1. 1 Chapter 1 Money, Banking, and Financial Markets --An Overview © Thomson/South-Western 2006

2. 2 Overview The role that money, banks, financial markets and the central bank play in a nation’s economy

3. 3 Changes Development of new financial markets and instruments Adoption of single currency by European nations A major consolidation of banking industry U.S. financial crisis: sub-prime market

4. 4 Money And Banking: Key Elements 1.Money 2.Financial intermediaries; Banks 3.Interest rates 4.Government budget deficits (or surpluses)

5. 5 1. Money Money is the stock of items widely used to make payment for goods and services. Money, or the money supply, includes: currency and coins in circulation, checking accounts in depository institutions, and other items, such as Certificates of Deposit (CDs), when measured more broadly.

6. 6 What Determines The Money Supply? The central bank is responsible for the trend or long- run behavior of the money supply In the United States, the central bank is the Federal Reserve System (the Fed) The Fed conducts monetary policy Easy, expansion Tight, contraction

7. 7 Money, Inflation, and Deflation When the money supply increases more rapidly than the output of goods and services, inflation occurs. Inflation targeting: when a central bank announces an explicit inflation range it pledges to maintain and enforces policies consistent with that goal. Deflation is a continuing decline in prices and is more damaging to a nation's economic health than inflation.

8. 8 Money, Inflation, and Deflation (2) Inflation is often associated with a robust economy and high levels of output and employment Deflation is generally accompanied by stagnant or falling output, high unemployment and severe financial distress (farm, home or business foreclosure)

9. 9 2. Banks & Other Financial Intermediaries Intermediaries match savers’ money with borrowers’ funding demands. Intermediaries Money B B B B B S S S S S

10. 10 2. Banks & Other Financial Intermediaries (2) Banks, Depository institutions accept various types of deposits and use the funds attracted primarily to grant loans. These behavior of banks will affect money supply and credit expansion process. Banks are the conduit for central bank’s monetary policy. Banks are older-generation financial intermediaries. Today, other intermediaries like pension funds and insurance companies are playing more important role in capital markets.

11. 11 3. Interest Rates (Yield) The interest rate expressed as a percent per year. the cost of borrowing the return for lending The real interest rate is the interest rate after adjusting for expected inflation. Nominal interest rate = Market interest rate Nominal interest rate – Expected Inflation = Real interest rate

12. 12 3. Interest Rates (Yield) ---2 Key interest rates: prime loan rate (benchmark for setting bank lending rates) 3-month U.S. Treasury securities Yield short-term corporate debt Yield For best customer  prime loan rate For lower credit customer  prime loan rate +..%

13. 13 3. Interest Rates (Yield) ---3 In competitive financial market, interest rates are established by market forces of demand and supply of loans. Central bank can change short-term interest rate by influencing the availability of loans through banks

14. 14 4. The Federal Budget Deficit The federal government’s budget deficit is the annual amount by which federal government expenditures exceed tax revenues collected. The national debt is the cumulative sum of past budget deficits less past surpluses.

15. 15 4. The Federal Budget Deficit (2) Gov. budget deficit (higher national debt) LT effect: Higher demand for loans, interest rate ST effect: Gov spends more, higher investment and employment

16. 16 Key Financial Markets 1.The stock market 2.The bond market 3.The foreign exchange (ForEx) market

17. 17 1. The Stock Market Shares are claims of ownership in individual corporations. A company’s stock share price reflects the opinion of the market about the corporation's continually changing prospects. Companies sell shares to raise fund Investors (shareholders) buy share to get Income Dividends pay out Capital gain/loss Shareholders = Owners of the company

18. 18 2. The Bond Market A bond is a debt instrument issued by a corporation, government, or government agency. A bond’s indenture is an agreement to make a stream of interest payments at specified future dates, and also to return the principal at maturity. Interest rates (or yields) are determined by market forces of supply and demand. Companies sell bonds to raise fund Investors (bondholders) buy bonds to get Income Coupon interest payments Bondholders = Lenders of the company

19. 19 Stock Vs Bond Company (Issuer) Investors (shareholders) Current price Shares D1 Future price D2D3D4 Company (Issuer) (Borrower) Investors (Bondholders) (Creditors) Par $ 1,000 Bond contract $ 50 $ 1,000 $ 50 D ?

20. 20 3. The Foreign Exchange Market The foreign exchange (ForEx) market is where various national currencies are traded. Foreign trade necessitates trade in national currencies in the ForEx market. The exchange rate is the price at which one country's currency exchanges for foreign currency.

21. 21 3. The Foreign Exchange Market (2) The past: Fixed exchange rate Exchange rate is pegged or held constant by direct government intervention At present: Floating exchange rate system Exchange rate is allowed to change continuously to response to market forces of demand and supply. Government occasionally influence it.

22. 22 3. The Foreign Exchange Market (3) Currency appreciation: an increase in value of one nation’s currency relative to other currency. Cost of domestic goods Price of foreign products (Export decreases but import increases) Currency depreciation: a decrease in value of one nation’s currency relative to other currency. Cost of domestic goods Price of foreign products (Export increases but import decreases) so reduce trade deficit…..