Chapter 1: Why study money, banking, and financial markets

• What is the typical relationship among interest rates on three-month Treasury bills, long-
term Government of Canada bonds, and corporate bonds?
They move together over time with corporate bond having the highest rate of interest.

• What effect might a fall in stock prices have on business investment?

A business tends to invest more when its stock prices rises and vice versa.

• Explain the main difference between a bond and a common stock.

Stocks give you partial ownership in a company whereas bonds are a loan that you give
a company or government.

• Explain the link between well-performing financial markets and economic growth. Name
one channel through which financial markets might affect economic growth and poverty.
Well performing financial markets allocate to their more efficient use, thereby allowing
the best investment opportunities to be undertaken.
Activities in financial markets directly affect individuals’ wealth, the behaviour of
businesses, and the efficiency of our economy.
Three financial markets deserve particular attention: the bond market (where interest rates
are determined), the stock market (which has a major effect on people’s wealth and on
firms’ investment decisions), and the foreign exchange market (because fluctuations in
the foreign exchange rate have major consequences for the Canadian economy).

• What was the main cause of the global financial crisis that began in 2007?
The 2007-2010 crisis was primarily caused by the housing bubble and the
subsequent subprime mortgage meltdown.

• Can you think of a reason why people in general do not lend money to one another to
buy a house or a car? How would your answer explain the existence of banks?
o The lenders may not know the borrowers and vice versa.
o There must be an economic advantage to lend money
o Verification of the borrower

• What are the other important financial intermediaries in the economy besides banks?
o Credit unions
o Pension funds
o Stock Exchanges
o Insurance companies
o
• Can you date the latest financial crisis in the United States or in Europe? Are there
reasons to think that these crises might have been related? Why?
European sovereign debt crises
• Has the inflation rate in Canada increased or decreased in the past few years? What
about interest rates?
• Inflation has increase post the pandemic. Interest rates have also been increased to
counter the inflation.

• If history repeats itself and we see a decline in the rate of money growth, what might you
expect to happen to
o real output? - When the money growth rate declines, the production and
manufacturing activities declines and as a result of which the GDP of the
economy falls.
o the inflation rates? – the inflation rate falls
o interest rates? The interest rates fall, to encourage borrowing to boost up
investments.

• When interest rates decrease, how might businesses and consumers change their
economic behaviour?
Decrease in interest rate makes the borrowings cheap and increases the demand of
loan for investment, this increases the money supply into the economy. Increase in
money supply will result into higher production, manufacturing, higher income, higher
profit and thus the national income will increase.

• Is everybody worse off when interest rates rise?

No, when interest rates rise, not everyone suffers. people who need to borrow funds for
any purpose are negatively because financing costs more; conversely, savers earn profit
because they can earn greater interest rates on their savings.

• Why do managers of financial institutions care so much about the activities of the Bank
of Canada?
Because the fiscal policy of the Bank of Canada affects the inflation, interest rates and
business cycles all of which have an impact on the profitability of the financial
institutions.

• How does the current size of the Canadian budget deficit compare to the historical
budget deficit or surplus for the time period since 1960?
Read up on this

• How would a fall in the value of the pound sterling affect British consumers?
• The fall in the value of pound sterling will depreciate the pound in comparison to dollar.
Which shows to buy a foreign commodity the British consumer will have to spend more
money out of their pockets. As compared to their home currency value the foreign goods
will become more cheap.

• How would an increase in the value of the pound sterling affect Canadian businesses?
 It will increase the cost of importing goods from UK, but it will make Canadian products
more affordable in UK.

• How can changes in foreign exchange rates affect the profitability of financial
institutions?
For instance, a decrease in the foreign exchange rates leads to the decline in the value
of the assets held by the financial institutions, hence incurring losses. In contrast, a rise
in the foreign exchange rates results in an increase in the value of the financial
institutions' assets, thus gaining profits.

• According to Figure 1-8, in which years would you have chosen to visit the Canadian
Rockies rather than the Grand Canyon in Arizona?
Year 2001

• When the dollar is worth more in relation to currencies of other countries, are you more
likely to buy Canadian-made or foreign-made jeans? Are Canadian companies that
manufacture jeans happier when the dollar is strong or when it is weak? What about a
Canadian company that is in the business of importing jeans into Canada?
I will buy foreign made jeans as that would make the foreign goods cheaper, give me
higher purchasing power in foreign markets.
They are happier when the Canadian dollar is weak, because then foreign markets are
happier buying products from them.
The company would be happy when the Canadian dollar is strong as that would make
importing cheaper.

• Much of the Canadian government debt is held by foreign investors as Government of

Canada bonds and bills. How do fluctuations in the dollar exchange rate affect the value
of that debt held by foreigners?
• When the value of currency appreciates, the borrower will have to pay less and when
value of currency depreciates, the borrower will pay more.
• Step 1: Concept
Currency exchange rate fluctuations have an impact on the economy because a weaker
currency makes imports more expensive, while a stronger currency stimulates exports by
making them cheaper for overseas buyers to buy. Over time, a weak or strong currency
can contribute to a country's trade deficit or surplus.
• Step 2. Explanation
Fluctuations in the dollar exchange rate have a direct impact on the value of foreign debt
held by foreigners by affecting the value of the money owed by the government to debtors.
Assume that one US dollar equals 20 pesos. When the exchange rate falls, the dollar
loses its purchasing power and can now only buy 15 pesos. Investors who own these
bonds are paid in less valuable dollars, lowering the value of the debt they owe.
The opposite is true when the exchange rate rises. Virtually, the dollar will be exchanged
for 25 pesos and investors will be paid in more valuable dollars. This enhances the value
of what they owe.