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MGEC71: Chapter 1

Why Study Money, Banking,

and Financial Markets

Chapter 1 - List of Topics

Why Study Money, Banking, and Financial Markets
1.1 Why Study Financial Markets
1.2 Why Study Banking & Financial Institutions
1.3 Why Study Money & Monetary Policy
1.4 How We Will Study Money, Banking, and
Financial Markets

Why Study Financial Markets?

1. Financial markets channel funds from
savers to investors (from those who have an excess of
available funds to people who have a shortage), thereby
promoting economic efficiency
2. Financial markets are a key factor in
producing economic growth
3. Financial markets affect personal wealth
and behaviour of businesses

Financial Securities - Assets

A security (financial instrument) is a

claim on the issuers future income or

A financial asset is any financial claim

that is subject to ownership

The Bond Market & Interest Rates

A bond is a debt security that

promises periodic payments for a
specified time (the bond market is
where interest rates are determined)

An interest rate is the cost of

borrowing (or the price paid on the
rental of funds)

The Bond Market & Interest Rates

High interest rates could deter purchases, or

investment, and encourage savings

Different interest rates have a tendency to

move in unison (Figure 1-1), perhaps
because of this correlation of interest rates
economists frequently lump interest rates
together and refer to the interest rate

Short-term interest rates tend to fluctuate

more and are lower on average than others

The Bond Market & Interest Rates

The Stock Market

Common stock represents a share

of ownership in a corporation

A stock is a security that is a claim on

the earnings and assets of that

Corporations issue & sell stock to the

public to raise funds to finance their

The Stock Market

The stock market is also an important factor in

business investment decisions because the
price of shares affects the amount of funds that
can be raised by selling newly issued stock to
finance investment spending (daily vote of

The stock market is a place where people get

rich and poor quickly with considerable
fluctuations in stock prices, which affect the size
of peoples wealth (and their willingness to
spend) Figure 1-2

Stock Market Fluctuations (S&P/TSX)


Financial Institutions and Banking

Banks and other financial institutions are what make

financial markets work

Financial Intermediaries - institutions that channel funds

from people who have saved to parties who wish borrow
(indirect finance)

Financial Crises disruption of the financial markets that

lead to decline in asset prices (can cause significant shortterm disruptions in the real economy non neutrality)

Banks - institutions that accept deposits and make loans

(chartered banks, trust and mortgage loan companies, and
credit unions & caisses populaires), these are the financial
intermediaries that the average person interacts with most

Financial Institutions and Banking

Other Financial Intermediaries - insurance companies,

finance companies, pension funds, mutual funds and
investment banks
Financial Innovation- in particular, dramatic
improvements in information technology have led to new
means of delivering financial services electronically (efinance) and higher profits result from creative thinking
Changes in Rules & Regulations also influence how
financial institutions behave and compete with each other,
how we interact with them, how profitable they are, and
how much benefit their customers gain (from their
These, & other, innovations impact the velocity of money
(MxV = PxY)

Money and Monetary Policy

Money anything that is generally accepted in

payment for goods and services or in the repayment of

Evidence suggests that money plays an important role

in generating business cycles (movements in
aggregate real output & unemployment) see figs

Recessions (unemployment) and booms (inflation) lead

to changes in aggregate economic activity

Monetary Theory relates changes in the quantity of

money (supplied) to changes in aggregate SR real
economic activity and the price level

Money and Monetary Policy

Every recession in the 20th century has been

preceded by a decline in the rate of money
growth, indicating that changes in money are
also a driving force behind business cycle
fluctuations (but not every decline in the rate
of money growth is followed by a recession)

The Canadian recession that started in late

2008 is sort of an exception (while preceded
by such a drop - it started with a financial
crisis in the US)

M2 Money Supply Growth & Business Cycles (Can)


Money and Business Cycles


Money and Inflation

The aggregate price level is the

average price of goods and services in an economy

Inflation - A continual rise in the price level, affects

all economic players & is generally regarded as an
important problem of concern to politicians &

The money supply and the price level generally

move closely together (QTM implies the continuing
increase in the money supply might cause the
continuing increase in the price level, Figure 1-4)

Inflation is always and everywhere a monetary

phenomenon (Milton Freidman, Figure 1-5)

Money and the Price Level


Money Growth and Inflation


Money and Interest Rates

Interest rates are the price (over time)

of (borrowing) money

Prior to 1980, the rate of money

growth and the interest rate on longterm bonds were closely tied (Fig 1-6)

Since then, the relationship is less

clear but still an important determinant
of interest rates (especially long-term
rates Fisher equation)

Money Growth and Interest Rates


Monetary and Fiscal Policy

Monetary policy is the management of

the money supply and interest rates
(Conducted by the Bank of Canada)

Fiscal policy is decisions about

government spending and taxation

Budget deficit/surplus is the excess of

exps/revenue over revenues/exps for a
particular year
Any deficit is usually financed solely by
borrowing (or sale of government assets)

Monetary and Fiscal Policy

Deficits increase the national debt and make it

vulnerable to increases in world interest rates
Some believe the ability to issue public debt
allows the government to smooth taxes and
inflation over time
Large budget deficits might lead to a financial
crisis and result in (monetization of debt) a
higher rate of money growth, a higher rate of
inflation, and higher interest rates


Fiscal Policy Budgetary Balance


Why Study International Finance?

Increasing integration of financial

markets (continued & growing
Canadian companies borrow in foreign
markets and foreign markets borrow
from Canada
Banks and other financial institutions
increasingly international foreign

Foreign Exchange Market

The foreign exchange market is where one

countrys currency is exchanged for another

The exchange rate is the price of one

countrys currency in terms of anothers (i.e. it
is the relative price of two national currencies)

Throughout this course, the exchange rate

is normally expressed as units of foreign
currency (purchased) per Canadian dollar

Foreign Exchange Market

Nominal appreciation (depreciation) is a rise

(fall) in the value of a countrys currency (in
terms of units of foreign currency it can

Changes in the exchange rate have direct effects on Canadian

consumers because it affects the cost of foreign goods

A stronger dollar benefits Canadian consumers by making

foreign goods cheaper but hurts Canadian businesses and
eliminates some jobs by cutting both domestic (imports are
cheaper) and foreign (our exports are more expensive) sales
of their products

Foreign Exchange Market


The International Financial System

Larger capital flows between countries

Greater importance of foreign financial
systems on domestic economy.
Potentially larger role for international
institutions (e.g. IMF, WTO, BIS, etc.)


How We Study Money and Banking

Develop an analytical framework that uses basic
economic concepts to organize our thinking
Simplified approach (partial equilibrium framework)
to the demand for assets (det of asset prices)
Basic supply and demand approach to understand
behaviour in (and structure of) financial markets
Profit maximization
Transactions cost and asymmetric information
approach to financial structure & bank management
Aggregate supply and demand analysis

How We Study Money and Banking II

Learning Tools:
1. Case studies
2. Applications
3. Special-interest boxes
4. Financial News boxes
5. Web Exercises and References
All present evidence that supports or casts
doubts on the theories being discussed