Chapter 1

Money, Banking, and

Financial Markets--An
Overview

Thomson/South-Western 2006

Money And Banking: Key

Elements
money
financial intermediaries
(traditionally,especially banks)
interest rates
government budget deficits (or surpluses)
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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.
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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.
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Figure 1-1

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.
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Figure 1-2

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.
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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
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Figure 1-3

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Figure 1-4

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The Federal Budget Deficit

The federal governments 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.

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Key Financial Markets

The stock market
The bond market
The foreign exchange (ForEx) market

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The Stock Market

Shares are claims of ownership in individual
corporations.
A companys 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)
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Figure 1-5

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The Bond Market

A bond is a debt instrument issued by a corporation,
government, or government agency.
A bonds 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.
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Figure 1-6

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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.
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Figure 1-7

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Foreign Exchange and Trade

Appreciation is an increase in the value of one nations
currency relative to another nations 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.)

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