Monetary Economic – ECS3701
CHAPTER 1 - WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS.
WHY STUDY FINANCIAL MARKETS
Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a proper use to people who ...
Monetary Economic – ECS3701
CHAPTER 1 - WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS.
WHY STUDY FINANCIAL MARKETS
Financial markets such as bond and stock markets are crucial to promoting greater economic efficiency by
channeling funds from people who do not have a proper use to people who do. Well functioning financial markets
are a key to producing high economic growth and have direct effects on personal wealth, behavior on business
consumers and the cyclical performance of the economy.
The Bond Market and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets. The bond market is
important because it enables corporations and governments to borrow to finance their activities and because it is
where interest rates are determined.
A bond is a debt that promises to make payments periodically for a specific period of time.
An interest rate is the cost of borrowing or the price paid for the rental of funds. Interest rates are important
because:
1. Higher rates could deter one from borrowing to buy a house or car.
2. Conversely, higher rates could encourage one to save money as cost of borrowing is higher.
3. They impact the general health of the economy as they affect consumers and business’s willingness to
spend, save or make investment decisions.
The Stock Market
A common stock represents a share of ownership in a corporation. It is a security claim on the earnings and assets
of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their
activities.
‘The market’ is a place where people can get rich – or poor – quickly.
The stock market is important as the price of the shares affects the amount of funds that can be raised be selling
newly issued stock to finance spending, a higher price means more funds.
WHY STUDY FINANCIAL INSTITUTIONS AND BANKING?
Banks and other financial institutions are what makes financial markets work, without them, financial markets
would not be able to move funds from people who save to people have productive investment opportunities.
Structure of the Financial System
The financial system is complex comprising of many different institutions such as banks, insurance companies,
mutual funds, finance companies and investment banks. Financial intermediaries borrow money from people who
have saved and in turn make loans to others. The cost being the interest rate.
Financial Crisis
A financial crisis is a major disruption in the financial markets that are characterized by sharp declines in assets
prices and the failures of many financial and nonfinancial firms. Defaults in subprime residential mortgages led to
major losses in the financial institutions producing two of the largest banks to fails, Bear Sterns and Lehman
Brothers causing the worst crises since the financial depression, starting in August 2007.
H. Crassas Page 1
, ECS3701 – Monetary Economics - 2014
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. These include commercial banks, savings and
loans associations, mutual savings banks & credit unions. Banks are the most interacted financial intermediaries
but other financial institutions such as insurance companies, finance companies, pension funds, mutual funds
have been growing at the expense of banks.
Financial Innovation
Financial Innovation is the development of new financial products and services is important as it makes the
financial system more efficient. It can also have a ‘dark side’ and lead to a financial crisis. Financial innovation
shows us how creative thinking can lead to profits or result in financial disasters. It provides clues how the
financial system may change over time.
WHY STUDY MONEY AND MONETARY POLICY?
Money or money supply is defines as anything that is generally accepted in payment for goods or services or in
the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important
to the health of the economy.
Money and Business Cycles
Why do economies undergo such pronounced fluctuations? Evidence shows money plays an important role in
generating business cycles, the upward and downward movement of aggregate output (the total production of
goods and services), produced in the economy. When output is raising unemployment decreases, when output is
falling, unemployment increases.
Recessions are periods of declining aggregate output we see that the rate of money growth has declined before
almost every recession indicating that changes in money might be the driving force behind business cycle
fluctuations but not every decline in money growth is followed by a recession.
Money and Inflation
The average price of goods and services in an economy is called the aggregate price level, or simply the price level.
Inflation is a continual increase in the price level and effect individuals, businesses and government.
What explains inflation? Data seems to indicate that a continuing increase in the money supply may be an
important factor of increasing inflation.
Evidence has found that the countries with the highest average inflation rate also have the highest interest rates.
Money and Interest Rates
Money also plays an important role in interest rate fluctuations. We analyze the relationship between money and
interest rates in Chapter 5.
Conduct of Monetary Policy.
The conduct of monetary policy is the management of money and interest rates. The central bank is responsible
for a nation’s monetary policy. In SA we have the South African Reserve Bank. The US has the Federal Reserve
System.
H. Crassas Page 2
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