Lecture 1: Introduction To Money and Banking PDF

**[Lecture 1: Introduction to Money and Banking]** **[Basic Macro Concepts]** **Nominal GDP** -- when calculated using current prices **Real GDP** -- when calculated using constant prices usually with a benchmark year **Inflation** -- creates the difference between nominal and real measures in a...

**[Lecture 1: Introduction to Money and Banking]** **[Basic Macro Concepts]** **Nominal GDP** -- when calculated using current prices **Real GDP** -- when calculated using constant prices usually with a benchmark year **Inflation** -- creates the difference between nominal and real measures in an economy - Percentage increase in the price level of an economy 2 Measures of the aggregate price level in economic data: - **GDP Deflator** - **Consumer Price Index (CPI)** **[Basic Financial Concepts]** Financial markets -- markets in which funds are transferred **from people and firms who have an excess of available funds to people and firms who have funds** **Security** (financial instrument) -- a claim on the issuer's future income or assets e.g., stocks and bonds **Share (or stock)** -- a claim on the residual earnings and assets of the corporation **Bond** -- a debt security that promises to make payments periodically for a specified time period **Interest Rate** -- the cost of borrowing or the price paid for the rental of funds **[Financial Intermediation, Innovation and Crises]** **Financial intermediaries** -- institutions that borrow funds from people who saved and in turn make loans to people who need funds - **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 - Examples: ATMs, tele-banking, online banking - Can be an importance force for good by making the financial system more efficient - Can create ways to transfer risks to the "unseen" parts of the financial system e.g., Collateralised Debt Obligations (CDOs) **Financial crises** -- sharp declines in asset prices and the sudden failures of financial and nonfinancial firms **[Fiscal Policy and Monetary Policy]** **Monetary Policy** -- the management of the money supply and interest rates - Conducted by the central banks **Fiscal policy** -- deals with government spending and taxation - **Budget deficit** -- excess of expenditure of revenues for a particular year - Any deficit must be financed by borrowing - **Budget surplus** -- excess of revenues over expenditures for a particular year **[Function of Financial Markets]** Performs the essential function of **channelling funds** from economic players that have saved surplus funds to those that have a shortage of funds A diagram of financial markets Description automatically generated **[Structure of Financial Markets]** Debt and Equity Markets: - Debt instruments (with [maturity]) -- bonds, mortgages, loans - **Equities** (pay [dividends]) -- stocks, shares Primary and Secondary Markets: - **Investment banks underwrite securities in primary markets** - **Brokers** and **dealers** work in **secondary markets** - Secondary markets bring **liquidity & price discovery** to primary markets Exchanges and Over-the-Counter (OTC) Markets: - **Exchanges** -- NYSE, LSE - **OTC markets** -- Foreign exchange, Federal Funds Money and Capital Markets: - **Money markets** deal in short-term debt instruments (more liquid, banks & corporations) - **Capital markets** deal in longer-term debt and equity instruments (pension funds, insurance companies) **[Function of Financial Intermediaries: Indirect Finance]** Lower transaction costs (time and money spent in carrying out financial transactions) - Economies of scale e.g., hiring a lawyer to draw up a loan contract - Economies of scope e.g., credit cards for depositors - Liquidity services e.g., availability on demand Reduce the exposure of investors to risk - Risk sharing e.g., **diversification** Deal with **asymmetric information** problems: - **Adverse Selection** (before transaction) -- try to avoid selecting the risky borrower by gathering information about them - Gather extensive information before lending - **Moral Hazard** (after transaction) -- ensure borrower will not engage in activities that will prevent him/her to repay loan - Monitor closely after lending **[Regulation of the Financial System]** To increase the information available to investors: - Reduce adverse selection and moral hazard problems - Reduce **insider trading** To ensure the soundness of financial intermediaries: - Restrictions on entry (chartering process) - Disclosure & inspection of information - Restrictions on assets and activities (control holding of risky assets) - **Deposit insurance** (private, public or hybrid) - Avoid **bank runs** - Limits on competition (mostly in the past): - Branching - Restrictions on interest rates **[Money and its Functions]** **Money** (or the "money supply"): anything that is generally accepted as payment for goods or services or in the repayment of debts. - **Currency** (paper bills & coins) is one type of money - **Wealth** is all assets that serve to store value - **Income** is a flow of earnings per unit of time **Medium of Exchange:** - Eliminates the trouble of finding a double coincidence of needs (reduces transactions costs vis-à-vis a barter economy) - Promote specialisation - A medium of exchange must be easily standardised, widely accepted, divisible easy to carry, not deteriorate quickly **Unit of Account:** - Used to measure value in the economy - Reduce transaction costs e.g., number of prices in a supermarket **Store of Value:** - Used to save purchasing power over time - Other assets also serve this function - Money is the most liquid of all assets but loses value during inflation **[Evolution of Money]** - Commodity money (made from precious metals) - Paper currency (convertible to commodity) - Fiat money (legal tender by governments, dependent on trust) - Cheques (nettable, theft-resistant but slow) - Electronic Payment (paying bills over internet) - E-money (debit card, gift cards, e-cash) **[Measuring Money]** Construct **monetary aggregates** using the concept of liquidity: - **M1** (most liquid assets) = currency + traveller's checks + demand deposits + other checkable deposits - **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