H OW W E W I L L ST U DY M O N E Y, B A N K I N G , A N D F I N A N C I A L M A R K E T S
This textbook stresses the economic way of thinking by developing a unifying framework to study money, banking, and financial markets. This analytic frame- work uses a few basic economic concepts to organize your thinking about the determination of asset prices, the structure of financial markets, bank manage- ment, and the role of money in the economy. It encompasses the following basic concepts:
A simplified approach to the demand for assets The concept of equilibrium
Basic supply and demand to explain behaviour in financial markets The search for profits
An approach to financial structure based on transaction costs and asymmetric information
Aggregate supply and demand analysis
The unifying framework used in this book will keep your knowledge from becoming obsolete and make the material more interesting. It will enable you to learn what really matters without having to memorize a mass of dull facts that you will forget soon after the final exam. This framework will also provide you with the tools to understand trends in the financial marketplace and in variables such as interest rates, exchange rates, inflation, and aggregate output.
To help you understand and apply the unifying analytic framework, simple mod- els are constructed in which the variables held constant are carefully delineated, each step in the derivation of the model is clearly and carefully laid out, and the models are then used to explain various phenomena by focusing on changes in one variable at a time, holding all other variables constant.
To reinforce the models usefulness, this text uses case studies, applications, and special-interest boxes to present evidence that supports or casts doubts on the theories being discussed. This exposure to real-life events and empirical data
The
International Financial System
should dissuade you from thinking that all economists make abstract assumptions and develop theories that have little to do with actual behaviour.
To function better in the real world outside the classroom, you must get into the lifelong habit of regularly following the financial news that appears in leading finan- cial publications such as The Globe and Mail: Report on Business and the National Post: Financial Post. To help and encourage you to read the financial section of the newspaper, this book contains two special features. The first is a set of special boxed inserts titled Financial News that contain actual columns and data from the media that appear daily or periodically. These boxes give you the detailed informa- tion and definitions you need to evaluate the data being presented.
In addition to these applications, this book also contains nearly 400 end-of- chapter problems that ask you to apply the analytic concepts you have learned to other real-world issues. Particularly relevant is a special class of problems headed Predicting the Future. So that you can work on these problems on your own, answers to half of them are found at the end of the book. These give you an opportunity to review and apply many of the important financial concepts and tools presented throughout the book.
E X P LO R I N G T H E W E B
The Internet has become an extremely valuable and convenient resource for finan- cial research. We emphasize the importance of this tool in several ways. First, wherever we utilize the web to find information to build the charts and tables that appear throughout the text, we include the source site s URL. These sites often contain additional information and are updated frequently. Second, we have added Web Exercises to the end of each chapter. These exercises prompt you to visit sites related to the chapter and work with real-time data and information. We have also provided Web References on the MyEconLab that accompanies this book (www.pearsoned.ca/myeconlab) that list the URLs of sites related to the mate- rial being discussed. Visit these sites to further explore a topic you find of partic- ular interest.
The following sample Web Exercise is especially important because it demon- strates how to export data from a website into Microsoft Excel for further analysis.
We suggest you work through this problem on your own so that you will be able to perform this activity when prompted in subsequent Web Exercises.
S A M P L E W E B E X E RC I S E
You have been hired by Risky Ventures Ltd. as a consultant to help the company analyze interest rate trends. Your employers are initially interested in determining the historical relationship between short-term interest rates. The biggest task you must immediately undertake is collecting market interest-rate data. You know the best source of this information is the web.
1. You decide that your best indicators of short-term interest rates are the bank rate, the one-month bankers acceptances rate, and the three-month prime corporate rate. Your first task is to gather historical data. Go to www.bankofcanada.ca and select Rates and Statistics and then Canadian Interest Rates. The site should look like the screen shown on page 14.
C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 13
Collecting and Graphing Data
14 PA R T I Introduction
2. Although you have located an accurate source of historical interest rate data, getting it onto a spreadsheet will be very tedious. You recall that Excel (Microsoft Excel) will let you convert text data into columns. Begin by indi- cating that you want to display the data in CSV format, sorted by date. Under the monthly series frequency, click on V122530, V122504, and V122491, specify dates by choosing the start and end dates, and click on Get Rates.
A new screen should appear with a link to download the CSV data to your computer.
3. You now want to analyze the interest rates by graphing them. Use Excel to open the CSV file you downloaded. Click on the Chart Wizard icon on the tool bar (or INSERT/CHART). Select scatter diagram and choose any type of scatter diagram that connects the dots. Let the Excel wizard take you through the steps of completing the graph.
C O N C L U D I N G R E M A R K S
The topic of money, banking, and financial markets is an exciting field that directly affects your life interest rates influence earnings on your savings and the pay- ments on loans you may seek on a car or a house, and monetary policy may affect your job prospects and the prices of goods in the future. Your study of money, banking, and financial markets will introduce you to many of the controversies about the conduct of economic policy that are hotly debated in the political arena and will help you gain a clearer understanding of economic phenomena you hear about in the news media. The knowledge you gain will stay with you and benefit you long after your course is done.
Source:Bank of Canada, www.bankofcanada.ca/en/rates/interest-look.html.
C H A P T E R 1 Why Study Money, Banking, and Financial Markets? 15
1. Activities in financial markets have direct effects on individuals wealth, the behaviour of businesses, and the efficiency of our economy. Three financial markets deserve particular attention: the bond market (where interest rates are determined), the stock market (which has a major effect on people s wealth and on firms investment decisions), and the foreign exchange mar- ket (because fluctuations in the foreign exchange rate have major consequences for the Canadian economy).
2. Banks and other financial institutions channel funds from people who might not put them to productive use to people who can do so and thus play a crucial role in improving the efficiency of the economy.
3. Money appears to have a major influence on infla- tion, business cycles, and interest rates. Because these economic variables are so important to the health of the economy, we need to understand how monetary policy is and should be conducted. We also need to study government fiscal policy because it can be an influential factor in the conduct of mon- etary policy.
4. This textbook stresses the economic way of thinking by developing a unifying analytic framework for the study of money, banking, and financial markets using a few basic economic principles. This textbook also emphasizes the interaction of theoretical analy- sis and empirical data.
S U M M A R Y
You will find the answers to the questions marked with an asterisk in the Textbook Resources section of your MyEconLab.
1. Has the inflation rate in Canada increased or decreased in the past few years? What about interest rates?
*2. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to a. real output
b. the inflation rate, and c. interest rates?
3. When was the most recent recession?
*4. When interest rates fall, how might you change your economic behaviour?
5. Can you think of any financial innovation in the past ten years that has affected you personally? Has it made you better off or worse off? Why?
*6. Is everybody worse off when interest rates rise?
7. What is the basic activity of banks?
*8. Why are financial markets important to the health of the economy?
9. What is the typical relationship among interest rates on three-month treasury bills, long-term Canada bonds, and long-term corporate bonds?
*10. What effect might a fall in stock prices have on busi- ness investment?
11. What effect might a rise in stock prices have on con- sumers decisions to spend?
*12. How does a fall in the value of the pound sterling affect British consumers?
13. How does an increase in the value of the pound sterling affect Canadian businesses?
*14. Looking at Figure 1-8 (page 11), in what years would you have chosen to visit the Canadian Rockies rather than Washington, D.C.?
15. When the dollar is worth more in relation to curren- cies of other countries, are you more likely to buy Canadian-made or foreign-made jeans? Are Canadian companies that make jeans happier when the dollar is strong or when it is weak? What about a Canadian company that is in the business of importing jeans into Canada?
Q U E S T I O N S
aggregate output, p. 6 aggregate price level, p. 7 appreciation, p. 11 asset, p. 3
Bank of Canada (the Bank), p. 9 banks, p. 5
bond, p. 3
budget deficit, p. 10 budget surplus, p. 10 business cycles, p. 7
central bank, p. 9 common stock, p. 3 depreciation, p. 11 e-finance, p. 6 financial crises, p. 5 financial intermediaries, p. 5 financial markets, p. 2 fiscal policy, p. 10
foreign exchange market, p. 11 foreign exchange rate, p. 11
inflation, p. 7 inflation rate, p. 8 interest rate, p. 3 monetary policy, p. 9 monetary theory, p. 7 money, p. 6
recession, p. 7 security, p. 3
unemployment rate, p. 6
K E Y T E R M S
16 PA R T I Introduction
CANSIM Questions
1. The following table lists monthly foreign exchange rates between the U.S. dollar and the Canadian dol- lar (in $/US$) for 2008 (this is CANSIM II series V41589522).
January 1.011132
February 0.999086
March 1.002025
April 1.013886
May 0.999371
June 1.016733
July 1.012695
August 1.054395
September 1.058295
October 1.184750
November 1.218174
December 1.234500
a. Which month would have been the best month to convert Canadian dollars into U.S. dollars?
Which month would have been the worst?
b. Did the Canadian dollar appreciate or depreciate in 2008?
c. What was the percentage appreciation or depre- ciation of the Canadian dollar?
d. If you convert the monthly observations into an annual observation (by taking the arithmetic average), how representative will the annual observation be of the exchange rate during 2008?
*2. The following table lists monthly stock prices in Canada as measured by the S&P/TSX Composite Index (this is CANSIM II series V122620) for 2008.
January 13 155.10
February 13 582.69
March 13 350.13
April 13 937.04
May 14 714.73
June 14 467.03
July 13 592.91
August 13 771.25
September 11 752.90
October 9 762.76
November 9 270.62
December 9 987.70
a. Which month would have been the worst month to buy the index?
b. What was the percentage decline in the index from January to December?
3. Get the monthly data for 1970 to 2009 on the M3 (gross) monetary aggregate (CANSIM series V41552794) from the Textbook Resources area of the MyEconLab.
a. Calculate the money growth rate over the entire period and present a time series plot of the series (that is, graph the money growth rate series against time).
b. Calculate the average monetary growth rate and its standard deviation over each of the last four decades.
c. Which decade had the lowest money growth?
The highest?
d. Which decade had the lowest money growth volatility? The highest?
Q U A N T I TAT I V E P R O B L E M S
1. In this exercise we will practise collecting data from the web and graphing it using Excel. Use the example on page 14 as a guide. Go to www.forecasts.org/data/index.htm, click on Stock Index Data at the top of the page, and then choose the U.S. Stock Indices Monthly option.
Finally, choose the Dow Jones Industrial Average option.
a. Move the data into an Excel spreadsheet.
b. Using the data from part (a), prepare a graph. Use the graphing wizard to properly label your axes.
2. In Web Exercise 1 you collected and graphed the Dow Jones Industrial Average. This same site reports fore- cast values of the DJIA. Go towww.forecasts. org.
Click on the Dow Jones Industrials link under 6 Month Forecasts in the far left column.
a. What is the Dow forecast to be in three months?
b. What percentage increase is forecast for the next three months?
W E B E X E R C I S E S
Be sure to visit the MyEconLab website atwww.myeconlab.com.This online homework and tutorial system puts you in control of your own learning with study and practice tools directly correlated to this chapter content.
On the MyEconLab website you will find the following appendix for this chapter:
Appendix 1.1: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate
17 Inez the Inventor has designed a low-cost robot that cleans house (even does win- dows), washes the car, and mows the lawn, but she has no funds to put her won- derful invention into production. Walter the Widower has plenty of savings, which he and his wife accumulated over the years. If Inez and Walter could get together so that Walter could provide funds to Inez, Inez s robot would see the light of day, and the economy would be better off: we would have cleaner houses, shinier cars, and more beautiful lawns.
Financial markets (bond and stock markets) and financial intermediaries (banks, insurance companies, pension funds) have the basic function of getting people like Inez and Walter together by moving funds from those who have a sur- plus of funds (Walter) to those who have a shortage of funds (Inez). More realis- tically, when Apple invents a better iPod, it may need funds to bring it to market.
Similarly, when a local government needs to build a road or a school, it may need more funds than local property taxes provide. Well-functioning financial markets and financial intermediaries are crucial to economic health.
To study the effects of financial markets and financial intermediaries on the economy, we need to acquire an understanding of their general structure and operation.
In this chapter we learn about the major financial intermediaries and the instru- ments that are traded in financial markets as well as how these markets are regulated.
This chapter presents an overview of the fascinating study of financial markets and institutions. We return to a more detailed treatment of the regulation, struc- ture, and evolution of financial markets in Chapters 8 through 12.
L E A R N I N G O B J E C T I V E S
After studying this chapter you should be able to
1. summarize the basic function performed by financial markets
2. explain why financial markets are classified as debt and equity markets, pri- mary and secondary markets, exchanges and over-the-counter markets, and money and capital markets
3. describe the principal money market and capital market instruments
4. express why the government regulates financial markets and financial interme- diaries (i.e., chartered banks, trust and mortgage loan companies, credit unions and caisses populaires, insurance companies, mutual fund companies, and other institutions)
An Overview of the Financial System