1

Chapter 1

Money, Banking, and Financial Markets--An

Overview

©Thomson/South-Western 2006

2

Money And Banking: Key Elements

money

financial intermediaries (traditionally,especially banks)

interest rates

government budget deficits (or surpluses)

3

Money

Money is the stock of items widely used to make payment for goods and services.

Money, or the money supply, includes: currency and coins in circulation, checking accounts in depository institutions, and other items, such as Certificates of Deposit (CDs),

when measured more broadly.

4

What Determines The Money Supply?

The central bank is responsible for the trend or long-run behavior of the money supply.

In the United States, the central bank is the Federal Reserve System (the Fed).

The Fed conducts monetary policy.

5

Figure 1-1

6

Money, Inflation, and Deflation

When the money supply increases more rapidly than the output of goods and services, inflation occurs.

Inflation targeting occurs when a central bank announces an explicit inflation range it pledges to maintain and enforces policies consistent with that goal.

Deflation is a continuing decline in prices and is more damaging to a nation's economic health than inflation.

7

Figure 1-2

8

Banks And Other Financial Intermediaries

Banks accept various types of deposits and use the funds attracted primarily to grant loans.

"Banks" is a generic term for all depository institutions.

Banks are older-generation financial intermediaries. Today, other intermediaries like pension funds and insurance companies are playing an increasingly important role in capital markets, encroaching on banks’ traditional role.

Intermediaries match savers’ money with borrowers’ funding demands.

9

Interest Rates The interest rate is the cost of borrowing (or the

return for lending), expressed as a percent per year.

The real interest rate is the stated interest rate adjusted for expected inflation.

Key interest rates: prime loan rate 3-month U.S. Treasury securities

short-term corporate debt

10

Figure 1-3

11

Figure 1-4

12

The Federal Budget Deficit

The federal government’s budget deficit is the annual amount by which federal government expenditures exceed tax revenues collected.

The national debt is the cumulative sum of past budget deficits less past surpluses.

13

Key Financial Markets

The stock market

The bond market

The foreign exchange (ForEx) market

14

The Stock Market Shares are claims of ownership in individual

corporations.

A company’s stock share price reflects the opinion of the market about the corporation's continually changing prospects.

Major indexes reflect changing sentiment about the nation's economic prospects. Dow-Jones Industrials Average (DJIA) Standard and Poor's 500 Average (S&P 500)

15

Figure 1-5

16

The Bond Market A bond is a debt instrument issued by a corporation,

government, or government agency.

A bond’s indenture is an agreement to make a stream of interest payments at specified future dates, and also to return the principal at maturity.

Bondholders are lenders; stockholders are owners.

Interest rates (or yields) are determined by market forces of supply and demand.

17

Figure 1-6

18

The Foreign Exchange Market

Various national currencies trade in the foreign exchange (ForEx) market.

Foreign trade necessitates trade in national currencies in the ForEx market.

The price at which one country's currency exchanges for foreign currency is the exchange rate.

19

Figure 1-7

20

Foreign Exchange and Trade Appreciation is an increase in the value of one nation’s

currency relative to another nation’s currency.

Depreciation is the opposite.

Appreciation causes: higher prices to foreign buyers of exports, lower prices to domestic consumers of imports, and a trade deficit (or a reduction in the trade surplus).

Depreciation causes: lower prices to foreign buyers of exports, higher prices to domestic consumers of imports, and a trade surplus (or a reduction in the trade deficit.)