Monetary Theory and PolicyChapter 1：Why Study Money, Banking, and Financial Markets?

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To examine how financial markets such as bond, stock

and foreign exchange markets work

To examine how financial institutions such as banks,

investment and insurance companies work

To examine the role of money in the economy

Preview

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Markets in which funds are transferred from people

who have an excess of available funds to people who

have a shortage of funds

Financial Markets

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The Bond Market and Interest Rates

A security (financial instrument) is a claim on the

issuer’s future income or assets

A bond is a debt security that promises to make

payments periodically for a specified period of time

An interest rate is the cost of borrowing or the price

paid for the rental of funds

Chapter 1

FIGURE 1 Interest Rates on Selected Bonds, 1950–2014

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Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

Chapter 1

The Stock Market

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Common stock represents a share of ownership in a

corporation

A share of stock is a claim on the earnings and assets of

the corporation

Chapter 1

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Stock Prices Measured by the Shanghai Stock Exchange Composite Indexs

0

1000

2000

3000

4000

5000

6000

1997

-03-

0319

97-0

8-07

1998

-01-

1419

98-0

7-01

1998

-12-

0319

99-0

5-26

1999

-11-

0220

00-0

4-20

2000

-09-

2720

01-0

3-21

2001

-08-

2820

02-0

2-07

2002

-07-

3120

03-0

1-09

2003

-07-

0120

03-1

2-08

2004

-05-

2720

04-1

1-03

2005

-04-

1520

05-0

9-22

2006

-03-

1420

06-0

8-21

2007

-01-

3120

07-0

7-17

2007

-12-

2420

08-0

6-06

2008

-11-

1720

09-0

4-29

2009

-10-

1220

10-0

3-22

2010

-08-

2720

11-0

2-16

2011

-07-

2520

12-0

1-04

2012

-06-

1920

12-1

1-27

2013

-05-

1620

13-1

0-30

2014

-04-

1020

14-0

9-16

2015

-03-

0420

15-0

8-07

2016

-01-

1920

16-0

7-01

2016

-12-

1220

17-0

5-25

2017

-11-

03

Source: WIND

Chapter 1

Stock Prices as Measured by Dow Jones Industrial Average

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0

5000

10000

15000

20000

25000

30000

1985

/3/4

1986

/3/4

1987

/3/4

1988

/3/4

1989

/3/4

1990

/3/4

1991

/3/4

1992

/3/4

1993

/3/4

1994

/3/4

1995

/3/4

1996

/3/4

1997

/3/4

1998

/3/4

1999

/3/4

2000

/3/4

2001

/3/4

2002

/3/4

2003

/3/4

2004

/3/4

2005

/3/4

2006

/3/4

2007

/3/4

2008

/3/4

2009

/3/4

2010

/3/4

2011

/3/4

2012

/3/4

2013

/3/4

2014

/3/4

2015

/3/4

2016

/3/4

2017

/3/4

Source: Dow Jones Indexes: http://finance.yahoo.com/?u.

Chapter 1

Financial Institutions and Banking

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Financial Intermediaries: institutions that borrow funds from

people who have saved and make loans to other people:

Banks: accept deposits and make loans

Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks

Financial Innovation: in particular, the advent of the

information age and e-finance

Chapter 1

Financial Crises

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Financial crises are major disruptions in financial

markets that are characterized by sharp declines in

asset prices and the failures of many financial and

nonfinancial firms.

Chapter 1

Money and Business Cycles

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Evidence suggests that money plays an important role in

generating business cycles

Recessions (unemployment) and expansions affect all of us

Monetary Theory ties changes in the money supply to

changes in aggregate economic activity and the price level

Chapter 1

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FIGURE 3 Money Growth (M2 Annual Rate) and the Business Cycle in the United States, 1950–2014

Note: Shaded areas represent recessions.

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

Chapter 1

Chapter 1

Money and Inflation

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The aggregate price level is the average price of goods

and services in an economy

A continual rise in the price level (inflation) affects all

economic players

Data shows a connection between the money supply

and the price level

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FIGURE 4 Aggregate Price Level and the Money Supply in the United States, 1950–2014

• Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

Chapter 1

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FIGURE 5 Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1997–2013

Chapter 1

Source: International Financial Statistics. http://www.imf.org/external/data.htm

Interest rates are the price of money

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

Money and Interest Rates

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FIGURE 6 Money Growth (M2 Annual Rate) and Interest Rates (Long-Term U.S. Treasury Bonds), 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

Chapter 1

Monetary and Fiscal Policy

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Monetary policy is the management of the money supply

and interest ratesConducted in the U.S. by the Federal Reserve System (Fed)

Fiscal policy deals with government spending and taxationBudget deficit is the excess of expenditures over revenues for aparticular year

Budget surplus is the excess of revenues over expenditures for aparticular year

Any deficit must be financed by borrowing

Chapter 1

FIGURE 7 Government Budget Surplus or Deficit as a Percentage of Gross Domestic Product, 1950–2013

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Source: www.gpoaccess.gov/usbudget/fy06/sheets/hist01z2.xls.

Chapter 1

The foreign exchange market is where funds are

converted from one currency into another

The foreign exchange rate is the price of one currency in

terms of another currency

The foreign exchange market determines the foreign

exchange rate

The Foreign Exchange Market

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Exchange Rate of the U.S. Dollar, 1970–2014

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Exchange Rate of the RMB to U.S. Dollar

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International Finance

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Financial markets have become increasingly integrated

throughout the world.

The international financial system has tremendous impact on

domestic economies:How a country’s choice of exchange rate policy affect its monetary policy?How capital controls impact domestic financial systems and therefore the performance of the economy?Which should be the role of international financial institutions like the IMF?

Chapter 1

Gross domestic product (GDP)Market value of all final goods and servicesProduced within a countryIn a given period of time

“GDP is the market value…”

Market prices - reflect the value of the goods

Appendix: Measurement of GDP

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“… of all…”

All items produced in the economyAnd sold legally in markets

Excludes most itemsProduced and sold illicitlyProduced and consumed at home

Appendix: Measurement of GDP

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“… final…”Value of intermediate goods is already included in the prices ofthe final goods

“… goods and services…”Tangible goods & intangible services

“… produced…”Goods and services currently producedOld products (inventory)

Appendix: Measurement of GDP

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“… within a country…”Goods and services produced domestically

Regardless of the nationality of the producer

“… in a given period of time”

A year or a quarter

Appendix: Measurement of GDP

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The GDP deflatorRatio of nominal GDP to real GDP times 100Equal to 100 in the base yearMeasures the current level of prices relative to the level ofprices in the base yearCan be used to take inflation out of nominal GDP(“deflate” nominal GDP)

Appendix: Price Index and Inflation

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Consumer price index (CPI)Measure of the overall cost of goods and services

Bought by a typical consumer

1. Fix the basketWhich prices are most important to the typical consumerDifferent weight

2. Find the prices at each point in time

3. Compute the basket’s costSame basket of goods

Appendix: Price Index and Inflation

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4. Choose a base year and compute the CPIBase year = benchmark

Price of basket of goods & services in current yearDivided by price of basket in base yearTimes 100

Appendix: Price Index and Inflation

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Calculating the Consumer Price Index and the Inflation Rate: An Example

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This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

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This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Calculating the Consumer Price Index and the Inflation Rate: An Example