ECON 354

1. ECON 354 • Lecture 1 • Syllabus • Introduction to Financial Markets and Money • Real World Observations and Basic Definitions Money and Banking

2. Resources Needed For This Class • Aplia Website: • http://econ.aplia.com • Use course code: M363-5FTK-EX38 • Mishkin, Frederick S. (2010), The Economics of Money, Banking and Financial Markets, 9th Edition, Pearson • 8th edition is also fine if you have it. Note: These notes are incomplete without having attended lectures

3. Success in an (Any!) Economics Course To do well in Economics, you need to be able to do 3 things well (in conjunction): • Think Mathematically: Don’t be afraid of equations! • Think graphically! • Abstract Logic! (Often the hardest part) Note: These notes are incomplete without having attended lectures

4. A Model of the Economy • As in Principles of Macro, divide the economy into different sectors and see how those sectors interact: • “Agents” in the Economy • Markets where Agents Interact • Equilibrium Note: These notes are incomplete without having attended lectures

5. The Agents in the System… • There are four agents that we will focus on when constructing a model of the economy: • Households • Firms • Government • “The Rest of the World” (ROW) Note: These notes are incomplete without having attended lectures

6. Markets • There are three markets that we typically focus on in macroeconomics: • The Factor Market • The Goods Market • The Financial Market (- we examine in detail in this course) Note: These notes are incomplete without having attended lectures

7. The Economy GOVERNMENT • Financial Markets: • Interest Rates-Risk-Expectations HOUSEHOLDS Financial Institutions - Financial Intermediaries Central Banking & Monetary Policy FIRMS Overview of the Course REST OF THE WORLD Note: These notes are incomplete without having attended lectures

8. Overview of the Course • Money • Monetary Theory and Monetary Policy • Financial Markets and Financial Intermediaries Note: These notes are incomplete without having attended lectures

9. Some Definitions • Money: Anything that is generally accepted in payment for goods and services • In the United States: • M1 = Currency + Traveler's Checks + Demand Deposits + Other Checkable Deposits • M2 = M1 + Small denomination time deposits & repurchase agreements + Savings Deposits and money market deposit accounts + retail Money Market mutual fund shares • There also used to be a broader measure of money, M3 which was discontinued as of March 2006. • See: http://www.federalreserve.gov/releases/h6/hist/ Note: These notes are incomplete without having attended lectures

10. Role of Money • Medium of exchange • Form of transaction technology • Unit of account • Store of value • Purchasing Power • Hence money helps to: • Lower transaction costs • Increase Liquidity in an economy Note: These notes are incomplete without having attended lectures

11. Overview of the Course • Money • Monetary Theory and Monetary Policy • Financial Markets and Financial Intermediaries Note: These notes are incomplete without having attended lectures

12. Monetary Theory and Policy • Why study Monetary Theory and Policy? • Influence on business cycles, inflation, and interest rates. • How Central Bank (Fed) can have a big influence on the economy?. Note: These notes are incomplete without having attended lectures

13. Money and Business Cycles • Shaded areas represent Recessions • Note: Figure above shows a decline in money growth rate prior to every recession (except the most recent one)! Note: These notes are incomplete without having attended lectures

14. Money and the Price Level • Note: Positive Relationship between Money and the Aggregate Price Level Note: These notes are incomplete without having attended lectures

15. Money Growth and Inflation • Note: Across different countries, positive correlation between avg. money growth rates and avg. inflation rates Note: These notes are incomplete without having attended lectures

16. Money Growth and Interest Rates • Positive correlation between money growth rates and interest rates in 1960’s & 1970’s • Relationship breaks down in 1980’s Note: These notes are incomplete without having attended lectures

17. Surpluses and Deficits 1991 Recession 1982 Recession OPEC Recession • Figure 10(a) shows the changing surplus and deficit of the federal and provincial governments in the United States since 1971. • Persistent federal deficit during the 1970s through 1990s. • Surplus from 1998 to 2001 • More deficits following. 2001 – 2002 Recession 1980’s expansion 2002 – 2007 expansion 1990’s expansion Source: Congressional Budget Office Note: These notes are incomplete without having attended lectures

18. Surpluses and Deficits International Surplus and Deficit • If a nation imports more than it exports, it has an international (trade) deficit. • If a nation exports more than it imports, it has an international (trade) surplus. • The current account deficit or surplus is the balance of exports minus imports plus net interest paid to and received from the rest of the world. Note: These notes are incomplete without having attended lectures

19. Surpluses and Deficits 1990’s Expansion 1980’s Expansion 2008 Recession • Figure 10(b) shows The U.S. current account balance since 1960. • Persistent current account deficit since 1983 • The deficit has swollen during the past few years 2001 – 2002 Recession OPEC Recession 1991 Recession 1981-82 Recession Source: Bureau of Economic Analysis Note: These notes are incomplete without having attended lectures

20. Interaction of Monetary and Fiscal Policy • Surpluses – good? Deficits – bad? • Examine how fiscal irresponsibility can lead to the onset of financial crises. • Why deficits might lead to a higher money growth rate, a higher rate of inflation and higher interest rates?. Note: These notes are incomplete without having attended lectures

21. Overview of the Course • Money • Monetary Theory and Monetary Policy • Financial Markets and Financial Intermediaries Note: These notes are incomplete without having attended lectures

22. Financial Markets • Why Study Financial Markets? • Channel funds from savers to investors, thereby promoting economic efficiency • Affect personal wealth and behavior of business firms • Brief Introduction to: • Bond Market • Stock Market • Foreign Exchange Market Note: These notes are incomplete without having attended lectures

23. Function of Financial Markets: Flow of Funds Indirect Finance Financial Intermediaries • Allows transfers of funds from person or business without investment opportunities to one who has them. • Improves economic efficiency. FinancialMarkets • Lender-Savers • Households • Firms • Government • Foreigners • Borrowers-Spenders • Business-Firms • Government • Households • Foreigners Direct Finance Note: These notes are incomplete without having attended lectures

24. Bond Market: 1953 - 2010 • Bonds, securities…. what are they? • Bond Market (and Money Markets): • determines interest rates Note: These notes are incomplete without having attended lectures

25. Stock Market: 1950 - 2010 • Stocks: • Share of ownership in a corporation/firm. • Stock Price volatility • “Bull Market” vs. “Bear Market” • Stock Price “Bubbles” • Technology bubble in 1990’s? Note: These notes are incomplete without having attended lectures

26. Foreign Exchange Market • Foreign Exchange Market: • Transfer funds from one country to another • Changes in Exchange rate: • Changes in relative prices Note: These notes are incomplete without having attended lectures

27. Some Basic Definitions Debt Instrument: • Debt Instrument: Contractual agreement by borrower to pay holder of the instrument a fixed dollar amount at regular intervals (principal + interest), until a specified date • Example: Car loan • The maturity of a debt instrument is the number of years (term) until the instrument expires Note: These notes are incomplete without having attended lectures

28. Classifications of Financial Markets • Primary Market • New security issues sold to initial buyers (often behind closed doors) • Investment banks typically underwrite securities (i.e. guarantees a price for the security and then sells it to the public) • Secondary Market • Securities previously issued are bought and sold • E.g.: NASDAQ, Futures, Options, Foreign Exchange • Exchanges • Trades conducted in central locations (e.g., New York Stock Exchange, NYSE; London Stock Exchange, LSE) • Over-the-Counter Markets • Dealers at different locations buy and sell Note: These notes are incomplete without having attended lectures

29. Methods of Raising Private Sector Funds • Debt Markets • Short-term (maturity < 1 year): Money Market • Intermediate-term (1year < maturity < 10 years) • Long-term (maturity > 10 years) • Equity Markets • Common stocks: claims to share in assets and net income • No maturity date; periodic payments known as dividends • Capital Market: Intermediate + Long Term Debt + Equity • Examples: Bonds, mortgages Note: These notes are incomplete without having attended lectures

30. Financial Market Instruments What are the kinds of securities traded in financial markets? • Money Market Instruments • Because of short term to maturity, debt instruments traded in the money market do not have much fluctuation in their prices, and hence are the least risky • Capital Market Instruments • Debt and equity instruments with maturities greater than a year; these have much greater fluctuations in their prices (compared to money market instruments) and as such are considered more risky Note: These notes are incomplete without having attended lectures

31. Examples: Money Market Instruments • US Treasury Bills • Issued by US govt, with 1, 3, and 6 month maturities. • Pay a set amount at maturity, and have no interest payments; effectively pay interest by selling at a discount. • Negotiable Bank Certificates of Deposit • CD’s are debt instruments sold by banks to depositors that pays an annual interest of a given amount, and pays back the original purchase price at maturity • Commercial Paper • Short term debt instrument issued by large banks and well known corporations (e.g. Microsoft, GM). Note: These notes are incomplete without having attended lectures

32. Examples: Money Market Instruments • Repurchase Agreements • Repos are effectively short term loans (usually with a maturity of less than 2 weeks) for which T-bills serve as collateral. The most important lenders in this market are usually large corporations. • Federal (Fed) Funds • These are typically overnight loans of reserves between banks, of their deposits at the Federal Reserve. Note: These notes are incomplete without having attended lectures

33. Table 1 Principal Money Market Instruments Note: These notes are incomplete without having attended lectures

34. Examples: Capital Market Instruments • Stocks • These are equity claims on net income and assets of a corporation. • Issue of new stocks in any given year is typically quite small, although the total value of stocks exceed that of any other type of security in the capital markets. • Mortgages • Mortgage market is the largest debt market in the US • Residential mortgages are approximately 4 times the amount of commercial and farm combined. • Corporate Bonds • Long term bonds issued by corporations with very strong credit ratings. • Typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. • Some “convertible” corporate bonds allows the holder to convert them into a specified number of shares of stock at any time up to the maturity date. Note: These notes are incomplete without having attended lectures

35. Examples: Capital Market Instruments • US Government Securities • These are long term debt instruments issued by the US Treasury to finance the deficits of the government. • US Government Agency Securities • Issued by various agencies such as Ginnie Mae, the Federal Farm Credit Bank, etc, to finance such items as mortgages, farm loans or power generating equipment. • Many of the securities are guaranteed by the federal government. • State and Local bonds • Also called municipal bonds, which are long term debt instruments issued by the state and local governments to finance expenditures on roads, schools, and other programs. • Interest payments from these bonds are exempt from federal income tax and generally from the state taxes issuing the bond. • Consumer and Bank loans Note: These notes are incomplete without having attended lectures

36. Table 2 Principal Capital Market Instruments Note: These notes are incomplete without having attended lectures

37. Internationalization of Financial Markets International Bond Market • Foreign bonds: bonds sold in a foreign country and denominated in that country’s currency. • Eurobonds: • Now larger than U.S. corporate bond market World Stock Markets • U.S. stock markets are no longer always the largest: Japan sometimes larger • E.g. Dow Jones Industrial Average (U.S.); Financial Times Stock Exchange (FTSE - London); Nikkei (Tokyo) Note: These notes are incomplete without having attended lectures

38. Common Confusions • Eurobond: bond denominated in a currency other than that of the country in which it is sold • E.g. Bond denominated in Sterling, sold in the U.S. • Eurocurrencies: foreign currencies deposited in banks outside the home country • E.g.: Eurodollar Market – U.S. dollars deposited in foreign banks outside the U.S. • Different to the Euro which is the national currency adopted in Europe after monetary union in 2002. Note: These notes are incomplete without having attended lectures

39. Function of Financial Markets: Flow of Funds Indirect Finance Financial Intermediaries FinancialMarkets • Lender-Savers • Households • Firms • Government • Foreigners • Borrowers-Spenders • Business-Firms • Government • Households • Foreigners Direct Finance Note: These notes are incomplete without having attended lectures

40. Function of Financial Intermediaries Financial Intermediaries: • Engage in process of indirect finance • More important source of finance than securities markets • Needed because of transactions costs and asymmetric information Note: These notes are incomplete without having attended lectures

41. Role of Financial Intermediaries • Transaction Costs • Risk Sharing • Asymmetric Information Note: These notes are incomplete without having attended lectures

42. Primary Assets and Liabilities of Financial Intermediaries Note: These notes are incomplete without having attended lectures

43. Financial Intermediaries and Value of Their Assets Note: These notes are incomplete without having attended lectures

44. Regulatory Agencies Note: These notes are incomplete without having attended lectures

45. Regulatory Agencies Note: These notes are incomplete without having attended lectures

46. Regulatory Agencies • The new Dodd-Frank Banking reform bill that was passed during June 2010 gives the following agencies additional power: Note: These notes are incomplete without having attended lectures

47. Banking and Financial Institutions • Financial Intermediation • Helps get funds from savers to investors through bond/equity/foreign exchange markets • Banks and Money Supply • Crucial role in creation of money • Financial Innovation Note: These notes are incomplete without having attended lectures