ECO-531-CHAPTER-1.pdf

ECO 531- CHAPTER 1 INTRODUCTION: OVERVIEW OF THE STUDY ON MONEY, BANKING & FINANCIAL MARKETS • Why study money, banking and financial markets? • To examine the role of money in the economy. • To examine the link between money and business cycles, money and inflation, money and interest rates....

ECO 531- CHAPTER 1 INTRODUCTION: OVERVIEW OF THE STUDY ON MONEY, BANKING & FINANCIAL MARKETS • Why study money, banking and financial markets? • To examine the role of money in the economy. • To examine the link between money and business cycles, money and inflation, money and interest rates. 2 INTRODUCTION • INTRODUCTORY REMARKS • Nominal • Some of the terms being discussed • Real • Financial Intermediaries throughout the study guide: Loading… • Financial Markets • Recession • Security • Inflation • Interest Rate • Monetary Policy • Money • Fiscal Policy • Aggregate Output • Asymmetric Information • Unemployment • Adverse Selection • Business Cycle • Moral Hazard 3 WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS? • This course provides answers to these and other questions by examining how financial markets (i.e. bonds, stocks and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work and by exploring the role of money in the economy. • Financial markets and institutions not only affect your everyday life but also involve flows trillions of dollars of funds throughout our economy, which in turn affect business profits, the production of goods and services, and even the economic well-being of countries. • The financial system is complex, comprising many different types of private sector financial institution (banks, insurance companies, mutual funds, finance companies, investment banks and other institutions). • What happens to financial markets, financial institutions and money is of great concern to politicians and even have a major impact on elections. • This will reward you with an understanding of many exciting issues. 4 CIRCULAR FLOW MODEL OF AN OPEN ECONOMY Loading… • 4 sectors: household – owner of resources, firm – produces products & services, government – collects taxes and spends them; and foreign sector – involved in the import and export of goods & services. • Monetary sector/ money market – for channeling of funds from severs to lenders. • The involvement of the monetary sector comes from savings, investments, and government borrowing - which will influence price level, interest rates and balance of payment. 5 MONEY IN RELATION TO INTEREST RATES One of the many definitions of interest rate is the price of money. • Money plays an important role in interest rate fluctuations - which are of great concern to both consumers and businesses. • The level of interest rate is mainly influenced by the process of demand and supply of money in the economy. • This shows the interdependence of the level of interest rate with money. • Past empirical data also shows that money growth rate has a positive relationship with the level of interest rate. • Demand for money could arise from transactions, precautions as well as speculation. • The supply of money comes from loanable funds quantity is determined by the monetary base as well as currency in circulation. • 6 MONEY IN RELATION TO INTEREST RATES • Money and interest rates are closely related in the field of economics and finance. Changes in interest rates can have significant effects on the supply and demand for money, and vice versa. Here's how they are interconnected: • Interest Rates and the Cost of Borrowing: Interest rates represent the cost of borrowing money. When interest rates are high, it becomes more expensive to borrow money through loans or credit, which can discourage borrowing and spending by both consumers and businesses. Conversely, when interest rates are low, borrowing becomes more affordable, and there is often an increase in borrowing and spending. • Monetary Policy: Central banks, like the Federal Reserve in the United States, use interest rates as a tool for monetary policy. By raising or lowering the target interest rate (usually the federal funds rate in the U.S.), central banks can influence the overall level of economic activity. Raising interest rates can be used to cool down an overheating economy with high inflation, while lowering rates can stimulate economic growth during a recession. • Money Supply and Demand: Interest rates also affect the demand for money. When interest rates are high, people may prefer to hold more of their wealth in interest-bearing assets like savings accounts or bonds, as they can earn more on their savings. Conversely, when interest rates are low, the opportunity cost of holding money is lower, so people may 7 hold less cash and opt for other assets. MONEY IN RELATION TO INTEREST RATES • Investment and Saving: Interest rates play a crucial role in investment and saving decisions. Higher interest rates can incentivize people to save more because they can earn more on their savings. On the other hand, businesses may be less inclined to invest in new projects when borrowing costs are high due to elevated interest rates. • Exchange Rates: Changes in interest rates can also impact exchange rates. When a country's central bank raises interest rates, it can attract foreign capital seeking higher returns. This increased demand for the country's currency can lead to an appreciation of the currency's value in foreign exchange markets. • Inflation Expectations: Interest rates can reflect expectations about future inflation. Higher interest rates might suggest that investors anticipate higher inflation in the future, as they demand compensation for the loss of purchasing power. Conversely, lower interest rates can signal expectations of lower future inflation. • Asset Prices: Low-interest rates can lead to higher asset prices, such as real estate and stocks, as investors seek higher returns in these markets when bond yields are low. This relationship can contribute to asset bubbles. inflation/interest rate /money supply : Bank Negara Malaysia -> md -> purchase -> SSgas Y - inflation ↑ 8 MONEY IN RELATION TO INTEREST RATES • In summary, money and interest rates are interconnected in complex ways that impact various aspects of the economy, including borrowing, spending, saving, investment, inflation, and exchange rates. Central banks and policymakers closely monitor these relationships and adjust interest rates as needed to achieve their economic objectives, such as price stability and sustainable economic growth. 9 MONEY IN RELATION TO FOREIGN EXCHANGE • The foreign exchange market is where funds to be transferred from one country to another, is being converted. • The foreign exchange rate is the price of one country’s currency in terms of another's. • The exchange rate fluctuation has a direct effect on consumers because it affects the cost of foreign goods & services. • For businesses, the exchange rate would translate to either higher exports or lower imports (more attractive) and vise versa. • This process will have a direct effect on a country’s Balance of Payments as it involves the trade & services balances i.e. the import and export of goods & services. Export I - growth ↓ + Output N 10 MONEY IN RELATION TO FOREIGN EXCHANGE • Money and foreign exchange (forex) are closely linked in the global economy. The foreign exchange market is where currencies are bought and sold, and it plays a critical role in international trade and finance. Here's how money is related to foreign exchange: • Currency Exchange Rates: Currency exchange rates determine the value of one currency in terms of another. These rates are influenced by a variety of factors, including interest rates, inflation, economic stability, geopolitical events, and market sentiment. Exchange rates reflect the relative strength or weakness of different currencies. • Currency Pairs: In the forex market, currencies are quoted in pairs, such as EUR/USD (Euro/US Dollar) or USD/JPY (US Dollar/Japanese Yen). When you exchange one currency for another, you are essentially trading one money for another. The exchange rate tells you how much of one currency you need to obtain a specific amount of another currency. • International Trade: Money and forex are essential for international trade. When businesses and individuals engage in cross-border transactions, they need to exchange their domestic currency for the foreign currency of the country they are dealing with. Exchange rates can impact the cost of imported goods and the revenue generated from exports.11 Loading… MONEY IN RELATION TO FOREIGN EXCHANGE • Foreign Investment: Investors often buy and sell foreign currencies when making international investments. They may invest in foreign stocks, bonds, real estate, or other assets denominated in foreign currencies. Changes in exchange rates can significantly impact the returns on these investments. • Hedging: Companies engaged in international business often use the forex market to hedge against currency risk. They may use financial instruments like forward contracts or options to lock in exchange rates, ensuring they will receive or pay a predetermined amount in their home currency regardless of exchange rate fluctuations. • Central Banks: Central banks play a pivotal role in managing a country's money supply and influencing exchange rates. They can intervene in the forex market to stabilize their currency's value or achieve other economic objectives. For example, a central bank may sell its own currency to lower its value and make its exports more competitive. 12 MONEY IN RELATION TO FOREIGN EXCHANGE • Speculation: Traders and investors in the forex market engage in speculation, hoping to profit from exchange rate movements. They buy and sell currencies based on their expectations of how currency values will change in the future. This speculative activity can contribute to short-term fluctuations in exchange rates. • Interest Rate Differentials: Differences in interest rates between countries can impact forex markets. Higher interest rates in one country may attract foreign capital seeking higher returns, leading to increased demand for that country's currency and an appreciation in its exchange rate. • Political and Economic Events: Political events, such as elections or geopolitical tensions, and economic events, like economic data releases or financial crises, can have a significant impact on exchange rates. These events can influence investor sentiment and risk appetite, affecting currency values. 13 MONEY IN RELATION TO FOREIGN EXCHANGE good services • stock bond 6 - In summary, money and foreign exchange are intertwined in the global financial system. Exchange rates are a key factor in international trade and investment decisions, and they are influenced by a wide range of economic, financial, and geopolitical factors. Understanding the relationship between money and forex is crucial for businesses, investors, and policymakers involved in international finance and trade. 14 MONEY AND THE BUSINESS CYCLE • Money plays an important role in generating business cycles, the upward and downward movement of aggregate output produced in the economy. • Excessive money will create inflation while too little of them could cause recession. 15 MONEY AND THE BUSINESS CYCLE • • Money plays a significant role in the business cycle, which refers to the recurring pattern of economic expansion and contraction. The business cycle consists of four main phases: expansion, peak, contraction (or recession), and trough. Here's how money is related to each phase of the business cycle: -> good phase Expansion Phase: • Money Supply Growth: During the early stages of an economic expansion, central banks often aim to stimulate economic activity by increasing the money supply. This can be achieved through measures like lowering interest rates or conducting open market operations (buying government securities). An increase in the money supply makes it easier for businesses and consumers to access credit, leading to increased spending and investment. - kita beli , government dpt duit • Borrowing↑and Investment:s As the money supply expands and interest rates decline, businesses and consumers are more inclined to borrow money for investment, expansion, and consumption. This increased borrowing and spending contribute to economic growth and job creation. • Asset Prices: Expansions are often associated with rising asset prices, such as stocks and real estate, partly due to lower interest rates that make these assets more attractive to investors. As asset prices rise, households may feel wealthier, leading to higher 16 consumer spending. At MONEY AND THE BUSINESS CYCLE - careful -> precaution • Peak Phase: • Money Supply Moderation: During the peak phase of the business cycle, central banks may begin to moderate the growth of the money supply to prevent the economy from overheating and inflation from rising to unsustainable levels. This might involve raising interest rates to make borrowing more expensive. • Business Investment: As the economy approaches its peak, businesses may become more cautious about investing further because they anticipate that growth will slow. Consumer spending may also slow as people begin to save more in anticipation of economic uncertainty. • Speculation: The peak phase can also be characterized by speculative behavior in financial markets as investors seek to take advantage of the remaining growth before a downturn. This speculative activity can contribute to asset bubbles. 17 MONEY AND THE BUSINESS CYCLE • Contraction (Recession) Phase: • Money Supply Tightening: During a recession, central banks may take measures to tighten the money supply, such as raising interest rates or reducing monetary stimulus. The goal is to control inflation and stabilize the economy. Economy Slow , can't invest , bug lambat beli • Reduced Borrowing and Investment: As interest rates rise and credit becomes less accessible and more expensive, both businesses and consumers may cut back on borrowing and investment. This leads to reduced economic activity, job losses, and a decline in overall economic output. • Consumer and Business Confidence: A lack of confidence in the economy during a recession can lead to reduced spending and investment. As people and businesses become more cautious, they save more and spend less, which exacerbates the economic downturn. 18 MONEY AND THE BUSINESS CYCLE • • Trough Phase: • Stabilization Measures: To combat a recession, central banks may implement monetary policies to stabilize the economy, including lowering interest rates and implementing quantitative easing programs to stimulate lending and economic activity. • Economic Recovery: As the money supply expands and interest rates decrease, businesses and consumers are encouraged to borrow and spend again. This leads to an economic recovery, marking the end of the recession phase. • Asset Prices: Asset prices may have fallen during the recession phase, but as the economy stabilizes and growth resumes, these prices can start to recover. In summary, the money supply, interest rates, and monetary policy all play critical roles in shaping the various phases of the business cycle. Central banks use these tools to influence economic activity and mitigate the severity of economic fluctuations. Money and credit conditions are closely tied to the ebbs and flows of the business cycle, impacting borrowing, spending, investment, and overall economic performance. 19 • TQ 20