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WHY STUDY MONEY & MONETARY POLICY?

MONEY AND BUSINESS CYCLES

Money plays an important role ingenerating


business cyclesthe upward and downward

movement of aggregate output produced in


the economy.

Monetary theory ties changes in the money


supply to changes in aggregate economic

activity and the price level

MONEY AND INFLATION


Inflation is always and everywhere a monetary phenomena.Milton Friedman Money also affects inflationthe continual rise in the price level of goods and services.

Money and Interest Rates

Monetary Policymanagement of money and interest rates. Fiscal Policytaxation and government spending decisions.

Budget Deficit-government expenditure exceeds tax revenues. Budget Surplus-tax revenue exceeds government expenditure.

AN OVERVIEW OF THE FINANCIAL SYSTEM

FUNCTION of FINANCIAL MARKETS


Channels funds from person or business without investment opportunities to one who has them Improves economic efficiency

Funds flow from Lender-Savers to Borrower-Spenders via Two Routes


1) Direct Finance -> Borrowers borrow directly from lenders in financial markets by selling securities/financial instruments which are claims on the borrowers future income or assets

2) Indirect Finance

Importance of Financial Markets


The people who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs. Financial markers are critical for producing an efficient allocation of capital, (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy.

Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

STRUCTURE OF FINANCIAL MARKETS

Debt and Equity Markets


Debt Market -Bond, Mortgage -Short-Term (maturity < 1 year) -Long-Term (maturity > 10 year) -Intermediate term (maturity in-between) Equity Market -Common stock -Pay dividends -Represents an ownership claim in the firm

Primary and Secondary Markets


Primary Market -New security issues sold to initial buyers -Typically involves an investment bank who underwrites the offering Secondary Market -Securities previously issued are bought and sold -Involves both brokers and dealers

Even though firms dont get any money, per se, from the secondary market, it serves two important functions: Provide liquidity, making it easy to buy and sell the securities of the companies Establish a price for the securities

Exchanges and Over-the-Counter Markets


Exchanges -Trades conducted in central locations (e.g., New York Stock Exchange, CBT) Over-the-Counter Markets -Dealers at different locations buy and sell -Very competitive

Money and Capital Markets


We can also further classify markets by the maturity of the securities: Money Market: Short-Term (maturity < 1 year)

Capital Market : Long-Term (maturity 1 year) plus equities

FINANCIAL MARKET INSTRUMENTS

Money Market Instruments


Because of their short terms to maturity, the debt instruments traded in the money market undergo the least price fluctuations and so are the least risky investments.

Primary Money Market Instruments


U.S. Treasury Bills -These short -term debt instruments of the US government are issued in one-, three-, and six-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount, that is , at a price lower than the set amount paid at maturity.

Negotiable Bank Certificates o f Deposit -a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price Commercial Paper -a short-term debt instrument issued by large banks and well-known corporations, such as Microsoft

Repurchase Agreements -are effectively short-term loans (usually with a maturity of less than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if the borrower does nor pay back the loan.

Federal (Fed) Funds -typically overnight loans between banks of their deposits at the Federal Reserve -designation is somewhat confusing because these loans are not made by the federal government or by the Federal Reserve but rather by banks to other banks

INTERNALIZATION OF FINANCIAL MARKETS


U.S. financial markets were much larger than financial markets outside the United States, but in recent years the dominance of U.S. markets has been disappearing. WHY?

TERMS
Foreign bonds are sold in a foreign country and are denominated in the countrys currency. Eurobond bond dominated in a currency other than that of the country in which it is sold. Eurocurrencies foreign currencies deposited in banks outside the home country

Provides funds Helps finance the federal government Leads way to a more integrated world economy

THE EFFECTS OF THE INTERNALIZATION OF FINANCIAL MARKETS

FUNCTION OF FINANCIAL INTERMEDIARIES


Indirect finance funds can move from lenders to borrowers by a second route with the use of a financial intermediary. Financial Intermediation primary route for moving funds from lenders to borrowers

Transaction cost time and money spent in carrying out financial transactions Risk uncertainty about the returns investors will earn on assets Asymmetric information one party does not know enough about the other party to make accurate decisions.

WHY ARE FINANCIAL INTERMEDIARIES AND INDIRECT FINANCE SO IMPORTANT IN FINANCIAL MARKET?

A. Adverse Selection before the transaction occurs. It occurs when the potential borrowers who are the most likely to produce an undesirable outcome are the ones who most actively seek out a loan and likely to be selected. B. Moral hazard after the transaction occurs. It is the risk that the borrower might engage in activities that are undesirable from the lenders point of view, making it less likely that the loan will be paid back.

WHY ARE FINANCIAL INTERMEDIARIES AND INDIRECT FINANCE SO IMPORTANT IN FINANCIAL MARKET?

PRINCIPAL FINANCIAL INTERMEDIARIES


3 CATEGORIES: 1. Depository Institutions banks. Accepts deposits from individuals and institutions and make loans. a. Commercial banks raise funds primarily by issuing chackable deposits, savings deposits, and time deposits. B. Savings and Loan Associations and Mutual banks obtain funds through savings deposits and time and chackable deposits.

PRINCIPAL FINANCIAL INTERMEDIARIES


C. Credit Unions very small cooperative lending institutions. Acquire funds from deposits and make consumer loans

PRINCIPAL FINANCIAL INTERMEDIARIES


2. Life insurance companies insure people against financila hazards following death and seel annuities. 3. Fire and Casualty Insurance Company insure policyholders against loss from theft, fire and accidents. 4. Pension funds and governement retirement funds acquired by contributions

INVESTMENT INTERMEDIARIES
Finance companies raise funds by selling commercial paper. Mutual funds acquire funds by selling shares to many individuals Money market mutual funds they sell shares to acquire funds that are then used to buy money market instruments; both liquid and safe.