1. Economics 330 – Money and Banking M and W from 3:30pm to 4:45pm Text: Cecchetti and Schoenholtz: Money, Banking, and Financial Markets, McGraw Hill, 4th edition.

2. Who am I ? Dr. John Neri Office Hours: M and W from 10:30am to 11:30am. Office: Morrill Hall, Room 1106

3. Who you are: Accounting – 10 Info Sys – 6 Computer Science – 2 IAP - 25 LTSC - 38 Sup MGMT - 1 Economics – 98 Foreign Exch - 4 Finance – 32 Kinesiology - 1 G & P – 5 Sociology - 1 Intl. Bus - 2 Marketing – 4 Journalism - 1

4. Course Webpage http://www.terpconnect.umd.edu/~jneri/Econ330 NOTE: upper-case E

5. Can you define each of the following? Federal Reserve System FOMC Federal Funds Market Federal Funds Rate Discount Loan Discount Rate Open Market Operation Quantitative Easing  QE 1, 2 and 3 Operation Twist MBS Money Market Capital Market Sub-prime Mortgage Shadow Banking System MMMF Large Scale Asset Purchase Term Structure Financial Intermediary

6. What is this?

7. Cecchetti - Chapter One An Introduction to Money and the Financial System

8. Learning Objectives In this chapter we cover: 1.The six parts of the financial system 2.The five core principles of money and banking

9. Six Parts of the Financial System 1.Money Used to pay for purchases and store wealth. 2.Financial Instruments Contracts used to transfer resources from savers to investors and to transfer risk to those best equipped to bear it. 3.Financial Markets To buy and sell financial instruments. 4.Financial Institutions Provide access to financial markets, collect information & provide services. 5.Regulatory Agencies Provide oversight for financial system. 6.Central Banks Monitor financial Institutions and stabilize the economy.

10. Six Parts of the Financial System 1.Money  Facilitates transactions  Money has changed over time from gold/silver coins to paper currency to electronic funds.  Cash can be obtained from an ATM any where in the world.

11. Six Parts of the Financial System 2.Financial instruments  Contracts used to transfer resources from savers to investors  Loans, bonds, stocks. Buying and selling individual stocks used to be only for the wealthy. Today we have mutual funds and other stocks available through banks or online.  Contracts used to transfer risk

12. Six Parts of the Financial System 3.Financial Markets  Allow the buying and selling of financial instruments easily  Went from being in coffee houses and tavern to well organized markets like the New York Stock Exchange.  Now transactions are mostly handled by electronic markets. This has reduced the cost of processing financial transactions making the way for a much broader array of financial instruments available.

13. Six Parts of the Financial System 4.Financial Institutions  Provide all the services of the financial system like providing access to financial markets and gathering information  Banks began as vaults, developed into institutions that accepted deposits and gave loans, and evolved to today’s financial supermarket.

14. Six Parts of the Financial System 5.Government regulatory agencies  Make sure the elements of the financial system operate safely and reliably.  Government regulatory agencies were introduced by federal government after the Great Depression.  They provide wide-ranging financial regulation, rules, and supervision; and examine the systems a bank uses to manage its risk.

15. Six Parts of the Financial System 6.Central banks  They monitor and stabilize the financial system  Central banks control the availability of money and credit to promote low inflation, high growth and stability of financial system.  Today’s policymakers strive for transparency in their operations.  The Financial crisis of 2007-2009 have lead the US central bank to try many new policy tools.

16. Five Core Principles of Money and Banking 1.Time has value. 2.Risk requires compensation. 3.Information is the basis for decisions. 4.Markets determine prices and allocation resources. 5.Stability improves welfare.

17. Five Core Principles of Money and Banking Core Principle 1: Time has value Time affects the value of financial instruments. Interest is paid to compensate the lenders for the time the borrowers have their money. Chapter 4 develops an understanding of interest rates and how to use them.

18. Five Core Principles of Money and Banking Core Principle 2: Risk requires compensation In a world of uncertainty, individuals will accept risk only if they are compensated. In the financial world, compensation comes in the form of explicit payments: the higher the risk the bigger the payment.

19. Five Core Principles of Money and Banking Core Principle 3: Information is the basis for decisions The more important the decision, the more information we gather. Collection and processing of information is the foundation of the financial system.

20. Five Core Principles of Money and Banking Core Principle 4: Markets determine prices and allocate resources Markets are the core of the economic system. Markets channel resources and minimize the cost of gathering information and making transactions. In general, the better developed the financial markets, the faster the country will grow.

21. Five Core Principles of Money and Banking Core Principle 5: Stability improves welfare A stable economy reduces risk and improves everyone's welfare. Financial instability in the autumn of 2008 triggered the worse global downturn since the Great Depression. A stable economy grows faster than an unstable one. One of the main roles of central banks is stabilizing the economy.

22. Well Functioning Financial System Promotes Economic Efficiency Facilitate Payments – currency, commercial bank checking accounts Channel Funds from Savers to Borrowers Enable Risk Sharing - Classic examples are insurance and forward markets

23. 1. Facilitate Payments Cash transactions (Trade value for value). Could hold a lot of cash on hand to pay for things. Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs Make transactions easier.

24. 2. CHANNEL FUNDS FROM SAVERS TO BORROWERS Lending is a form of trade ( Trade value for a promise) Give up purchasing power today in exchange for purchasing power in the future. Savers: have more funds than they currently need; would like to earn capital income Borrowers: need more funds than they currently have; willing and able to repay with interest in the future.

25. 2. CHANNEL FUNDS FROM SAVERS TO BORROWERS Why is this important? A) Allows those without funds to exploit profitable investment opportunities. Examples: Commercial loans to growing businesses; Venture capital; Student loans (investment in human capital); investment in physical capital and new products/processes crucial to economic growth.

26. 2. CHANNEL FUNDS FROM SAVERS TO BORROWERS B) Financial System allows the timing of income and expenditures to be decoupled. - Household earning potential starts low, grows rapidly until the mid 50s, then declines with age. Financial system allows households to borrow when young to prop up consumption (mortgages, car loans), repay and then accumulate wealth during middle age, then live off wealth during retirement.

27. TIMING OF INCOME AND EXPENDITURES DECOUPLED Consumption Income Dissaving Saving Dissaving $ Time Retirement Begins

28. 3. Risk Sharing The world is an uncertain place. The financial system allows trade in risk. Two principal forms of trade in risk are insurance and forward contracts. Trade value for a Promise

29. Risk Sharing Example Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to replace lost income to provide for their family. Options ?

30. The Bond Market and Interest Rates A bond is a debt security that promises to make payments periodically for a specified period of time  A security (a financial instrument) is a claim on the issuer’s future income or assets The interest rate is the cost of borrowing.  Price paid for the rental of funds, expressed as a percentage.  Pay $5.00 to rent $100 for one year - 5.0% interest

31. Interest Rates on Selected Bonds, 1950–2015 Three things this graph demonstrates?? 3-month Bill 10-year Treasury 10-year Corporate Baa

33. The Stock Market Common stock represents a share of ownership in a corporation  An equity security (financial instrument) that is a claim on the residual earnings and assets of the corporation  Residual claim Firms can issue new shares to finance investment spending

34. Mishkin Figure 2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2014

35. Shiller: Real Terms. Note the behavior of price relative to earnings. Mishkin starts at 1950.

37. Financial Institutions and Banking Financial Intermediaries: institutions that “borrow funds from” (“issue liabilities to”) people who save and make loans to other people:  Commercial Banks: accept deposits and make loans  Other financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks

38. deposits Loans Insurance Policies Bonds Stocks Retirement Plans StocksShares Bonds Stocks Commercial paper T-Bills Shares/ “deposits” Commercial Banks Insurance Companies Pension FundsMutual Funds Money Market Mutual Funds

39. Money and Economic Activity (Business Cycles) Evidence suggests that money plays an important role in generating business cycles  Recessions and expansions in economic activity Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level

40. Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2008 Note: Shaded areas represent recessions.

41. The aggregate price level is the average price of goods and services in an economy  A continual rise in the price level is inflation - affects all economic players Data shows a connection between the growth in the money supply and the rate of inflation

42. Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007 Source: International Financial Statistics.

43. Examples of Hyperinflation: 1980s and Early 1990s

44. M2 Money Growth and Inflation - US

45. Mankiw Inflation and Nominal Interest Rates

46. Inflation and Nominal Interest rates