money, & BANKING, > Why Study Money, Banking, and Financial Markets? - provides answers to personal financial questions - develops knowledge base for high income jobs - explains how the economy works > The role of money & banking in macroeconomic analysis THE THREE SECTOR CIRCULAR FLOW OF INCOME MODEL Household Income (Y) y Household Firm ¥ Consumption spending (C) Savings (S) Investment (I) Capital Market c Capital markets are places where savings and investments are channeled between the suppliers who have capital and those who are in need of capital (businesses, governments, and people). 1> Financial Institutions and Banking - Financial interme: institutions that borrow funds from people who have saved and make loans to other people: a. Banks: accept deposits and make loans b. Other Financial Institutions: insurance companies, finance companies, pension funds, and investment banks - Why Study Financial Institutions and Banking? © Financial Intermediation helps get funds from savers to investors © Bank decisions affect the size of the money supply and the changes in the money supply affect the price level, inflation rate, level of output and the rate of economic growth - Financial Markets: Markets in which people trade financial securities - Why Study Financial Markets? ‘© Promoting economic efficiency o Affect personal wealth and behavior of business firms - Financial markets example: bond, stock markets and Foreign exchange market - Financial Instruments Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world's investors.+ Financial Instruments : “Securities” is a name that commonly refers to financial instruments that are traded on financial markets. A security (financial instrument) is a formal obligation that entitles one party to receive payments and/or a share of assets from another party; ¢.g., loans, stocks, bonds.—Even an ordinary bank loan is a financial instrument. Tuer eet icd Cc Bonds Common stock represents a share of ownership in a corporation and gives its holder unlimited proportionate claim on the assets and income of the firm Abond is a debt security that promises to make payments periodically for a specified period of time. Loan: is when money is given to another party in exchange for repayment of the /oan principal amount plus interest.* The difference between bond & Loan ‘The main difference is that a bond is highly tradeable. If you purchase a bond, there is usually a marketplace where you can trade it. It means you can sell the bond rather than wait for the bond’s maturity. Loans are generally non-tradeable, and the bank will be obliged to see out the entire term of the loan. Bond Loan Definition | Itis akind of debt instrument. It is a way for the government or a A loan is another kind of debt company to raise money with | imstrument provided by a interest payments annually. bank@yith a variable interest Tate. Government bond yields are likely Interest |i be low and are a. safer| Comparatively to Bond, the Rates Peotntt loan interest rates in most cases are higher _ Governments or firms usually sell OwnersttP ty ands, Corporates. or individuals borrow them. Trading _ | Bonds are sold and purchased at the bond markets, and bond prices can move up and down like the stock prices, Tradable Loans are generally fixed with the bank that has to lend them. Non-Tradableeaepoce CHAPTER (1) The Nature of Money Money is defined as anything that is generally accepted as a medium of exchange for goods and services, and can also serve as store of value and a unit of account. Medium of Exchange for goods and services A Store of value A Unit of Accou i, Medium of Exchange for goods and services. The major difficulty with the barter system is that each transaction requires a double coincidence of wants: anyone specialized in producing one commodity would have to spend a great deal of time searching for satisfactory transaction Money makes possible the benefits of specialization and the division of labor, which in turn contribute to the efficiency of the economic system. Characteristics of money to serve as an efficient medium of exchange: It must be generally accepted. . tt must have a high value relative to its weight. It must be divisible . It must be durableji, A Store of value, money is a convenient to store purchasing power, when the price level is stable. ili, A.Unit of Account: money is used as standard of value, or as a measure of the value of goods and services denominated in money terms. Money developed over time: First: Commodity money + All sorts of commodities have been used as money at one time to another. + Precious stones & metals came to circulate as money and to be used in many transactions. + The precious metals such as gold and silver proved to have great advantages — as commodity money. + Advantages of gold and silver as commodity money: - They tended to have high and stable value. - They were easily recognized, - They were divisible into small units - They did not easily wear out. + Before the invention of coins as the form of money, it was necessary to carry the metals in bulk. + When a purchase was made, the requisite quantity of the metal was carefully weighted on a scale.Second: The invention of coins: Third The invention of coins eliminated the need to weight the metal at each transaction, because the authority, who made the coins affixed his or her stamp, guaranteeing the amount of precious metal the coin contained. |: Representative Money It was paper currency that had a promise to be convertible into coins or into a quantity of precious metal on demand. Fully backed paper money: Such paper money was backed by precious metal and was convertible on demand into this metal. Fractionally Backed paper money: - Atany one time, some of the bank’s customers would be withdrawing gold, others would be depositing it, and most would be trading in the bank’s paper notes without any need or desire to convert them into gold. - Asa result, the bank was able to issue more money redeemable in gold than the amount of gold that it held in its vaults. We say that the currency issued in such a situation is fractionally backed by the reserves. Fourth: Fiat money: Fiat money is a paper currency that is not convertible by the law into anything valuable, derives its value from its acceptability in exchange . Such Fait moneys widely acceptable because it is declared by government order to be legal tender. Legal tender is anything that by law must be accepted when offered either for the purchase of goods or services or to for repayment of a debt. Today, almost all currency is fiat money.Fifth: Deposit Money: Deposit Money is defined as money held by the publicin the form of current deposits in commercial banks that can be withdrawn on demand by checks. Note: A check is a written, dated, and signed instrument that directs a bank to pay a specific sum of money to the bearer. Checks, unlike bank notes, do not circulate freely from hand to hand; hence checks are not currency. However, checks are widely used because they are easily drawn and deposited and are relatively safe from theft. SO DOES FIAT MONEY MEET ALL THE NECESSARY REQUIREMENTS?22 © Portability- light weight, convenient, easily transferable © Durable- Coins tend to last over 20 years, and paper currency lasts 18 months in circulation before being replaced © Divisible- it is small enough for almost all purchases, and can write checks for exact amounts © Limited Supply/Stability- Fluctuates, but for the most part there is a stable and limited supplyThe possible methods of payment are: 1. Commodity and Fiat Money 2. Checks 3. Electronic Payments + Electronic payments take the form o! * Credit and debit cards + Electronic funds transfers * Bitcoin Debit Works like a check - tells the bank to transfer funds from your Cards account to another. Credit | A promise by a bank to lend the cardholder money to make a Cards _| purchase, They do not represent money. Electronic | Movements of funds directly from one account to another funds transfers: Digital | + Any means of payment that exists purely in electronic form money | Digital money is not tangible like a dollar bill or a coin. It is |accounted for and transferred using computers. The most successful and widely-used form of digital money is the cryptocurrency Bitcoin.> The demand for money refers to how much assets individuals wish to hold in the form of money (as opposed to illiquid physical assets such as bonds). It is sometimes referred to as liquidity preference. > Liquidity preference (LP) is the desire to hold assets in liquid form that can be easily transformed into assets. > The demand for money is inversely related to the interest rate. At high-interest rates, people prefer to hold bonds (which give a high- interest payment). When interest rates fall, holding bonds gives a lower return so people prefer to hold cash. The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money. Higher interest rate (higher opportunity cost) causes lower money demand. ‘> Types of demand for money Transaction demand ~ money needed to buy goods ~ this is related to income. It refers to demand for money as a medium of exchange (independent of the interest rate). Precautionary demand ~ money needed for financial emergencies. Asset motive/speculative demand ~ when people wish to hold money rather than buy assets/bonds/risky investment. It refers to demand for money as a store of value (dependent on the interest rate). 10NOTE: Money balances held for transactions and precautionary motives are called active balances. While money demanded for speculative purposes is called the demand for idle balances. As the rate of interest declines, the demand for speculative balances increases. When the rate of interest becomes so low that people prefer to hold the whole of their assets in cash only, the speculative demand for money becomes perfectly elastic. This is known as liquidity trap. Such a situation arises when the rate of interest falls to r*. If the economy is in liquidity trap, it would mean the rate of interest will not fall as the economy is already operating at the minimum rate of interest. Rate of Interest 0 we Speculative Demand for Money 11* According to the Keynesian Theory, the total demand for money MD is composed of L1 and 12 ie. MD =L1 (Y) +12 (r) > Where, L1 (Y) represents the transactions and precautionary demands for money, both of them being an increasing function of the level of money income (Yj. > 2 (1), represents the speculative demand for money which is a declining function of rate of interest (r). > MD is positively related to Y and negatively related to r. ‘© Keynes considered holding bonds as an alternative to holding cash. Given a choice between bonds and money, the higher the rate of interest, the greater is the opportunity cost of holding cash Hence, at higher interest rates more bonds and less cash are held => inverse relationship. * MD is downward sloping because the nominal interest rate is the opportunity cost of holding money. At lower interest rates people sacrifice less when they hold money. At low interest rates the amount that people wish to hold as money will be high. ‘© A change in the interest rate involves a movement along the money demand curve. Interest rate( r) nt rn 3 Quantity of money (M) 12‘© We draw the demand curve for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged. A change in those “other determinants” will shift the demand for money. Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences. a- Real GDP; Money holdings depend upon planned spending. The quantity of money demanded in the economy as a whole depends on Real GDP. Higher income leads to higher expenditure. People hold more money to finance the higher volume of expenditure b- The Price Level: The higher the price level, the more money is required to purchase a given quantity of goods and services. All other things unchanged, the higher the price level, the greater the demand for money. If price increases by 10%, people will hold 10% more of money to buy the same bundle of goods. For example, if you spent $20 to buy a cup of tea and a toast before, now you need to hold $2 more to buy the same bundle. 13The Demand for Money as a Function of Interest Rates, Income, and the Price Level: t E 3 ~-. 3 E 2; 2 8 aq Z a 5 cle (mp) q ip + o Mm Mm o mm M o Mm M Quantity of Money anti of Money Quantity of Money (0 Ligeiiy preference (i) Real GDP (i Pricer! + The demand for money shifts out when the nominal level of output increases. + Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP — Nominal GDP? .:MD‘ => shifts rightward — NominalGDP).:MD | => shifts leftward 14ee—SSCC Shifts of the Money Demand Curve A fall in money demand Interest shifts the money demand rate, r 4-——",— My ‘Quantity GOOD LUCK 15