ECS3701 exam prep.

comments. ii OVERVIEW OF THE COURSE ............................................................................ ...................... iv Prerequisites for this course ............................................................................ ......................................iv The prescribed book .............................................................................. ................................................iv Purpose of the study guide ............................................................................. .......................................iv Contents and goals ............................................................................. ................................................... v PART 1: INTRODUCTION ...................................................................... ................ viii Chapter 1: Chapter 2: Chapter 3: Why study money, banking and financial markets?........................................................ 1 An overview of the financial system............................................................................. ... 5 What is money? ............................................................................ .................................. 9 PART 2: FINANCIAL MARKETS ........................................................................... ................. 20 Chapter 4: Chapter 5: Chapter 6: Understanding interest rates.............................................................................. ........... 21 The behaviour of interest rates ............................................................................. ........ 24 The risk and term structure of interest rates ................................................................. 29 PART 3: FINANCIAL INSTITUTIONS ...................................................................... ............... 33 Chapter 8: Chapter 9: Chapter 10: Chapter 11: An economic analysis of financial structure .................................................................. 34 Financial crises in Advanced economies ...................................................................... 40 Financial Crises in emerging market economies .......................................................... 41 Banking and the management of financial institutions.................................................. 42 PART 4: CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY .................. 48 Chapter 14: Chapter 15: Chapter 16: Chapter 17: Central banks: a global ECS3701 exam prep. perspective........................................................................ ...... 49 The money supply process ........................................................................... ................ 58 Tools of monetary policy ............................................................................ ................... 69 The conduct of monetary policy: Strategy and tactics .................................................. 77 PART 6: MONETARY THEORY............................................................................. ................. 85 Chapter 20: Chapter 21: Chapter 24: Chapter 25: Chapter 26: Quantitty theory, Inflation and the demand for money .................................................. 86 The IS Curve.............................................................................. ................................... 90 Monetary Policy Theory ............................................................................ .................... 95 The Role of Expectations in Monetary Policy ............................................................. 113 Transmission mechanisms of Monetary Policy........................................................... 114 ECS3701/001 TABLE OF CONTENTS Page iii OVERVIEW OF THE COURSE Prerequisites for this course The formal prerequisites for this third level monetary economics course are the second-level macro- and microeconomics courses. The reason is that monetary economics draws heavily on the concepts and tools of analyses of both micro- and macroeconomics. There is also some overlap between monetary economics and Unisa's ECS2605: The South African financial system. Although ECS2605 is not a formal prerequisite for this course, it deals with some of the financial institutions and financial instruments also dealt with in this course. As in the case of second-level macro- and microeconomics you must have the basic mathematical skills in order to deal with equations and graphs. Economic models are an integral part of monetary economics. The prescribed book The prescribed book for this course is: Mishkin, SF. 2012. The Economics of Money, Banking and Financial Markets. 10th edition, Global edition. Boston: Pearson Addison Wesley. Mishkin is probably one of the best and most widely used international undergraduate texts on monetary economics and Money & Banking. It is a US textbook which focuses on the situation in the USA, although it also has an international slant. It does however not deal with the South African situation. This study guide follows the same structure as the Mishkin textbook, but also includes additional material that addresses the South African situation in detail. Purpose of the study guide Each unit of the study guide (a unit is roughly equivalent to a chapter of the textbook) will consist of the following sections: A Purpose of study unit ...provides the goals of the study unit, and effectively provides a brief summary of what is covered in the study unit. In some chapters an "Economics in action" statement is given as well, which focuses on some practical aspects relevant to the study unit. B Prescribed sections In most cases the corresponding headings and subheadings of the textbook are used to indicate the prescribed content. C Additional explanations ...either wraps up some important aspect/s and/or discusses the South African situation where it differs from the USA/international one. In cases where an "Economics in action" statement has been provided (section A) it may also provide feedback on this statement. iv D Activities This section either provides a list of statements which you must evaluate and/or it provides practical problems. The answers are provided in this study guide. E Examination questions ...provides a list of possible examination questions. This list probably covers more than 80% of the questions which may appear in the exam and provides a good idea of what is expected of you in the exam. However, it is not an exhaustive list of exam questions – questions may be phrased differently in the exam, possibly requiring less or more detail or a slightly different approach from the "original" questions listed here. Please use this list of questions to test your understanding of the study material and to prepare effectively for the exam. It is strongly suggested that you use sections D and E as a “checkpoint” after each chapter to test your understanding. Contents and goals The prescribed book is divided into six parts, the following parts and chapters of which are prescribed. Note that part 5 (International finance and monetary policy) and the chapters in it are not prescribed. Chapters which are not prescribed are marked with a double hash (##), either at the beginning of a section header or as a superscript at the end of a section/chapter header## or number (7##). ECS3701/001 v Part Chapter in textbook Goals 1 Introduction 1 Why study money, banking, and financial markets? 2 An overview of the financial system 3 What is money? A comparative approach to measuring money. Explain the meaning of financial markets and financial instruments. Explain the basic concepts relating to monetary policy. What functions does money perform? A brief history of money. How money is measured. 2 Financial markets 4 Understanding interest rates 5 The behaviour of interest rates 6 The risk and term structure of interest rates 7## The stock market, the theory of rational expectations and the efficient market hypothesis The meaning of interest rates. How the interest rate is determined on the bond and the money markets. Explain why interest rates differ. Not prescribed 3 Financial institutions 8 An economic analysis of financial structure 9 Financial crises in Advanced economies 10 Financial crises in emerging market economies 11 Banking and the management of financial institutions 12## Economic analysis of financial regulation 13## Banking industry: structure and competition Explain how financial structure affects the economic efficiency of markets. Explain why financial crises occurred in advanced economies. Explain the dynamics of financial crisis in emerging economies. Explain the functioning of banks. Not prescribed Not prescribed 4 Central banking and the conduct of monetary policy 14 Central banks: A global perspective 15 The money supply process Explain the role of the central bank in the banking system. Explain the money supply process and derive two simple formulas vi ECS3701/001 16 The tools of monetary policy 17 The conduct of monetary policy: Strategy and tactics ∆D = (1/r)∆R M= 1+c (MB) r+e+c Explain how the three instruments of monetary policy are applied (open- market operations, changes in the borrowed reserves and changes in the reserve requirement). Consider the goals of monetary policy. 5## International finance and monetary policy Chapter 18 -19 not prescribed 6 Monetary theory 20 21 22## 23## 24 25 26 Quantity Theory, Inflation and the demand for money The IS curve The Monetary Policy and Aggregate Demand Curves Aggregate demand and supply analysis Monetary Policy Theory The Role of Expectations in Monetary Policy Transmission mechanisms of monetary policy Determine which factors affect the demand for money Explain the IS model and use it to analyse the impact of fiscal policy on output and the interest rate. Not prescribed Not prescribed Explain the role of monetary policy in preventing inflation Explain the role of monetary policy in time-inconsistency and nominal anchor Explain alternative transmission mechanisms of monetary policy. Note that not all chapters are prescribed. Similarly, if a chapter is prescribed, it does not imply that all its sections are prescribed. The prescribed sections are clearly indicated in each chapter of this study guide. There are six parts in this one-semester course. Please note that the semester has at the most 15, but effectively only 12 weeks in which to complete this course. This means that you have to complete at least one part every two weeks. You will find a suggested study programme included in Tutorial letter 101. vii PART 1: INTRODUCTION Chapter Goals 1 Why study money, banking and financial markets? 2 An overview of the financial system 3 What is money? Explain the meaning of financial markets and financial instruments. Explain the basic concepts relating to monetary policy What functions does money perform? A brief history of money. How money is measured. viii Chapter 1: Why study money, banking and financial markets? ECS3701/001 A Purpose of study unit This introductory chapter explains basic concepts related to money, banking and financial markets, and to monetary policy. • What is a financial market? What are bonds and stocks? What is the meaning of the interest rate on securities? • What is the role of financial institutions? • Why and how do we measure the stock of money, aggregate income and the aggregate price level? • What is the meaning and the purpose of monetary policy? Economics in action: Bankers have a bad habit of making economic cycles worse. They are notorious for lending people umbrellas when the sun is shining and asking for them back when rain starts to fall. When the economy is strong and asset prices are rising, banks are only too eager to lend to those wanting to buy assets, helping to push prices higher. In bad times, when prices are falling, banks ask for their loans back, forcing the borrowers to sell assets and driving prices down further. Source: Bank capital: adjusting banking regulation for the economic cycle (2008:19) B Prescribed sections Why study financial markets? The bond market and interest rates; The stock market Why study financial institutions and banking? Structure of the financial system (financial intermediaries); Financial crises; Banks and Other Financial institutions; Financial innovation Why study money and monetary policy? Money and business cycles; Money and inflation; Money and interest rates; Conduct of monetary policy; Fiscal policy and monetary policy ## Why study international finance? Not prescribed ## How we will study money, banking and financial markets The sections on exploring the web and collecting and graphing data are not prescribed. Appendix to chapter 1 Aggregate output and income; Real versus nominal magnitudes; Aggregate price level; Growth rates and the inflation rate 1 C Additional explanations Key things to note are the following: 1 This chapter introduces some basic concepts of the world of money, banking and financial markets. Make sure that you understand these concepts well, as it forms the foundations of this module. In particular, make sure you understand the meaning of a security and how it facilitates direct borrowing and lending. 2 Money, banking and financial markets are heavily regulated and are substantially affected by monetary policy. The reasons for, and the forms of regulation, will be dealt with in later chapters. 3 The goal of monetary policy is to attain a number of economic goals (for example price stability and economic growth). Some of these goals, however, may appear to conflict and will be discussed in later chapters. 4 In South Africa the major instrument of monetary policy is the control of an interest rate called the repo rate. The central bank of South Africa – the South African Reserve Bank (SARB) – sets the repo rate. The repo rate in South Africa is the equivalent of the federal funds rate in the USA. The repo rate is a short-term interest rate which represents an interest rate paid by commercial banks to the SARB to obtain reserve funding (i.e. borrowing money from the SARB), yet it impacts on all interest rates in the economy. Thus changes in the repo rate impact the economy at large. 5 This impact is largely on two aspects of the economy, that is, its impact on the volume of output (real production) and on the aggregate price level. This explains why the appendix to chapter 1, which explains measures of real output and of the aggregate price level, is prescribed. 6 A note on the Economics in action statement: