Ch. 1

Introduction to Financial System

This course is about money, banking, and financial institutions and markets.

We are going to study macroeconomics with a focus on monetary issues of the economy.

Chapter 1 provides an overview of the topics that will be covered in later chapters.

We study money, banking, and financial Markets1.To examine the role of money in the economy2.To examine how financial institutions such as

banks and insurance companies work3.To examine how financial markets (such as

bond, stock and foreign exchange markets) work

The Five Components of the Financial The Five Components of the Financial SystemSystem

1.1. money; money;

2.2. financial institutions (including banks); financial institutions (including banks);

3.3. financial instruments (including loans, financial instruments (including loans, stocks, and bonds); stocks, and bonds);

4.4. financial markets (like Bahrain Stock financial markets (like Bahrain Stock Exchange); Exchange);

5.5. and central banks (like the Central and central banks (like the Central Bank of Bahrain (CBB)).Bank of Bahrain (CBB)).

1. Money1. Money MoneyMoney is defined as anything that is generally is defined as anything that is generally

accepted in payment for goods and services.accepted in payment for goods and services.Monetary theory ties changes in the money Monetary theory ties changes in the money

supply to changes in aggregate economic supply to changes in aggregate economic activity and the price levelactivity and the price level

Money and RecessionMoney and RecessionThe periodic but irregular upward and The periodic but irregular upward and downward movement of aggregate output downward movement of aggregate output produced in the economy is referred to as produced in the economy is referred to as the the business cyclebusiness cycle..

Sustained (persistent) downward Sustained (persistent) downward movements in the business cycle are movements in the business cycle are referred to as referred to as recessionsrecessions. .

Sustained (persistent) upward movements Sustained (persistent) upward movements in the business cycle are referred to as in the business cycle are referred to as expansionsexpansions. .

Recessions (unemployment) and booms or Recessions (unemployment) and booms or expansion (inflation) affect all of usexpansion (inflation) affect all of us

Evidence from business cycle fluctuations Evidence from business cycle fluctuations in many countries indicates that recessions in many countries indicates that recessions may be caused by steep declines in the may be caused by steep declines in the growth rate of money. growth rate of money.

Money and InflationMoney and InflationThe aggregate The aggregate price levelprice level is the average is the average price of goods and services in an economyprice of goods and services in an economyInflationInflation is a continual rise in the price is a continual rise in the price level.level. Inflation affects all Inflation affects all economic players playersThere is a strong positive association There is a strong positive association between inflation and growth rate of money between inflation and growth rate of money over long periods of time. A sharp increase over long periods of time. A sharp increase in the growth of the money supply is likely in the growth of the money supply is likely followed by an increase in the inflation rate.followed by an increase in the inflation rate.Countries that experience very high rates Countries that experience very high rates of inflation have rapidly growing money of inflation have rapidly growing money supplies.supplies.

2. Banking and Financial 2. Banking and Financial InstitutionsInstitutionsFinancial IntermediariesFinancial Intermediaries are are institutions that channel funds from institutions that channel funds from individuals with surplus funds to individuals with surplus funds to those desiring funds but have those desiring funds but have shortage of it. shortage of it. Among other services, they allow Among other services, they allow individuals to earn a decent return on individuals to earn a decent return on their money while at the same time their money while at the same time avoiding risk; e.g., banks, insurance avoiding risk; e.g., banks, insurance companies, finance companies, companies, finance companies, investment banks, mutual funds, investment banks, mutual funds, brokerage houses,brokerage houses,

Banks Banks are financial institutions that accept are financial institutions that accept deposits and make loans.deposits and make loans.Banks make the monetary system a lot Banks make the monetary system a lot more efficient by reducing our need to more efficient by reducing our need to carry a lot of cash. carry a lot of cash. People have tended to use checks instead People have tended to use checks instead of cash for large purchases and bills.of cash for large purchases and bills.InnovationsInnovations in banking like debit cards, in banking like debit cards, direct deposit, and automatic bill-paying direct deposit, and automatic bill-paying reduce that inconvenience even further, reduce that inconvenience even further, and also reduce such bank-related and also reduce such bank-related inconveniences of time spent standing in inconveniences of time spent standing in line at the bank, writing checks, or visiting line at the bank, writing checks, or visiting the ATM.the ATM.

Financial innovationFinancial innovation refers refers to both technological to both technological advances, which facilitate access to information, advances, which facilitate access to information, trading and means of payment, and to the trading and means of payment, and to the emergence of new financial instruments and emergence of new financial instruments and services, new forms of organization and more services, new forms of organization and more developed and complete financial markets. developed and complete financial markets.

To be successful, financial innovation must either To be successful, financial innovation must either reduce costs and risks or provide an improved reduce costs and risks or provide an improved service that meets the particular needs of service that meets the particular needs of financial system participants. financial system participants.

E-financeE-finance is a delivery of financial services is a delivery of financial services electronicallyelectronically

Banks are important to the study of money and Banks are important to the study of money and the economy because they have been a source of the economy because they have been a source of rapid financial innovation.rapid financial innovation.

3. Financial Instruments3. Financial Instruments““Securities”Securities” is a name that commonly refers is a name that commonly refers to financial instruments that are tradedto financial instruments that are traded on on financial markets.financial markets.

A securityA security (financial instrument) is a formal (financial instrument) is a formal obligation that entitles one party to receive obligation that entitles one party to receive payments and/or a share of assets from payments and/or a share of assets from another party; e.g., loans, stocks, bonds.another party; e.g., loans, stocks, bonds.

Even an ordinary bank loan is a financial Even an ordinary bank loan is a financial instrument. instrument.

4. Financial Markets4. Financial MarketsFinancial marketsFinancial markets are mechanisms (or are mechanisms (or arrangements) that allows people to easily buy arrangements) that allows people to easily buy and sell (trade) financial securities (such as and sell (trade) financial securities (such as stocks and bonds), commodities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other precious metals or agricultural goods), and other tangible items of value at low transaction costs tangible items of value at low transaction costs and at prices that reflect; e.g., Bahrain Stock and at prices that reflect; e.g., Bahrain Stock Exchange, New York Stock Exchange, U.S. Exchange, New York Stock Exchange, U.S. Treasury's online auction site for its bonds.Treasury's online auction site for its bonds.

Financial markets such as stock market and bond Financial markets such as stock market and bond market are essential to promote greater economic market are essential to promote greater economic efficiency by channeling funds from who do not efficiency by channeling funds from who do not have productive use of fund (savers) to those have productive use of fund (savers) to those who do (investors). who do (investors).

While well-functioning financial markets While well-functioning financial markets promote growth, poorly performing promote growth, poorly performing financial markets can be the cause of financial markets can be the cause of poverty .poverty .

Thus, activities in financial markets may Thus, activities in financial markets may increase or decrease personal wealthincrease or decrease personal wealth

Activities in financial markets affect Activities in financial markets affect business cycle.business cycle.

The Bond Market and Interest RatesThe Bond Market and Interest RatesA bondA bond is a debt security that promises to is a debt security that promises to make specified rate of interest payments make specified rate of interest payments periodically for a specified period of time, periodically for a specified period of time, with principal to be repaid when the bond with principal to be repaid when the bond matures.matures.An An interest rateinterest rate is the cost of borrowing or is the cost of borrowing or the price paid for the rental of borrowed the price paid for the rental of borrowed funds (usually expressed as a percentage funds (usually expressed as a percentage of the rental of $100 per year)of the rental of $100 per year)Everything else held constant, a decline in Everything else held constant, a decline in interest rates will cause consumption and interest rates will cause consumption and investment to increase; e.g. spending on investment to increase; e.g. spending on housing or cars would risehousing or cars would rise

An increase in interest rates might An increase in interest rates might encourage consumers to save more encourage consumers to save more because more can be earned in interest because more can be earned in interest income but discourage investors from income but discourage investors from taking loans. Thus, consumption and taking loans. Thus, consumption and investment would decrease.investment would decrease.

The bond markets are important because The bond markets are important because they are the markets where interest rates they are the markets where interest rates are determinedare determined

The Stock MarketThe Stock MarketA A stockstock (a common stock) represents a (a common stock) represents a share of ownership of a corporation, or a share of ownership of a corporation, or a claim on a firm's earnings/assets. claim on a firm's earnings/assets. Stocks are part of wealth, and changes in Stocks are part of wealth, and changes in their value affect people's willingness to their value affect people's willingness to spend. spend. Changes in stock prices affect a firm's Changes in stock prices affect a firm's ability to raise funds, and thus their ability to raise funds, and thus their investment. investment. The stock market is important because it is The stock market is important because it is the most widely followed financial market the most widely followed financial market nowadays.nowadays.

A rising stock market index due to higher A rising stock market index due to higher share prices increases people's wealth and share prices increases people's wealth and as a result may increase their willingness as a result may increase their willingness to spend.to spend.When stock prices fall an individual's When stock prices fall an individual's wealth may decrease and their willingness wealth may decrease and their willingness to spend may decrease.to spend may decrease.Changes in stock prices affect firms' Changes in stock prices affect firms' decisions to sell stock to finance decisions to sell stock to finance investment spending.investment spending.Fear of a major recession causes stock Fear of a major recession causes stock prices to fall, everything else held constant, prices to fall, everything else held constant, which in turn causes consumer spending which in turn causes consumer spending to decreaseto decrease

The Foreign Exchange MarketThe Foreign Exchange MarketThe The foreign exchange marketforeign exchange market is where is where funds are converted from one currency into funds are converted from one currency into anotheranother

The The foreign exchange rateforeign exchange rate is the price of is the price of one currency in terms of another currencyone currency in terms of another currency

The foreign exchange market determines The foreign exchange market determines the foreign exchange ratethe foreign exchange rate

Everything else constant, a stronger dinar will Everything else constant, a stronger dinar will mean that vacationing in England becomes less mean that vacationing in England becomes less expensive. And the country’s goods exported expensive. And the country’s goods exported abroad will cost more in foreign countries, and so abroad will cost more in foreign countries, and so foreigners will buy fewer of them.foreigners will buy fewer of them.Everything else held constant, a stronger dollar Everything else held constant, a stronger dollar benefits the country’s consumers and hurts the benefits the country’s consumers and hurts the country’s businesses.country’s businesses.Everything else held constant, a decrease in the Everything else held constant, a decrease in the value of the dollar relative to all foreign value of the dollar relative to all foreign currencies means that the price of foreign goods currencies means that the price of foreign goods purchased by Americans increasespurchased by Americans increasesIf the price of a euro (the European currency) If the price of a euro (the European currency) increases from $1.00 to $1.10, then, everything increases from $1.00 to $1.10, then, everything else held constant, a European vacation becomes else held constant, a European vacation becomes more expensive.more expensive.

5. Central Banks5. Central Banks

A A central bankcentral bank is a governmental body is a governmental body that regulates financial institutions, that regulates financial institutions, controls the supply of money and credit controls the supply of money and credit in the economy, handles the in the economy, handles the government's finances, and serves as the government's finances, and serves as the bank to commercial banks.bank to commercial banks.

Commercial banks deposit some of their Commercial banks deposit some of their reserves at the central bank, and the reserves at the central bank, and the central bank is the "lender of last resort" central bank is the "lender of last resort" to commercial banks in times of crisis.to commercial banks in times of crisis.

Monetary theory relates changes in the Monetary theory relates changes in the quantity of money to changes in aggregate quantity of money to changes in aggregate economic activity and the price level. economic activity and the price level.

Monetary policy is the management of the Monetary policy is the management of the money supply and interest rates and is money supply and interest rates and is conducted by a nation's central bankconducted by a nation's central bank

Fiscal policyFiscal policy involves decisions about involves decisions about government spending and taxationgovernment spending and taxationo Budget deficitBudget deficit is the excess of expenditures is the excess of expenditures

over revenues for a particular year over revenues for a particular year o Budget surplusBudget surplus is the excess of revenues over is the excess of revenues over

expenditures for a particular yearexpenditures for a particular yearo Any deficit must be financed by borrowingAny deficit must be financed by borrowingo Budgets deficits can be a concern because Budgets deficits can be a concern because

deficits can result in higher rates of monetary deficits can result in higher rates of monetary growth and they might ultimately lead to higher growth and they might ultimately lead to higher inflationinflation

Five Core Principles of Money and Five Core Principles of Money and BankingBanking

1.1. Time has value. Time has value.

2.2. Risk requires compensation. Risk requires compensation.

3.3. Information is the basis for decisions. Information is the basis for decisions.

4.4. Markets set prices and allocate resources. Markets set prices and allocate resources.

5.5. Stability improves welfare (i.e., well-Stability improves welfare (i.e., well-being).being).

– Five Core Principles Of Money And Banking (Reading)Five Core Principles Of Money And Banking (Reading)

TIME has value.TIME has value. A dollar today is worth more than a dollar a A dollar today is worth more than a dollar a year from now. Why is this? (Several reasons: inflation year from now. Why is this? (Several reasons: inflation erodes the buying power of money over time; having the erodes the buying power of money over time; having the money now means you can spend it now; having the money money now means you can spend it now; having the money now means you can invest it and turn it into more money.) now means you can invest it and turn it into more money.)

RISK requires compensationRISK requires compensation. . For securities like For securities like stocks and bonds, the higher the risk, the higher stocks and bonds, the higher the risk, the higher the return has to be. For individuals, minimizing the the return has to be. For individuals, minimizing the risk of such things as accidents, illness, and theft risk of such things as accidents, illness, and theft is worth the expense of monthly insurance is worth the expense of monthly insurance premiums. (A note on usage: "Risk" refers to your premiums. (A note on usage: "Risk" refers to your potential losses, financial and otherwise, not potential losses, financial and otherwise, not merely to the probability of unwanted events. For merely to the probability of unwanted events. For example, fire insurance might not reduce the example, fire insurance might not reduce the likelihood of your house burning down, but it will likelihood of your house burning down, but it will compensate you for the damage from your house compensate you for the damage from your house burning down.)burning down.)

INFORMATIONINFORMATION is the basis for decisions.is the basis for decisions. This rather general sentence relates to money, This rather general sentence relates to money, banking, and finance because we live in a world banking, and finance because we live in a world of imperfect information. It is hard for financial of imperfect information. It is hard for financial transactions to take place when one or both transactions to take place when one or both parties lack adequate information about the parties lack adequate information about the other, because one party could easily end up other, because one party could easily end up getting burned. As a result, banks and other getting burned. As a result, banks and other financial institutions that make loans gather a financial institutions that make loans gather a considerable amount of information about their considerable amount of information about their potential borrowers before advancing them potential borrowers before advancing them money. The collection and provision of company money. The collection and provision of company financial information by government agencies financial information by government agencies can aid the growth of financial markets by can aid the growth of financial markets by making them more transparent, thus reducing making them more transparent, thus reducing the information barrier for potential investors. the information barrier for potential investors. Recent advances in computer and Recent advances in computer and communications technology have greatly helped communications technology have greatly helped the spread of financial information, thereby the spread of financial information, thereby paving the way for the growth of important new paving the way for the growth of important new financial markets like the junk-bond market.financial markets like the junk-bond market.

MARKETS set prices and allocate MARKETS set prices and allocate resources.resources. Financial institutions and Financial institutions and markets, by connecting savers with markets, by connecting savers with borrowers, allow for people's leftover borrowers, allow for people's leftover money (savings) to be channeled into money (savings) to be channeled into productive investment in capital (e.g., productive investment in capital (e.g., new technology, machinery, and new technology, machinery, and buildings). Financial markets for assets buildings). Financial markets for assets like stocks and bonds allow some like stocks and bonds allow some companies, especially well-established companies, especially well-established companies, to obtain funds for new companies, to obtain funds for new capital investment more cheaply than capital investment more cheaply than they could borrow from a bank.they could borrow from a bank.

Stability improves welfare (i.e., well-being).In the interest of stability in the financial sector, governments have created centralbanks to try to guard against bank failures and financial panics. The tasks ofcentral banks have grown in recent years, as they are now expected to keepinflation low and stable, and also to avoid or minimize recessions.Bank deposit insurance is another example of a government intervention for thesake of financial and social stability.