Chapter 1

The Role of Money and Financial

System

Assoc. Prof., PhD. Hoai Bui

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 Objectives

 Answer 3 questions:
 Why Study Financial Markets?

 Why Study Financial Institutions and Banking?

 Why Study Money and Monetary Policy?

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 Contents

 Financial Markets

 The Overview of Financial System

 Financial Intermediaries (Financial

Institutions and Banking)

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 Financial Markets

• Financial markets?
• Structure of Financial Markets
• Function of Financial Markets

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 Financial markets?
• Financial markets
are markets in which
funds are transferred from people and
Firms who have an excess of available
funds to people and Firms who have a
need of funds.

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 Structure of Financial Markets

• Debt and Equity Markets

– Debt instruments (bonds,…)
– Equities (stocks,…)
• Primary and Secondary Markets
– Investment Banks underwrite securities in
primary markets
 In Vietnam: Sicurities Companies; Commercial Banks.
– Brokers and dealers work in secondary markets

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Structure of Financial Markets (cont’d)

• Exchanges and Over-the-Counter (OTC)

Markets
– Exchanges: NYSE, …
VN: Ho Chi Minh Stock Exchange (HOSE) , Ha Noi Stock
Exchange.

– OTC Markets
• Money and Capital Markets
– Money markets deal in short-term debt
instruments
– Capital markets deal in longer-term debt and
equity instruments

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 The Bond Market and Interest Rates

• A security (financial instrument) is a claim

on the issuer’s future income or assets.
• A bond (a debt security) is a document
containing an agreement by a government
or a company (bond issuer) to pay bond
holders interest on the money the holders
have lent.
• An interest rate is the cost of borrowing or
the price paid for the rental of funds.
– Differences between interest rate and interest?

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 Figure 1 Interest Rates on Selected
Bonds, 1950–2011

Sources: Based on Federal Reserve Bulletin;

www.federalreserve.gov/releases/H15/data.htm.

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 The Stock Market

 Common stock:
 represents a share of ownership in a
corporation;
 a security that is a claim on the residual
earnings and assets of the corporation.
 Preferred stock?

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 Figure 2 Stock Prices as Measured by
the Dow Jones Industrial Average,
1950–2011

Source: Based on Dow Jones Indexes: http://nance.yahoo.com/?u.

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 Function of Financial Markets
• Perform the essential function of channeling funds
from economic players that have saved surplus
funds to those that have a shortage of funds;
• Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling them
debt securities

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 Function of Financial Markets

• Promotes economic efficiency by producing an

efficient allocation of capital, which increases
production
• Directly improve the well-being of consumers by
allowing them to time purchases better

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Internationalization of Financial Markets

• Foreign Bonds: sold in a foreign country and

denominated in that country’s currency
• Eurobond: bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies: foreign currencies deposited in
banks outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
https://www.thesaigontimes.vn/127716/eurocurrency-la-gi

• World financial Markets

– Also help finance the federal government

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 Why Study Financial Markets?
 Activities in financial markets also have direct
effects on
 personal wealth
 the behavior of businesses and consumers, and
 the cyclical performance of the economy.

 In Chapter 2:
 examine what the phrase interest rates means,
 explain why interest rates change.

 in Chapter 3:
 examine how stock prices behave and respond to
information in the marketplace.

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 Why Study Financial Markets?

 in chapter 7:
 explain how the foreign exchange market works
 identify the main factors that affect exchange rates.

 In chapter 8:
 examine how international financial transactions
 the structure of the international financial system
affect monetary policy.

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 Financial Intermediaries

• Financial Intermediaries?
• Function of Financial Intermediaries

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 Financial Intermediaries

• Financial Intermediaries: institutions that

borrow funds from people who have saved and
make loans to other people:
– Banks: accept deposits and make loans
– Other Financial Institutions: insurance
companies, finance companies, pension funds,
mutual funds and investment companies
What are the differences between banking
institutions and non-banking institutions?

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 Function of Financial Intermediaries:
Indirect Finance

 Lower transaction costs (time and money spent in

carrying out financial transactions)
– Economies of scale
– Liquidity services
 Reduce the exposure of investors to risk
– Risk Sharing (Asset Transformation)
– Diversification

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 Function of Financial Intermediaries:
Indirect Finance (cont’d)

 Deal with asymmetric information problems

 Adverse Selection (before the transaction): try to avoid
selecting the risky borrower.
- Gather information about potential borrower.
 Moral Hazard (after the transaction): ensure borrower will
not engage in activities that will prevent him/her to repay
the loan.
- Sign a contract with restrictive covenants.

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 Function of Financial Intermediaries:
Indirect Finance (cont’d)

• Conclusion:
– Financial intermediaries allow “small” savers
and borrowers to benefit from the existence of
financial markets.

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 Why Study Financial Institutions and
Banking?
• Without financial Institutions, financial markets
would not be able to move funds from people
who save to people who have productive
investment opportunities.
 If an individual wanted to make a loan to IBM or General
Motors, for example, how can she or he do?
 Why are financial intermediaries so crucial to well-
functioning financial markets? We answer this question in
chapter 4.
 We will examine how banks and other financial institutions
manage their assets and liabilities to make profits in
chapter 5

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 The Overview of Financial System

• The financial system is complex,

 comprising different types of private sector financial
institutions, including:
- banks,

- insurance companies,
- mutual funds,
- finance companies,
- and investment banks,
 all of which are heavily regulated by the government.

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 Figure 1 Flows of Funds Through the
Financial System

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 Regulation of the Financial System

• To increase the information available to

investors:
– Reduce adverse selection and moral hazard
problems
– Reduce insider trading (SEC).

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 Regulation of the Financial System
(cont’d)
• To ensure the soundness of financial
intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
• Restrictions on Interest Rates

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 Table 5 Principal Regulatory Agencies
of the U.S. Financial System

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 The Foreign Exchange Market

• The foreign exchange market is where

funds are converted from one currency into
another
• The foreign exchange rate is the price of
one currency in terms of another currency
• The foreign exchange market determines
the foreign exchange rate

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 Figure 8 Exchange Rate of the
U.S. Dollar, 1970–2011

Source: Federal Reserve; www.federalreserve.gov/releases/H10/summary/indexbc_m.txt/.

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 The International Financial System

• Financial markets have become increasingly

integrated throughout the world.
• The international financial system has
tremendous impact on domestic economies:
– How a country’s choice of exchange rate policy
affect its monetary policy?
– How capital controls impact domestic financial
systems and therefore the performance of the
economy?
– Which should be the role of international
financial institutions like the IMF?

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Role of Money and Monetary Policy

• Evidence suggests that money plays an

important role in generating business cycles
 Recessions (unemployment) and expansions
affect all of us
Figure 3 shows a connection between Money Growth
(M2 Annual Rate) and the Business Cycle

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 Figure 3 Money Growth (M2 Annual
Rate) and the Business Cycle in the
United States 1950–2011

Source: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

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Role of Money and Monetary Policy

• Monetary Theory ties changes in the money

supply to changes in aggregate economic
activity and the price level
 Figure 4 shows a connection between the money
supply and the price level
 Figure 5 shows a connection between Average
Inflation Rate Versus Average Rate of Money
Growth

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 Figure 4 Aggregate Price Level and
the Money Supply in the United
States, 1950–2011

Sources: Based on www.stls.frb.org/fred/data/gdp/gdpdef;

www.federalreserve.gov/releases/h6/hist/h6hist10.txt.

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 Figure 5 Average Inflation Rate Versus
Average Rate of Money Growth for
Selected Countries, 2000-2010

Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

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 Money and Interest Rates

• Prior to 1980, the rate of money growth

and the interest rate on long-term Treasury
bonds were closely tied
• Since then, the relationship is less clear but
the rate of money growth is still an
important determinant of interest rates
 Figure 6 shows a connection between Money
Growth (M2 Annual Rate) and Interest Rates
(Long-Term U.S. Treasury Bonds)

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 Figure 6 Money Growth (M2 Annual
Rate) and Interest Rates (Long-Term
U.S. Treasury Bonds), 1950–2011

Sources: Based on Federal Reserve Bulletin, p. A4, Table 1.10;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

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 Why Study Money and Monetary
Policy?
• a continual rise in the price level (inflation) and a
change of interest rates affect all economic players
• Monetary policy is the management of the money
supply and interest rates
– Conducted in the U.S. by the Federal Reserve System (Fed)

We summarize how conventional monetary policy

tools are implemented and the advantages and
limitations of each tool in chapter 6.

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