Chapter 1 Why Study Money, Banking, and Financial Markets Money and Banking Chapter 1 Why Study Money, Banking, and Financial Markets

Questions for the Semester What are financial markets? Why are they important for the economy? What role do banks play in the economy? Why do they matter so much? What are interest rates? How are interest rates determined? How can we link the financial system with the real economy?

Learning Objectives Recognize the importance of financial markets in the economy. Describe how financial intermediation and financial innovation affect banking and the economy. Identify the basic links among monetary policy, the business cycle, and economic variables.

Financial Markets Markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds Demand Funds (Investment) Excess Funds (Savings) Financial Markets (Stocks/Bonds) Brings funds directly from savers to borrowers

Financial Markets - Bonds Bonds are certificates of indebtness Can be issued by corporations or governments Issuer (firm/government) issues a bond with a certain face value Saver purchases the bond – giving the issuer the face value of the bond In return, saver receives interest payments until the bond matures At bond maturity – issuer pays saver face value back Interest rates determine the cost to borrow funds The interest rate of a bond – the amount of interest payments (share of face value) that the issuer must pay the saver Price of the loan

Interest Rates on Selected Bonds 1950–2014

Wall Street Journal Data – Group Work Log on the wsj.com Go to http://online.wsj.com/mdc/public/page/mdc_bonds.html Which bonds have the highest yields (interest)? Which have the lowest? With your group, choose three US bonds you want to look at What are the rates today? How are they different among the three bonds? Why are they different? How has the bond price changed over the last month, six months, 1 year, 5 years?

Financial Markets - Stocks Common stock represents a share of ownership in a corporation. A share of stock is a claim on the residual earnings and assets of the corporation. Stock price – determined by company valuation (expected profits) which drive demand for the stock Stock Index (SP500, Dow Jones, Nasdaq) – Index that tracks a combination of stocks from companies in various industries Tracks the progress of the market overall Index is down – stock values for most firms are down

Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2014

Wall Street Journal Data – Group Work Go back to http://online.wsj.com/mdc/public/page/mdc_bonds.html Click on U.S Stocks What is happening with the major stock indices? Are the moving the same direction (all positive, all negative)? Check their progress over the last 1 month, 6 months, 1 year, 5 years. What do you observe?

Financial Intermediaries Institutions that borrow funds from people who have saved and in turn make loans to other people Excess Funds (Savings) Demand Funds (Investment) Financial Intermediary (Banks) Loans with Banks Deposits in Banks Bank works as a middleman that takes deposits from savers and issues loans to borrows Other financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment companies

Why are banks important? Banks (financial intermediaries) help facilitate economic activity Take money from people who aren’t using it (deposits of savers) Give it to people that need it for economic activity (borrowers of loans) Improve information flow between savers and borrowers Mitigate risk by vetting the borrowers to see if they are qualified Promote saving by people Contribute to the flow of money through the economy

What is money? Money is an asset used to transact in the economy – used to buy goods and services Medium of Exchange – buy goods with it Unit of Account – use it to state the value of a good Store of Value – keeps its “worth” overtime Money plays an important role in the generation of business cycles Changes in monetary policy or in money demand affect the real economy in the short run

From EC 12 – Monetary Policy + AD Changes in the money supply – change interest rates and investment spending – therefore impact AD Increase in MS  decrease interest rates  increase Investment  increase AD Increase AD  increase output and increase price level Decrease in MS  increase interest rates  decrease Investment  decrease AD Decrease AD  decrease output and decrease price level Changes in MS – affect the price level and real economy

Money Growth and the Business Cycle in the United States 1950–2014

Money and Interest Rates Interest rates are the price of money At low price level – value of money is high People can hold less money to buy the same stuff Put more wealth in interest bearing assets Interest rates are high At high price level – value of money is low People need to hold more money to buy the same stuff Put less wealth in interest bearing assets Interest rates are low

Key Takeaways Throughout the semester – we will study each of these topics in depth Financial markets – stocks and bonds Interest rates Banking system Money, Monetary Policy and the Aggregate Economy