The Economics of Money , Banking and Financial Markets

1. Ch. 1
Introduction to Financial
System

2.  This course is about money, banking, and financial
institutions and markets.
 We are going to study macroeconomics with a
focus on monetary issues of the economy.
 Chapter 1 provides an overview of the topics that
will be covered in later chapters.
 We study money, banking, and financial Markets
1.To examine the role of money in the economy
2.To examine how financial institutions such as
banks and insurance companies work
3.To examine how financial markets (such as
bond, stock and foreign exchange markets)
work

3. The Five Components of the FinancialThe Five Components of the Financial
SystemSystem
1.1. money;money;
2.2. financial institutions (including banks);financial institutions (including banks);
3.3. financial instruments (including loans,financial instruments (including loans,
stocks, and bonds);stocks, and bonds);
4.4. financial markets (like Bahrain Stockfinancial markets (like Bahrain Stock
Exchange);Exchange);
5.5. and central banks (like the Centraland central banks (like the Central
Bank of Bahrain (CBB)).Bank of Bahrain (CBB)).

4. 1. Money1. Money
MoneyMoney is defined as anything that is generallyis defined as anything that is generally
accepted in payment for goods and services.accepted in payment for goods and services.
Monetary theory ties changes in the moneyMonetary theory ties changes in the money
supply to changes in aggregate economicsupply to changes in aggregate economic
activity and the price levelactivity and the price level

5. Money and RecessionMoney and Recession
The periodic but irregular upward andThe periodic but irregular upward and
downward movement of aggregate outputdownward movement of aggregate output
produced in the economy is referred to asproduced in the economy is referred to as
thethe business cyclebusiness cycle..
Sustained (persistent) downwardSustained (persistent) downward
movements in the business cycle aremovements in the business cycle are
referred to asreferred to as recessionsrecessions..
Sustained (persistent) upward movementsSustained (persistent) upward movements
in the business cycle are referred to asin the business cycle are referred to as
expansionsexpansions..

6. Recessions (unemployment) and booms orRecessions (unemployment) and booms or
expansion (inflation) affect all of usexpansion (inflation) affect all of us
Evidence from business cycle fluctuationsEvidence from business cycle fluctuations
in many countries indicates that recessionsin many countries indicates that recessions
may be caused by steep declines in themay be caused by steep declines in the
growth rate of money.growth rate of money.

7. Money and InflationMoney and Inflation
The aggregateThe aggregate price levelprice level is the averageis the average
price of goods and services in an economyprice of goods and services in an economy
InflationInflation is a continual rise in the priceis a continual rise in the price
level.level.
Inflation affects allInflation affects all economic playersplayers
There is a strong positive associationThere is a strong positive association
between inflation and growth rate of moneybetween inflation and growth rate of money
over long periods of time. A sharp increaseover long periods of time. A sharp increase
in the growth of the money supply is likelyin the growth of the money supply is likely
followed by an increase in the inflation rate.followed by an increase in the inflation rate.
Countries that experience very high ratesCountries that experience very high rates
of inflation have rapidly growing moneyof inflation have rapidly growing money
supplies.supplies.

8. 2. Banking and Financial2. Banking and Financial
InstitutionsInstitutions
Financial IntermediariesFinancial Intermediaries areare
institutions that channel funds frominstitutions that channel funds from
individuals with surplus funds toindividuals with surplus funds to
those desiring funds but havethose desiring funds but have
shortage of it.shortage of it.
Among other services, they allowAmong other services, they allow
individuals to earn a decent return onindividuals to earn a decent return on
their money while at the same timetheir money while at the same time
avoiding risk; e.g., banks, insuranceavoiding risk; e.g., banks, insurance
companies, finance companies,companies, finance companies,
investment banks, mutual funds,investment banks, mutual funds,
brokerage houses,brokerage houses,

9. BanksBanks are financial institutions that acceptare financial institutions that accept
deposits and make loans.deposits and make loans.
Banks make the monetary system a lotBanks make the monetary system a lot
more efficient by reducing our need tomore efficient by reducing our need to
carry a lot of cash.carry a lot of cash.
People have tended to use checks insteadPeople have tended to use checks instead
of cash for large purchases and bills.of cash for large purchases and bills.
InnovationsInnovations in banking like debit cards,in banking like debit cards,
direct deposit, and automatic bill-payingdirect deposit, and automatic bill-paying
reduce that inconvenience even further,reduce that inconvenience even further,
and also reduce such bank-relatedand also reduce such bank-related
inconveniences of time spent standing ininconveniences of time spent standing in
line at the bank, writing checks, or visitingline at the bank, writing checks, or visiting
the ATM.the ATM.

10. Financial innovationFinancial innovation refersrefers to both technologicalto both technological
advances, which facilitate access to information,advances, which facilitate access to information,
trading and means of payment, and to thetrading and means of payment, and to the
emergence of new financial instruments andemergence of new financial instruments and
services, new forms of organization and moreservices, new forms of organization and more
developed and complete financial markets.developed and complete financial markets.
To be successful, financial innovation must eitherTo be successful, financial innovation must either
reduce costs and risks or provide an improvedreduce costs and risks or provide an improved
service that meets the particular needs ofservice that meets the particular needs of
financial system participants.financial system participants.
E-financeE-finance is a delivery of financial servicesis a delivery of financial services
electronicallyelectronically
Banks are important to the study of money andBanks are important to the study of money and
the economy because they have been a source ofthe economy because they have been a source of
rapid financial innovation.rapid financial innovation.

11. 3. Financial Instruments3. Financial Instruments
““Securities”Securities” is a name that commonly refersis a name that commonly refers
to financial instruments that are tradedto financial instruments that are traded onon
financial markets.financial markets.
A securityA security (financial instrument) is a formal(financial instrument) is a formal
obligation that entitles one party to receiveobligation that entitles one party to receive
payments and/or a share of assets frompayments and/or a share of assets from
another party; e.g., loans, stocks, bonds.another party; e.g., loans, stocks, bonds.
Even an ordinary bank loan is a financialEven an ordinary bank loan is a financial
instrument.instrument.

12. 4. Financial Markets4. Financial Markets
Financial marketsFinancial markets are mechanisms (orare mechanisms (or
arrangements) that allows people to easily buyarrangements) that allows people to easily buy
and sell (trade) financial securities (such asand sell (trade) financial securities (such as
stocks and bonds), commodities (such asstocks and bonds), commodities (such as
precious metals or agricultural goods), and otherprecious metals or agricultural goods), and other
tangible items of value at low transaction coststangible items of value at low transaction costs
and at prices that reflect; e.g., Bahrain Stockand at prices that reflect; e.g., Bahrain Stock
Exchange, New York Stock Exchange, U.S.Exchange, New York Stock Exchange, U.S.
Treasury's online auction site for its bonds.Treasury's online auction site for its bonds.
Financial markets such as stock market and bondFinancial markets such as stock market and bond
market are essential to promote greater economicmarket are essential to promote greater economic
efficiency by channeling funds from who do notefficiency by channeling funds from who do not
have productive use of fund (savers) to thosehave productive use of fund (savers) to those
who do (investors).who do (investors).

13. While well-functioning financial marketsWhile well-functioning financial markets
promote growth, poorly performingpromote growth, poorly performing
financial markets can be the cause offinancial markets can be the cause of
poverty .poverty .
Thus, activities in financial markets mayThus, activities in financial markets may
increase or decrease personal wealthincrease or decrease personal wealth
Activities in financial markets affectActivities in financial markets affect
business cycle.business cycle.

14. The Bond Market and Interest RatesThe Bond Market and Interest Rates
A bondA bond is a debt security that promises tois a debt security that promises to
make specified rate of interest paymentsmake specified rate of interest payments
periodically for a specified period of time,periodically for a specified period of time,
with principal to be repaid when the bondwith principal to be repaid when the bond
matures.matures.
AnAn interest rateinterest rate is the cost of borrowing oris the cost of borrowing or
the price paid for the rental of borrowedthe price paid for the rental of borrowed
funds (usually expressed as a percentagefunds (usually expressed as a percentage
of the rental of $100 per year)of the rental of $100 per year)
Everything else held constant, a decline inEverything else held constant, a decline in
interest rates will cause consumption andinterest rates will cause consumption and
investment to increase; e.g. spending oninvestment to increase; e.g. spending on
housing or cars would risehousing or cars would rise

15. An increase in interest rates mightAn increase in interest rates might
encourage consumers to save moreencourage consumers to save more
because more can be earned in interestbecause more can be earned in interest
income but discourage investors fromincome but discourage investors from
taking loans. Thus, consumption andtaking loans. Thus, consumption and
investment would decrease.investment would decrease.
The bond markets are important becauseThe bond markets are important because
they are the markets where interest ratesthey are the markets where interest rates
are determinedare determined

16. The Stock MarketThe Stock Market
AA stockstock (a common stock) represents a(a common stock) represents a
share of ownership of a corporation, or ashare of ownership of a corporation, or a
claim on a firm's earnings/assets.claim on a firm's earnings/assets.
Stocks are part of wealth, and changes inStocks are part of wealth, and changes in
their value affect people's willingness totheir value affect people's willingness to
spend.spend.
Changes in stock prices affect a firm'sChanges in stock prices affect a firm's
ability to raise funds, and thus theirability to raise funds, and thus their
investment.investment.
The stock market is important because it isThe stock market is important because it is
the most widely followed financial marketthe most widely followed financial market
nowadays.nowadays.

17. A rising stock market index due to higherA rising stock market index due to higher
share prices increases people's wealth andshare prices increases people's wealth and
as a result may increase their willingnessas a result may increase their willingness
to spend.to spend.
When stock prices fall an individual'sWhen stock prices fall an individual's
wealth may decrease and their willingnesswealth may decrease and their willingness
to spend may decrease.to spend may decrease.
Changes in stock prices affect firms'Changes in stock prices affect firms'
decisions to sell stock to financedecisions to sell stock to finance
investment spending.investment spending.
Fear of a major recession causes stockFear of a major recession causes stock
prices to fall, everything else held constant,prices to fall, everything else held constant,
which in turn causes consumer spendingwhich in turn causes consumer spending
to decreaseto decrease

18. The Foreign Exchange MarketThe Foreign Exchange Market
TheThe foreign exchange marketforeign exchange market is whereis where
funds are converted from one currency intofunds are converted from one currency into
anotheranother
TheThe foreign exchange rateforeign exchange rate is the price ofis the price of
one currency in terms of another currencyone currency in terms of another currency
The foreign exchange market determinesThe foreign exchange market determines
the foreign exchange ratethe foreign exchange rate

19. Everything else constant, a stronger dinar willEverything else constant, a stronger dinar will
mean that vacationing in England becomes lessmean that vacationing in England becomes less
expensive. And the country’s goods exportedexpensive. And the country’s goods exported
abroad will cost more in foreign countries, and soabroad will cost more in foreign countries, and so
foreigners will buy fewer of them.foreigners will buy fewer of them.
Everything else held constant, a stronger dollarEverything else held constant, a stronger dollar
benefits the country’s consumers and hurts thebenefits the country’s consumers and hurts the
country’s businesses.country’s businesses.
Everything else held constant, a decrease in theEverything else held constant, a decrease in the
value of the dollar relative to all foreignvalue of the dollar relative to all foreign
currencies means that the price of foreign goodscurrencies means that the price of foreign goods
purchased by Americans increasespurchased by Americans increases
If the price of a euro (the European currency)If the price of a euro (the European currency)
increases from $1.00 to $1.10, then, everythingincreases from $1.00 to $1.10, then, everything
else held constant, a European vacation becomeselse held constant, a European vacation becomes
more expensive.more expensive.

20. 5. Central Banks5. Central Banks
AA central bankcentral bank is a governmental bodyis a governmental body
that regulates financial institutions,that regulates financial institutions,
controls the supply of money and creditcontrols the supply of money and credit
in the economy, handles thein the economy, handles the
government's finances, and serves as thegovernment's finances, and serves as the
bank to commercial banks.bank to commercial banks.
Commercial banks deposit some of theirCommercial banks deposit some of their
reserves at the central bank, and thereserves at the central bank, and the
central bank is the "lender of last resort"central bank is the "lender of last resort"
to commercial banks in times of crisis.to commercial banks in times of crisis.

21. Monetary theory relates changes in theMonetary theory relates changes in the
quantity of money to changes in aggregatequantity of money to changes in aggregate
economic activity and the price level.economic activity and the price level.
Monetary policy is the management of theMonetary policy is the management of the
money supply and interest rates and ismoney supply and interest rates and is
conducted by a nation's central bankconducted by a nation's central bank

22. Fiscal policyFiscal policy involves decisions aboutinvolves decisions about
government spending and taxationgovernment spending and taxation
o Budget deficitBudget deficit is the excess of expendituresis the excess of expenditures
over revenues for a particular yearover revenues for a particular year
o Budget surplusBudget surplus is the excess of revenues overis the excess of revenues over
expenditures for a particular yearexpenditures for a particular year
o Any deficit must be financed by borrowingAny deficit must be financed by borrowing
o Budgets deficits can be a concern becauseBudgets deficits can be a concern because
deficits can result in higher rates of monetarydeficits can result in higher rates of monetary
growth and they might ultimately lead to highergrowth and they might ultimately lead to higher
inflationinflation

23. Five Core Principles of Money andFive Core Principles of Money and
BankingBanking
1.1. Time has value.Time has value.
2.2. Risk requires compensation.Risk requires compensation.
3.3. Information is the basis for decisions.Information is the basis for decisions.
4.4. Markets set prices and allocate resources.Markets set prices and allocate resources.
5.5. Stability improves welfare (i.e., well-Stability improves welfare (i.e., well-
being).being).

24. TIME has value.TIME has value. A dollar today is worth more than a dollar aA dollar today is worth more than a dollar a
year from now. Why is this? (Several reasons: inflationyear from now. Why is this? (Several reasons: inflation
erodes the buying power of money over time; having theerodes the buying power of money over time; having the
money now means you can spend it now; having the moneymoney now means you can spend it now; having the money
now means you can invest it and turn it into more money.)now means you can invest it and turn it into more money.)
RISK requires compensationRISK requires compensation.. For securities likeFor securities like
stocks and bonds, the higher the risk, the higherstocks and bonds, the higher the risk, the higher
the return has to be. For individuals, minimizing thethe return has to be. For individuals, minimizing the
risk of such things as accidents, illness, and theftrisk of such things as accidents, illness, and theft
is worth the expense of monthly insuranceis worth the expense of monthly insurance
premiums. (A note on usage: "Risk" refers to yourpremiums. (A note on usage: "Risk" refers to your
potential losses, financial and otherwise, notpotential losses, financial and otherwise, not
merely to the probability of unwanted events. Formerely to the probability of unwanted events. For
example, fire insurance might not reduce theexample, fire insurance might not reduce the
likelihood of your house burning down, but it willlikelihood of your house burning down, but it will
compensate you for the damage from your housecompensate you for the damage from your house
burning down.)

25. This rather general sentence relates to money,This rather general sentence relates to money,
banking, and finance because we live in a worldbanking, and finance because we live in a world
of imperfect information. It is hard for financialof imperfect information. It is hard for financial
transactions to take place when one or bothtransactions to take place when one or both
parties lack adequate information about theparties lack adequate information about the
other, because one party could easily end upother, because one party could easily end up
getting burned. As a result, banks and othergetting burned. As a result, banks and other
financial institutions that make loans gather afinancial institutions that make loans gather a
considerable amount of information about theirconsiderable amount of information about their
potential borrowers before advancing thempotential borrowers before advancing them
money. The collection and provision of companymoney. The collection and provision of company
financial information by government agenciesfinancial information by government agencies
can aid the growth of financial markets bycan aid the growth of financial markets by
making them more transparent, thus reducingmaking them more transparent, thus reducing
the information barrier for potential investors.the information barrier for potential investors.
Recent advances in computer andRecent advances in computer and
communications technology have greatly helpedcommunications technology have greatly helped

26. MARKETS set prices and allocateMARKETS set prices and allocate
resources.resources. Financial institutions andFinancial institutions and
markets, by connecting savers withmarkets, by connecting savers with
borrowers, allow for people's leftoverborrowers, allow for people's leftover
money (savings) to be channeled intomoney (savings) to be channeled into
productive investment in capital (e.g.,productive investment in capital (e.g.,
new technology, machinery, andnew technology, machinery, and
buildings). Financial markets for assetsbuildings). Financial markets for assets
like stocks and bonds allow somelike stocks and bonds allow some
companies, especially well-establishedcompanies, especially well-established
companies, to obtain funds for newcompanies, to obtain funds for new
capital investment more cheaply thancapital investment more cheaply than
they could borrow from a bank.they could borrow from a bank.

27. Stability improves welfare (i.e., well-being).
In the interest of stability in the financial sector,
governments have created central
banks to try to guard against bank failures and
financial panics. The tasks of
central banks have grown in recent years, as
they are now expected to keep
inflation low and stable, and also to avoid or
minimize recessions.
Bank deposit insurance is another example of a
government intervention for the
sake of financial and social stability.