Economics 330 – Money and Banking

• T and Th from 9:30am to 10:45am

• Text: Mishkin, Frederic: The Economics of Money, Banking, and Financial Markets, Addison-Wesley, Business School Edition, 2nd or 3rd edition, 2010.

Who am I ?

• Dr. John Neri

• Office Hours: T and Th from 3:30pm to 4:30pm.

• Office: Morrill Hall, Room 1102B

Who you are: (182 students) as of 1/19/15

• Accounting – 13 MGMT - 4

• Computer Science – 10 Undecided - 26

• IAP - 18

• Economics - 50

• Finance – 27

• G & P – 6

• Intl. Bus - 2

• Marketing – 8

• Math/Math Stat - 4

Course Webpage

• http://www.terpconnect.umd.edu/~jneri/Econ330

NOTE: upper-case E

Can you define each of the following?

• Federal Reserve System

• FOMC

• Federal Funds

• Federal Funds Rate

• Discount Loan

• Discount Rate

• Open Market Operation

• Quantitative Easing QE 1, 2 and 3

• Operation Twist

• MBS

• Money Market

• Capital Market

• Sub-prime Mortgage

• QE 4

• Shadow Banking System

• MMMF

• Large Scale Asset Purchase

What is this?

Chapter 1

Why Study Money, Banking, and

Financial Markets?

Why Study Money, Banking & Financial Markets

• To understand how financial markets work

- Obviously, there are many financial markets.

- We focus primarily on bond and credit markets

• To examine how financial institutions work

- Many types of financial institutions

- We focus primarily on commercial banks

• To examine the role of money in the economy

- How the Federal Reserve System works

Five Parts of the Financial System1. Money

An asset used to pay for purchases, repay of debt, pay taxes

- a store of wealth

- a medium of exchange

2. Financial Instruments

Used to transfer wealth from savers/lenders to investors/borrowers and to transfer risk to those best equipped to bear it.

Five Parts of the Financial System3. Financial Markets

Allow us to buy and sell financial instruments quickly and cheaply. Funds are transferred from people who have an excess

of available funds to people who have a shortage of funds

4. Financial Institutions.

Firms that provide access to financial markets

Five Parts of the Financial System

5. Central Banks monitor and stabilize the economy, monitor financial institutions.

Well Functioning Financial System Promotes Economic Efficiency

• Facilitate Payments – commercial bank checking accounts

• Channel Funds from Savers to Borrowers

• Enable Risk Sharing - Classic examples are insurance and forward markets

The Bond Market and Interest Rates

• A bond is a debt security that promises to make payments periodically for a specified period of time A security (a financial instrument) is a claim on the

issuer’s future income or assets

• The interest rate is the cost of borrowing. Price paid for the rental of funds, expressed as a

percentage.

Pay $5.00 to rent $100 for one year - 5.0% interest

Interest Rates on Selected Bonds, 1950–2015 Three things this graph demonstrates??

3-month Bill10-year Treasury10-year Corporate Baa

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-15

The Stock Market

• Common stock represents a share of ownership in a corporation An equity security (financial instrument) that is a

claim on the earnings and assets of the corporation

Residual claim

• Firms can issue new shares to finance investment spending

Shiller: Real Terms. Note the behavior of price relative to earnings. Mishkin starts at 1950.

Financial Institutions and Banking• Financial Intermediaries: institutions that

“borrow funds from” (“issue liabilities to”) people who save and make loans to other people:

Commercial Banks: accept deposits and make loans

Other financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks

depositsLoans Insurance Policies

BondsStocks

Retirement Plans

Stocks SharesBondsStocks

Commercial paperT-Bills

Shares/ “deposits”

Commercial Banks Insurance Companies

Pension Funds Mutual Funds

Money Market Mutual Funds

Money and Economic Activity (Business Cycles)

• Evidence suggests that money plays an important role in generating business cycles Recessions and expansions in economic

activity

• Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level

Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2008

Note: Shaded areas represent recessions.

• The aggregate price level is the average price of goods and services in an economy A continual rise in the price level is inflation -

affects all economic players

• Data shows a connection between the growth in the money supply and the rate of inflation

Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2007

Source: International Financial Statistics.

Examples of Hyperinflation:1980s and Early 1990s

M2 Money Growth and Inflation - US

Money and Interest Rates

• Prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely tied

• Since then, the relationship is less clear but the rate of money growth is still an important determinant of interest rates

FIGURE 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2008

Mankiw

Inflation and Nominal Interest Rates

Inflation and Nominal Interest rates