Money and Banking

1. Money and Banking

2. Description of course and Motivation: • This course offers a systemic of monetary theories and the financial system. • The course will cover the structure and importance of the functions of money, the financial system, bank management and regulation, debates on macroeconomic and monetary policies, the targets and instruments of monetary policies, the transmission mechanism of monetary policy and its effectiveness ,money and inflation.

3. Course Objective: • Our aim in this course will be double. First, to develop a basic understanding of the financial system: how it operates and why it plays a central role in the economy. second, is to analyze in details the aims, conduct, influence, and the limitations of monetary policy. • by the end of the course, you should have a firm grasp of the fundamental issues in monetary policy and should more fully appreciate the importance of a well-functioning financial system.

4. Required Textbook: Ritter ,Silber & Udell ,Principle of Money , Banking and Financial Markets 11th edition, available at University Book Store. • Supplementary Readings: Business magazine, text books, articles, internet, newspapers.

5. Course contains Chapter 1: Introduction: Money and Banking and Financial Markets Chapter 2:The role of money in the macro economy: Introducing money Chapter 3:Financial instruments, Markets and Institutions Chapter 4:The monetary theories Chapter 5:The monetary policies Chapter 6:The Inflation

6. Delivery methods: This course is delivered in the form of interactive lectures summarized in handouts and accompanied by transparency presentations.  Most important issues within each concept and/or topic are clarified through discussions and class participation. Method of teaching will totally depend on: L=Lecture; T=Transparency; D=Discussion

7. Student evaluation as per course outline: Homework ,Attendance and Participation 10% 1st Exam 25% 2nd Exam 25% Final Exam 40% Total 100%

8. Chapter 1: Introduction Money and Banking and Financial Markets

9. Why Study Money, Banking, and Financial Markets: • To examine how financial markets work • To examine how financial institutions such as banks and insurance companies work • To examine the role of money in the economy

10. Introduction of Concepts • Financial Markets/Institutions • Bringing together of buyers and sellers of financial securities to establish prices • The formal setting/mechanism that brings buyers and sellers together to value financial assets • Provides a mechanism for those with excess funds (savers) to lend to those who need funds [borrowers]

11. Introduction of Concepts (Cont.) • Money • “Lubricant that greases the wheels of economic activity” • Not just limited to currency (bills and coins)—also includes demand deposits (checking accounts) issued by banks • Plays a key role in influencing the behavior of the economy as a whole and the performance of financial institutions and markets

12. Introduction of Concepts (Cont.) • Money (Cont.) • More broadly the monetary economy • Facilitates transactions within the economy • Principal mechanism through which central banks attempt to influence aggregate economic activity • Economic Growth • Employment • Inflation

13. Introduction of Concepts (Cont.) • Banking • Banks and other financial intermediaries (insurance companies, pension funds) take funds from one group (savers) and re-deploy these funds by investing or lending (borrowers) • Banks provide a place where individuals and businesses can invest their funds to earn interest with a minimum of risk • Well-equipped to invest in the most challenging types of financial investments—loans to individuals and small businesses

14. Flow of funds from lenders to borrowers

15. Introduction of Concepts (Cont.) • Banking (Cont.) • Banks serve as the principal caretaker of the economy’s money supply, and along with other financial intermediaries, provide important source of funds • Banks are intimately involved in how the central bank of the United States (Federal Reserve) [Fed] influences overall economic activity • The Monetary policy is the control of the money supply while using the interest rate and others instruments. The [Fed] directly influences the lending and deposit creation activities of banks.

16. Chapter 2 The Role of Money in the Macroeconomy

17. Introduction • Recurrent theme—What is the proper amount of money for the economy? • Sir William Petty (1623–87) wrote in 1651 “To which I say that there is a certain measure and proportion of money requisite to drive the trade of a nation, more or less than which would prejudice the same” • Too much money will lead to inflation • Too little money will result in an inefficient economy

18. Introducing Money • Uses of Money • Standard of value: or unit of account for all the goods and services we might wish to trade. • Medium of exchange: it is the only financial asset that virtually every business, household, and unit of government will accept in payment of goods and services. • Store of value: reserve of future purchasing power.

19. Introducing Money • Liquid Asset • Something that can be turned into a generally acceptable medium of exchange, without loss of value • Liquidity is a continuum from very liquid to illiquid • Currency and checking accounts are most liquid assets

20. Primary Definition of Money (M1) • Currency outside banks plus checking accounts (demand deposits) • Other definitions of money (M2 and M3) start with M1 and add progressively less liquid financial assets • Refer to following page for basic composition of the money supply (M1, M2, and M3) • Most economists prefer the narrow definition of money supply (M1) since it is generally acceptable as a means of payment

21. Composition of the Money Supply (Money Aggregates) • M1 consists of coins and currency in circulation, checking accounts • M2 is a more broad definition of money than M1. M2 = M1 + small savings accounts, money market funds and small time deposits. • M3 is even more broad and includes M2 + large time deposits, large money market funds.

22. Who Determines Our Money Supply? • Gold does not determine the money supply—this link was abolished in 1968 • Federal Reserve is responsible for execution of national monetary policy • Created by Congress in 1913 • Twelve district Federal Reserve Banks scattered throughout the country • Board of Governors located in Washington, D.C.

23. Who Determines Our Money Supply? (Cont.) • Fed influences the total money supply, but not the fraction of money between currency and demand deposits which is determined by public preferences • Fed implements monetary policy by altering the money supply and influencing bank behavior

24. The Importance of Money:Money Versus Barter • Barter—direct exchange of goods/services for other goods/services • Very inefficient and limited economy • No medium of exchange or unit of account • Requires double coincidence of wants—”I have something you want and you have something I want” • Items must have approximate equal value • Need to determine the “exchange rate” between different goods/services

25. The Importance of Money:Money Versus Barter (Cont.) • Money • Any commodity accepted as medium of exchange can be used as money (commodity money:  gold, silver, salt, tea, shells) • Certainty of exchange • Frees people from need to barter • Makes exchange more efficient

26. The Importance of Money:Money Versus Barter (Cont.) • Money (Cont.) • Prices, expressed in money terms, permit comparison of values between different goods • Must retain its value—the value of money varies inversely with the price level (inflation) • Rely on the Fed to control the supply of money to preserve the value of money • If money breaks down as a store of value (hyperinflation), economy resorts to barter

27. The Importance of Money, Financial Institutions and Markets • For an economy to grow, it must forgo present consumption (save) and invest in new capital assets • Money contributes to economic development and growth by stimulating savings and investing • Money separates the act of saving from investing

28. The Importance of Money, Financial Institutions and Markets (Cont.) • Savers receive interest payments and investors expect to earn a return over the cost of borrowing • Financial institutions and markets act as intermediaries between savers and borrowers

29. Money, The Economy, and Inflation • Bank Reserves and the Money Supply • Demand deposits (money) are created when banks extend loans through the issuance of credit • Banks are required by the Fed to hold reserves in the form of vault cash or on deposit with the Fed against checking account liabilities (demand deposits). • Current the reserve requirement is approximately 10% of demand deposits

30. Money, The Economy, and Inflation (Cont.) • Bank Reserves and the Money Supply (Cont.) • Banks create money by making loans with excess reserves, those above the Fed’s required level of reserves • Through manipulation of excess reserves, Fed influences the federal funds rate (rate banks charge for overnight loans), bank lending, and, therefore creation of money

31. The Money Creation Process • The sum of bank deposits at the Fed and the bank’s cash vault is total bank reserves. • The Fed mandates member commercial banks to hold a certain fraction of their checkable deposits in reserve form. This fraction is called the required reserve ratio. • The difference between a bank’s total reserves and its required reserves is its excess reserves.

32. The Banking System and The Money Creation Process • The process starts with the Fed. • The Fed prints the funds, and Jack deposits the funds in his bank. • The Reserves of the bank increases, while the reserves of no other bank decreased. • The banking system made loans and in the process created checkable deposits for the people who received the loans. • Remember, checkable deposits are part of the money supply. So, in effect, by extending loans, and in the process creating checkable deposits, the banking industry has increased the money supply.

33. The Banking System CreatesCheckable Deposits (Money)

34. The Money Expansion Process • When the $9000 that bankers created in new checkable accounts is added to the $1000 the Fed initially printed, we see that $10,000 has been added to the money supply. Maximum change in checkable deposits = (1/r) x R • Where r = the required reserve ratio and R is the change in reserves resulting from the original injection of funds. • In the formula, (1/r) is known as the simple deposit ratio.

35. Money, The Economy, and Inflation (Cont.) • How Large Should the Money Supply Be? • Purchase goods/services economy can produce, at current prices • Generate level of spending on Gross Domestic Product (GDP) that produces high employment and stable prices • Monetary Policy is used as a countercyclical tool—vary the money supply to influence economic activity

36. Money, The Economy, and Inflation (Cont.) • Increases in money supply alters public’s liquidity and influences spending • Direct Impact—excess liquidity is spent on goods/services • Indirect Impact—purchase financial assets which lowers interest rates which stimulates business investment and consumer spending • However, changes in liquidity may alter demand for money and not influence GDP—people hoard the additional money • Public’s reaction to changes in liquidity is not consistent, so Fed cannot always judge impact of a change in money supply

37. Money, The Economy, and Inflation (Cont.) • Velocity: The missing Link • When the Fed increases the money supply, recipients of this additional liquidity probably will spend some on GDP • However, it is possible the public will choose to hold onto the additional liquidity (hoarding of money) • Over time there will be a multiple increase in spending

38. Money, The Economy, and Inflation (Cont.) • Velocity: The missing Link (Cont.) • Velocity of money (also called the velocity of circulation of money) • The number of times the money supply turns over in a period of time to support spending on output (it measures how quickly the money supply is spent in an economy) • Technically, velocity is determined by dividing the cumulative increase in GDP by the initial increase in the money supply • The Fed has no control over the velocity of money since this is dependent on behavior of the public • Ultimately, the Fed needs to be concerned whether the additional spending which results from increased money supply will result in higher production or higher prices

39. Money, The Economy, and Inflation (Cont.) • Money and Inflation • Inflation—Persistent rise of prices • Hyperinflation—Prices rising at a fast and furious pace • Deflation—Falling prices, usually during severe recessions or depressions • Inflation reduces the real purchasing power of the currency—can buy fewer goods/services with the same nominal amount of money

40. Money, The Economy, and Inflation (Cont.) • Economists generally agree that, in the long-run, inflation is a monetary phenomenon—can occur only with a persistent increase in money supply • Increase in money supply is a necessary condition for persistent inflation, but it is probably not a sufficient condition • Case 1—Economy in a recession. Expanding money supply may lead to more employment and higher output • Case 2—Economy near full employment/output. Expanding money supply can lead to higher output/employment, but also higher prices • Case 3—Economy producing at maximum. Expanding money supply will most likely lead to increasing inflation.

41. Chapter 3 Financial Instruments, Markets, and Institutions

42. Flow of Funds • Financial system provides a transmission mechanism between saver-lenders and borrower-spenders. • Savers benefit—earn interest • Investors benefit—access to money otherwise not available • Economy benefits—efficient means of bringing savers and borrowers together

43. Flow of Funds (Cont.) • Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directlythrough financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households] (See Figure 3.1) • In order for financial system to function smoothly, must be adequate information about the markets and their operation

44. Figure 3.1Flow of funds from lenders to borrowers

45. Financial Instruments and Markets • Primary Markets • Market for issuing a new security and distributing to saver-lenders. • Investment Banks—Information and marketing specialists for newly issued securities. • Secondary Markets • Market where existing securities can be exchanged • New York Stock Exchange • American Stock Exchange

46. Financial Instruments and Markets (Cont.) • Bonds Represent Borrowing • Agreement by issuer to pay interest on specified dates and redeem (buy back) the bond upon maturity. • Consols—Bond with no maturity date, pay interest forever • Coupon Securities—Attached to bond and sent in to collect interest [generally semi-annually] (A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures). • Zero-coupon—Sold at price well below face value. Collect “interest” when the bond matures (is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity).

47. Financial Instruments and Markets (Cont.) • Stocks Represent Ownership • Stockholder owns part of the corporation and receives dividends (a distribution of a portion of a company's earnings, decided by the board of directors) from the issuer. • No government stock—individuals cannot “own” part of the government • Types of Corporate stocks • Preferred Stock—Fixed dividends, priority over common stock • Common Stock—Variable dividends, based on company’s profits. • Convertible—Convert preferred into common

48. Financial Instruments and Markets (Cont.) • Stocks Represent Ownership (Cont.) • Existing stock may be exchanged through secondary markets. • Capital Gains—Difference between price initially paid and amount received when stock is sold. • Measures of trends in overall common stock prices • Standard & Poor’s 500 Stock Index—based on prices of 500 individual stocks • NASDAQ Composite Index—based on all stocks listed in NASDAQ • Dow Jones Industrial Average—based on price of 30 “blue-chip” (the largest and most widely held public companies in the United States) stocks

49. Financial Instruments and Markets (Cont.) • Both stocks and bonds [securities] represent a claim to a stream of payments [cash flows] in the future • Bonds—Interest payment and face value at maturity • Stocks—Dividends and sales price when sold

50. Financial Instruments and Markets (Cont.) • Options and Futures Contracts • Contractual agreement between two parties to exchange a third asset in the future at a stated price • Often called derivative financial instruments because they derive value from underlying assets • Long—Buyer of the contract, receive commodity in the future • Short—Seller of the contract, provide commodity in the future • Gamble on price fluctuations and hope to profit • Eliminate the risk of price fluctuations