Chapter 1

Why Study
Money, Banking,
and Financial
Markets?
 Preview

• To examine how financial markets such as bond,

stock and foreign exchange markets work

• To examine how financial institutions such as

banks, investment and insurance companies work

• To examine the role of money in the economy

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 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.

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 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

• Financial markets are important to the health of

the economy.

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 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 at personal
and more general level) .

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 Figure 1 Interest Rates on Selected
Bonds, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 The Stock Market

• Common stock represents a share of ownership

in a corporation.

• A share of stock is a claim on the residual

earnings and assets of the corporation.

• Effect of fall in stock prices on business investment

and consumers’ consumption decisions.

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 Figure 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Why Study 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

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 Why Study Financial Institutions
and Banking?
• Financial crises: major disruptions in financial
markets that are characterized by

➢ sharp declines in asset prices

➢ the failures of many financial and nonfinancial

firms.

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 Why Study Money and Monetary
Policy?
• 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.

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 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

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 Figure 3 Money Growth (M2 Annual Rate) and the
Business Cycle in the United States 1950–2014

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, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Figure 5 Average Inflation Rate Versus Average Rate
of Money Growth, Selected Countries, 2003-2013

Source: International Financial Statistics. http://www.imf.org/external/data.htm

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 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

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 Figure 6 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Fiscal Policy and Monetary Policy

• Monetary policy is the management of the money supply

and interest rates
– Conducted in Egypt by the Central Bank of Egypt (CBE)

• Fiscal policy deals with government spending

and taxation

– Budget deficit is the excess of expenditures over revenues for a

particular year

– Budget surplus is the excess of revenues over expenditures for a

particular year

– Any deficit must be financed by borrowing

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 Figure 7 Government Budget Surplus or Deficit
as a Percentage of Gross Domestic Product,
1950–2013

Source: Economic Report of the President, Table B79 at http://www.gpoaccess.gov/eop/tables09.html

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 The Foreign Exchange Market

• The foreign exchange market: where funds are

converted from one currency into another

• The foreign exchange rate is the price of one

currency in terms of another currency.

• The foreign exchange market determines the

foreign exchange rate.

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 Why Study International Finance

• 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?

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 Figure 8 Exchange Rate of the U.S.
Dollar, 1970–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Think!!!

• Is everybody worse off when interest rates rise?

• Why do managers of financial institutions care so

much about the activities of the central bank?

• How does a fall in the value of the pound affect

Egyptian consumers?

• How does an increase in the value of the dollar

affect Egyptian businesses?

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 Assignment
(Due Wednesday, 22nd of February)

• Has the inflation rate in Egypt increased or

decreased in the past 10 years? What about
interest rates?

• Relate each of these developments to the money

growth rate and comment on the revealed
relationship, in light of what you have studied so
far.

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 Appendix 1:

Defining Aggregate Output, Income, the

Price Level, and the Inflation Rate

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 Aggregate Output
and Aggregate Income
• Aggregate Output
– Gross Domestic Product (GDP) = market value of all final
goods and services produced in the domestic economy
during a particular year

• Aggregate Income
– Total income of the factors of production (land, capital,
labor) during a particular year

• Distinction Between Nominal and Real

– Nominal = values measured using current prices
– Real = quantities measured with constant prices

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 Real vs. nominal GDP

Nominal GDP Real GDP

• Represents the total • Real GDP (Q) removes
money value of final price changes from
goods and services nominal GDP and
produced in a given calculates GDP in terms
year, where the values of the quantities of
are expressed in terms goods and services
of the market prices of
each year

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 Real vs. nominal GDP

• Nominal GDP is calculated by valuing all outputs at current

prices, it is called “money GDP”, or “GDP in current pounds”.
But nominal GDP rises when prices rise and falls when prices
fall

• There is an alternative measure that correct for inflation by

valuing goods and services produced in different years at the
same set of prices, that is called real GDP

• Real GDP or “GDP in constant pound”, is calculated by

valuing outputs of different years at constant prices

• Therefore, real GDP is a far better measure than nominal GDP

because it is corrected for inflation

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 Aggregate Price Level

• Aggregate price level is a measure of average

prices in the economy

• Price index is a measure of average level of prices,

which is the a weighted average of the price of a
basket of goods and services

• There are different kinds of price indexes, but we

will study the following two index:
1. Consumer price index (CPI)
2. GDP price index (GDP deflator)

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 CPI & GDP deflator

1. Consumer price index [CPI], is a measure of the average

price paid by urban consumers for a market basket of
consumer goods and services

2. GDP deflator is another, widely used price index, which is the

price of all goods and services produced in the country
(consumption, investment, government purchases, and net
exports) rather than consumption goods only in case of
constructing CPI

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 Economic growth rate

• The growth rate of real GDP (economic growth) is

the percentage change of real GDP in two
consecutive years.

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 Inflation rate

• Annual Inflation rate is the percentage change in

price index [CPI] of two consecutive years

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