Professor Yamin Ahmad, Money and Banking – ECON 354
ECON 354
Money and Banking
Professor Yamin Ahmad, Money and Banking – ECON 354
Resources Needed For This Class
• Aplia Website:
 http://econ.aplia.com
 Use course code: N797-QVAJ-S4W8
Professor Yamin Ahmad
• Mishkin, Frederick S. (2010), The Economics of
Money, Banking and Financial Markets, 9th
Edition, Pearson
• Lecture 1
 Syllabus
 Introduction to Financial
Markets and Money
 Real World Observations
and Basic Definitions
 8th edition is also fine if you have it.
• Course Homepage:
 http://facstaff.uww.edu/ahmady/courses/econ354/
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Requirements
Grades
• Homework Assignments, Experiments
• Option A:
• 4 Quizzes
 Multiple choice questions
 Homework assignments
 Quizzes
 Final
10%
15% each
30%
• One Final Exam
 Multiple choice questions
Note: These notes are incomplete without having attended lectures
• Option B:
 Homework Assignments
 3 Best Quizzes
 Final
Note: These notes are incomplete without having attended lectures
15%
15% each
40%
Professor Yamin Ahmad, Money and Banking – ECON 354
Extra Credit
Extra Credit will be available during the summer session
in the following manner:
• Additional Extra Credit problem sets on Aplia
 These are used to replace low scoring problem sets
 Count only towards the “homework” part of the
course score
Professor Yamin Ahmad, Money and Banking – ECON 354
Success in an (Any!) Economics Course
To do well in Economics, you need to be able to
do 3 things well (in conjunction):
1. Think Mathematically: Don’t be afraid of
equations!
2. Think graphically!
3. Abstract Logic! (Often the hardest part)
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
The Keys to Success in this Course…
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Things to Review from Principles of Macro…
• Do homework assignments on Aplia
 Designed to make you think about topics! Oftentimes,
challenging
 Typically, questions here are harder than those you will face in
exam
• Don’t be shy!
 Come to class ready to ask questions! Use lecture time to “fill in
the gaps”!
• Understand differences between movements
and shifts of curves!
• (Aggregate) Demand and (Aggregate) Supply
• Market Equilibrium
• Practice and Discuss!!!
 Think about “what happens if … ?” It’s the only real way to grasp
concepts in economics – and economics itself!
• Utilize my office hours!!
 Come chat with me about concepts you are having trouble with,
ideas you haven’t grasped fully etc.
Note: These notes are incomplete without having attended lectures
• The structure of the economy
 Make sure you read (and understand) Appendix of
Chapter 1 in Mishkin!
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
A Model of the Economy
The Agents in the System…
• As in Principles of Macro, divide the economy
into different sectors and see how those sectors
interact:
• There are four agents that we will focus on when
constructing a model of the economy:
 Households
 “Agents” in the Economy
 Firms
 Markets where Agents Interact
 Government
 Equilibrium
 “The Rest of the World” (ROW)
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Markets
• There are three markets that we typically focus
on in macroeconomics:
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
The Map of the Economy
That is: Y = C + I + G + X - M
 The Factor Market
 The Goods Market
 The Financial Market (- we examine in detail in this
course)
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Overview of the Course
Overview of the Course
GOVERNMENT
• Money
HOUSEHOLDS
Financial Markets:
Central Banking &
Monetary Policy
-Interest Rates
-Risk
-Expectations
• Monetary Theory and Monetary Policy
• Financial Markets and Financial Intermediaries
FIRMS
Financial Institutions
- Financial Intermediaries
The Economy
REST OF THE
WORLD
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Role of Money
Some Definitions
• Money: Anything that is generally accepted in payment
for goods and services
• Medium of exchange
 Form of transaction technology
• In the United States:
 M1 = Currency + Traveler's Checks + Demand Deposits +
Other Checkable Deposits
• Unit of account
 M2 = M1 + Small denomination time deposits & repurchase
agreements + Savings Deposits and money market deposit
accounts + retail Money Market mutual fund shares
• Store of value
 Purchasing Power
 Hence money helps to:
• There also used to be a broader measure of money, M3
which was discontinued as of March 2006.
 Lower transaction costs
 Increase Liquidity in an economy
• See: http://www.federalreserve.gov/releases/h6/hist/
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Overview of the Course
Monetary Theory and Policy
• Money
• Why study Monetary Theory and Policy?
 Influence on business cycles, inflation, and interest
rates
• Monetary Theory and Monetary Policy
 How Central Bank (Fed) can have a big influence on
the economy
• Financial Markets and Financial Intermediaries
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Money and Business Cycles
Money and the Price Level
Money (M2) Growth and the Business Cycle: 1950 - 2010
120
11
100
9
7
5
Index (2005 = 100)
13
Money Growth Rate (%)
15
140
80
60
40
3
20
1
1960 1962 1965 1967 1970 1972 1975 1977 1980 1982 1985 1987 1990 1992 1995 1997 2000 2002 2005 2007 2010
-1
0
1960
1965
1970
1975
1980
M2
• Shaded areas represent Recessions
• Note: Figure above shows a decline in money growth rate
prior to every recession (except the most recent one)!
Note: These notes are incomplete without having attended lectures
1985
1990
1995
2000
2005
2010
GDP Deflator
• Note: Positive Relationship between Money and the Aggregate
Price Level
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Money Growth and Inflation
Money Growth and Interest Rates
• Positive correlation between money growth rates and
interest rates in 1960’s & 1970’s
• Relationship breaks down in 1980’s
• Note: Across different countries, positive correlation between avg.
money growth rates and avg. inflation rates
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Surpluses and Deficits
3.0
2002 –
2007
expansion
2.0
Government Budget Balance (percentage of GDP)
• Figure 10(a) shows the
changing surplus and
deficit of the federal and
provincial governments
in the United States
since 1971.
• Persistent federal deficit
during the 1970s
through 1990s.
• Surplus from 1998 to
2001
• More deficits following.
Surpluses and Deficits
1990’s
expansion
1.0
0.0
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
-1.0
1980’s
expansion
International Surplus and Deficit
• If a nation imports more than it exports, it has an
international (trade) deficit.
• If a nation exports more than it imports, it has an
international (trade) surplus.
-2.0
• The current account deficit or surplus is the
balance of exports minus imports plus net
interest paid to and received from the rest of the
world.
-3.0
-4.0
OPEC
Recession
2001 –
2002
Recession
-5.0
-6.0
-7.0
1982
Recession
1991
Recession
(a) U.S. Government Budget Deficit
Source: Congressional Budget Office
Note: These notes are incomplete without having attended lectures
23
24
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Surpluses and Deficits
• Persistent current
account deficit since
1983
• The deficit has
swollen during the
past few years
2.000
OPEC
Recession
1981-82
Recession
• Surpluses – good? Deficits – bad?
1991
Recession
1.000
Current Account Balance (percentage of GDP)
• Figure 10(b) shows
The U.S. current
account balance
since 1960.
Interaction of Monetary and Fiscal Policy
2001 –
2002
Recession
0.000
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
-1.000
• Examine how fiscal irresponsibility can lead to
the onset of financial crises.
-2.000
2008
Recession
-3.000
1980’s
Expansion
• Why deficits might lead to a higher money
growth rate, a higher rate of inflation and higher
interest rates.
1990’s
Expansion
-4.000
-5.000
-6.000
-7.000
(b) U.S. International Deficit
Source: Bureau of Economic Analysis
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Overview of the Course
• Money
• Monetary Theory and Monetary Policy
• Financial Markets and Financial Intermediaries
25
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Financial Markets
• Why Study Financial Markets?
 Channel funds from savers to investors, thereby
promoting economic efficiency
 Affect personal wealth and behavior of business firms
• Brief Introduction to:
 Bond Market
 Stock Market
 Foreign Exchange Market
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Function of Financial Markets: Flow of Funds
Bond Market: 1953 - 2010
20
Indirect Finance
18
16
Financial
Intermediaries
Interest Rate (%)
14
12
10
8
6
Lender-Savers
• Households
• Firms
• Government
• Foreigners
Borrowers-Spenders
• Business-Firms
• Government
• Households
• Foreigners
Financial
Markets
4
2
0
1953
1963
1968
1973
3 Month T-Bills
1978
1983
1988
Corporate BAA Bonds
1993
1998
2003
2008
U.S. Government Long-Term Bonds
• Bonds, securities…. what are they?
Direct Finance
• Allows transfers of funds from person or business
without investment opportunities to one who has them
• Improves economic efficiency
Note: These notes are incomplete without having attended lectures
1958
• Bond Market (and Money Markets):
 determines interest rates
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Stock Market: 1950 - 2010
Foreign Exchange Market
16000
Dollar-Sterling Exchange Rate
• Stocks:
14000
 Share of ownership in a
corporation/firm.
12000
10000
3.000
2.500
2.000
1.500
1.000
• Stock Price volatility
8000
0.500
0.000
Q1
1970
6000
4000
2010
2006
2003
2000
1996
1993
1990
1986
1983
1980
1976
1973
1970
1966
1963
1960
1956
1953
1950
Dow Jones Industrial Average
Note: These notes are incomplete without having attended lectures
Q1
1975
Q3
1977
Q1
1980
Q3
1982
Q1
1985
Q3
1987
• “Bull Market” vs. “Bear
Market”
• Foreign Exchange Market:
• Stock Price “Bubbles”
• Changes in Exchange rate:
2000
0
Q3
1972
 Technology bubble in
1990’s?
Q1
1990
Q3
1992
Q1
1995
Q3
1997
Q1
2000
Q3
2002
 Transfer funds from one country to another
 Changes in relative prices
Note: These notes are incomplete without having attended lectures
Q1
2005
Q3
2007
Q1
2010
Professor Yamin Ahmad, Money and Banking – ECON 354
Some Basic Definitions
Debt Instrument:
Professor Yamin Ahmad, Money and Banking – ECON 354
Classifications of Financial Markets
1. Primary Market


1. Debt Instrument: Contractual agreement by borrower to
pay holder of the instrument a fixed dollar amount at
regular intervals (principal + interest), until a specified
date

Example: Car loan
New security issues sold to initial buyers (often behind closed
doors)
Investment banks typically underwrite securities (i.e.
guarantees a price for the security and then sells it to the
public)
2. Secondary Market



Securities previously issued are bought and sold
E.g.: NASDAQ, Futures, Options, Foreign Exchange
Exchanges
o
2. The maturity of a debt instrument is the number of
years (term) until the instrument expires
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Methods of Raising Private Sector Funds
• Debt Markets
 Short-term (maturity < 1 year): Money Market
 Intermediate-term (1year < maturity < 10 years)
 Long-term (maturity > 10 years)
• Equity Markets
 Common stocks: claims to share in assets and net income
 No maturity date; periodic payments known as dividends

Trades conducted in central locations (e.g., New York Stock
Exchange, NYSE; London Stock Exchange, LSE)
Over-the-Counter Markets
o
Dealers at different locations buy and sell
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Financial Market Instruments
What are the kinds of securities traded in financial
markets?
• Money Market Instruments
 Because of short term to maturity, debt instruments traded in the
money market do not have much fluctuation in their prices, and
hence are the least risky
• Capital Market Instruments
• Capital Market: Intermediate + Long Term Debt +
Equity
• Examples: Bonds, mortgages
Note: These notes are incomplete without having attended lectures
 Debt and equity instruments with maturities greater than a year;
these have much greater fluctuations in their prices (compared to
money market instruments) and as such are considered more
risky
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Examples: Money Market Instruments
• US Treasury Bills
 Issued by US govt, with 1, 3, and 6 month maturities.
 Pay a set amount at maturity, and have no interest
payments; effectively pay interest by selling at a discount.
Examples: Money Market Instruments
• Repurchase Agreements
 Repos are effectively short term loans (usually with a
maturity of less than 2 weeks) for which T-bills serve
as collateral. The most important lenders in this
market are usually large corporations.
• Negotiable Bank Certificates of Deposit
 CD’s are debt instruments sold by banks to depositors that
pays an annual interest of a given amount, and pays back
the original purchase price at maturity
• Federal (Fed) Funds
 These are typically overnight loans of reserves
between banks, of their deposits at the Federal
Reserve.
• Commercial Paper
 Short term debt instrument issued by large banks and well
known corporations (e.g. Microsoft, GM).
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Table 1 Principal Money Market
Instruments
Professor Yamin Ahmad, Money and Banking – ECON 354
Examples: Capital Market Instruments
•
Stocks
 These are equity claims on net income and assets of a corporation.
 Issue of new stocks in any given year is typically quite small, although the
total value of stocks exceed that of any other type of security in the capital
markets.
•
Mortgages
 Mortgage market is the largest debt market in the US
 Residential mortgages are approximately 4 times the amount of commercial
and farm combined.
•
Corporate Bonds
 Long term bonds issued by corporations with very strong credit ratings.
 Typical corporate bond sends the holder an interest payment twice a year
and pays off the face value when the bond matures.
 Some “convertible” corporate bonds allows the holder to convert them into a
specified number of shares of stock at any time up to the maturity date.
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Examples: Capital Market Instruments
•
Professor Yamin Ahmad, Money and Banking – ECON 354
Table 2 Principal Capital Market
Instruments
US Government Securities
 These are long term debt instruments issued by the US Treasury to finance
the deficits of the government.
•
US Government Agency Securities
 Issued by various agencies such as Ginnie Mae, the Federal Farm Credit
Bank, etc, to finance such items as mortgages, farm loans or power
generating equipment.
 Many of the securities are guaranteed by the federal government.
•
State and Local bonds
 Also called municipal bonds, which are long term debt instruments issued
by the state and local governments to finance expenditures on roads,
schools, and other programs.
 Interest payments from these bonds are exempt from federal income tax
and generally from the state taxes issuing the bond.
•
Consumer and Bank loans
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Internationalization of Financial Markets
International Bond Market
• Foreign bonds: bonds sold in a foreign country and
denominated in that country’s currency.
• Eurobonds:
 Now larger than U.S. corporate bond market
World Stock Markets
• U.S. stock markets are no longer always the largest:
Japan sometimes larger
• E.g. Dow Jones Industrial Average (U.S.); Financial
Times Stock Exchange (FTSE - London); Nikkei (Tokyo)
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Common Confusions
• Eurobond: bond denominated in a currency other than
that of the country in which it is sold
 E.g. Bond denominated in Sterling, sold in the U.S.
• Eurocurrencies: foreign currencies deposited in banks
outside the home country
 E.g.: Eurodollar Market – U.S. dollars deposited in foreign banks
outside the U.S.
• Different to the Euro which is the national currency
adopted in Europe after monetary union in 2002.
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Function of Financial Markets: Flow of Funds
Financial Intermediaries:
Indirect Finance
Financial
Intermediaries
Lender-Savers
• Households
• Firms
• Government
• Foreigners
Financial
Markets
Function of Financial Intermediaries
1. Engage in process of indirect finance
Borrowers-Spenders
• Business-Firms
• Government
• Households
• Foreigners
Direct Finance
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Role of Financial Intermediaries
2. More important source of finance than
securities markets
3. Needed because of transactions costs and
asymmetric information
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Primary Assets and Liabilities of Financial Intermediaries
Type of Intermediary
Primary Liabilities
Primary Assets
Deposits
Business and consumer loans,
mortgages, US Govt securities
and municipal bonds
Savings and Loans Institutions
Deposits
Mortgages
Mutual Savings Banks
Deposits
Mortgages
Credit Unions
Deposits
Consumer Loans
Life Insurance Companies
Premium from Policies
Corporate bonds and mortgages
Fire and Casualty Insurance Companies
Premium from Policies
Municipal bonds, corporate
bonds and stocks, US Govt
securities
Pension Funds, Government Retirement Funds
Employee and Employer
Contributions
Corporate bonds and stock
Commercial paper, stock, bonds
Consumer and business loans
Mutual Funds
Shares
Stocks and bonds
Money Market Mutual Funds
Shares
Money market instruments
Depository Institutions (banks)
Commercial Banks
1. Transaction Costs
2. Risk Sharing
3. Asymmetric Information
Contractual Savings Institutions
Investment Intermediaries
Finance Companies
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Regulatory Agencies
Financial Intermediaries and Value of Their Assets
Value of Assets (Billions of $)
Type of Intermediary
1970
1980
1990
2007
2010Q1
Commercial Banks
517
1481
3334
11809.5
14438
Savings and Loans Institutions and Mutual Savings
Banks
250
792
1365
1815.0
1262.3
18
67
215
758.7
892.4
Depository Institutions (banks)
Credit Unions
Regulatory Agency
Subject of Regulation
Nature of Regulation
Securities and Exchange
Commission (SEC)
Organized Exchanges and
Financial Markets
Requires disclosure of
information; restricts insider
trading
Commodities Futures Trading
Commission (CFTC)
Futures Markets Exchanges
Regulates procedures for
trading in futures markets
Office of the Comptroller of the
Currency
Federally charted commercial
banks
Charters and examines the
books of federally chartered
commercial banks and imposes
restrictions on assets they can
hold
National Credit Union
Administration (NCUA)
Federally chartered credit
unions
Charters and examines the
books of federally chartered
credit unions and imposes
restrictions on assets they can
hold
State banking and Insurance
Commissions
State chartered depository
institutions
Charters and examines the
books of state chartered banks
and insurance companies;
imposes restrictions on assets
they can hold and imposes
restrictions on branching
Contractual Savings Institutions
Life Insurance Companies
201
464
1367
4952.5
4919.0
Fire and Casualty Insurance Companies
50
182
533
1381.0
1386.1
Pension Funds (Private)
112
504
1629
6410.6
5726.7
State and local Government Retirement Funds
60
197
737
3198.8
2793.9
Investment Intermediaries
Finance Companies
64
205
610
1911.2
1665.8
Mutual Funds
47
70
654
7829.0
7311.9
0
76
498
3033.1
2930.7
Money Market Mutual Funds
Note: These notes are incomplete without having attended lectures
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Professor Yamin Ahmad, Money and Banking – ECON 354
Regulatory Agencies
Regulatory Agency
Subject of Regulation
Nature of Regulation
Federal Deposit Insurance
Corporation (FDIC)
Commercial banks, mutual savings
banks, savings and loans
associations
Provides insurance for each
depositor. Currently it is set to
$250000 per depositor, until
12/31/2013, whereas it will revert
back to the pre-crisis level of $100000
per depositor; examines the books of
insured banks and imposes
restrictions on assets they can hold
Office of Thrift Supervision
Federal Reserve System
Savings and Loans Associations
All depository institutions
Note: These notes are incomplete without having attended lectures
Examines the books of savings and
loans associations and imposes
restrictions on assets they can hold
Regulatory Agencies
• The new Dodd-Frank Banking reform bill that was passed during
June 2010 gives the following agencies additional power:
Regulatory Agency
Subject of Regulation
New Powers
Federal Deposit Insurance
Corporation (FDIC)
Commercial banks, mutual savings
banks, savings and loans
associations
Will be able to unwind giant financial
firms in the same way it takes down
banks.
Federal Reserve System
All depository institutions
Fed will have powers to crack down on
interchange fees, which retailers pay to
banks to cover the operational cost of
transferring money. Fed can cap the fees
Consumer Financial Protection
Bureau
Consumer loans and credit cards
Establishes an independent Consumer
Financial Protection Bureau housed
inside the Federal Reserve. Fees paid by
banks fund the agency, which would set
rules to curb unfair practices in consumer
loans and credit cards. It would not have
power over auto dealers.
Government Accountability Office
Federal Reserve (excluding FOMC
and Monetary Policy)
Allows Congress to order the
Government Accountability Office to
review Fed activities, excluding monetary
policy. Audits would be allowed two
years after the Fed makes emergency
loans and gives financial help to ailing
financial firms.
Examines the books of commercial
banks that are members of the
system; sets reserve requirements for
all banks
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354
Banking and Financial Institutions
• Financial Intermediation
 Helps get funds from savers to investors through
bond/equity/foreign exchange markets
• Banks and Money Supply
 Crucial role in creation of money
• Financial Innovation
Note: These notes are incomplete without having attended lectures