Republic of the Philippines

City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

DETAILED LEARNING MODULE

Title: GLOBAL FINANCE WITH ELECTRONIC BANKING
Module No.

I. Introduction
The global financial system is the worldwide framework of legal agreements,
institutions, and both formal and informal economic actors that together facilitate
international flows of financial capital for purposes of investment and trade
financing. While Electronic banking is a form of banking in which funds are
transferred through an exchange of electronic signals rather than through an
exchange of cash, checks, or other types of paper documents.
II. Learning Objectives
After studying this module, you should be able to:

 Discuss the Interest Rates, Expectation and Equilibrium

 Know the Money supply and demand
 Money supply and the exchange

III. Topics and Key Concepts

Interest Rates, Expectation and Equilibrium

Money supply and demand
Money supply and the exchange
IV. Teaching and Learning Materials and Resources
 Internet
 Laptop/ android phones
 Power point presentation
V. Learning Task

 View on line video included on the power point presentation

 Short online quiz
VI. Reference
https://en.wikipedia.org/wiki/Interest_rate
 Republic of the Philippines
City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

https://www.investopedia.com/terms/e/equilibrium.asp#:~:text=Equilibrium%20is
%20the%20state%20in,which%20results%20in%20higher%20demand.
https://financetrain.com/demand-and-supply-of-money/
https://www.investopedia.com/trading/factors-influence-exchange-rates/

LECTURE:

Interest Rates, Expectation and Equilibrium

An interest rate is the amount of interest due per period, as a proportion of the amount
lent, deposited or borrowed (called the principal sum). The total interest on an amount
lent or borrowed depends on the principal sum, the interest rate, the compounding
frequency, and the length of time over which it is lent, deposited or borrowed.
It is defined as the proportion of an amount loaned which a lender charges as interest to
the borrower, normally expressed as an annual percentage. It is the rate a bank or other
lender charges to borrow its money, or the rate a bank pays its savers for keeping money
in an accountThe annual interest rate is the rate over a period of one year. Other interest
rates apply over different periods, such as a month or a day, but they are
usually annualized.
Interest rates vary according to:

 the government's directives to the central bank to accomplish the government's

goals
 the currency of the principal sum lent or borrowed
 the term to maturity of the investment
 the perceived default probability of the borrower
 supply and demand in the market
 the amount of collateral
 special features like call provisions
 reserve requirements
 compensating balance

Monetary policy
Interest rate targets are a vital tool of monetary policy and are taken into account when
dealing with variables like investment, inflation, and unemployment. The central banks of
countries generally tend to reduce interest rates when they wish to increase investment
and consumption in the country's economy. However, a low interest rate as a macro-
economic policy can be risky and may lead to the creation of an economic bubble, in
which large amounts of investments are poured into the real-estate market and stock
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City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

market. In developed economies, interest-rate adjustments are thus made to keep

inflation within a target range for the health of economic activities or cap the interest
rate concurrently with economic growth to safeguard economic momentum.

Reasons for changes

 Political short-term gain: Lowering interest rates can give the economy a short-run
boost. Under normal conditions, most economists think a cut in interest rates will
only give a short term gain in economic activity that will soon be offset by inflation.
The quick boost can influence elections. Most economists advocate independent
central banks to limit the influence of politics on interest rates.
 Deferred consumption: When money is loaned the lender delays spending the money
on consumption goods. Since according to time preference theory people prefer
goods now to goods later, in a free market there will be a positive interest rate.
 Inflationary expectations: Most economies generally exhibit inflation, meaning a
given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this.
 Alternative investments: The lender has a choice between using his money in
different investments. If he chooses one, he forgoes the returns from all the others.
Different investments effectively compete for funds.
 Risks of investment: There is always a risk that the borrower will go bankrupt,
abscond, die, or otherwise default on the loan. This means that a lender generally
charges a risk premium to ensure that, across his investments, he is compensated for
those that fail.
 Liquidity preference: People prefer to have their resources available in a form that
can immediately be exchanged, rather than a form that takes time to realize.
 Taxes: Because some of the gains from interest may be subject to taxes, the lender
may insist on a higher rate to make up for this loss.
 Banks: Banks can tend to change the interest rate to either slow down or speed up
economy growth. This involves either raising interest rates to slow the economy
down, or lowering interest rates to promote economic growth.
 Economy: Interest rates can fluctuate according to the status of the economy. It will
generally be found that if the economy is strong then the interest rates will be high, if
the economy is weak the interest rates will be low.

Market rates
There is a market for investments, including the money market, bond market, stock
market, and currency market as well as retail banking.
Interest rates reflect:
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Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

 The risk-free cost of capital

 Expected inflation
 Risk premium
 Transaction costs
Inflationary expectations
According to the theory of rational expectations, borrowers and lenders form an
expectation of inflation in the future. The acceptable nominal interest rate at which they
are willing and able to borrow or lend includes the real interest rate they require to
receive, or are willing and able to pay, plus the rate of inflation they expect.
Risk
The level of risk in investments is taken into consideration. Riskier investments such
as shares and junk bonds are normally expected to deliver higher returns than safer ones
like government bonds.
The additional return above the risk-free nominal interest rate which is expected from a
risky investment is the risk premium. The risk premium an investor requires on an
investment depends on the risk preferences of the investor. Evidence suggests that most
lenders are risk-averse
A maturity risk premium applied to a longer-term investment reflects a higher perceived
risk of default.
There are four kinds of risk:

 repricing risk
 basis risk
 yield curve risk
 optionality
Liquidity preference
Most investors prefer their money to be in cash rather than in less fungible investments.
Cash is on hand to be spent immediately if the need arises, but some investments require
time or effort to transfer into spendable form. The preference for cash is known
as liquidity preference. A 1-year loan, for instance, is very liquid compared to a 10-year
loan. A 10-year US Treasury bond, however, is still relatively liquid because it can easily
be sold on the market.

In macroeconomics
Output and unemployment
Higher interest rates increase the cost of borrowing which can reduce physical
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City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

investment and output and increase unemployment. Higher rates encourage more saving
and reduce inflation.
Open market operations in the United States
The effective federal funds rate in the US charted over more than half a century
The Federal Reserve (often referred to as 'the Fed') implements monetary policy largely
by targeting the federal funds rate. This is the rate that banks charge each other for
overnight loans of federal funds, which are the reserves held by banks at the Fed. Open
market operations are one tool within monetary policy implemented by the Federal
Reserve to steer short-term interest rates using the power to buy and sell
treasury securities.
Money and inflation
Loans, bonds, and shares have some of the characteristics of money and are included in
the broad money supply.
the government institution can affect the markets to alter the total of loans, bonds and
shares issued. Generally speaking, a higher real interest rate reduces the broad money
supply.
Through the quantity theory of money, increases in the money supply lead to inflation.

Impact on savings and pensions

Financial economists such as World Pensions Council (WPC) researchers have argued that
durably low interest rates in most G20 countries will have an adverse impact on
the funding positions of pension funds as “without returns that outstrip inflation, pension
investors face the real value of their savings declining rather than ratcheting up over the
next few years”
From 1982 until 2012, most Western economies experienced a period of low inflation
combined with relatively high returns on investments across all asset classes including
government bonds. This brought a certain sense of complacency[citation needed] amongst some
pension actuarial consultants and regulators, making it seem reasonable to use optimistic
economic assumptions to calculate the present value of future pension liabilities.
What is Equilibrium?
Equilibrium is the state in which market supply and demand balance each other, and  as a
result prices become stable. Generally, an over-supply of goods or services causes prices
to go down, which results in higher demand. The balancing effect of supply and demand
results in a state of equilibrium.

Understanding Equilibrium
The equilibrium price is where the supply of goods matches demand. When a
major index experiences a period of consolidation or sideways momentum, it can be said
that the forces of supply and demand are relatively equal and the market is in a state of
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City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

equilibrium.

As proposed by New Keynesian economist Huw Dixon, there are three properties to a

state of equilibrium: the behavior of agents is consistent, no agent has an incentive to
change its behavior, and equilibrium is the outcome of some dynamic process. Dixon
names these principles: equilibrium property 1, equilibrium property 2, and equilibrium
property 3, or P1, P2, and P3, respectively.1

KEY TAKEAWAYS

 A market is said to have reached equilibrium price when the supply of goods
matches demand.
 A market in equilibrium demonstrates three characteristics: behavior of agents is
consistent, there are no incentives for agents to change behavior, and a dynamic
process governs equilibrium outcome.
 Disequilibrium is the opposite of equilibrium and it is characterized by changes in
conditions that affect market equilibrium.

Notes on Equilibrium
Economists like Adam Smith believed that a free market would trend towards
equilibrium. For example, a dearth of any one good would create a higher price generally,
which would reduce demand, leading to an increase in supply provided the right
incentive. The same would occur in reverse order provided there was excess in any one
market.

Modern economists point out that cartels or monopolistic companies can artificially hold

prices higher and keep them there in order to reap higher profits. The diamond industry
is a classic example of a market where demand is high, but supply is made artificially
scarce by companies selling fewer diamonds in order to keep prices high.

Paul Samuelson argued in a 1983 book Foundations of Economic Analysis published by

Harvard University Press that giving equilibrium markets what he described as a
"normative meaning" or a value judgment was a misstep. 2 Markets can be in equilibrium,
but it may not mean that all is well. For example, the food markets in Ireland were at
equilibrium during the great potato famine in in the mid 1800s. Higher profits from
selling to the British made it so the Irish/British market was at equilibrium price was
higher than what farmers could pay, contributing to one of the many reasons people
starved. 

Equilibrium vs. Disequilibrium

When markets aren't in a state of equilibrium, they are said to be in disequilibrium.
Disequilibrium either happens in a flash, or is a characteristic of a certain market. At
times disequilibrium can spillover from one market to another, for instance if there aren’t
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City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

enough companies to ship coffee internationally then the coffee supply for certain
regions could be reduced, affecting the equilibrium of coffee markets. Economists view
many labor markets as being in disequilibrium due to how legislation and public policy
protect people and their jobs, or the amount them are compensated for their labor. 

Example of Equilibrium
A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is
willing buy them at that price. To pump up demand, the store reduces their price to $8.
There are 250 buyers at that price point. In response, the store further slashes the retail
cost to $5 and garners five hundred buyers in total. Upon further reduction of the price
to $2, one thousand buyers of the spinning top materialize. At this price point, supply
equals demand. Hence $2 is the equilibrium price for the spinning tops.

Money supply and demand

Demand of Money

The demand for money refers to the total amount of wealth held by the household and
companies. The demand for money is affected by several factors such as income levels,
interest rates, price levels (inflation), and uncertainty.

The impact of these factors on the demand for money is explained in terms of the three
primary reasons to hold money. The three reasons are:

Transactions: This is the money needed for fulfilling transactions. As the total number
and size of transactions increases in an economy, the transaction demand for money also
increases.

Precautionary: This is the money needed for uncertain future needs, for example,
unexpected medical expenses. The precautionary demand for money increases as the
size of economy increases.

Speculative: People also hold money for speculative purposes so that they can take
advantage of investment opportunities in the future. If the current returns on financial
products are high, people will rather invest than hold money with a speculative motive.
We can say that the demand for money for speculative motive increases with the
increase in perceived risk in other financial instruments.
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City of Olongapo
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Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

There is an inverse relationship between the short-term interest rates and the demand
for money that households and firms want to hold. If the interest rates are low, the
demand for money is high and if the interest rates are high, the demand for money is
low. This is because as interest rates increase, the opportunity cost of holding money
increases, and people will be better off by investing in other financial instruments than
holding money.

Supply of Money

The supply of money in an economy is controlled by its central bank, for example, Fed in
the US. The Fed may change the money supply by using open market operations or by
changing reserve requirements.

The short-term interest rate (i) is determined by the equilibrium of the supply and
demand for money. If the interest rates are above the equilibrium, there is excess supply
of money. This means the households and firms are holding more money and they will
purchase securities to lower their money balances. This will lead to an increase in
security prices and a drop in interest rates. Similarly, if interest rates are lower than the
equilibrium rate, there is excess demand for money and people desire to hold money
than they actually have. To do so, firms and households will sell securities, which will
decrease the security prices and increase the interest rates.

The central bank can change the money supply, which will influence the interest rates. An
increase in money supply will create excess supply, which will put a downward pressure
on interest rates.

Money supply and the exchange

6 Factors That Influence Exchange Rates

Aside from factors such as interest rates and inflation, the currency exchange rate is one
of the most important determinants of a country's relative level of economic health.
Exchange rates play a vital role in a country's level of trade, which is critical to most every
free market economy in the world. For this reason, exchange rates are among the most
 Republic of the Philippines
City of Olongapo
GORDON COLLEGE
Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

watched analyzed and governmentally manipulated economic measures. But exchange

rates matter on a smaller scale as well: they impact the real return of an investor's
portfolio. Here, we look at some of the major forces behind exchange rate movements.

Overview of Exchange Rates

Before we look at these forces, we should sketch out how exchange rate movements
affect a nation's trading relationships with other nations. A higher-valued currency makes
a country's imports less expensive and its exports more expensive in foreign markets. A
lower-valued currency makes a country's imports more expensive and its exports less
expensive in foreign markets. A higher exchange rate can be expected to worsen a
country's balance of trade, while a lower exchange rate can be expected to improve it.

KEY TAKEAWAYS

 Aside from factors such as interest rates and inflation, the currency exchange rate
is one of the most important determinants of a country's relative level of
economic health.
 A higher-valued currency makes a country's imports less expensive and its exports
more expensive in foreign markets.
 Exchange rates are relative and are expressed as a comparison of the currencies
of two countries.
Determinants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are related to the
trading relationship between the two countries. Remember, exchange rates are relative,
and are expressed as a comparison of the currencies of two countries. The following are
some of the principal determinants of the exchange rate between two countries. Note
that these factors are in no particular order; like many aspects of economics, the relative
importance of these factors is subject to much debate.

Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half
of the 20th century, the countries with low inflation included Japan, Germany, and
Switzerland, while the U.S. and Canada achieved low inflation only later. 1 Those countries
with higher inflation typically see depreciation in their currency about the currencies of
their trading partners. This is also usually accompanied by higher interest rates.

Differentials in Interest Rates

Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
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Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

higher interest rates is mitigated, however, if inflation in the country is much higher than
in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates – that is, lower interest rates tend to
decrease exchange rates.

Current Account Deficits

The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it receives through sales
of exports, and it supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the country's exchange rate
until domestic goods and services are cheap enough for foreigners, and foreign assets are
too expensive to generate sales for domestic interests.

Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations
with large public deficits and debts are less attractive to foreign investors. The reason? A
large debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably causes inflation. Moreover, if a government is
not able to service its deficit through domestic means (selling domestic bonds, increasing
the money supply), then it must increase the supply of securities for sale to foreigners,
thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if
they believe the country risks defaulting on its obligations. Foreigners will be less willing
to own securities denominated in that currency if the risk of default is great. For this
reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for
example) is a crucial determinant of its exchange rate.

Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in turn,
results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports rises
by a smaller rate than that of its imports, the currency's value will decrease in relation to
its trading partners.
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City of Olongapo
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Olongapo City Sports Complex, East Tapinac, Olongapo City
Tel. No. (047) 224-2089 loc. 314

Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes will
draw investment funds away from other countries perceived to have more political and
economic risk. Political turmoil, for example, can cause a loss of confidence in a currency
and a movement of capital to the currencies of more stable countries.

The Bottom Line

The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the
exchange rate influences other income factors such as interest rates, inflation and even
capital gains from domestic securities. While exchange rates are determined by
numerous complex factors that often leave even the most experienced economists
flummoxed, investors should still have some understanding of how currency values and
exchange rates play an important role in the rate of return on their investments.