Transcript Lecture 1 Chapter 1PPT

Economics 330 – Money and Banking
• T and Th from 9:30am to 10:45am
• Text: Cecchetti and Schoenholtz:
Money, Banking, and Financial Markets,
McGraw Hill, 4th edition.
Who am I ?
• Dr. John Neri
• Office Hours: T and Th from 3:30pm to
4:30pm.
• Office: Morrill Hall, Room 1106
Course Webpage
• http://www.terpconnect.umd.edu/~jneri/Econ330
NOTE: upper-case E
• Students using DSS, please see me within the
first 2 weeks of class.
Can you define each of the following?
• Federal Reserve System
• Forward Guidance
• 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
• TAP
• Term Structure
• Financial Intermediary
What is this?
Cecchetti - Chapter One
An Introduction to Money and
the Financial System
Learning Objectives
In this chapter we introduce:
1. The six parts of the financial system
2. The five core principles of money and
banking
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.
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.
Six Parts of the Financial System
2. Financial instruments

Contracts used to transfer resources from
savers to investors
• Loans, bonds, stocks (this is financial capital)

Contracts used to transfer risk
• Insurance policies
• Derivative contracts
Six Parts of the Financial System
3. Financial Markets

make buying and selling financial instruments
easy

Went from being in coffee houses and
taverns to well organized markets like the
New York Stock Exchange.

Now transactions are mostly handled by
electronic markets.
• As the cost of processing financial transactions
has fallen a broader array of financial instruments
available.
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.
Six Parts of the Financial System
5. Government regulatory agencies

Make sure the financial system operates safely
and reliably.

Government regulatory agencies were
introduced by federal government after the
Great Depression.

Wide-ranging financial regulation: rules,
supervision, examine the systems a bank uses
to manage its risk.
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.
Cecchetti’s 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.
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.
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.
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.
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.
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.
Bottom Line: A 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.
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
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
Inflation and Nominal Interest Rates
Mankiw
Inflation and Nominal Interest rates