The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Chapter 1
Why Study Money, Banking,
and Financial Markets?
Preview
• To examine how the workings of financial markets such as
bond, stock and foreign exchange markets affect your
everyday life
• To examine how financial institutions such as banks,
investment and insurance companies work
• To examine the role of money in the economy
Learning Objectives
• Recognize the importance of financial markets in the
economy.
• Describe how financial intermediation and financial
innovation affect banking and the economy.
• Identify the basic links among monetary policy, the
business cycle, and economic variables.
• Explain the importance of exchange rates in a global
economy.
• Explain how the study of money, banking, and financial
markets may advance your career.
Why Study 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
 Why Study Financial Markets? (1 of 2)
Financial markets are crucial in
our economy.
1. Channels funds from savers
to investors. Result?
2. economic efficiency = 
economic growth.
– “rich” vs “poor” countries.

3. Affects: personal wealth,

business firms, and
economy (not always good)
– Example: World map of real GDP
growth (before [2007] & after [2009]
https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD
 Why Study Financial Markets?
Debt Markets & Interest Rates
• Debt markets allow governments, corporations, and
individuals to borrow.
• Borrowers often issue a security, called a bond, offering
interest and principal over time.
• The interest rate is the cost of borrowing.
• Usually expressed as a
percentage per year
• Many types of interest
rates: mortgage, car,
credit card, etc.
• “Benchmark” interest rate
set by Central Bank
The Bond Market and Interest Rates
• A security (financial instrument) is a claim on the issuer’s
future income or assets.
• A bond is a debt security that promises to make payments
periodically for a specified period of time.
• An interest rate is the cost of borrowing or the price paid
for the rental of funds.
– Important to understand how bonds and interest rates
are related
The Bond Market and Interest Rates
Figure 1 Interest Rates on Selected Bonds,
1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/BAA
South Africa 10-Year Government Bond Yield - Quote - Chart - Historical Data - News
(tradingeconomics.com)
 Why Study Financial Markets?
The Stock Market
• The stock market is the market where common company
shares (or stock) are traded.
– “Common stock” = a share of ownership in a corporation.
– “shares of stock” = tradeable “pieces” of stock.
• Companies initially sell stock (in the primary market) to
raise money. After that, the stock is traded among
investors in the secondary market.
• Share prices are very volatile
– Affects wealth and willingness to spend
– Affects businesses’ ability to make (real) investment decisions.
– Important to understand what causes such volatility and how
investment decisions (& economic growth) can be affected.
• Stock market receives the most attention from the media.
Figure 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA

United States Stock Market Index - Quote - Chart - Historical
Data - News (tradingeconomics.com)
 Why Study Financial Institutions? (1 of 3)
• Financial intermediaries:
Borrow funds from surplus
units and lend to deficit units.
– Banks: Accept deposits and
make loans
▪ Very important, thus
heavily regulated
– Other financial institutions:
insurance companies, finance
companies, pension funds, mutual
funds and investment companies
– Without them financial
intermediation, -markets,
efficiency and economic
activity would be much less.
Why Study Financial Institutions? (2 of 3)
Also need to understand
• Failures of financial institutions and the financial system
– Financial Crises: The “Great Recession” of 2007–2009
was the worst financial crisis since the Great
Depression. Why did it happen?
• Central Banks and the Conduct of Monetary Policy
– Central banks’ role in the management of interest rates
(and the money supply)

• The International Financial System

– Cross-country capital flows impact domestic economies
– Need to understand exchange rates, capital controls,
and the role of agencies such as the IMF
 Why Study Financial Institutions? (3 of 3)
• Financial Innovation
– the development of new
financial products and services
– focus on improvements in
technology and the impact on
financial product delivery
– Can also have severe
consequences - GFC 2007-8
• Managing Risk in Financial
Institutions
– Focusing on risk management
in the financial institution
 Why Study Financial Institutions and
Banking?
• To better understand financial crises:
– Major disruptions in financial markets that are
characterized by sharp declines in asset prices and the
failures of many financial and nonfinancial firms.
World map showing real GDP growth rates for 2009. (Countries in brown were in recession.)
 Why Study Money and Monetary Policy?

• Evidence suggests that money, defined as anything that is

generally accepted as payment for goods or services or in
the repayment of debts, plays an important role in
generating business cycles.
• Recessions (unemployment) and expansions affect all of us.
• Monetary theory ties changes in the money supply to
changes in aggregate economic activity and the price level.
 Do you think what happens in the USA affects South Africa?
Does US monetary policy (Fed Funds rate) influence SA interest
rates?
Figure 3 Money Growth (M2 Annual Rate) and
the Business Cycle in the United States, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL

Money Growth (M2) and the Business Cycle in
South Africa, 1966–2020

Source: Federal Reserve Bank of St. Louis, FRED database:

https://fred.stlouisfed.org/series/ZAFREC#0
Money, Business Cycles, and Inflation
• The aggregate price level is the average price of goods
and services in an economy
• A continual rise in the price level (inflation) affects all
economic players
• Data show a connection between the money supply and
the price level
Figure 4 Aggregate Price Level and the Money
Supply in the United States, 1960–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GDPDEF
Average Inflation Rate Versus Average Rate of Money
Growth for Selected Countries

“Inflation is always and

everywhere a monetary
phenomenon” (Friedman)

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/

Money and Interest Rates
• Interest rates are the price of money
• 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 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/M2SL
 Fiscal Policy and Monetary Policy
• Monetary policy is the management of the money supply
and interest rates
– Conducted in the United States by the Federal Reserve System (Fed)
– Conducted in SA by the South African Reserve Bank (SARB)
– Important to understand how/why MP affects money, interest rates,
inflation and growth.

• Fiscal policy deals with government spending

and taxation
– Budget deficit: expenditures > revenues for a particular year
▪ Any deficit must be financed by borrowing (or creating money?)
– Budget surplus: revenues > expenditures for a particular year
– Important to understand how fiscal deficits could cause higher money
growth, interest and inflation rates and even financial crisis.
Figure 7 Government Budget Surplus or Deficit as a
Percentage of Gross Domestic Product, 1950–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/M2SL;

https://fred.stlouisfed.org/series/FYFSGDA188Sl
Fiscal Cliff?
http://www.usdebtclock.org/index.html
 Why Study Financial Markets?
The Foreign Exchange Market
• The forex market is where
international currencies
trade and exchange rates
are set.
• Most know little about this
market, but it has a daily
volume around $7 trillion!
• Important to examine how
exchange rates are
determined in both the
short- and long-run.
– affects economic growth
(trade and investment).
Figure 8 Exchange Rate of the U.S. Dollar,
1973–2017

Source: Federal Reserve Bank of St. Louis, FRED database:

https://fred.stlouisfed.org/series/TWEXMMTH
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?
Money, Banking, and Financial Markets
and Your Career
• Understanding monetary policy may help you
– predict when interest rates will rise or fall,
– make decisions about whether it is better to borrow
now or to wait until later,
– know how banks and other financial institutions are
managed which may help you get a better deal when
you need to borrow from them
– make better investment decisions, whether for yourself
or for the company you work for
How We Will Study Money, Banking, and
Financial Markets
• A simplified approach to the demand for assets
• The concept of equilibrium
• Basic supply and demand to explain behavior in financial
markets
• The search for profits
• An approach to financial structure based on transaction
costs and asymmetric information
• Aggregate supply and demand analysis
 Exploring the Web
• You can view the most current data for most of the in-text
data figures from the Federal Reserve Bank of St. Louis’s
FRED database (https://fred.stlouisfed.org/ )
• Similar data for South Africa also available on FRED
database, but also on the SARB website
(www.resbank.co.za).
• At the end of most chapters there are several real-time
data analysis problems, which ask you to download the
most recent data from the Federal Reserve Bank of St.
Louis’s FRED database and then use these data to answer
interesting questions.
 Appendix 1:

Defining Aggregate Output, Income, the Price Level, and

the Inflation Rate
Aggregate Output and Income
• The most commonly reported measure of aggregate
output, the gross domestic product (GDP), is the market
value of all final goods and services produced in a country
during the course of a year.
• Aggregate income, the total income of factors of
production (land, labor, and capital) from producing goods
and services in the economy during the course of the year,
is equal to aggregate output.
Real Versus Nominal Magnitudes (1 of 2)
• When the total value of final goods and services is
calculated using current prices, the resulting GDP measure
is referred to as nominal GDP. The word nominal indicates
that values are measured using current prices.
Real Versus Nominal Magnitudes (2 of 2)
• A more reliable measure of economic production
expresses values in terms of prices for an arbitrary base
year, currently 2005. GDP measured with constant prices
is referred to as real GDP, the word real indicating that
values are measured in terms of fixed prices.
Aggregate Price Level
• The aggregate price level is a measure of average prices
in the economy.
• Three measures of the aggregate price level are
commonly encountered in economic data:
– The GDP deflator
– The PCE deflator
– The Consumer Price Index (CPI)