Economics of Money & Banking
ECF3143
Introduction
Dr Solmaz Moslehi
1
Lecture : Introduction to money and the
financial system
• Why Study Money, Banking, and Financial
Markets? (Ch. 1)
• An Overview of the Financial System (Ch. 2)
• What is Money (Ch. 3)
2
Preamble: Understanding the news
• Tuesday, 2 February 2021. The Reserve Bank of Australia
announced that
– “the Board decided to maintain the targets of 10 basis points for the cash rate
and the yield on the 3-year Australian Government bond, as well as the
parameters of the Term Funding Facility. It also decided to purchase an
additional $100 billion of bonds issued by the Australian Government and
states and territories when the current bond purchase program is completed in
mid April. These additional purchases will be at the current rate of $5 billion a
week.”
– Link: https://www.rba.gov.au/media-releases/2021/mr-21-01.html
• Why the RBA decided to keep the interest rate unchanged? Why it
matters?
3
Understanding the news
• You can think of the aim of this course as of making sense of the
previous statement.
• We want to understand why money matters and how the authority
in charge of it – the Central Bank – takes decision.
• To do so, we need to understand:
– What is money?
– What is the role of financial markets in the economy?
– What is the economic model that central banks have in mind
when they take their decisions?
4
Lecture 1: Overview
• First, we will introduce some key concepts in
financial markets
• We will then explain the structure of financial
markets and the role of financial intermediaries
• Finally, we will introduce money and monetary
policy
5
Lecture 1: Learning Objectives
• By the end of this lecture, you should understand
–What is traded on financial markets?
–How financial markets are structured?
–What is the role of financial intermediaries?
–What is money?
–What is the role of monetary policy?
6
The Financial System
Financial Markets and Financial
Intermediaries
7
Key concepts in financial markets
• A security (financial instrument) is a claim
on the issuer’s future income or assets.
• Securities are typically divided into debt and
equities.
8
Key concepts in financial markets: bond
• A debt security represents money that is borrowed and must
be repaid, with conditions that depend on
– the amount borrowed
– the interest rate
– the maturity of the debt.
• A bond is a debt security that promises to make payments
periodically for a specified period of time. They are typically
issued by governments or corporations
• An interest rate is the cost of borrowing or the price paid for
the rental of funds.
9
Figure 1 Interest Rates on Selected
Bonds, 1950–2017
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
10
Figure 1b Interest Rates on Selected
Bonds, Australia 1968–2018
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/graph/?g=mLGK
11
Key concepts in financial markets: stock
• Equity securities represent
ownership interest held by
shareholders in a corporation.
• Common stock (or simply
stock) is the typical equity.
• It represents a share of
ownership in a corporation.
• A share of stock is a claim
on the residual earnings and
assets of the corporation.
12
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
13
Figure 2b Stock Prices as Measured by the
ASX, Australia 1971–2015
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
14
Financial Institutions and Banking
• Financial intermediaries: institutions that borrow funds from
people who have saved and in turn make loans to other people.
– Banks: accept deposits and make loans
– Other financial institutions: insurance companies, finance
companies, pension funds, mutual funds and investment
companies
• Financial innovation: the development of new financial products
and services
– Can be an important force for good by making the financial
system more efficient but can create instabilities than can lead
to banking and financial crises
15
Function of Financial Markets
• Perform the essential function of channeling funds
from economic players that have saved surplus
funds to those that have a shortage of funds
• Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling them
securities
• Indirect finance: borrowers borrow funds from
financial intermediaries who collect money from
lenders
16
Figure 1 Flows of Funds Through the
Financial System
17
Function of Financial Markets
• Promotes economic efficiency by producing an
efficient allocation of capital, which increases
production
• Directly improve the well-being of consumers
by allowing them to time purchases better –
consumption smoothing
18
Structure of Financial Markets: Direct
Finance Channel
• Financial markets can be distinguished:
–The type of security that is traded: debt vs.
equity markets
–Whether the traded securities are newly issued
or not: primary vs. secondary markets
–The maturity of the traded securities: money
vs. capital markets
19
Structure of Financial Markets
• Debt and Equity Markets
– Debt instruments (e.g., bonds, mortgage): pay the holder a fixed
amount of money (interest and principal) at regular intervals
• Maturity: number of years until the instrument expires.
– Short-term debt: <1 year.
– Long-term debt: >10 years.
– Equities (e.g. common stock): claims to share in the net income
and the assets of a business
• Dividends: periodic payments to holders
20
Structure of Financial Markets
• Primary and Secondary Markets
– Primary markets: Financial markets where new issues
of a security are sold to initial buyers.
• Investment banks underwrite securities
– Secondary markets: Financial markets where securities
that have been previously issued can be resold
• Brokers and dealers operate in secondary markets.
– Brokers are agent of investors who match buyers with
sellers of securities.
– Dealers link buyers and sellers by buying and selling
securities at stated prices.
21
Structure of Financial Markets
• Secondary markets are particularly important because
they: i) make financial instruments more liquid, and ii)
determine the price of newly issued securities.
• They can be organized as: Exchanges and Over-the-
Counter (OTC) Markets
– Exchanges: Buyers and sellers physically meet in one location,
e.g. NYSE, Chicago Board of Trade, ASX
– OTC markets: Dealers are located in different places and buy
and sell securities “over the counter” to anyone willing to accept
their price, e.g. U.S. government bonds, federal funds, foreign
exchange instruments
22
Exchange markets …
23
… and OTC markets
24
Structure of Financial Markets
• Financial markets can be distinguished on the
basis of the maturities of the securities traded
–Money markets deal in short-term (< 1 year)
debt instruments
–Capital markets deal in longer-term debt and
equity instruments
25
Financial Market Instruments
26
Financial Market Instruments
27
Function of Financial Intermediaries: Indirect
Finance
• Lower transaction costs
(time and money spent in
carrying out financial
transactions)
– Economies of scale
– Liquidity services
• Reduce the exposure of
investors to risk
– Risk Sharing (Asset
Transformation)
– Diversification
28
Function of Financial Intermediaries:
Indirect Finance
• Deal with asymmetric information problems:
–Adverse Selection (before the transaction): try
to avoid selecting the risky borrower by
gathering information about them
29
Function of Financial Intermediaries:
Indirect Finance
• Deal with asymmetric information problems:
–Moral Hazard (after the transaction): ensure
borrower will not engage in activities that will
prevent him/her to repay the loan
30
Function of Financial Intermediaries:
Indirect Finance
• Conclusion:
–Financial intermediaries allow “small” savers
and borrowers to benefit from the existence of
financial markets.
31
Money and Monetary
Policy
32
Meaning of Money
• Money (or the “money supply”): anything that is
generally accepted as payment for goods or services
or in the repayment of debts.
• Money (a stock concept) is different from:
– Wealth: the total collection of pieces of property
that serve to store value (a stock concept)
– Income: flow of earnings per unit of time (a flow
concept)
33
Meaning of Money
34
Functions of Money
35
Functions of Money
• Medium of Exchange:
– Eliminates the trouble of finding a double
coincidence of needs (reduces transaction
costs)
– Promotes specialization
• A medium of exchange must:
– be easily standardized
– be widely accepted
– be divisible
– be easy to carry
– not deteriorate quickly
36
Functions of Money
• Unit of Account:
– Used to measure value in the economy
• Store of Value:
– Used to save purchasing power over time
– Other assets also serve this function but money is the
most liquid of all assets but loses value during
inflation
– Liquidity: relative ease and speed with which an asset can
be converted into a medium of exchange
37
Evolution of the Payments System
• Commodity Money: valuable, easily
standardized and divisible commodities (e.g.
precious metals, salt)
• Fiat Money: paper money decreed by
governments as legal tender, with no intrinsic
value
38
39
40
Evolution of the Payments System
• Checks: an instruction to your bank to transfer
money from your account
• Electronic Payment (e.g. online bill pay).
• E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash
41
Measuring Money
• How do we measure money? Which particular
assets can be called “money”?
• Construct monetary aggregates using the
concept of liquidity:
–M1 (most liquid assets) = currency + traveler’s
checks + demand deposits + other checkable
deposits
42
Measuring Money
• M2 (adds to M1 other assets that are not so
liquid) = M1 + small denomination time
deposits + savings deposits and money
market deposit accounts + money market
mutual fund shares
43
The Federal Reserve’s Monetary Aggregates
44
The Federal Reserve’s Monetary Aggregates
• M1 versus M2: Does it matter which measure
of money is considered?
• M1 and M2 generally move in the same
direction, but they can move in different
directions in the short run.
• Conclusion: the choice of monetary aggregate
is important for policymakers, who typically
target M2 (or Broad Money).
45
Figure 1 Growth Rates of the M1 and M2 Aggregates,
1960–2017
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
46
Figure 1b Growth Rates of the M1 and M2 Aggregates,
Australia, 1961–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
47
Why Money and Monetary Policy Matter?
• Evidence suggests that money 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.
48
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 shows a connection between the money
supply and the price level
49
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
50
Figure 3 Money Growth (Broad Money Annual Rate) and the
Business Cycle in the Australia 1960–2015
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
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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
52
Figure 4b Aggregate Price Level and the Money Supply in
Australia, 1960–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
53
Figure 5 Average Inflation Rate Versus Average Rate of Money
Growth, Selected Countries, 2003-2016
Source: International Financial Statistics. http://www.imf.org/external/data.htm
54
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
55
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
56
Figure 6a Money Growth (Broad Money Annual Rate) and Interest Rates
(Long-Term Australia Treasury Bonds), 1970–2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
57
Monetary Policy
• Monetary policy is the management of the money supply and
interest rates
– Conducted in the U.S. by the Federal Reserve System (Fed)
58
Monetary Policy
• Monetary policy is the management of the money supply and
interest rates
– Conducted in Australia by the Reserve Bank of Australia
59
Monetary Policy
• Does monetary policy matter? Let’s ask an expert
60
Monetary Policy
• Paul Krugman (1997): Indeed, if you want a simple
model for predicting the unemployment rate in the United
States over the next few years, here it is: It will be what
Greenspan wants it to be, plus or minus a random error
reflecting the fact that he is not quite God.
• Paul Krugman (2016): Monetary policy is pretty much
ineffective
• By the end of the course, we will be able to understand
the reasons behind these apparently conflicting views
61
How We Will Study Money, Banking, Financial
Markets and Monetary Policy?
• A simplified approach to the demand for assets
• The concept of equilibrium
• Basic supply and demand to explain behavior in
financial markets
• A simplified version of the model used by central
banks to take decisions in normal times (the 3-
equations model)
• The challenges of liquidity traps, low interest rates,
and the role of unconventional monetary policy
62
Where to find the data
• https://fred.stlouisfed.org/
• http://ausmacrodata.org/ (developed at Monash
University)
• http://www.rba.gov.au/statistics/
• See also the following blog
https://plottingdownunder.wordpress.com/
• Bloomberg
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