ECS3701 NOTES. VERIFIED AND UPDATED.

Table of Contents Part 1- Introduction Chapter 1: Why study money, banking and financial markets? Chapter 2: An overview of the financial system Chapter 3: What is money? Part 2 - Financial Markets Chapter 4: Understanding interest rates Chapter 5: The behaviour of interest rates Chapter 6: The risk and term structure of interest rates Part 3 - Financial institutions Chapter 8: An economic analysis of financial structure Chapter 9: Financial crises in advanced economies Chapter 10: Financial crises in emerging market economies Chapter 11: Banking and the management of financial institutions Part 4 - Central banking and the conduct of monetary policy Chapter 14: Central banks: a global perspective Chapter 15: The money supply process Chapter 16: Tools of monetary policy Chapter 17: The conduct of monetary policy Part 5 - Not Prescribed Part 6 - Monetary theory Chapter 20: Quantitative theory, Inflation and the demand for money Chapter 21: The IS curve Chapter 24: Monetary policy theory Chapter 25: The role of expectations in monetary policy Chapter 26: Transmission mechanisms of monetary policy 3 ECS 3701 Part one: Introduction (Textbook: Chapters 1, 2 and 3) CHAPTER 1: WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS Why study financial markets? Securities - a claim on the issuer’s future income or assets that is sold by a borrower to a lender. Securities may also be referred to as financial instruments. Financial instruments may be divided into two main categories: money market instruments (e.g. Negotiable Certificate of Deposit (NCDs), Commercial Papers; Retirement Annuity (RAs) and Bankers Acceptance (Bas)) and capital market instruments (e.g. bonds and shares). Bonds - a specific type of security, namely a debt security that promises to make payments periodically for a specified period of time. Interest rate - cost of borrowing or the price paid for the rental of funds. “The” interest rate is made up of a number of different interest rates that exist in an economy. E.g. mortgage, car loan etc Bond Market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and it is where interest rates are determined. Stock Market is the market in which claims on the earnings of corporations (shares of stocks) are traded. In SA we refer to the trading of shares rather than stocks. Stock (share) - equity: a financial instruments representing part ownership of a corporate entity. Sometimes referred to as common stock as compared to the more specialized type of share, e.g. preference shares. Issuing shares is a way in which a company can raise funds. Importance of stock /stock market: the price (value) of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. The higher the price of a firm’s shares the more money can be raised to buy, e.g. machinery and equipment to increase production. Also, as per the study guide: the stock market creates a facility for financial investors to invest their surplus funds and for firms to facilitate real investment. Why study financial institutions and banking? Structure of the Financial System: The financial system is complex, comprising many different types of private sector financial institutions (banks, insurance companies, mutual funds, finance companies, investment banks) all of which are heavily regulated by Government. 4 ECS 3701 Financial Intermediaries - institutions that borrow funds from people (surplus units) who have saved and in turn make loans to others (deficit units). Financial Innovation - shows how creative thinking on the part of financial institutions can lead to higher profits. To keep in touch with what is happening within the financial systems of the world it is necessary to study the changes that innovation has brought about. One example is the way in which dramatic improvements in information technology have brought about new means of delivering financial services electronically (e-finance). Why study money and monetary policy? Definition of money: money is defined as anything that is generally accepted in payment for goods and services (in terms of its function as a medium of exchange). In this course, the term money generally refers to the money supply. Importance of Money: money is linked to changes in economic variables and is important to the health of the economy. Money plays an important role in generating business cycles: empirical data indicates that, in the USA, the rate of growth in money supply has declined before every recession; however, not every decline in money growth is followed by a recession. Inflation is believed to be caused by continuing increases in money supply. Money plays an important role in interest rate fluctuations. Aggregate Output: gross domestic product (GDP) = the market (total) value of all final goods and services produced in a country during the course of a year. Aggregate Income: total income received for the use of factors of production (land, labour and capital) used to produce all the goods and services in the economy during the course of the year. Business Cycles: the upward and downward movement of aggregate output produced in the economy. Aggregate price level: the average price of goods and services in an economy. Three commonly used measures are the GDP deflator (nominal GDP divided by real GDP), the consumer price index (CPI) and the personal consumption expenditure deflator (PCE). Inflation: a continual increase in the aggregate price level in an economy. The price level and money supply generally rise together.