid to the holder-of the security.
3) Corporate Bonds. Issued by corporations with strong credit ratings. Convertible bonds can be
changed into stock anytime up till maturity. Principle buyers are life insurance, pension funds
households and other large holders. Not as liquid as government securities. Larger than new
stock issues.
4) US Government Securities. Most liquid security.
5) US Government Agency Securities
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, ESC3701 Monetary Economics III
6) State and Local Government Bonds (Municipal bonds). Issued by state and local governments
for big projects, exempt for income tax. Banks largest holders.
7) Consumer and Bank Commercial Loans.
Indirect finance and 4 financial intermediary functions
→ The basic function of financial markets is to channel funds from savers who have excess funds to
spenders who have a shortage of funds.
→ Direct finance is when borrowers borrow funds directly from lenders by selling them securities
→ The process of indirect finance using financial intermediaries is call financial intermediation.
→ More important source of funds for corporations than securities markets.
→ Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn
use those funds to acquire assets by purchasing securities or making loans.
→ Indirect finance involves an intermediary that stands between lenders and borrows and helps
transfer funds from one to the other.
Transaction Costs / Liquidity services
→ Time and money spent in carrying out financial transactions.
→ Intermediaries can reduce transaction because they benefit from economies of scale due to
expertise and size.
→ Intermediaries provide liquidity services that make it easier for customers to conduct transactions.
e.g Checking accounts to pay bills.
Risk sharing
→ They sell less risky investment and then use the funds to purchase more risky investments.
→ They earn profit on the difference between the returns on risky assets they bought and the
payments made on assets they sold. Also called asset transformation.
→ They help individuals to diversify and thereby lower the amount of risk through low costs and
assets pooling.
Asymmetric information
→ One party does not know enough about the other party to make accurate decisions.
→ Intermediaries are better equipped and can alleviate asymmetric information problems.
→ Two forms
1) Adverse selection
→ Occurs before the transaction
→ Potential borrowers who are the mostly like to produce an undesirable outcome are the ones
who most actively seek out a loan and are thus most likely to be selected.
→ Results in fewer loans to all as lenders hesitate to lend at all.
2) Moral hazard
→ Occurs after the transaction.
→ The risk that the borrower will engage in activities undesirable to the lender hence increase in
chance of default.
→ Reduces loans for all due hesitation to lend.
→ If there were no asymmetric information there could still be a moral hazard problem because
the lender knows there might be a default and reducing such risk is too costly, therefore still a
moral hazard.
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