The Economics of Money, Banking, and Financial Markets PDF

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 1 Why Study Money, Banking, and Financial Markets? Cop...

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 1 Why Study Money, Banking, and Financial Markets? Copyright © 2023 Pearson Canada Inc. 1-1 Learning Objectives Develop an Economic Way of Thinking – examines how choices are made Copyright © 2017 Pearson Canada Inc. 1-2 Learning Objectives Develop an Economic Way of Thinking – examines how choices are made… …by people under conditions of … Copyright © 2017 Pearson Canada Inc. 1-3 Learning Objectives Develop an Economic Way of Thinking – examines how choices are made by people under conditions of … …SCARCITY… Copyright © 2017 Pearson Canada Inc. 1-4 Learning Objectives Develop an Economic Way of Thinking – examines how choices are made by people under conditions of scarcity and systems of Copyright © 2017 Pearson Canada Inc. 1-5 The Economy Without an Exchange System Basic Economic Systems: An economy can survive with just the production, consumption, and redistribution systems. Goods and services can be produced, consumed, and redistributed within the community through barter or direct allocation. Limited Efficiency: Without an exchange system (financial sector), the economy lacks a medium of exchange (money), making transactions less efficient. Barter systems or direct redistribution can still function, but they are cumbersome and limit growth. Survival, Not Thrival: The economy will survive because people can still produce what they need, consume it, and share resources. However, without a financial sector, opportunities for growth, specialization, and efficient resource allocation are significantly reduced. Copyright © 2017 Pearson Canada Inc. 1-6 Learning Objectives Develop an Economic Way of Thinking – examines how choices are made by people under conditions of scarcity and systems of production, consumption, exchange, and distribution. Copyright © 2017 Pearson Canada Inc. 1-7 What is exchange and why? Copyright © 2017 Pearson Canada Inc. 1-8 Barter markets Copyright © 2017 Pearson Canada Inc. 1-9 Our first show Copyright © 2017 Pearson Canada Inc. 1 - 10  Copyright © 2009 Pearson Addison- Wesley. All rights reserved. Barter 3-11 Copyright © 2017 Pearson Canada Inc. 1 - 11 Understanding the Barter Economy Definition: A barter economy is a system where goods and services are exchanged directly for other goods and services without using money. How It Works: In a barter system, trade requires a mutual exchange of items that both parties want. For example, a farmer might trade a bushel of wheat for a carpenter’s labor to build a barn. Copyright © 2017 Pearson Canada Inc. 1 - 12 The Challenge of Double Coincidence of Wants Double Coincidence of Wants: In a barter system, both parties must have exactly what the other wants at the same time. This condition is called the "double coincidence of wants." Example: A farmer wanting apples must find someone who not only has apples but also wants the rooster he is offering in return. Inefficiency: The need for this double coincidence makes barter transactions inefficient and limits economic growth and trade opportunities. Copyright © 2017 Pearson Canada Inc. 1 - 13 The Introduction of Money: Solving Barter Limitations Medium of Exchange: Money serves as a commonly accepted medium of exchange, eliminating the need for a double coincidence of wants. Facilitating Trade: With money, the farmer can sell his rooster to someone who wants it, receive money, and then use that money to buy apples from someone else, regardless of whether they want a rooster. Economic Growth: By simplifying transactions and making trade more flexible, money allows for greater specialization, higher efficiency, and increased economic growth. Copyright © 2017 Pearson Canada Inc. 1 - 14 Metal Money Copyright © 2017 Pearson Canada Inc. 1 - 15 The ancient paper money Copyright © 2017 Pearson Canada Inc. 1 - 16 Copyright © 2017 Pearson Canada Inc. 1 - 17 The Gold Standard Copyright © 2017 Pearson Canada Inc. 1 - 18 Copyright © 2017 Pearson Canada Inc. 1 - 19 Problems? Copyright © 2017 Pearson Canada Inc. 1 - 20 Solutions? Copyright © 2017 Pearson Canada Inc. 1 - 21 Assets vs. Liabilities Copyright © 2017 Pearson Canada Inc. 1 - 22 Learning Objectives 1. Why study financial markets? 2. Why study financial institutions and banking? 3. Why study money and monetary policy? 4. Why study international finance? 5. How will we study all of these areas? Copyright © 2017 Pearson Canada Inc. 1 - 23 Copyright © 2017 Pearson Canada Inc. 1 - 24 Copyright © 2017 Pearson Canada Inc. 1 - 25 Copyright © 2017 Pearson Canada Inc. 1 - 26 Copyright © 2017 Pearson Canada Inc. 1 - 27 Why Study Financial Markets? Financial Markets: channel funds from those who do not have a productive use for them to those that do It directly affects our lives, businesses, and economy To learn about bond markets, interest rates, and stock markets Copyright © 2017 Pearson Canada Inc. 1 - 28 Flows of Funds Through the Financial System Copyright © 2017 Pearson Canada Inc. 1 - 29  Please download and install the Slido app on all computers you use Please type 3 words to highlight what you have learned. ⓘ Start presenting to display the poll results on this slide. The Bond Market and Interest Rates A security (or a 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 – Usually expressed as a percent – 4% interest on $100 means you must repay $104 when due Copyright © 2017 Pearson Canada Inc. 1 - 31 Treasury Bills (T-bills) Copyright © 2017 Pearson Canada Inc. 1 - 32 Copyright © 2017 Pearson Canada Inc. 1 - 33 Treasury Bonds Copyright © 2017 Pearson Canada Inc. 1 - 34 Treasury Bills (T-bills)  Short-term federal government bonds that provide no interest, but sold at a discount.  For example,  A T-bill with $100 face value was sold at the following price: 1. $90, 2. $80, 3. $50 Copyright © 2017 Pearson Canada Inc. 1 - 35 Pre-pandemic Canada T-bills (1-year) Rates Copyright © 2017 Pearson Canada Inc. 1 - 36 Copyright © 2017 Pearson Canada Inc. 1 - 37 Copyright © 2017 Pearson Canada Inc. 1 - 38 Canada Savings Bonds Copyright © 2017 Pearson Canada Inc. 1 - 39 Interest Rates on Selected Bonds Copyright © 2017 Pearson Canada Inc. 1 - 40 Copyright © 2017 Pearson Canada Inc. 1 - 41 The Stock Market A stock is a share of ownership in a corporation – Gives claim to the corporation’s earnings and assets A stock market is where stocks are bought and sold The value of stocks reflects the current value of a company, and expectations of future earnings growth – Big swings in share price are often major news stories Copyright © 2017 Pearson Canada Inc. 1 - 42 Stock Prices Copyright © 2017 Pearson Canada Inc. 1 - 43 Cryptocurrency Crash 2022 Copyright © 2017 Pearson Canada Inc. 1 - 44 Short-selling Selling short implies establishing a market position by selling a security one does not own. Copyright © 2017 Pearson Canada Inc. 1 - 45 The Economics of Money, Banking, and Financial Markets Sixth Canadian Edition Chapter 2 An Overview of the Financial System Copyright © 2017 Pearson Canada Inc. 1 - 46 Financial System Financial Markets, for The bonds market example The stock market Financial Institutions, for Commercial banks example Investment banks Financial Instruments, Stocks, bonds, checks, for example and derivatives… Copyright © 2017 Pearson Canada Inc. 1 - 47 Why Study Financial Institutions and Banking? They play a crucial role in the economy Banks and other financial institutions are what make financial markets work In short: they are the entities that move funds from people who save to people who have productive investment opportunities Copyright © 2017 Pearson Canada Inc. 1 - 48 Financial Intermediaries(Institutions) Institutions that borrow funds from people who have saved and then make loans to people who need funds chartered banks, trust and Banks: Borrow funds mortgage loan companies, by accepting deposits and credit unions and caisses populaires Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks Copyright © 2017 Pearson Canada Inc. 1 - 49 Flows of Funds Through the Financial System Copyright © 2017 Pearson Canada Inc. 1 - 50 Copyright © 2017 Pearson Canada Inc. 1 - 51 Copyright © 2017 Pearson Canada Inc. 1 - 52 Debt and Equity Markets Bonds - Debt instruments – A contract between a borrower (who issues the bond) and lender (who owns it) – Regularly payments until Maturity (short-term, < 1 year, intermediate-term, 1-10 years, and long-term, >10 years) Equity – Shares in a corporation – Don’t have maturity dates – Some make dividend payments – Equity holders are residual claimants Copyright © 2017 Pearson Canada Inc. 1 - 53 Primary and Secondary Financial Markets Primary Market – New security issues sold to initial buyers – Not well known to public; typically private – Investment banks guarantee prices (called underwriting) Secondary Market – Previously issued securities can be bought and sold – Brokers match buyers and sellers with each other – Dealers offer to buy and sell securities at stated prices Copyright © 2017 Pearson Canada Inc. 1 - 54 Exchanges and Over-the-Counter Markets Two main ways to organize a secondary market: Exchanges – Buyers and sellers meet in one central location – Toronto Stock Exchange for stocks – ICE Futures Canada for commodities (wheat, oats) Over-the-Counter Markets (OTC) – Dealers have inventory, ready to buy/sell at stated prices – Many stocks are traded OTC, but most are on exchanges – Canadian government bond market is an OTC market Copyright © 2017 Pearson Canada Inc. 1 - 55 Money and Capital Markets Distinguish markets by maturity of the securities Money Markets – Only short-term debt instruments are traded (1 year) Money markets are more liquid than capital markets Copyright © 2017 Pearson Canada Inc. 1 - 56 Money Market Instruments Government of Canada Treasury Bills Certificates of Deposit Commercial Paper Repurchase Agreements Overnight Funds Copyright © 2017 Pearson Canada Inc. 1 - 57 Capital Market Instruments Stocks Mortgages and mortgage-backed securities Corporate bonds Government of Canada bonds Canada Savings bonds Provincial and municipal government bonds Government agency securities Consumer and bank commercial loans Copyright © 2017 Pearson Canada Inc. 1 - 58 Financial Intermediaries: Indirect Finance (1 of 2) Financial Intermediation – Indirect financing using financial intermediates (banks) – Primary route to move funds from lenders to borrowers – Three main roles of financial intermediates 1. Lowers Transaction Costs – Economies of scale – Economies of scope – Liquidity services Copyright © 2017 Pearson Canada Inc. 1 - 59 Financial Intermediaries: Indirect Finance (2 of 2) 2. Improves Risk Sharing – Asset transformation – Diversification 3. Help solve Asymmetric Information problems – Adverse Selection: Potential borrows who are more likely to default are the ones who most actively seek out loans – Moral Hazard: Borrowers might engage in activities that are undesirable from a lender’s point of view – Financial intermediates can screen and monitor borrowers Copyright © 2017 Pearson Canada Inc. 1 - 60 Types of Financial Intermediaries Depository Institutions – Chartered Banks, Trusts and Mortgage Loan Companies, Credit Unions and Caisses Populaires Contractual Savings Institutions – Life Insurance Companies, Property and Casual Insurance Companies, Pension Funds and Retirement Funds Investment Intermediaries – Finance Companies, Mutual Funds, Money Market Mutual Funds, Hedge Funds, Investment Banks Copyright © 2017 Pearson Canada Inc. 1 - 61 Which of the following is an example of a capital market instrument? ⓘ Start presenting to display the poll results on this slide. What is the difference between primary and secondary financial markets? ⓘ Start presenting to display the poll results on this slide. What is the primary function of financial intermediaries? ⓘ Start presenting to display the poll results on this slide. Financial Innovation Innovation in financial markets is the development of new financial products and services – As with innovation in any sector, it is an important force for good by making the financial system more efficient E-Finance: Delivering financial services electronically Creative thinking by financial institutions can improve efficiency, increase profits, but can also sometimes result in financial disasters Copyright © 2017 Pearson Canada Inc. 1 - 65 Copyright © 2017 Pearson Canada Inc. 1 - 66 FinTech Fintech stands for Financial technologies. It means technologies used and applied in the financial system, including mobile payments, money transfers, loans, fundraising, and asset management. Copyright © 2017 Pearson Canada Inc. 1 - 67 Includes… Digital Payments (e.g., PayPal, Venmo) Lending Platforms (e.g., LendingClub, SoFi) Cryptocurrencies (e.g., Bitcoin, Ethereum) Robo-Advisors (e.g., Betterment, Wealthfront) Digital Banks (e.g., Revolut, Chime) Copyright © 2017 Pearson Canada Inc. 1 - 68 The Evolution of Fintech Emergence of online banking Growth in peer-to-peer and digital payments (e.g., lending, robo-advisors, and PayPal). digital-only banks. 2000s 2020s 1990s 2010s Rise of mobile banking and Expansion into AI, blockchain payment apps (e.g., Venmo, technology, and decentralized Square). finance (DeFi). Copyright © 2017 Pearson Canada Inc. 1 - 69 The Future of Fintech Emerging Trends: Central Bank Digital Currencies (CBDCs): Digital versions of national currencies. Decentralized Finance (DeFi): Financial services without intermediaries. Open Banking: Seamless integration of financial services across platforms. Potential for Growth: Continued expansion into new markets and innovations in AI and blockchain. Copyright © 2017 Pearson Canada Inc. 1 - 70 The China Factor China has been at the forefront of fintech growth and is the largest fintech market in the world. In terms of investments, according to the Accenture analysis, the value of fintech deals in China in 2018 was $25.5 billion. Copyright © 2017 Pearson Canada Inc. 1 - 71 P2P Lending Copyright © 2017 Pearson Canada Inc. 1 - 72 Copyright © 2017 Pearson Canada Inc. 1 - 73 Case Study: The Rise and Fall of China's P2P Lending Market The Promise of Financial Innovation and the Perils of Regulatory Neglect Copyright © 2017 Pearson Canada Inc. 1 - 74 The Rise of P2P Lending in China Copyright © 2017 Pearson Canada Inc. 1 - 75 The Problems Lack of Regulation Mounting Defaults Copyright © 2017 Pearson Canada Inc. 1 - 76 Ezubao – The Biggest P2P Scam in China Copyright © 2017 Pearson Canada Inc. 1 - 77 The Ezubao Scam Ezubao was one of the largest P2P platforms in China, claiming to offer annual returns of up to 14.6%. It attracted around 900,000 investors and raised over $7.6 billion within just 18 months. However, in 2016, it was revealed that Ezubao was a Ponzi scheme. The company had fabricated most of the investment projects listed on its platform and used new investors' money to pay returns to earlier investors. Copyright © 2017 Pearson Canada Inc. 1 - 78 Copyright © 2017 Pearson Canada Inc. 1 - 79 Which statement best describes the concept of financial innovation? ⓘ Start presenting to display the poll results on this slide. Ponzi Scheme Copyright © 2017 Pearson Canada Inc. 1 - 81 Copyright © 2017 Pearson Canada Inc. 1 - 82 Ponzi Pyramid Schemes Copyright © 2017 Pearson Canada Inc. 1 - 83 Show 2: The Ponzi Pitch Copyright © 2017 Pearson Canada Inc. 1 - 84 Recent Ponzi Schemes CryptoFX LLC - A $300 million Ponzi scheme National Realty Investment Advisors (NRIA) - A $658 million Ponzi scheme JuicyFields - A EUR 645 million Ponzi scheme Copyright © 2017 Pearson Canada Inc. 1 - 85 What is a key characteristic of a Ponzi scheme? ⓘ Start presenting to display the poll results on this slide. Regulation of Financial Markets Primary Reasons for Regulation 1. Increase information available to investors – Reduce adverse selection and moral hazard problems – Increase efficiency of financial markets 2. Ensure soundness of financial intermediaries – Restrictions on entry and competition, reporting requirements, and restrictions on assets and activities – Deposit insurance Copyright © 2017 Pearson Canada Inc. 1 - 87 Principal Regulatory Agencies of the Canadian Financial System (1 of 2) Table 2-5 Principal Regulatory Agencies of the Canadian Financial System Regulatory Agency Subject of Regulation Nature of Regulations Provincial securities and Organized exchanges and Requires disclosure of information and restricts exchange commissions financial markets insider trading Bank of Canada Chartered banks, TMLs, and Examines the books of the deposit taking institutions CUCPs and coordinates with the federal agencies that are responsible for financial institution regulation: OSFI and CDIC Office of the All federally regulated chartered Sets capital adequacy, accounting, and board-of- Superintendent of Financial banks, TMLs, CUCPs, life directors responsibility standards; conducts bank Institutions Canada (OSFI) insurance companies, P&C audits and coordinates with provincial securities insurance companies, and commissions pension plans Canada Deposit Insurance Chartered banks, TMLs, Provides insurance of up to $100 000 for each Corporation (CDIC) CUCPs depositor at a bank, examines the books of insured banks, and imposes restrictions on assets they can hold Copyright © 2017 Pearson Canada Inc. 1 - 88 Principal Regulatory Agencies of the Canadian Financial System (2 of 2) [Table 2-5 Continued] Regulatory Agency Subject of Regulation Nature of Regulations Québec Deposit Insurance TMLs and credit cooperatives in Similar role to the CDIC Board Québec Canadian Life and Health Life insurance companies Compensates policyholders if the issuing life Insurance Compensation insurance company goes bankrupt Corporation (CompCorp) P&C Insurance Property and casualty insurance Compensates policyholders if the issuing P&C Compensation Corporation companies insurance company goes bankrupt (PACIC) Copyright © 2017 Pearson Canada Inc. 1 - 89  What is the primary reason for regulation in financial markets? ⓘ Start presenting to display the poll results on this slide. Exploring the Web Statistics Canada: CANSIM database Federal Reserve Bank of St. Louis: FRED database Bank of Canada website Myeconlab: first homework will be assigned this weekend. Economics-games.com Copyright © 2017 Pearson Canada Inc. 1 - 91 John Maynard Keynes Copyright © 2017 Pearson Canada Inc. 1 - 92 How might bounded rationality affect market predictions? Copyright © 2017 Pearson Canada Inc. 1 - 93 THE 2/3 GUESSSING GAME (THE BEAUTY CONTEST GAME) Copyright © 2017 Pearson Canada Inc. 1 - 94 Copyright © 2017 Pearson Canada Inc. 1 - 95 Rules of the Game Each player will be asked to pick an integer between 0 and 100, inclusive. The winner will be the participant whose number is closest to two- third of the average of all chosen numbers. The winner will receive 100 points, while other participants will receive nothing. In case of a tie, the 100 points will be equally divided between winners. Copyright © 2017 Pearson Canada Inc. 1 - 96 Rules of the Game Guessing Game – Who is playing? – What are they playing with; i.e., strategies? – When does each player get to play? – How much is the gain (or loss)? – What information does each player know? How much are the players in a game supposed to know about the rules? Chapter 2 97 Copyright © 2017 Pearson Canada Inc. 1 - 97 Online Game to Play….. Economics-games.com Click on the login button on the top right corner User ID for the left: _i, where i is the number I assigned to you or your group earlier. User ID for the right: _i, where i is the number I assigned to you or your group earlier. Password: pass Copyright © 2017 Pearson Canada Inc. 1 - 98 THE GUESSING GAME REVISITED Copyright © 2017 Pearson Canada Inc. 1 - 99 Why? Bounded rationality – People do not naturally use deep levels of strategic thinking. They just think 2-3 steps ahead Players may be fully rational, however if a player believes that all other players will say a bigger number, that player will declare 2/3 of the bigger number. – Stock market bubbles Copyright © 2017 Pearson Canada Inc. 1 - 100 Connection to Financial Markets Keynes' Analogy: Financial markets resemble the beauty contest game. Investors predict market trends by anticipating others' actions, not just fundamentals. Focus is often on "what the average opinion expects the average opinion to be." Market Behavior: Reflects layers of expectations and beliefs about others' expectations. Can lead to market bubbles or crashes driven by speculative dynamics rather than intrinsic value. Copyright © 2017 Pearson Canada Inc. 1 - 101