Why Study Money, Banking, and Financial

MarketsMishkin, Chapter 1

Financial Markets

Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.

Financial markets such as bond and stock markets - channel funds from people who do not have a productive use for them to those who do.

Definition of termsA security 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. Bond market enables corporations or governments to borrow to finance their activities and where interest rates are determined.

An interest rate is the cost of borrowing or the price paid for the rental of funds.

Implication of interest rates

interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions.

a high interest rates encourages a consumer to save but deters the same consumer from buying a house because financing it would be high.

The Stock Market

A common stock represents a share of ownership in a corporation. It is a security, a claim on the earnings and assets of the corporation.

Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities.

The Foreign Exchange Market

It is instrumental in moving funds between countries (conversion of currencies)

Foreign exchange rate, the price of one country’s currency in terms of another’s

Structure of the Financial Systems

Financial intermediaries are institutions that borrows funds from people (through deposits, bonds) who saved and in turn make loans to others.

Banks are financial institutions that accept deposits and make loans (i.e. commercial banks, savings and loan associations, mutual savings banks, and credit unions).

Financial innovations - the dramatic improvements in information technology have led to new means of delivering financial services electronically, e-finance.

Money and Monetary Policy

Money, or money supply, is defined as anything that is generally accepted in payment for goods or services or in the payment of debts.

Evidence suggests that money plays an important role in generating business cycle, the upward and downward movement of aggregate output (production of goods and services) produced in the economy.

Money and Inflation

The average price of goods and services in an economy is called the aggregate price, or price level.

Inflation, a continual increase in the price level. Inflation is an important problem to be solved. To solve this problem, we need to know something about its causes.

Money Policy

Because money can affect many economic variables, policymakers care about the conduct of monetary policy, the management of money and interest rates.

Banko Sentral ng Pilipinas is the organization responsible for conducting the nation’s monetary policy.

Fiscal Policy and Monetary Policy

Fiscal policy involves decisions about government spending and taxation.

Budget deficit = government expenditure > tax revenues for a particular time period.

Budget surplus = tax revenues exceed government spending

Government must finance any deficit by borrowing

Aggregate Output and Income

Gross Domestic Product (GDP) is the most commonly reported measure of aggregate output. This is the market value of all FINAL (no intermediate goods) goods and services PRODUCED (auction of 30 year old painting is not included) in a country during the course of the year.

Aggregate income, the total income of factors of production (land, labor, and capital) from producing goods and services in the economy during the course of the year, equal to aggregate output.

Income payments must equal payments for final goods and services

Real Versus Nominal Magnitudes

When the total value of final goods and services is calculated using CURRENT PRICES, the resulting GDP measures is referred to as nominal GDP.

Nominal variables can be misleading. A more reliable measure of economic well-being expresses values in terms of prices for an arbitrary base year, currently 2000.

GDP measured in CONSTANT PRICES is referred to as real GDP. This indicates that values are measured in terms of fixed prices.

Real Versus Nominal Magnitudes

Real variables thus measure the quantities of goods and services and do not change because prices have changed, but rather only if actual quantities have changed.

ExampleFor example, the Philippine nominal GDP was US$ 200 B in 2013 and in 2000 it was US $ 100 B. If all prices doubled between 2000 and 2013, is the Philippines better off?

Answer: NO

Although the income doubled, the 200B US$ produced only the same amount of goods because prices have also doubled.

A real income measure indicates that the income in terms of the goods it has produced is the same, US$100 B

Because real income is actually same in the two years, the country is no better or worse off than it was in 2000.

Aggregate Price Level (1) GDP deflator

Aggregate price level is a measure of average prices in the economy.

Three measures used:

GDP deflator =

This indicates that on average, prices have risen 33% since the base year (i.e. 2000)

Typically, measures of the price level are presented in the form of a price index, which expresses the price level for the base year as 100.

Thus the GDP deflator for 2013 would be 133

$200B 2013nominal ——————————

$150B 2013real = 1.33

Aggregate Price Level (2) PCE deflator

(3) CPIPCE is the nominal personal consumption expenditures.

PCE deflator =

Lastly, the measure of the aggregate price level that tis most frequently reported int he press is the consumer price index (CPI)

CPI is measured by pricing a “basket” list of goods and services bought by a typical household.

The CPI is also expressed as a price index with the base year equal to 100.

PCE nominal ——————————

PCE real

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Technical Notes

Consumer Price IndexCOMPONENTS

A . Market Basket

The CPI market basket contains a sample of goods and services commonly purchased by a group ofhouseholds in a particular area. The 1988-based CPI series has 13 regional market baskets which arethe combined market baskets of the bottom-30% and upper-70% income groups for each region.

Computation of the provincial CPI uses the market basket for the region where the province belongs.

The number of items comprising the market basket for all-income group for each region is shownbelow:

Metro ManilaRegion 1Region 2Region 3Region 4Region 5Region 6

= 384= 548= 565= 526= 651= 525= 645

Region 7Region 8Region 9Region 10Region 11Region 12

= 500= 524= 549= 619= 635= 582

B. Weighting System

Weights used in the current CPI series were derived from the results of the 1988 Family Income andExpenditures Survey (FIES). The weight is computed as the proportion of expenditure on a specificgroup of items to total expenditure.

Aggregated weights for the six item major groups are shown below:

Weights for the CPI (1988 = 100)

Commodity Group PhilippinesAreas

OutsideMetroManila

MetroManila

All Items 100.00 24.42 75.58Food, Beverage and Tobacco 58.47 11.84 46.63Clothing 4.35 0.87 3.49Housing and Repairs 13.30 5.40 7.90Fuel, Light and Water 5.36 1.45 3.91Services 10.90 3.32 7.58Miscellaneous 7.59 1.53 6.06

C. Base Period

The CPI series constructed by NSO since 1945 has undergone several revisions. The 1988-based CPI,the current series, is the sixth rebasing.

D. Index Formula

The construction of the CPI basically uses a Laspeyres Formula (fixed base year weights).

The formula is modified as the weighted arithmetic mean of price relatives. That is,

Consumer Price Index (CPI) is a measure of change in the average retail prices of goods and services commonly purchased by a particular group of people in a particular area.

Market basket refers to a sample of goods and services used to represent all goods and services bought by a particular group of consumers in a particular area.

Base period, usually a year, is the reference period of the index number. It is the period at which the index is set to 100.

Sample outlets are outlets or establishments where prices of sample commodities are quoted.

Weight is a value attached to a commodity or group of commodities to indicate the relative importance of that commodity or group of commodities in the market basket.

The CPI, the PCE deflator and GDP deflator

The 3 measures of the price level can be used to convert or deflate a nominal magnitude by the price index.

For example, if the GDP deflator for 2013 is 1.33 (expressed as an index value of 133), real GDP for 2013 equals

$200 B / 1.33 = $150 B in 2000 prices

- Paul A. Samuelson

“Economics has never been a science - and it is even less now that a few years ago.”

Growth Rates and the Inflation Rate