Transcript Lecture 1 Chapter 1PPT

Economics 330 – Money and Banking
• T and Th from 9:30am to 10:45am
• Text: Mishkin, Frederic: The Economics
of Money, Banking, and Financial
Markets, Addison-Wesley, Business
School Edition, 4th, 3rd or 2nd edition.
Who am I ?
• Dr. John Neri
• Office Hours: T and Th from 3:30pm to
4:30pm.
• Office: Morrill Hall, Room 1102B
Who you are: (238 students) as of 1/22/16
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Accounting – 8
Computer Science – 4
LTSC - 70
Economics – 89
Finance – 30
G&P–6
Intl. Bus - 1
Marketing – 6
BioSci Chem - 2
Info Sys – 4
Sup MGMT - 8
Foreign Exch - 6
Course Webpage
• http://www.terpconnect.umd.edu/~jneri/Econ330
NOTE: upper-case E
Can you define each of the following?
• Federal Reserve System
• MBS
• FOMC
• Money Market
• Federal Funds Market
• Capital Market
• Federal Funds Rate
• Sub-prime Mortgage
• Discount Loan
• Shadow Banking System
• Discount Rate
• MMMF
• Open Market Operation
• Large Scale Asset
Purchase
• Quantitative Easing

QE 1, 2 and 3
• Operation Twist
• Term Structure
• Financial Intermediary
What is this?
Why Study Money, Banking, and
Financial Markets?
Chapter 1
Why Study Money, Banking & Financial Markets
• To understand how financial markets work
- Obviously, there are many financial markets – stocks,
bonds, foreign exchange.
- We focus primarily on bond and credit markets
• To examine how financial institutions work
- Many types of financial institutions – banks, investment
banks, insurance companies, pension funds
- We focus primarily on commercial banks
• To examine the role of money in the economy

How the Federal Reserve System works
Five Parts of the Financial System
1. Money
An asset used to pay for purchases, repay of
debt, pay taxes
- medium of exchange
- a store of wealth
- a unit of account
Five Parts of the Financial System
2. Financial Instruments
Contracts used to transfer wealth from
people who have an excess of available
funds (savers/lenders/investors) to people
who have a shortage of funds
(borrowers/entrepreneurs)
Also, contracts to transfer risk to those best
equipped to bear it.
Five Parts of the Financial System
3. Financial
Markets
Allow us to buy and sell financial instruments
quickly and cheaply. Funds are transferred from
people who have an excess of available funds to
people who have a shortage of funds
4.
Financial Institutions.
Firms that provide access to financial markets
Five Parts of the Financial System
5. Central Banks

monitor and stabilize the economy,

monitor financial institutions.
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
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.
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.
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.
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.
TIMING OF INCOME AND EXPENDITURES
DECOUPLED
$
Income
Consumption
Saving
Dissaving
Dissaving
Retirement
Begins
Time
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
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 ?
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
Interest Rates on Selected Bonds, 1950–2015
Three things this graph demonstrates??
3-month Bill
10-year Treasury
10-year Corporate Baa
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
Mishkin Figure 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2014
Shiller: Real Terms. Note the behavior of price relative to
earnings. Mishkin starts at 1950.
CAPE Price E10 Ratio
50
2000
45
1981
Price-Earnings Ratio (CAPE, P/E10)
40
35
1929
Price-Earnings
Ratio
1901
30
25
1966
24.0
20
15
10
5
1921
0
1860
1880
1900
1920
1940
1960
1980
2000
2020
2040
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
Commercial Banks
Loans
deposits
Pension Funds
Stocks
Retirement
Plans
Insurance Companies
Bonds
Stocks
Insurance
Policies
Mutual Funds
Bonds
Stocks
Shares
Money Market
Mutual Funds
Commercial Shares/
paper
“deposits”
T-Bills
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
Money Growth (M2 Annual Rate) and the Business Cycle in
the United States, 1950–2008
Note: Shaded areas represent recessions.
• 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
Average Inflation Rate Versus Average Rate of Money
Growth for Selected Countries, 1997–2007
Source: International Financial Statistics.
Examples of Hyperinflation:1980s and
Early 1990s
M2 Money Growth and Inflation - US
Money and Interest Rates
• Prior to 1980, the rate of money
growth and the interest rate on longterm Treasury bonds were closely
tied
• Since then, the relationship is less
clear but the rate of money growth
is still an important determinant of
interest rates
FIGURE 6 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2008
Inflation and Nominal Interest Rates
Mankiw
Inflation and Nominal Interest rates