Lecture Notes
Davion Brown
Money and Banking (MGEC71)
Professor: Michael Ho
Summer 2025
June 14, 2025
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1
Financial Markets
1.1
Surpulus and Deficit of Funds
This is referring to the government expenditures at the end of the year or a given period.
ˆ Budget Deficit: Excess government expenditures with respect to tax revenues, requiring the
gov’t to finance by borrowing
ˆ Budget Surplus: Tax revenues are greater than the expenditures, lower government debt
burden, higher rate of money growth, higher interest rates.
1.2
Key Innovations in Financial Markets
ˆ Passbooks: An old fashioned physical record of deposits, withdrawals, interest earned, and other
account activities provided by the bank
ˆ E-Finance: New innovative means of delivering financial services electronically
1.3
Problems in Financial Markets
We often refer to the ”problems” as Financial Crisis and the intituion is to think of the market being
sick.
ˆ Innovations too far head of regulations and the devlopment of loophole products.
ˆ Conflicts of interests (Type of Moral Hazard Problem) which likely occurs when an institution
or indivisual has multiple objectives were some conflict with one another. Ex: Credit Rating
Agencies were advising clients on how to structure complex financial instruments as well as
providing ratings. When it came to advising they get a fee, however their was no incentive for
them to provide accurate ratings compared to the lucrative fee they were earning. All leading
to poor assement of risk, inflated ratings and the financial crisis. This is also another prime
example of the worsening of Asymmetric Information.
1.4
Monetary Policy (Money)
Monetary policy is the process by which the monetary authority of a country controls the supply of
money, which often affects the following:
Money / Money Supply → Interest Rate → Output → Unemployment
Money / Money Supply → Price.
1.5
Technology
The key takeways about technology in the financial markets is the the fact that technology has probed
Globalization which brings about increased efficiency but also increase contagiousness meaning
the world has become more connected due to the reduction of distance and time by technology.
Examples include:
ˆ Reduced cost of transportation services for quality assurance
ˆ Online communication
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1.6
Supply and Demand Equalibrium
What do the following have to do with Supply and Demand Equalibrium ??
ˆ Asymmetric Information - when one party has more or better information than the other
party.
ˆ Adverse Selection - when one party in a transaction has information that the other party
does not have, and this information is used to their advantage.
ˆ Moral Hazard - when one party in a transaction takes risks because they do not have to bear
the full consequences of those risks.
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2
Financial System
2.1
Debt
ˆ Loan Contract, has a ”maturity” date
ˆ Periofic Payments of interest and principal
ˆ The lender has earlier claim to the assets of the borrower (Earlier Claimant)
2.2
Equity
ˆ Ownership, has no ”maturity” date
ˆ Dividends are not guaranteed
ˆ The lender has a later claim to the assets of the borrower (Residual Claimant)
2.3
Primary Markets
These are the ”big boys” consisting of investment banks and bond dealers and include the following
markets:
ˆ IPO offers from investment banks
ˆ Bonds from bond dealers
2.4
Secondary Markets
These are markets facilitated by brokers and dealers who are always ready to buy or sell over generally
an exchange done ”over-the-counter” and they include the following markets:
ˆ Stock Exchanges
ˆ Bond Exchanges
An Exhange is a defined as a place where buyers and sellers of securities (or their agents or brokers)
meet in one central location to conduct trades. Examples given include the New York Stock Exchange
for stocks and the Chicago Board of Trade for commodities.
2.5
Terms to Maturity
Markets are classified by their terms of maturity:
ˆ Money Market: (Maturity of less than 1 year), Examples include: Treasury Bills, Commercial
Paper, and Repurchase Agreements
ˆ Capital Market: (Maturity of more than 1 year), Examples include: Treasury Bonds, Corporate
Bonds, and Mortgages
2.6
Foreign Bonds
The bond issuer is in a Foreign Country and the bond is demominated in the Domestic Currency
of the country, for example:
ˆ A bond issued by a Japanese company in the US and denominated in US dollars is a foreign
bond.
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2.7
Eurobonds
The bond issuees the bond in a Foreign Currency something other than the domestic currency, for
example:
ˆ A bond issued by a Japanese company in the US and denominated in Japanese yen is a Eurobond.
ˆ A bond issued by a US company in the US and denominated in euros is also a Eurobond.
2.8
Eurocurrencies
Foreign currencies deposited in banks outside of home country. There is also a specific type
of Eurocurrency called Eurodollars which are defined as U.S. dollars that are deposited in foreign
banks outside the United States or in foreign branches of U.S. banks.
2.9
Regulators
The job of regualtors are to ensure the full and timely disclosure of information to the public, prevent
panick, and prevent financial crisis.
2.10
Financial Intermediaries
The purpose of Financial Intermediaries is the following:
ˆ To reduce transaction costs
ˆ Risk sharing, reducing indivisual risk
ˆ Asymmetic Information, reducing the information gap between lenders and borrowers
The different types of financial intermediaries are:
ˆ Despository Insititutions: Banks, Credit Unions, and Savings and Loans
ˆ Contractual Savings Institutions: Life Insurance Companies, Pension Funds, and Fire and Casualty Insurance Companies
ˆ Investment: Investment Banks, Mutual Funds, and Hedge Funds
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3
Money
3.1
Functions of Money
ˆ Medium of Exchange: Money is used to facilitate transactions for goods and services.
ˆ Unit of Account: Money provides a standard measure of value, allowing for the comparison
of prices.
ˆ Store of Value: Money retains its value over time, allowing individuals to save and defer
consumption.
3.2
Payment System Transitions
1. Barter System: Direct exchange of goods and services without money. Was inefficent due to
the need double coincidence of wants and infinite number of exchange systems.
2. Commodity Money: Use of a commodity (e.g., gold, silver) as money. But was inefficent due
to the bulkiness of gold and the possibility of thieft.
3. Paper Money: Use of paper notes as a representation of value backed by gold, ”gold standard”.
But inefficent maintaince of the gold standard can leave people with no gold to exchange for
their paper money, i.e Great Depression.
4. Fiat Money: Government-issued currency that is not backed by a physical commodity having
no intrinsic value.
3.3
Currency in Currculation
In terms of monetary aggregates, currency in circulation specifically refers to paper money and
coins that are in the hands of the public. The sources available do not explicitly state that this
definition does not include cash held in ATMs or bank vaults. This specific exclusion, while
implied by the concept of ”in the hands of the public”, is not directly verifiable within the provided
excerpts and may require independent verification.
Economists consider currency in circulation to be a monetary liability of the central bank
21, 405, 570. For example, Federal Reserve notes are considered IOUs from the Fed to the bearer 21.
Here’s how it relates to different measures of the money supply:
ˆ M1 is the narrowest measure of money and includes the most liquid assets. Its components are:
– Currency (in the hands of the nonbank public).
– Checking account deposits (or checkable deposits).
– Traveler’s checks (not issued by banks).
– The sources note that, surprisingly, over $4,500 of cash is in circulation for each person in
the United States.
ˆ M2 is a broader monetary aggregate that adds to M1 other assets that are not quite as
liquid but can be turned into cash quickly and at very little cost. These include:
– Small-denomination time deposits (certificates of deposit with a denomination of less
than $100,000).
– Savings deposits.
– Money market deposit accounts.
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– Retail money market mutual fund shares.
ˆ Broader Measures (Bank of Canada context): The sources also mention even broader
definitions used by the Bank of Canada:
– M1+ (gross): Includes currency outside banks and all chequable deposits at chartered
banks, Trust and Mortgage Loan Companies (TMLs), and Credit Unions and Caisses Populaires (CUCPs).
– M1++ (gross): Adds all non-chequable deposits at chartered banks, TMLs, and CUCPs
to M1+ (gross).
– M2 (gross): Includes currency, plus all deposits (excluding interbank deposits) at chartered banks.
– M2+ (gross): Includes M2 (gross) plus deposits at near banks (TMLs and CUCPs), life
insurance company annuities, and money market mutual funds.
– M2++ (gross): Adds Canada Savings Bonds and non-money market mutual funds to
M2+ (gross).
The Federal Reserve publishes data for M1 and M2 weekly in its H.6 release. It is important for
policymakers to understand these different measures because they do not always move together,
leading to potentially conflicting information about the state of the money supply and the appropriate course of monetary policy. For instance, discrepancies were observed between M1 and M2
growth rates in the early 1990s and from 2004 to 2007.
Currency in circulation also plays a role in the money supply process through the money
multiplier. If a portion of an increase in the monetary base finds its way into currency holdings
instead of deposits, it does not undergo the multiple deposit expansion seen with bank deposits.
This means that if proceeds from loans are not deposited but are instead used to increase currency
holdings, the overall multiple expansion is reduced, and the money supply increases by less than what
a simple model might predict.
3.4
Innovation of Money
ˆ Debit Cards
ˆ Credit Cards
ˆ Electronic Payments
3.5
Cashless Society
This would be impossible because criminals will always use cash because it is hard to trace.
3.6
Bitcoin
This is a new type of electronic money with no single entity controlling the currency like a sentral
bank. Bitcoin does not satisfy the units of account or store of value functions of money because no
one quotes their prices in terms of bitcoin due to their volitilty and again by the same reasoning it is
too risky for people to store their wealth in bitcoin.
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4
Bonds and Interest Rates
4.1
Calculation of PV to FV
P V (1 + i) = F V1
P V (1 + i)2 = F V2
P V (1 + i)3 = F V3
..
.
P V (1 + i)n = F Vn
F Vn
Thus we get by re-arraging: P V (1 + i)n = F Vn =⇒ P V = (1+i)
n . This calculation demonstrates
discounting the FV n periods from now to today using the discount factor.
4.2
Introduction to Loans: Simple Loan
These are very old fashioned loan agreements and are not too popular today and only require the
following information:
ˆ How much will you pay me back in the future
ˆ When will you pay me back in the future
Simple Loans are a Ballon Type Loan, the longer the period the more the borrower must pay
back, which has the additional following problems:
ˆ Borrowers need strong self-displine to put aside the required amount every month to make
the final payment otherwise they will default.
ˆ Asymmetric information deteriorates becuase the borrower and lender do not contact again
until the date of payment (moral hajard).
4.3
Yield-To-Maturity / Interest Rate
From finance we know that the Net Present Value (NPV) of any project is the Present Value of all
inflows substracted by the Present Value of all outflows shown by the following equation:
N P V = P V of Inflows − P V of Outflows
The interest rate which discounts the future inflows (revenues) to equal the present value of outflows
which is often a single payment in year t = 0 is called Yield to Maturity.
4.4
Types of Loans
ˆ Ballon Type Loans:
ˆ Fixed Payment Loans: Mortgages are an example of these type of loans because for every
period their is a ”fixed” loan repayment of Principle & Interest. Once the loan has been paid of
we call the the loan Fully Amortized.
Comparing the two loan types: The fixed payments will be much cheaper than the ballon
type because their declining outstanding balance property on the principle amount also reducing the
interest cost for each sucessive payment. And the overall interest cost is less than the ballon type.
Preferrences:
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ˆ Borrowers: Reduced interest costs
ˆ Lenders: Increased points of contact / periodic payments reducing the asymmetric risk from
asymmetric information problem.
4.5
Loan Agreements
Loan agreements tend to be done by bug companies and banks, these loan agreements are called
Bonds have has the following information which never changes:
ˆ Coupon Payment each period (C0 )
ˆ Terms to Maturity (n)
ˆ Face Value (F ) referring to the amount the lender will receive at maturity.
4.6
Coupon Bonds
Coupon bond price is determined by the Basic Asset Pricing Method meaning the price is equal
to the present value of all future cashflows. For coupon bond with n = t, C, F we have the formula to
calculate price as:
C
C
C +F
C
+
+ ... +
+
P =
1 + i (1 + i)2
(1 + i)t−1
(1 + i)t
The Coupon Rate is defined as CR = C
F =⇒ C = CR · F then we get the formula:
CR · F
CR · F
CR · F + F
CR · F
+
+ ... +
+
2
t−1
1+i
(1 + i)
(1 + i)
(1 + i)t
CR
CR
CR
CR + 1
=⇒ P = F
+
+ ... +
+
1 + i (1 + i)2
(1 + i)t−1
(1 + i)t
CR
CR
CR
CR + 1
P
=
+
+ ... +
+
=⇒
F
1 + i (1 + i)2
(1 + i)t−1
(1 + i)t
P =
4.7
Facts About General Coupon Bonds
ˆ CR = i =⇒ P = F , At Par
ˆ ↑ i =⇒ ↓ P , The negative relationship between interest rate and price
R
ˆ CR > i =⇒ 1+C
1+i > 1 =⇒ P > F , Over-Par
R
ˆ CR < i =⇒ 1+C
1+i < 1 =⇒ P < F , Under-Par
4.8
Consol
A consol is a bond which has infinite number of coupon payments but no face value. The price
of a consol can be calculated by:
C
P =
i
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Proof. Using the again the Basic Asset Pricing Method, all future cash flows is as follows:
P =
=
C
C
C
+ ... +
+
(1 + i) (1 + i)2
(1 + i)∞
∞
X
C
t=1
=C·
(1 + i)t
∞ X
t=1
=C·
∞
X
1
(1 + i)
t
λt where
t=1
Recall:
∞
X
t=0
λt =
1
=λ
(1 + i)
∞
∞
X
X
λ
1
1
1
=⇒ λ0 +
=⇒
−1=
λt =
λt =
1−λ
1
−
λ
1
−
λ
1
−
λ
t=1
t=1
λ
1−λ
"
1
(1+i)
1
1 − (1+i)
"
1
1+i
1+i−1
1+i
1
1+i−1
P =C·
=C·
=C·
=C·
=
#
#
C
i
The only fact about bonds which still holds for consols is as ↑ i =⇒ ↓ P , The negative
relationship between interest rate and price. All other facts do not apply.
4.9
Discount Bonds
The most common type of discount bond is Treasury Bills (T-Bills), these discount bonds are distinctive because they have no coupon payments and are generally calculated with the following
formula:
F
P =
1+i
The formula for Capital Gain (Loss) / Bond Yield is:
i=
F −P
F − P 365
=⇒
i=
·
for Treasury Bills (91 days maturity)
Annualizing
P
P
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This is only an approximation. The more accurate calculation of i is done by:
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F −P
i= 1+
−1
P
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4.10
Interest Rates
Nominal Interest Rates
Real Interest Rate
Rate of Return (R)
The rate of return describes the interest rate risk of holding a bond. The calculation of rate of return
can be separtated into the Current Yield (ic ) and Capital Gain (Loss) (g) as follows:
R=
C
Pt+1 − Pt
+
= ic + g
Pt
Pt
We can consider the following senarios affecting R of holding a bond:
A : Holding onto the bond until maturity, changing interest rate has no effect on rate of return
ˆ O
B : if ↑ i =⇒ i′ > i then Pt+1 < Pt
ˆ O
C : Longer term the bond period the price decreases in addition to as ↑ n =⇒ ↓ g
ˆ O
Overall, for investors not holding bonds until maturity, changing interest rates affects:
ˆ Future Price (Pt+1 )
ˆ Capital Gain or Loss (g)
ˆ Rate of Return (R)
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5
Behaviour of Interest Rates
The main takeaway is that nominal interest rates are determined by supply and demand of bonds and
the liquidity preference framework.
5.0.1
Asset Demand
We care about asset demand because we want to understand the factors that influence people to buy
and hold an asset.
5.0.2
The Determinants of Asset Demand
ˆ Wealth: An increase in wealth generally increases the quantity demanded of an asset becauase....
ˆ Expected Return: An increase in an asset’s expected return relative to alternatives increases
its quantity demanded of an asset because...
ˆ Risk: An increase in an asset’s risk relative to alternatives decreases its quantity demanded of
an asset because. . .
ˆ Liquidity: An increase in an assets liquidity relative to alternatives increases its quantity
demanded for asset because. . .
These are extemely relevant as they are the direct factors which shift bond demand. These factors
will be discussed again in terms of bond demand in the bond market.
5.1
Bond Market
The intersection of bond supply and demand curves is what specifically determines the equilibrium interest rate.
Bond Demand
This represent the amount people are willing to purchase bonds at a specific quantity assuming all
other economic variables remain constant.
ˆ Negative Relationship with Price and Interest Rates
ˆ Downward Sloping
ˆ Determinants of Demand Shifts
– Wealth
– Expected Returns on Bonds Relative to Alternatives (Stocks, Options)
– Risk of Bonds Relative to Alternative Assets
– Liquidity of Bonds Relative to Alternative Assets
Bond Supply
This represents the amount firms and governments are willing to sell bonds at for a specific quantity
assuming all other economic variables remain constant.
ˆ Upward Sloping
ˆ Determinants of Supply Shifts
– Expected Profitability of Investment Opportunities
– Government Budget Deficits
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Market Equilibrium
The equilibrium interest rate in the bond market is determined at a point where quantity of bonds
demanded equals the quantity of bonds supplied. The market equilibrium price is also determined at
said point.
ˆ Fisher Effect: Simply states that if expected inflation rises then interest rates rises for the
following reasons.
– Bond Demand shifts Left
– Bond Supply shifts Right
– Total effect is a fall in bond prices which is directly negatively correlated to interest rates
so the equilibrium interest rate rises.
ˆ Market Adjustment Mechanism:
– Bond Price above equilibrium price, excess supply of bonds, prices are driven down and
interest rates driven up until at equilibrium
– Bond Price below equilibrium price, excess demand of bonds, prices driven up and interest
rates driven down until at equilibrium
5.2
Money Market
This is also called the Liquidity Preference Framework and it determines the equilibrium interest
rate exactly like the bond market except with the supply and demand curves of money.
Money Supply
Anything that us generally accept as payment for goods and services or in the repayment of debts
Money Demand
This represents the quantity of money people want to hold and people hold money because they need
to conduct day-to-day transactions, precautionary motives, speculative motives. If these need were
to increase they are negatively related to interest rates.
ˆ Liquidity Preference Function: Negatively correlated to nominal interest rates & Positively
correlated to real income
ˆ Two Primary Factors for the shifts:
– Income Effect
– Price-Level Effect
ˆ Other Factors Shifting Money Demand:
– Wealth
– Inflation Risk
– Risk
– Liquidity
– Payment Technology
Market Equilibrium
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Computations
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