The Economics of Money, Banking, and Financial Markets
Notes on chapter 1/2/12/13
For A1S2
,CHAPTER 1
Study Money, Banking, and Financial Markets?
WHY STUDY FINANCIAL MARKETS?
- financial markets: markets in which funds are transferred from people who have an excess of
available funds to people who have a shortage.
- Financial markets, such as bond and stock markets, are crucial to promoting greater
economic efficiency by channelling 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 behaviour of
businesses and consumers, and the cyclical performance of the economy
Debt Markets and Interest Rates
- Security (also called a financial instrument): a claim on the issuer’s future income or assets
(any financial claim or piece of property that is subject to ownership).
- Bond: a debt security that promises to make periodic payments for a specified period of
time.
- Debt markets, also often generically referred to as bond markets, are especially important to
economic activity because they enable corporations and governments to borrow money to
finance their activities, and because it is where interest rates are determined.
- Interest rate: is the cost of borrowing or the price paid for the rental of funds (usually
expressed as a percentage of the rental of $100 per year).
- Many types of interest rates are found in the economy—mortgage interest rates, car loan
rates, and interest rates on many different types of bonds.
- Interest rates are important on a number of levels:
1. A personal level - high interest rates might deter you from buying a house or a car because
the cost of financing would be high. Conversely, high interest rates might encourage you to
save because you can earn more interest income by putting aside some of your earnings as
savings.
,2. General level - interest rates have an impact on the overall health of the economy because
they affect not only consumers’ willingness to spend or save but also businesses’ investment
decisions. High interest rates, for example, 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 40 years.
- Because different interest rates have a tendency to move in unison, economists frequently
lump interest rates together and refer to “the” interest rate.
- However, interest rates on several types of bonds can differ substantially.
The Stock Market
- A common stock (typically called simply a stock): represents a share of ownership in a
corporation.
- It is 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.
- The stock market, in which claims on the earnings of corporations (shares of stock) are
traded, is the most widely followed financial market in almost every country that has one;
that’s why it’s often called simply “the market.”
- Stock prices are extremely volatile.
- After rising steadily during the 1980s, the market experienced the worst one-day drop in its
entire history on October 19, 1987—“Black Monday”—with the Dow Jones Industrial
Average (DJIA) falling by 22%.
- From then until 2000, the stock market experienced one of the greatest rises (often referred
to as a “bull market”) in its history, with the Dow climbing to a peak of over 11,000.
- These considerable fluctuations in stock prices affect the size of people’s wealth and, as a
result, their willingness to spend.
- 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 shares means that the firm can raise a larger amount of funds,
which it can then use to buy production facilities and equipment.
, 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.
Structure of the Financial System
- The financial system is complex, comprising many different types of private sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and
investment banks, all of which are heavily regulated by the government.
- If an individual wanted to make a loan to General Motors, he or she would not go directly to
the company and offer a loan. Instead, he or she would lend to such a company indirectly
through financial intermediaries, which are institutions that borrow funds from people who
have saved and in turn make loans to people who need funds.
Banks and Other Financial Institutions
- Banks: are financial institutions that accept deposits and make loans.
- The term banks include firms such as commercial banks, savings and loan associations,
mutual savings banks, and credit unions.
- Banks are the financial intermediaries that the average person interacts with most
frequently.
- A person who needs a loan to buy a house or a car usually obtains it from a local bank.
- Because banks are the largest financial intermediaries in our economy, they deserve the
most careful study.
- However, banks are not the only important financial institutions, in recent years, other
financial institutions, such as insurance companies, finance companies, pension funds,
mutual funds, and investment banks, have been growing at the expense of banks, so we
need to study them as well.
Financial Innovation
Financial Crises
