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ECS3701 NOTES
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- University Of South Africa (Unisa)
ECS3701 (MONETARY ECONOMICS)COMPLETE, CLEAR & VERY GOOD NOTES
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ECS3701 – Monetary EconomicsMonetary Economic – ECS3701
CHAPTER 1 - WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS.
WHY STUDY FINANCIAL MARKETS
Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a proper use to people who do. Well functioning financial markets
are a key to producing high economic growth and have direct effects on personal wealth, behavior on business
consumers and the cyclical performance of the economy.
The Bond Market and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets. The bond market is
important because it enables corporations and governments to borrow to finance their activities and because it is
where interest rates are determined.
A bond is a debt that promises to make payments periodically for a specific period of time.
An interest rate is the cost of borrowing or the price paid for the rental of funds. Interest rates are important
because:
1. Higher rates could deter one from borrowing to buy a house or car.
2. Conversely, higher rates could encourage one to save money as cost of borrowing is higher.
3. They impact the general health of the economy as they affect consumers and business’s willingness to
spend, save or make investment decisions.
The Stock Market
A common stock represents a share of ownership in a corporation. It is a security 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 market’ is a place where people can get rich – or poor – quickly.
The stock market is important as the price of the shares affects the amount of funds that can be raised be selling
newly issued stock to finance spending, a higher price means more funds.
WHY STUDY FINANCIAL INSTITUTIONS AND BANKING?
Banks and other financial institutions are what makes financial markets work, without them, financial markets
would not be able to move funds from people who save to people have productive investment opportunities.
Structure of the Financial System
The financial system is complex comprising of many different institutions such as banks, insurance companies,
mutual funds, finance companies and investment banks. Financial intermediaries borrow money from people who
have saved and in turn make loans to others. The cost being the interest rate.
Financial Crisis
A financial crisis is a major disruption in the financial markets that are characterized by sharp declines in assets
prices and the failures of many financial and nonfinancial firms. Defaults in subprime residential mortgages led to
major losses in the financial institutions producing two of the largest banks to fails, Bear Sterns and Lehman
Brothers causing the worst crises since the financial depression, starting in August 2007.
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,ECS3701 – Monetary Economics
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. These include commercial banks, savings and
loans associations, mutual savings banks & credit unions. Banks are the most interacted financial intermediaries
but other financial institutions such as insurance companies, finance companies, pension funds, mutual funds
have been growing at the expense of banks.
Financial Innovation
Financial Innovation is the development of new financial products and services is important as it makes the
financial system more efficient. It can also have a ‘dark side’ and lead to a financial crisis. Financial innovation
shows us how creative thinking can lead to profits or result in financial disasters. It provides clues how the
financial system may change over time.
WHY STUDY MONEY AND MONETARY POLICY?
Money or money supply is defines as anything that is generally accepted in payment for goods or services or in
the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important
to the health of the economy.
Money and Business Cycles
Why do economies undergo such pronounced fluctuations? Evidence shows money plays an important role in
generating business cycles, the upward and downward movement of aggregate output (the total production of
goods and services), produced in the economy. When output is raising unemployment decreases, when output is
falling, unemployment increases.
Recessions are periods of declining aggregate output we see that the rate of money growth has declined before
almost every recession indicating that changes in money might be the driving force behind business cycle
fluctuations but not every decline in money growth is followed by a recession.
Money and Inflation
The average price of goods and services in an economy is called the aggregate price level, or simply the price level.
Inflation is a continual increase in the price level and effect individuals, businesses and government.
What explains inflation? Data seems to indicate that a continuing increase in the money supply may be an
important factor of increasing inflation.
Evidence has found that the countries with the highest average inflation rate also have the highest interest rates.
Money and Interest Rates
Money also plays an important role in interest rate fluctuations. We analyze the relationship between money and
interest rates in Chapter 5.
Conduct of Monetary Policy.
The conduct of monetary policy is the management of money and interest rates. The central bank is responsible
for a nation’s monetary policy. In SA we have the South African Reserve Bank. The US has the Federal Reserve
System.
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,ECS3701 – Monetary Economics
Fiscal Policy and Monetary Policy
Fiscal policy involves decisions about government appending and taxation. A budget deficit is the excess of
government expenditure over tax revenues for a particular time period. A budget surplus is when tax revenues
exceed government expenditure. The government must finance any deficit by borrowing. We explore if budget
deficits are a good thing and why deficit may result in higher rate of money growth, higher inflation and higher
interest rates.
APPENDIX TO CH 1: DEFINING AGGREGATE OUTPUT, INCOME, THE PRICE LEVEL AND THE INFLATION RATE.
AGGREGATE OUTPUT AND INCOME
Gross domestic product: The most common measure of aggregate output is the market value of all final goods
and services produced in a country during the course of the year. It excludes two sets of items:
1. Purchases of goods that have been produced in the past.
2. Purchases of stocks or bonds.
Aggregate income: is the total income of the factors of production (land, labour, capital) from producing goods
and services in the economy during the year.
REAL VERSUS NOMINAL MAGNITUDES
Nominal GDP – When the total value of goods and services are calculated using current prices. Nominal indicates
values measured at current prices.
Real GDP – Expresses values of economic production in terms of prices for an arbitrary base year. Real GDP
measures the quantities of goods and services and do not change because the prices have changed.
AGGREGATE PRICE LEVEL
Three measures of aggregate price level are encountered in economic data:
1. GDP Deflator – Typically measures of the price level are presented in the form of a price index, which
expresses the price level for the base year as 100. It is defined as the nominal GDP divided by the real GDP.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
2. PCE Deflator – Similar to GDP deflator and is defined as nominal Persons Consumption Expenditures (PCE)
divided by real PCE.
3. Consumer Price Index (CPI) – is measured by pricing a ‘basket’ of goods and services bought through a
typical household. The CPI is als expressed as a price index with the base year equal to 100.
GROWTH RATES AND THE INFLATION RATE
The media often talk about the economy’s growth rate and the growth rate of real GDP. A growth rate is defined
as the percentage change in variable, i.e.
𝑋𝑡 −𝑋𝑡−1
𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑥 = 𝑋𝑡−1
𝑥 100
Where t indicates today and t-1 a year earlier.
The inflation rate is defined as the growth rate of the aggregate price level.
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, ECS3701 – Monetary Economics
CHAPTER 2 – AN OVERVIEW OF THE FINANCIAL SYSTEM
FUNCTION OF FINANCIAL MARKETS
In direct finance, borrowers borrow funds
directly from lenders in financial markets by
selling the securities which are claims on the
borrowers future income or assets.
Securities are assets for the person who buys
them but liabilities for the individual or firms
that sells/issues them.
Financial markets allow funds to move from
people who lack productive investment
opportunities to people who have these
opportunities.
They are crucial for the efficient allocation of
capital, which contribute to higher production
and efficiency.
STRUCTURE OF FINANCIAL MARKETS
Debt and equity markets
One can obtain funds in two ways, the most common method is to issue a debt instrument such as a bond or a
mortgage which is a contractual agreement by the borrower o pay the holder of the instrument a fixed amount
over a certain period of time.
The maturity of a debt instrument is the number of years until the instruments expiration date. A debt instrument
is short-term if it is less than a year, and long-term if it is more than 10 years. 1 – 10 year debt instruments are said
to be intermediate-term instruments.
The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the
net income and assets of a business. Equities make payments in term of dividends to their holders and known as
long-term securities as they have no maturity.
Primary and Secondary Markets
A primary market is a financial market in which new issues of a security, such as a bond or stock, are sold to initial
buyers by the corporation borrowing the funds.
A secondary market is a financial market in which securities that have previously been issued can be resold.
An important financial institution that assists in the initial sale of securities in the primary market is the
investment bank. It does this by underwriting securities, it guarantees a price for corporation’s securities and then
sells them to the public. Examples include; stock exchanges, forex markets, futures markets and options markets.
Brokers are agents of investors who match buyers with sellers of securities, dealer’s link buyers and sellers by
buying and selling securities as stated prices.
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