Chapter
1
Why Study
Money, Banking,
and Financial
Markets?
© 2005 Pearson Education Canada Inc.
Introduction
• When SAMA is raising the funds rate (interest rate) by 1%
percentage point. What effect might this have on the
interest rate of an automobile loan?
• Does it mean that a house will be more or less affordable in
the future?
• We provides answers to these and other questions by
examining how financial markets and financial institutions
work and by exploring the role of money in the economy.
• Financial markets and institutions not only affect your
everyday life but also affect business profits, the production
of goods and services, and even the economic well-being of
countries.
1-2
Why Study Financial Markets?
• Financial markets, are markets in which funds are
transferred from people who have an excess of available
funds to people who have a shortage.
• Financial markets such as bond and stock markets are
important to promoting greater economic efficiency by
channeling funds from people who do not have a
productive use for them to those who do.
• Indeed, well-functioning financial markets are a key factor
in producing high economic growth.
• Activities in financial markets also have direct effects on
personal wealth, the behavior of businesses and
consumers.
1-3
Why Study Financial Markets?
• 1- The Bond Market and Interest Rates:
• A bond (kind of security) is a debt security that promises to
make payments periodically for a specified period of time.
• The bond market is especially important to economic
activity because it enables corporations and governments
to borrow to finance their activities and because it is where
interest rates are determined.
• An interest rate is the cost of borrowing or the price paid
for the rental of funds.
1-4
1- The Bond Market and Interest Rates:
• High interest rates, for example, might cause a
corporation to postpone building a new plant that would
ensure more jobs.
• On a personal level, high interest rates could discourage
you from buying a house or a car because the cost of
financing it would be high.
• Conversely, high interest rates could encourage you to
save because you can earn more interest income by
putting aside some of your earnings as savings.
© 2005 Pearson Education Canada Inc. 1-5
Why Study Financial Markets?
• 2- The stock market:
• A common stock (typically just called a stock) represents a
share of ownership in a corporation. It is a security that is a
claim on the earnings and assets of the corporation.
• Issuing stock and selling it to the public is a way for
corporations to raise funds to finance their activities.
• The considerable fluctuations in stock prices affect the size
of people’s wealth and as a result may affect their
willingness to spend.
• The stock market is also an important factor in business
investment decisions, because the price of shares affects
the amount of funds that can be raised.
1-6
Why Study Financial Markets?
• 3- The Foreign Exchange Market:
• For funds to be transferred from one country to another,
they have to be converted from the currency in the
country of origin (say, Riyal) into the currency of the
country they are going to (say, euros).
• It is where the foreign exchange rate, the price of one
country’s currency in terms of another’s, is determined.
• A change in the exchange rate has a direct effect on
Saudi consumers because it affects the cost of imports.
1-7
• 3- The Foreign Exchange Market:
• a weaker Riyal leads to more expensive foreign goods,
makes vacationing abroad more expensive, and raises the
cost of your desire for imported delicacies. When the
value of the Riyal drops, Saudi will decrease their
purchases of foreign goods and increase their
consumption of domestic goods.
• Conversely, a strong Riyal means that Saudi goods
exported abroad will cost more in foreign countries, and
hence foreigners will buy fewer of them.
• A strong Riyal benefited Saudi consumers by making
foreign goods cheaper but hurt Saudi businesses and
eliminated some jobs by cutting both domestic and foreign
sales of their products.
1-8
Why Study Banking and Financial Institutions?
• Banks and other financial institutions are what make financial
markets work. Without them, financial markets would not be
able to move funds from people who save to people who have
productive investment opportunities.
1- Structure of Financial System:
• The financial system is complex, comprising many different types
of private sector financial institutions, including banks, insurance
companies, mutual funds, finance companies, and investment
banks, all of which are heavily regulated by the government.
• If someone wanted to make a loan to GM he cannot make it
directly but through financial intermediaries.
1-9
Why Study Banking and Financial Institutions?
• 2- Banks and Other Financial Institutions
• Banks are financial institutions that accept deposits and
make loans. Included under the term banks are firms such as
commercial banks, savings and loan associations, mutual
savings banks, and credit unions. Banks are the financial
intermediaries that the average person interacts with most
frequently. A person who needs a loan to buy a house or a
car usually obtains it from a local bank.
• Banks are not the only important financial institutions.
Other financial institutions such as insurance companies,
finance companies, pension funds, mutual funds, and
investment banks have been growing so we need to study
them as well.
1-10
Why Study Money and Monetary Policy?
• Money also referred to as the money supply, is defined
as anything that is generally accepted in payment for
goods or services or in the repayment of debts.
• Money is linked to changes in economic variables that
affect all of us and are important to the health of the
economy.
• Evidence suggests that money plays an important role in
generating business cycles, the upward and downward
movement of aggregate output produced in the
economy.
• When output is rising, for example, it is easier to find a
good job; when output is falling, finding a good job might
be difficult.
1-11
Money and Business Cycles
Money
growth rate
© 2005 Pearson Education Canada Inc. 1-12
Why Study Money and Monetary Policy?
• What we conclude is that the rate of money growth has
declined before every recession.
• Changes in money might also be a driving force behind
business cycle fluctuations.
• Inflation, a continual increase in the price level, affects
individuals, businesses, and the government.
• As we can see (next slide), the price level and the money
supply generally move closely together.
• These indicate that a continuing increase in the money
supply might be an important factor in causing the
continuing increase in the price level that we call inflation.
1-13
© 2005 Pearson Education Canada Inc. 1-14
Money Growth and Inflation
© 2005 Pearson Education Canada Inc. 1-15
