WHY STUDY MONEY & MONETARY POLICY?

MONEY AND BUSINESS CYCLES

• Money plays an important role ingenerating
business cycles—the 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 inflation—the continual rise in the price level of goods and services. .

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Money and Interest Rates .

• Fiscal Policy—taxation and government spending decisions. • Budget Surplus-tax revenue exceeds government expenditure. . • Budget Deficit-government expenditure exceeds tax revenues.• Monetary Policy—management of money and interest rates.

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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 .

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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 borrower’s future income or assets 2) Indirect Finance .

the entrepreneurs. • Financial markets also improve the well-being of consumers.Importance of Financial Markets • The people who save are frequently not the same people who have profitable investment opportunities available to them. allowing them to time their purchases better. that is employed to produce more wealth). either financial or physical. • Financial markers are critical for producing an efficient allocation of capital. (wealth. which contributes to higher production and efficiency for the overall economy. .

STRUCTURE OF FINANCIAL MARKETS .

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 .Debt and Equity Markets • Debt Market -Bond.

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 .

per se.Even though firms don’t get any money. 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 . from the secondary market.

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

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 .

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

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

such as Microsoft .• 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.

• 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 .

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

• Eurobond – bond dominated in a currency other than that of the country in which it is sold.TERMS • Foreign bonds – are sold in a foreign country and are denominated in the country’s currency. • 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? .

making it less likely that the loan will be paid back. 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. It is the risk that the borrower might engage in activities that are undesirable from the lender’s point of view. WHY ARE FINANCIAL INTERMEDIARIES AND INDIRECT FINANCE SO IMPORTANT IN FINANCIAL MARKET? . Moral hazard –after the transaction occurs. • B.• A. Adverse Selection –before the transaction occurs.

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

Acquire funds from deposits and make consumer loans . Credit Unions – very small cooperative lending institutions.PRINCIPAL FINANCIAL INTERMEDIARIES • C.

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

. • 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.INVESTMENT INTERMEDIARIES • Finance companies – raise funds by selling commercial paper. both liquid and safe.