ECO 531- CHAPTER 1

INTRODUCTION: OVERVIEW OF THE

STUDY ON MONEY, BANKING &
FINANCIAL MARKETS
◼Why study money, banking and financial markets?
◼To examine the role of money in the economy.
◼To examine the link between money and business cycles,
money and inflation, money and interest rates.
INTRODUCTION

◼ Nominal
◼ INTRODUCTORY REMARKS
◼ Real
◼ Some of the terms being discussed
throughout the study guide: ◼ Financial Intermediaries

◼ Financial Markets ◼ Recession

◼ Security ◼ Inflation

◼ Interest Rate ◼ Monetary Policy

◼ Money ◼ Fiscal Policy

◼ Aggregate Output ◼ Asymmetric Information

◼ Unemployment ◼ Adverse Selection

◼ Business Cycle ◼ Moral Hazard

 WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS?

◼ This course provides answers to these and other questions by examining how financial markets (i.e.
bonds, stocks and foreign exchange) and financial institutions (banks, insurance companies, mutual
funds, and other institutions) work and by exploring the role of money in the economy.
◼ Financial markets and institutions not only affect your everyday life but also involve flows trillions
of dollars of funds throughout our economy, which in turn affect business profits, the production of
goods and services, and even the economic well-being of countries.
◼ The financial system is complex, comprising many different types of private sector financial
institution (banks, insurance companies, mutual funds, finance companies, investment banks and
other institutions).
◼ What happens to financial markets, financial institutions and money is of great concern to
politicians and even have a major impact on elections.
◼ This will reward you with an understanding of many exciting issues.
 CIRCULAR FLOW MODEL OF AN OPEN ECONOMY

◼ 4 sectors: household – owner of resources, firm – produces products &

services, government – collects taxes and spends them; and foreign sector
– involved in the import and export of goods & services.
◼ Monetary sector/ money market – for channeling of funds from severs to
lenders.
◼ The involvement of the monetary sector comes from savings, investments,
and government borrowing - which will influence price level, interest
rates and balance of payment.
MONEY IN RELATION TO INTEREST RATES

• One of the many definitions of interest rate is the price of money.

• Money plays an important role in interest rate fluctuations - which are of great concern
to both consumers and businesses.
• The level of interest rate is mainly influenced by the process of demand and supply of
money in the economy.
• This shows the interdependence of the level of interest rate with money.

• Past empirical data also shows that money growth rate has a positive relationship with
the level of interest rate.
• Demand for money could arise from transactions, precautions as well as speculation.
• The supply of money comes from loanable funds quantity is determined by the
monetary base as well as currency in circulation.
 MONEY IN RELATION TO FOREIGN EXCHANGE

◼ The foreign exchange market is where funds to be transferred from one country to
another, is being converted.
◼ The foreign exchange rate is the price of one country’s currency in terms of another's.
◼ The exchange rate fluctuation has a direct effect on consumers because it affects the
cost of foreign g&S.
◼ For businesses, the exchange rate would translate to either higher exports or lower
imports (more attractive) and vise versa.
◼ This process will have a direct effect on a country’s Balance of Payments as it
involves the trade & services balances i.e. the import and export of g&S.
MONEY AND THE BUSINESS CYCLE

◼Money plays an important role in generating business cycles,

the upward and downward movement of aggregate output
produced in the economy.
◼Excessive money will create inflation while too little of them
could cause recession.