Mishkin Ch. 1 - 6, 9, 14, 15
Chapter 1 – Why Study Money, Banking, and Financial Markets? (p48-60)
Why Study Financial Markets?
Financial markets are markets in which funds are transferred from people who have an excess of
available funds to people who have a shortage. Financial markets are crucial to promoting greater
economic efficiency by channeling 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.
The Bond market and Interest Rates
- A security (a financial instrument) is a claim on an issuer’s future income or assets (any financial
claim or piece of property that is subject to ownership).
- A bond is a debt security that promises to make periodic payments for a specified period of
time. The bond market is important to economic activity as it enables corporations and
governments to borrow money to finance their activities, and it is where interest rates are
determined.
- An interest rate is the cost of borrowing or the price paid for the rental of funds. There are
many types of interest rates (mortgage interest rates, car loan rates, interest rates on different
types of bonds).
Þ High interest rates = not buying a house or a car because the cost of financing would
be high.
Þ High interest rates = encourages saving because you can earn more interest income
Because different interest rates might move in unison, economists group 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 stock): a share of ownership in a corporation. It is a security that is a
claim on the earnings and assets of a corporation. Issuing stock and selling it is a way for corporations
to raise funds to finance activities. The stock market (“the market”) is the market in which claims on the
earnings of corporations (shares of stock) are traded.
Stock prices can be very volatile. Considerable fluctuations in stock prices affect the size of people’s
wealth and their willingness to spend.
- The stock market is also an important factor in business investment decisions, as 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 = firm can raise a larger amount of
funds.
Structure of the Financial System
The financial system is complex, including many types of private sector financial institutions (banks,
insurance companies, mutual funds, finance companies, and investment banks).
An individual cannot go to the president of a company and offer a loan. 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. “Banks” include firms such as
commercial banks, savings and loan associations, mutual savings banks, and credit unions.
Banks are the financial intermediaries that people interact with most frequently. A person who needs
a loan to buy a house usually obtains it from a local bank.
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,Financial Innovation
Financial innovation is the development of new financial products and services. E-finance is part of this,
which is the ability to deliver financial services electronically. Financial innovation shows us how
creative thinking on the part of financial institutions can lead to higher profits but can also sometimes
result in financial disasters.
Financial Crises
At times, the financial system seizes up and produces financial crises, which are disruptions in financial
markets that are characterized by sharp declines in asset prices and the failures of many financial and
nonfinancial firms. Financial crises are typically followed by severe business cycle downturns.
Why Study Money and Monetary Policy?
Money, or money supply, is defined as anything that is generally accepted as payment for goods or
services or in the repayment of debts. Money is linked to changes in economic variables and are
important to the health of the economy.
Money and Business Cycles
The total production of goods and services is called aggregate output. The unemployment rate is the
percentage of the available labor force unemployed.
Money plays an important role in generating business cycles, which is the upward and downward
movement of aggregate output produced in the economy. When output is rising, it is easier to find a
good job; when output is falling, finding a good job might be difficult. Recessions are periods of declining
aggregate output. The monetary theory is the theory that relates the quantity of money and monetary
policy to changes in aggregate economic activity and inflation.
Money and Inflation
The prices of most items are quite a bit higher now than they were
before. The average price of goods and services in an economy is called
the aggregate price level or, more simply, the price level.
Inflation, a continual increase in the price level, affects individuals,
businesses, and the government. It is regarded as an important problem
to be solved. However, what explains inflation? The price level and the
money supply generally rise together. A continuing increase in money
supply might be an important factor in causing continuing increase in
price level that we call inflation.
The average inflation rate is the rate of change of the price level, usually
measured as a percentage change per year. There is a positive
association between inflation and the growth rate of money supply: countries with the highest inflation
rates are also the ones with the highest money growth rates.
Money and Interest Rates
In addition to other factors, money plays an important role in interest-rate fluctuations, which are of
great concern to businesses and consumers. As the money growth rate rises the long-term bond rate
rises with it.
Conduct of Monetary Policy
Because money affects many economic variables that are important to the well-being of the economy,
politicians and policymakers throughout the world care about the conduct of monetary policy, the
management of money and interest rates. The organization responsible for the conduct of a nation’s
monetary policy is the central bank. The United States’ central bank is the Federal Reserve System (“the
Fed”).
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,Fiscal Policy and Monetary Policy
Fiscal policy involves decisions about government spending and taxation.
A budget deficit is an excess of government expenditures with respect to tax revenues.
A budget surplus arises when tax revenues exceed government expenditures.
The government must finance any budget deficit by borrowing, whereas a budget surplus leads to a
lower government debt burden. The gross domestic product (GDP) is a measure of aggregate output.
Normally, budget surpluses are a good thing, and deficits are undesirable.
The Foreign Exchange Market
For funds to be transferred from one country to another, they have to be converted from the currency
of the country of origin into the currency of the country they are going to. The foreign exchange market
is where this conversion takes place. It is also where the foreign exchange rate, the price of one
country’s currency in terms of another’s, is determined.
A change in the exchange rate has a direct effect on (American) consumers because it affects the cost
of imports. A weaker dollar leads to more expensive foreign goods, makes vacationing abroad more
expensive, and raises the cost of imported goods. When the value of the dollar drops, Americans
decrease their purchases of foreign goods and increase their consumption of domestic goods.
Conversely, a strong dollar means that U.S. goods exported abroad will cost more in foreign countries,
and hence foreigners will buy fewer of them.
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, Chapter 2 – An Overview of the Financial System (p68-82)
Function of Financial Markets
Financial markets perform the economic function of
channeling funds from households, firms, and governments
that have saved surplus funds to those that have a shortage
of funds.
The lender-savers are households, business enterprises and
the government, as well as foreigners and their government.
The most important borrower-spenders are businesses and
the government, but households and foreigners also borrow
to finance their purchases.
Funds flow from lender-savers to borrower-spenders via
two routes.
1. Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling lenders
securities (financial instruments). Securities are assets for the person who buys them but
liabilities (IOUs or debts) for the individual or firm that sells (issues) them.
2. Indirect finance: involves financial intermediary that borrows funds from lender-savers and
makes a loan to borrower-spenders using these funds. The process of indirect financing using
intermediaries is called financial intermediation (primary route for moving funds from lenders
to borrowers).
Why is the channeling of funds from savers to spenders important to the economy?
Financial markets are essential to promoting economic efficiency, as it is hard to transfer funds from a
person who has no investment opportunities to one who has them.
Financial markets allow funds to move from people who lack productive investment opportunities to
people who have such opportunities. Financial markets are critical for producing an efficient allocation
of capital (wealth that is employed to produce more wealth), which contributes to higher production
and efficiency for the economy. Well-functioning financial markets also directly improve the well-being
of consumers by allowing them to time their purchases better. They provide funds to young people to
buy what they need (and will eventually be able to afford) without forcing them to wait until they have
saved up the entire purchase price. Financial markets that are operating efficiently improve the
economic welfare of everyone in the society.
Debt and Equity Markets
There are two methods to obtain funds in a financial market:
1. The issuance of a debt instrument (bond or mortgage)
• A contractual agreement by the borrower to pay the holder of the instrument fixed dollar
amounts at regular intervals (interest and principal payments) until a specified date (the
maturity date).
The maturity of a debt instrument is the number of years (term) until its expiration date.
A debt instrument is short-term if its maturity term is less than a year and long- term if its
maturity term is ten + years. Debt instruments with a maturity term between one - ten years
are intermediate-term.
2. The issuance of equities (common stock)
• If you own one share of common stock in a company that has issued 10 shares, you are entitled
to 1/10 of the firm’s net income and 1/10 of the firm’s assets. Equities often make periodic
payments (dividends) to their holders and are long-term securities because they have no
maturity date. Owning stock means you own a portion of the firm and have the right to vote
on issues important to the firm.
The main disadvantage of owning a corporation’s equities over its debt is that an equity holder is a
residual claimant; the corporation must pay all its debt holders before it pays its equity holders.
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