Why Study Financial Markets?

The Bond Market and Interest Rates

• A security (also referred to as a financial instrument) is a claim on the issuer’s future income or assets.

• Assets are any financial claim or piece of property that is subject to ownership.

• 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.

◦ Types of interest rates include mortgage interest rates, car loan rates, and interest rates on different types of bonds.

◦ Interest rates are important on a number of levels. For example, high interest rates could deter someone from buying a house or a car because the cost of financing it would be high.

◦ High interest rates could also encourage someone to save because they can earn more interest income by putting aside some of their earnings as savings.

◦ 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. For example, high interest rates may cause a corporation to postpone building a new plant that would provide more jobs.

The Stock Market

• A  stock is a share of ownership in a corporation.

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

• The stock market is where shares of stock are traded.

◦ Stock markets are extremely volatile, meaning its stock prices fluctuate up and down.

◦ For example, October 19th, 1987 is known as Black Monday, a day when the United states experienced the largest one-day percentage drop in stock market history.

Why Study Financial Institutions and Banking?

Structure of the Financial System

• Private sector financial institutions (e.g., banks, insurance companies, mutual funds, finance companies, and investment banks) are heavily regulated by the government.

• If an individual wants to make a loan to a corporation or business, they would not go directly to the president of the company and offer a loan. Rather, they would lend to the company indirectly through financial intermediaries, which are institutions that borrow money from people who have saved and lend it out.

Financial Crises

• When the financial system seizes up, financial crises occurs, which are major disruptions in financial markets characterized by sharp declines in asset prices and the failure of numerous financial and nonfinancial businesses.

◦ Financial crises are often followed by extreme economic cycle downturns. For example, the biggest financial crisis to affect the American economy since the Great Depression began in August 2007.

◦ The result of the 2007 market crises is now referred to as the “Great Recession” and was brought on by defaults in subprime residential mortgages which generated significant losses for financial institutions and resulted in numerous bank failures.

Banks and Other Financial Institutions

• Banks are financial institutions that accept deposits and make loans.

◦ Commercial banks, savings and loan associations, mutual savings banks, and credit unions are all firms that fall within the definition of "banks."

◦ There are many other important financial institutions aside from banks, including: insurance companies, finance companies, pension funds, mutual funds, and investment banks.

Financial Innovation

• Financial innovation is the development of new financial products and services.

◦ For example, financial innovation has resulted in significant advances in information technology such as e-finance, the ability to deliver financial services electronically.

Why Study Money and Monetary Policy?

Money, often known as the money supply, is defined as anything that is generally accepted as payment for goods or services or for debt repayment.

Money and Business Cycles

• Aggregate output is the total production of goods and services.

• The upward and downward movement of aggregate output produced in the economy is known as business cycles.

• Recessions are periods of declining aggregate output.

• The monetary theory relates the quantity of money and monetary policy to changes in aggregate economic activity and inflation.

• The average price of goods and services in an economy is called the price level.

• Inflation is a continual increase in the price level and it can affects individuals, businesses, and the government.

• The average inflation rate is the rate of change of the price level.

Conduct of Monetary Policy

• The conduct of monetary policy is the management of money and interest rates.

◦ The organization responsible for the conduct of a nation’s monetary policy is the central bank.

◦ The United States’ central bank is the Federal Reserve System.

Fiscal Policy and Monetary Policy

• Fiscal policy deal with decisions about government spending and taxation.

• A budget deficit is the excess of government expenditures over tax revenues for a particular time period.

◦ The government finances budget deficits by borrowing.

• A budget surplus occurs when tax revenues exceed government expenditures.

◦ Budget surpluses lead to lower government debt burdens.

Why Study International Finance?

American companies often borrow in foreign financial markets, and foreign companies borrow in U.S. financial markets. Banks and other financial institutions, including JP Morgan Chase, Citigroup, UBS, and Deutschebank, have become increasingly international, with operations in many countries throughout the world.

The Foreign Exchange Market

• To transfer funds from one country to another, the funds have to be converted from the currency in the country of origin into the currency of the country they are going to, for example from dollars to euros.

◦ The foreign exchange market is where this conversion takes place.

• The foreign exchange rate is the price of one country’s currency in terms of another’s.

Chapter 1 Appendix ⎸Defining Aggregate Output, Income, the Price Level, and the Inflation Rate

Aggregate Output and Income

• Gross domestic product (GDP) is the market value of all final goods and services produced in a country during the course of the year.

• 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 known as aggregate income and is thought of as being equal to aggregate output.

Real Versus Nominal Magnitudes

• When the total value of final goods and services is calculated using current prices, the resulting GDP measure is known as nominal GDP.

◦ The term “nominal” means that values are measured in terms of current prices.

• GDP measured with constant prices is known as real GDP.

◦ The term “real” means that values are measured in terms of fixed prices.

Aggregate Price Level

• There are three measures of the aggregate price level commonly encountered in economic data: GDP deflator, PCE deflator, and the CPI.

• The GDP deflator is found by dividing the nominal GDP by the real GDP. For example, if 2013 nominal GDP is $10 trillion but 2013 real GDP in 2005 prices is $9 trillion:

◦ GDP deflator = $10 trillion/$9 trillion = 1.11

◦ Thus, the GDP deflator for 2013 would be 111

• The PCE deflator is another popular measure of the aggregate price level and is found by dividing the nominal personal consumption expenditures (PCE) by real PCE.

• The consumer price index (CPI) is measured by pricing a “basket” of goods and services bought by a typical urban household. For example, If over the course of the year, the cost of this basket of goods and services rises from $500 to $600, the CPI has risen by 20%.

Growth Rates and The Inflation Rate

• A growth rate is the percentage change in a variable.

• The inflation rate is the growth rate of the aggregate price level.