In Money and Banking, we study several important issues that affect the economy -
1. The Role of Money in the Economy
2. The role of financial markets - stock, bond and derivative
3. The role of financial institutions (banks, mutual
funds, ins cos.)
Applied macro to policy issues and financial markets.....
Money and Banking is the most exciting part of economics
- many important changes. Innovation in fin markets, deregulation of banking,
the S&L collapse, the increased international integration of world
currency and financial mkts.
WHY STUDY MONEY AND MONETARY POLICY?
Money or money supply (MS) is anything that is accepted
as final payment for goods, services or debts.
We now have a "Fiat" money system - no link to commodity.
The FED directly controls the MS, which indirectly affects
which important economic variables????
Why are commercial banks important in the MS process???
Money and Business Cycles:
When we study monetary theory, we look at how money is linked to the business cycle, the alternating periods of economic expansion and contraction. We are in the expansionary phase of the 10th bus cycle since WWII.
Money is linked to aggregate econ activity - GDP (aggregate
output), unempl, recession, bus cycle, etc. See page 9.
Money, Inflation and Interest Rates
Money is also linked to inflation and interest rates.
Inflation = percentage change (or growth rate) in the
price level.
Inflation: ((CPIt - CPIt-1) / CPIt-1)
* 100
GDP deflator - aggregate, broad based price index.
CPI - narrower, consumer-based index.
Look at graphs on p. 10 and 11.
"Inflation is always and everywhere a monetary phenomenon."
Money affects int rates. See p. 12.
Why Study Monetary Policy? - because money affects so much of the economy - bus cycle, un, inf, int rates - monetary policy is very important. FRS is responsible for conducting monetary policy. Politicians and fin markets are very concerned about monetary policy.
FRB chairman is the "second most powerful person in the
world."
Budget Deficits and Monetary Policy
See graph p. 13. We now have budget surpluses. WHY??
Last balanced budget before the late 90s was 1969, and the last period
of several surpluses was early 50s. Do budget deficits lead to higher
money growth, higher inflation and higher int rates?
WHY STUDY BANKING?
Banking in U.S. was historically separated into two types - commercial and investment banks. Result of the Glass-Steagall Act of 1933 that separated banks and brokers. Glass-Steagall has just been repealed with the Gramm-Leach-Bliley Act in 1999.
Banks are important because:
1. They link savers and borrowers through a process called "Financial intermediation." Banks are the largest financial intermediaries in the economy and deserve careful study. Funds are channeled from people with excess money (savers, suppliers of credit), to people have a deficiency of money (borrowers, demanders of credit).
Commercial banks are actually a far more important source of funds than stocks or bonds! See page 182.
Financial disintermediation is the flow of funds AWAY from commercial banks- commercial paper, money market mutual funds, junk bonds are examples of "cutting out the middleman."
2. Banks are the link between monetary policy of FRS (Federal Reserve System) and the economy. Money is created through the banking system through the expansion of bank reserves, bank loans, and checking deposits, not by actually printing dollar bills.
3. Banks are in the process of rapid innovation and change.
Deregulation is constantly taking place (see page 291 for a list of the
7 major bank deregulation acts since 1980), as well as innovation. Futures,
options, derivatives, forward markets, global investing, digital economy,
etc.
WHY STUDY FINANCIAL MARKETS?
Financial markets transfer and channel money from people who have excess funds to people and firms who have a shortage, which increases overall economic efficiency. Why???
1. Bond Market - Fixed Income Market. Bonds and Mortgages. Bond is a debt security with a stated coupon rate, fixed coupon pmts, fixed payoff at maturity and fixed maturity date. The bond market is extremely important because it is where corporations, universities, cities, governments, etc. obtain funds for business expansion, business starts, daily operation of a business or government, etc. Think of life without credit markets!
The bond market is also important because it is where Interest Rates are determined. (Interest rate = rental rate on money). Actually there are many interest rates: mortgage rates, car loan rates, junk bonds, T-bonds, muni bonds, AAA corporate bonds, etc., although sometimes we talk about "the" interest rate. How often do interest rates change? In CH 4, 5 and 6 we study interest rates in detail.
See page 5 for a graph of interest rates over the last
50 years. T-Bills reached 16% in 1981, then fell to 3% in 1992-93,
have risen since then to about 6% now. Why do interest rates change?
Why are interest rates so important???
2. Stock Market - Equity market. 6500 publicly traded companies in the US in three stock markets - NYSE, AMEX, NASDAQ. See page 6. As a shareholder you are a "residual claimant."
Stock market is especially concerned with monetary policy
and int rates. Why does the stock market do well when int rates are low??
Why does a company care about its stock price?
FOREIGN EXCHANGE MARKET
Foreign exch rate is the price of one country's currency in terms of another currency. For example, the Yen/$ ex rate = approx. 106 Yen/$.
See graph on p. 7. Dollar weakened in the 1970s, strengthened in the 80s and weakened again in the 90s. Monetary policy directly affects ex rates by changing the relative supply of currency.
Weak dollar, strong foreign currency, helps our export industries by making our goods more competitive, hurts our imports by making them more expensive.
Strong dollar, weak foreign currency, hurts our export industries by making our goods more expensive to foreigners. Fluctuations in the ex rate affect the economy and the ex rate is directly tied to mon policy. We study exchange rates in Ch 7.
Money and Banking should be an exciting course - it is very practical and applied because we are talking about real world activity - banking, monetary policy, int rates, fin markets, inflation, etc.... Emphasis is on applied macro and using the economic way of thinking.
We develop some basic supply and demand models for bonds, credit, money, etc. to help understand the mechanics of the financial markets. Understanding basic models for how interest rates, exchange rates and inflation are determined give you tools that won't become obsolete, will allow you to understand future changes in interest rates, stock market, ex-rates, etc.
Questions 4, 6, 14, 15
Appendix to Chapter 1
Clarification of common terms:
1. Aggregate Output and Income - Most common measure of national income or national output is Gross Domestic Product (GDP) - about $10T per year. Total value of all final goods and services produced in U.S. during some period - quarter or year.
NOT counted in GDP:
a) used, second-hand goods. Examples: Used cars, antiques, houses that are not new.
b) purchases of financial assets - stocks, bonds, mutual funds, options, futures contracts, etc. Commisions are counted as current services but not the value of the asset.
c) intermediate goods at the wholesale level. To avoid double-counting.
GDP=Total Expenditures=Total Income Received
National Income = National Output
2. Real versus Nominal Values
Nominal = measured in current dollars
Real = measured in constant dollars, using some year
as the base year.
Since the value of the dollar changes over time, due to inflation, nominal values can be misleading. We usually want to account for the effects of inflation by converting to real value. Real income, real output, real interest rates, real wages, real returns, real asset prices, real cash flows, etc.
When discussing output or income, we usually assume that we mean REAL output/income, measured by real GDP.
Example: GDP = SUM Pi Qi or
%GDP (nominal) = % Real Output + % Price Level
Money illusion: confusing nominal and real variables.
3. Aggregate Price Level - can be either GDP deflator or CPI. Current debate: Does CPI overstate inflation (cost of living)? Yes.