Money and Banking Lesson 1 Introduction PDF

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Summary

Gives a description of money and banking,why it is important to study money as well an a birds eye view of the financial system...

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1.0 WHY STUDY MONEY AND BANKING?  People’s everyday lives are affected by the economic environment in which they exist.  Factors in the economy such as interest rates, money, foreign exchange rates etc affect the standard of life of people and the economic decisions they make.  Individuals’ decisions to consume, save or invest are affected by the factors in the economy.  Business decisions to invest in factories, to produce new products, to raise funds to finance projects are affected by factors in the economy.  Money, financial markets, and financial institutions affect

factors

in

an

economy

which

affect

the

performance of the economy and hence affect people’s everyday lives.

1.1 Why study money?  The study of money is an extremely important part of both economics and finance. Research has found that money plays an important role in the determination of aggregate output, the aggregate price level, the rate of inflation, and the level of interest rates.  Money helps people to carry on transactions in a more efficient way. For example, it helps individuals by

avoiding the double coincidence of needs inherent with a barter system and also allows people to specialise.

 The amount of money in an economy i.e. the money supply has a number of consequences for the wellbeing of people in an economy; for example, it is well known that money supply affects the prices of goods and this has a direct effect on people’s lives. When the price of goods increases people lose their purchasing power hence their standard of life goes down.

 It is believed that changes in the rate of money growth are linked to business cycles. Evidence suggests that money plays an important role in generating business cycles i.e. the upward and downward movement of aggregate output produced in the economy. It has been observed that every recession has been preceded by a decline in the rate of money growth indicating that changes in money might also be a driving force behind business cycle fluctuations.

 It is believed that money supply affects interest rates. The interest rate is the price of money as you all know. If the money supply is shrinking, interest rates will go up. This will affect people’s decisions to buy assets

because the cost of obtaining finance has gone up. On the other hand, it may influence people to save as they would expect to earn more income through higher rates of interest on their savings. However, higher interest rates may deter companies from raising finance to fund new factories which can affect availability of jobs for people.

 Governments use monetary policy as one of the tools for influencing their economies. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed Central Bank. Studying money should therefore be a matter of interest especially to students of economics.

1.2 Why study financial markets? Financial markets are markets in which funds are channelled from people who have an excess of available

funds to those who have a shortage of funds. This enables people with entrepreneurial abilities to acquire the funds they need to invest in their various endeavours. It also enables individuals to invest for future returns and also to acquire assets which they would otherwise not be able to acquire. The process of channelling funds from savers to spenders is not trivial; the more efficiently this process is carried out, the better the welfare of the economy as a whole.

 Financial markets are also markets where important economic variables such as interest rates, prices of shares, foreign exchange rates are determined. o Interest rates are determined in the bond market o Share prices are determined in the stock market o Foreign exchange rates are determined in the foreign exchange market.

THE BOND MARKET This is the market in which organisations and government raise funds through borrowing. Borrowing in the bond market is enabled by the issuing of debt securities by the borrower. A security (also called a financial instrument) is a claim on the issuer’s future income or assets.

 A bond is a debt instrument that promises to make payments periodically for a specified period of time.  An organisation or government wishing to borrow money from the public can issue a bond. People who buy bonds from the issuer are lending money to the issuer. The bond is thus a liability to the issuer and an asset to the holder of the bond.  The issuer of the bond (borrower) pays a price for borrowing, which is a return to the lender. This price is the interest the issuer pays to the bond holder. The interest rate is the cost of borrowing to the issuer of the bond and a return to the lender. The lender and borrower must agree on this price hence the bond market is the market in which interest rates are determined.  Interest rate being the cost of borrowing and return to the borrower and lender respectively, it influences their decisions to borrow or lend respectively. o When interest rates are high the borrower may be reluctant to borrow and this will affect his/her ability to raise the funds he/she requires for investment projects and thus affect the production of goods and services and employment. o Low interest rates may discourage potential lenders from making their money available to

borrowers; hence potential entrepreneurs will not be able to finance their investment projects. This will affect the production of goods and services and employment.  If it is very difficult for companies to get funds to build factories or to develop new products, it will become very difficult for an economy to grow. Interest rates are thus a very important economic variable hence the workings of the bond market are important to the performance of an economy.

THE STOCK MARKET Another way in which companies raise capital is by issuing stocks. A common stock (also called an ordinary share) represents a share of the ownership of a company. People who buy shares in a company own part of the company and are entitled to a share of the company’s earnings and assets.

Ownership

of

a

company’s

shares

represents

an

investment in the company by the holder of the shares and hence he expects a return on his investment. The price which the investor is willing to pay to acquire the shares will depend on the return he expects to get from the investment. The price which people are willing to pay

to acquire shares in a company will determine the amount of capital the company is able to raise through an issue of shares.

The expected return from investing in companies is judged from information available on companies and the stock market has mechanisms for making such information available to potential investors. The stock market therefore enables the prices of company stocks to be determined.

THE FOREIGN EXCHANGE MARKET The foreign exchange market is another important market in an economy. Countries buy and sell goods and services to each other; but different countries have different currencies. In order for one country to pay another country for goods and services bought, it is necessary that the currency of one country should be exchanged for that of the other country. The rate at which the currency of one country is exchanged for that of another country is the foreign exchange rate and this is determined in the foreign exchange market. The foreign exchange rate therefore enables funds to move between countries without which trade between countries would not be possible. The understanding of the workings of the foreign exchange market is thus very important.

FINANCIAL INSTITUTIONS Financial

institutions

such

as

banks,

insurance

companies, mutual funds, finance companies, investment banks etc expedite the transfer of funds between lenders and borrowers. These act as intermediaries. It is very difficult for most potential lenders to deal directly with potential borrowers because of transaction costs and risks associated with lending. Financial institutions alleviate these problems. o Because

of

economies

of

scale,

financial

institutions reduce transaction costs considerably. o Financial institutions have the expertise and resources to acquire information about potential borrowers and are thus able to assess risk of lending and thus select borrowers with the lowest risk

hence

the

risk of

lending

is reduced

significantly. o Financial institutions are able to pool funds from a multitude of investors and are thus able to spread the funds into a varied portfolio of investments thereby diversifying away risk for their many clients. Financial institutions therefore play a very important role in the channelling of funds from lenders to borrowers and

thus bring efficiency to the working of the financial markets....