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

Why Study Financial Markets? Financial markets channel funds from savers to investors, thereby promoting economic efficiency 2. Financial markets are a key factor in producing economic growth 3. Financial markets affect personal wealth and behaviour of business firms

The Bond Market & Interest Rates A security (financial instrument) is a claim on the issuer’s future income or assets An asset is any financial claim that is subject to ownership

The Bond Market & Interest Rates A bond is a debt security that promises periodic payments for a specified time An interest rate is the cost of borrowing or the price paid on the rental of funds Interest rate and the US subprime mortgage crisis

The Bond Market & Interest Rates

The Stock Market A stock represents a share of ownership in a corporation A stock is a security that is a claim on the earnings and assets of that corporation

Stock Market

Ten Largest Canadian Companies by Market Cap Royal Bank of Canada Manulife Financial Bank of Nova Scotia Toronto-Dominion Bank EnCana Corp. Suncor Energy Imperial Oil Cdn. Natural Resources CIBC Bank of Montreal

Foreign Exchange Market The foreign exchange market is where one country’s currency is exchanged for another The exchange rate is the price of one country’s currency in terms of another Appreciation/depreciation is a rise/fall in the value of a country’s currency Recent exchange rate fluctuation of CND

Foreign Exchange Market

Banking and Financial Institutions Financial Intermediaries - institutions that borrow funds from people who have saved and make loans to other people Banks - institutions that accept deposits and make loans Other Financial Institutions - insurance companies, finance companies, pension funds, mutual funds and investment banks Financial Innovation- in particular, the advent of the information age and e-finance

Money and Business Cycles Evidence suggests that money plays an important role in generating business cycles Evidence also suggests that monetary policies are often a response to business cycles Recessions (unemployment) and booms (inflation) affect all of us Mckenzie and Fort St. John

Money and Business Cycles

The decline of money supply is an indication of recession, not the driving force behind recession. Most Canadian recessions are caused by recessions south of border. When was the last recession in Prince George? Was it caused by any monetary policy?

Money and Inflation The aggregate price level is the average price of goods and services in an economy A continual rise in the price level (inflation) affects all economic players Data shows a connection between the money supply and the price level

Money and the Price Level

Question Why inflation rates lower than growth rate of money supply, especially after 1998?

Money Growth and Inflation

Money and Interest Rates Interest rates are the price of money Prior to 1980, the rate of money growth and the interest rate on long-term bonds were closely tied Since then, the relationship is less clear but still an important determinant of interest rates

Money Growth and Interest Rates

The sharp turning point at 1998 was during Asian financial crisis when money flowed to North America, keeping Money Growth Rate High and Interest Rate low. Another point when the direction of money growth rate differ very much from interest rate is at 1985, when oil price reach the lowest point and Iran-Iraq was at war.

Monetary and Fiscal Policy Monetary policy is the management of the money supply and interest rates Conducted by the Bank of Canada Fiscal policy is government spending and taxation Budget deficit/surplus is the excess of expenditures/revenue over revenues/expenditures for a particular year Any deficit must be financed by borrowing

How We Study Money and Banking Basic Analytic Framework Simplified approach to the demand for assets Concept of equilibrium Basic supply and demand approach to understand behaviour in financial markets Search for profits Transactions cost and asymmetric information approach to financial structure Aggregate supply and demand analysis

How We Study Money and Banking (Cont’d) Features: 1.Case studies 2. Applications 3. Special-interest boxes 4. Financial News boxes 6. Web Exercises and References

Appendix: Definitions Aggregate Output Gross Domestic Product (GDP) = Value of all final goods and services produced in domestic economy during year. Aggregate Income - Total income of factors of production (land, capital, labour) during year Nominal = values measured using current prices Real = quantities measured with constant prices

Appendix: Definitions Aggregate Price Level GDP Deflator = Nominal GDP/Real GDP Consumer Price Index = (CPI) price of a “basket” of goods and services Inflation rate = growth rate of the aggregate price level (percent change from previous period)

Note on the definition of inflation Inflation rate often underestimate the cost of housing because new houses only represent a small percentage of housing purchases and even smaller percentage of potential house buyers. Inflation rate is especially not helpful in indicating the difficulty of first time house buyers.

Homework 2, 4, 6, 10