ECOS2004 Money and Banking
ECOS2004 Money and Banking
Semester 1, 2022
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Tutors: Loki Nedunuri
Classes: Delivered online
Some preliminary concepts and questions
Why does this piece of plastic have value?
Why do central banks have the power to set interest rates …
… and why are they so low? (excerpt from AFR 28/1 2022)
What causes a financial crisis? …
Scene from September 2007
About the course
Textbook: , The Economics of Money, Banking, and Financial Markets, Global Edition (13th preferred, but 11th or 12th can be used)
Make sure you have access to a copy of the textbook (available online, or through the Co-op).
Other required readings are indicated in the UoS Outline and on the Modules page for this course.
We will also make use of recent speeches and official policy statements
Tutorials will consist of:
review of answers to exercises set for discussion that week
opportunity to discuss course material and ask questions
Students should do all tutorial exercises in order to understand the course material
Students are required to submit one set of written answers during term
Tutorials commence in week 3
Please see the Canvas site for detailed instructions about submission requirements
Make sure you know which week you have to submit
Course assessment structure
See UoS Outline for details:
Assessment items
Mid-semester exam 1 20% Week 7:
60-minute exam during the regular class slot
Tutorial assignment 20% Variable
Mid-semester exam 2 (essay written under exam conditions) 20% Week 11:
60-minute exam during the regular class slot
Final exam 40% Final exam period
Lecture 1.1
Why study money, banking and financial markets?
Source: Mishkin, Ch 1
Learning Objectives
Examine how financial markets such as bond markets are connected to the aggregate economy
Examine how financial institutions, especially banks, play a role in the behaviour of the economy
Examine the role of monetary and financial policy in the economy
A very policy-oriented course—not primarily theory-based
Learning Objectives (2)
Recognize the importance of financial markets in the economy
Identify the basic links among monetary policy, the business cycle, and economic variables
Explain the importance of exchange rates in the global economy and in policy decisions
Why Study Financial Markets?
Financial markets are markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds
In this way, financial markets contribute to efficient allocation of productive resources
But, financial markets can also be a source or amplifier of instability
World economic conditions are still being affected by the legacy of the GFC
The Bond Market and Interest Rates:
Some definitions
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. Principal is returned to lender at maturity.
An interest rate is the cost of borrowing or the price of credit (the price paid for the rental of funds) expressed as a percentage annual rate.
Bonds: paper and electronic
Bonds were historically issued in paper form
A bond is a promise to make certain fixed payments at a fixed date or dates in the future (see example at right)
Nowadays these commitments are made and registered in electronic form
Interest Rates on 10-year
US Government bonds, 1962–2022
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
Policy Interest Rates: major advanced economies
Interest rates: Australia
Housing Rates and the Cash Rate
… policy and bank interest rates are connected
The Stock Market
Common stock (equity) represents a share of ownership in a corporation
The owner of a share of stock holds a claim on the net earnings of the corporation, or the net assets in liquidation (if the company fails)
US stock prices since 1950
Stock prices tend to rise over time: Why?
Stock prices are volatile: they fell by about 50 per cent over 2007-2009
What causes this?
Why Study Financial Institutions and Banking?
Financial intermediaries: institutions that borrow funds from people (households and firms) who have saved, and in turn make loans to other people.
Banks: accept deposits and make loans
Other financial institutions: pension funds, mutual funds and investment companies
These institutions accept funds from households and make investments
Financial innovation: the development of new financial products and services
Can be an important force for good by making the financial system more efficient
Can go wrong, encourage excessive risk taking (eg during the GFC)
Financial crises: major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures (or emergency rescues) of many financial and nonfinancial firms.
This happened on a large scale over 2007 – 2009
Why Study Financial Institutions and Banking?
Why Study Money and Monetary Policy?
History shows that financial events and monetary policy can play an important role in macroeconomic outcomes:
business cycles
Monetary theory ties monetary policy actions to changes in aggregate economic activity and the price level
The causation flows in both directions:
policy makers respond to the economy
the economy responds to policy decisions
Money, Business Cycles, and Inflation
The aggregate price level is the average price (a weighted index of prices) of goods and services in an economy
Inflation is a continual rise in the price level
History has generally shown a connection between the money supply and the price level, but the link is complex
We will be studying traditional and modern views as to how this link works
From the textbook: Money supply and the business cycle are related (but not mechanistically)
Similarly, the money supply and inflation are related
Stimulating the economy during the pandemic
Fiscal Policy and Monetary Policy
Monetary policy is the management of interest rates and the central bank balance sheet
Conducted in the U.S. by the Federal Reserve System (Fed); by RBA in Australia
Fiscal policy deals with government spending and taxation
Budget deficit is the excess of expenditures over revenues for a particular year
Budget surplus is the excess of revenues over expenditures for a particular year
Any deficit must be financed by borrowing or by money creation
Budget projection for 2020/21 was a deficit of $214 bn ( = 11 per cent of GDP)
Governments at present are running historically large deficits
United States
Quantity of money: definitions (Australia)
Currency = notes and coin in circulation
M3 = currency + bank deposits held by the public
Broad money = M3 + deposits with non-bank financial institutions (NBFIs)
NBFIs are credit unions and building societies
Money and Interest Rates
Traditional monetary theory postulates that central banks conduct policy by controlling the money supply
Since the 1990s, central bank policy makers no longer think in those terms
Their actions (in normal times) set the short-term policy interest rate
Money and credit growth respond to these actions and to broader economic conditions
In Australia this has been explicit in policy statements since 1990
The ability to control interest rates becomes limited once the zero bound is reached – this is a major current issue
The Foreign Exchange Market
The foreign exchange market: where funds are converted from one currency into another
The foreign exchange rate is the price of one currency in terms of another currency
In a floating rate system, the market determines the foreign exchange rate
Australian dollar exchange rates
The International Financial System
Financial markets have become increasingly integrated throughout the world.
The international financial system has important effects on domestic economies:
Effect of the exchange rate on domestic economy
International transmission of financial stress
Role of international financial institutions like the IMF
How We Will Study Money, Banking, and Financial Markets
Overview of basic concepts: the financial system, money and interest rates
Strategic approaches to monetary policy, particularly inflation targeting
Current issues in monetary and financial policy
Defining Aggregate Output, Income, the Price Level, and the Inflation Rate
Aggregate Output and Income
The most commonly reported measure of aggregate output, gross domestic product (GDP), is the market value of all goods and services produced in a country during the course of a 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, is equal to aggregate output
So, Output (or production) = Income
Real versus Nominal Magnitudes
When the total value of goods and services is calculated using current prices, the resulting GDP measure is referred to as nominal GDP. The word “nominal” indicates that values are measured using current prices (that is, the dollar values of spending actually prevailing in the economy today).
To allow comparisons across time, real GDP removes from the nominal figure the impact of price movements
hence, the change in real GDP is a measure of the change in the quantity of production, measured independently of price movements
Aggregate Price Level
The aggregate price level is a measure of average prices in the economy
The inflation rate is its percentage increase
The most commonly used measure in Australia is the Consumer Price Index (CPI)
20182014201020062022 -1 0 1 2 3 4 5 % -1 0 1 2 3 4 5 % PolicyInterestRates US Japan Euroarea* * Mainrefinancingrateuntiltheintroductionof3-yearLTROsin December2011;depositfacilityratethereafter. Source:Centralbanks
20182014201020062022 -2 0 2 4 6 8 % -2 0 2 4 6 8 % PolicyInterestRates–Selected AdvancedEconomies UK Canada Sweden NZ Switzerland Source:Centralbanks
MonetaryPolicy–China Interestrates 201720122022 0 2 4 6 8 % (monthaverage) One-year benchmark lending One-year benchmark deposit One-yearMLF* Seven-day repo Reserverequirementratios 201720122022 0 5 10 15 20 % Smallinstitutions * Mediumtermlendingfacility. Sources:CEICData;RBA
201720122007200219972022 0 1 2 3 4 5 6 7 % 0 1 2 3 4 5 6 7 % AustralianCashRateTarget Source:RBA
201820142010200620022022 0 1 2 3 4 5 6 7 % 0 1 2 3 4 5 6 7 % 10-yearAustralianGovernmentBondYield Sources:RBA;Yieldbroker
201720122007200219972022 40 100 200 400 600 800 index 40 100 200 400 600 800 index AdvancedEconomies’SharePriceIndices Logscale,endDecember1994=100 Japan Euroarea US UK Sources:Bloomberg;RBA
16/1708/0900/0192/9384/8524/25 -8 -6 -4 -2 0 2 % -8 -6 -4 -2 0 2 % AustralianGovernmentBudgetBalance* PercentofnominalGDP * Underlyingcashbalance;2021/22mid-yeareconomicandfiscal outlook. Source:AustralianTreasury
201420072000199319862021 40 50 60 70 80 index 40 50 60 70 80 index AustralianDollarTrade-weightedIndex* Nominal Real * May1970=100fornominal;realindexedtoequatepost-float averages;latestobservationsforrealTWIareestimates Sources:ABS;RBA;Refinitiv;WM/Reuters
201420072000199319862021 50 100 150 200 yen 0.40 0.80 1.20 1.60 US$, euro AustralianDollar YenperA$ (LHS) (RHS) US$perA$ (RHS) EuroperA$* * ECUperA$until31December1998. Source:Bloomberg
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