Why Study Money, Banking, and Financial Markets 1.1 Why Study Financial Markets 1.2 Why Study Banking & Financial Institutions 1.3 Why Study Money & Monetary Policy 1.4 How We Will Study Money, Banking, and Financial Markets
Why Study Financial Markets?
1. Financial markets channel funds from savers to investors (from those who have an excess of available funds to people who have a shortage), thereby promoting economic efficiency 2. Financial markets are a key factor in producing economic growth 3. Financial markets affect personal wealth and behaviour of businesses 3
Financial Securities - Assets
A security (financial instrument) is a
claim on the issuers future income or assets
A financial 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 (the bond market is where interest rates are determined)
An interest rate is the cost of
borrowing (or the price paid on the rental of funds) 5
The Bond Market & Interest Rates
High interest rates could deter purchases, or
investment, and encourage savings
Different interest rates have a tendency to
move in unison (Figure 1-1), perhaps because of this correlation of interest rates economists frequently lump interest rates together and refer to the interest rate
Short-term interest rates tend to fluctuate
more and are lower on average than others 6
The Bond Market & Interest Rates
The Stock Market
Common 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
Corporations issue & sell stock to the
public to raise funds to finance their activities 8
The Stock Market
The stock market is also an important factor in
business investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending (daily vote of confidence)
The stock market is a place where people get
rich and poor quickly with considerable fluctuations in stock prices, which affect the size of peoples wealth (and their willingness to spend) Figure 1-2 9
Stock Market Fluctuations (S&P/TSX)
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Financial Institutions and Banking
Banks and other financial institutions are what make
financial markets work
Financial Intermediaries - institutions that channel funds
from people who have saved to parties who wish borrow (indirect finance)
Financial Crises disruption of the financial markets that
lead to decline in asset prices (can cause significant shortterm disruptions in the real economy non neutrality)
Banks - institutions that accept deposits and make loans
(chartered banks, trust and mortgage loan companies, and credit unions & caisses populaires), these are the financial intermediaries that the average person interacts with most frequently 11
Financial Institutions and Banking
Other Financial Intermediaries - insurance companies,
finance companies, pension funds, mutual funds and investment banks Financial Innovation- in particular, dramatic improvements in information technology have led to new means of delivering financial services electronically (efinance) and higher profits result from creative thinking Changes in Rules & Regulations also influence how financial institutions behave and compete with each other, how we interact with them, how profitable they are, and how much benefit their customers gain (from their services) These, & other, innovations impact the velocity of money (MxV = PxY) 12
Money and Monetary Policy
Money anything that is generally accepted in
payment for goods and services or in the repayment of debts
Evidence suggests that money plays an important role
in generating business cycles (movements in aggregate real output & unemployment) see figs
Recessions (unemployment) and booms (inflation) lead
to changes in aggregate economic activity
Monetary Theory relates changes in the quantity of
money (supplied) to changes in aggregate SR real economic activity and the price level 13
Money and Monetary Policy
Every recession in the 20th century has been
preceded by a decline in the rate of money growth, indicating that changes in money are also a driving force behind business cycle fluctuations (but not every decline in the rate of money growth is followed by a recession)
The Canadian recession that started in late
2008 is sort of an exception (while preceded by such a drop - it started with a financial crisis in the US) 14
M2 Money Supply Growth & Business Cycles (Can)
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Money and Business Cycles
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Money and Inflation
The aggregate price level is the
average price of goods and services in an economy
Inflation - A continual rise in the price level, affects
all economic players & is generally regarded as an important problem of concern to politicians & policymakers
The money supply and the price level generally
move closely together (QTM implies the continuing increase in the money supply might cause the continuing increase in the price level, Figure 1-4)
Inflation is always and everywhere a monetary
phenomenon (Milton Freidman, Figure 1-5) 17
Money and the Price Level
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Money Growth and Inflation
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Money and Interest Rates
Interest rates are the price (over time)
of (borrowing) money
Prior to 1980, the rate of money
growth and the interest rate on longterm bonds were closely tied (Fig 1-6)
Since then, the relationship is less
clear but still an important determinant of interest rates (especially long-term rates Fisher equation) 20
Money Growth and Interest Rates
21
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 decisions about
government spending and taxation
Budget deficit/surplus is the excess of
exps/revenue over revenues/exps for a particular year Any deficit is usually financed solely by borrowing (or sale of government assets) 22
Monetary and Fiscal Policy
Deficits increase the national debt and make it
vulnerable to increases in world interest rates Some believe the ability to issue public debt allows the government to smooth taxes and inflation over time Large budget deficits might lead to a financial crisis and result in (monetization of debt) a higher rate of money growth, a higher rate of inflation, and higher interest rates
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Fiscal Policy Budgetary Balance
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Why Study International Finance?
Increasing integration of financial
markets (continued & growing globalization) Canadian companies borrow in foreign markets and foreign markets borrow from Canada Banks and other financial institutions increasingly international foreign exposures 25
Foreign Exchange Market
The foreign exchange market is where one
countrys currency is exchanged for another
The exchange rate is the price of one
countrys currency in terms of anothers (i.e. it is the relative price of two national currencies)
Throughout this course, the exchange rate
is normally expressed as units of foreign currency (purchased) per Canadian dollar 26
Foreign Exchange Market
Nominal appreciation (depreciation) is a rise
(fall) in the value of a countrys currency (in terms of units of foreign currency it can purchase)
Changes in the exchange rate have direct effects on Canadian
consumers because it affects the cost of foreign goods
A stronger dollar benefits Canadian consumers by making
foreign goods cheaper but hurts Canadian businesses and eliminates some jobs by cutting both domestic (imports are cheaper) and foreign (our exports are more expensive) sales of their products 27
Foreign Exchange Market
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The International Financial System
Larger capital flows between countries
Greater importance of foreign financial systems on domestic economy. Potentially larger role for international institutions (e.g. IMF, WTO, BIS, etc.)
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How We Study Money and Banking
Develop an analytical framework that uses basic economic concepts to organize our thinking Simplified approach (partial equilibrium framework) to the demand for assets (det of asset prices) Basic supply and demand approach to understand behaviour in (and structure of) financial markets Profit maximization Transactions cost and asymmetric information approach to financial structure & bank management Aggregate supply and demand analysis 30
How We Study Money and Banking II
Learning Tools: 1. Case studies 2. Applications 3. Special-interest boxes 4. Financial News boxes 5. Web Exercises and References All present evidence that supports or casts doubts on the theories being discussed 31