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Chapter 1 Why Study Money, Banking, and Financial Markets? Why Study Financial Markets? 1. Channel funds from savers to investors, thereby promoting economic efficiency 2. Affect personal wealth and behavior of business firms Why Study Banking and Financial Institutions? 1. Financial Intermediation Helps get funds from savers to investors 2. Banks and Money Supply Crucial role in creation of money 3. Financial Innovation Why Study Money and Monetary Policy? 1. Influence on business cycles, inflation, and interest rates © 2004 Pearson Addison-Wesley. All rights reserved 1-2 Issues to Address on Financial Markets • What are bonds? What are stocks? • What is the relation between bond prices and interest rates? • Why rate of return can be negative for bonds with positive coupon rate? • What determines the interest rates? • What explains the risk and term structure of the interest rates? • How are stocks priced? • Is the financial market efficient? © 2004 Pearson Addison-Wesley. All rights reserved 1-3 Bond Market © 2004 Pearson Addison-Wesley. All rights reserved 1-4 Stock Market © 2004 Pearson Addison-Wesley. All rights reserved 1-5 Banks and Other Financial Institution • Banks are financial institutions that accept deposits and make loans. • Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. • Other financial institutions include insurance companies, finance companies, pension funds, mutual funds, and investment banks. © 2004 Pearson Addison-Wesley. All rights reserved 1-6 Questions to Address • Why banks are the most important source of external funds used to finance business? • Why is the financial system among the most heavily regulated sectors of the economy? • How to read the balance sheet of commercial banks? • How do banks manage their assets, liabilities and bank capital? • How to analyze interest risk facing banks? • How has the competitive environment changed for banks? • Why are there so many banks in the United States? • How to use financial derivatives to hedge risk? © 2004 Pearson Addison-Wesley. All rights reserved 1-7 Money and Business Cycles • Money is store of value, unit of account and medium of exchange. • Business cycles are the upward and downward movements of aggregate output produced in the economy. • Data: Every recent recession has been preceded by a decline in the rate of money growth. © 2004 Pearson Addison-Wesley. All rights reserved 1-8 Money and Business Cycles © 2004 Pearson Addison-Wesley. All rights reserved 1-9 Money and Inflation • The inflation rate is defined as the growth rate of the aggregate price level. • What explains inflation? • Data: Inflation seems tied with increases in the money supply across time and countries. • Theory: Money’s role in creating inflation (27). © 2004 Pearson Addison-Wesley. All rights reserved 1-10 Issues on Money • How is the money supply determined? • What are tools of monetary policy? • What are the transmission mechanism of the monetary policy? © 2004 Pearson Addison-Wesley. All rights reserved 1-11 Money and the Price Level © 2004 Pearson Addison-Wesley. All rights reserved 1-12 Money Growth and Inflation © 2004 Pearson Addison-Wesley. All rights reserved 1-13 Money Growth and Interest Rates © 2004 Pearson Addison-Wesley. All rights reserved 1-14