Economics of Money,

Banking and Financial

Markets
Course Code: BHUM221L- Summer sem.
Instructor: Adil Shah
Course Objectives

• Financial markets and institutions.

• Meaning of money- history, present and
future
• Use of monetary policy, tools and
implications for personal financial
decisions
• Understand exchange rate determination
and its impact on various entities
• Global financial system and dynamism
 Potential end result
• Do you invest/trade in stock market? and
• How many of you wish to invest/trade?
• The people who invest: What is your
strategy/parameters?
• Have you ever studied (either formally or
informally) Financial economics?
• Economic well-being of countries
• Your job prospects: the role of interest rate,
inflation, unemployment, fiscal policy,
subsidies….
• Your standard of living (present and future)-
Recommended Books
 Money, Banking, and Financial
Markets
• Money (medium of exchange)

• Financial institutions (banks, insurance

companies, mutual funds…)

• Financial markets (such as those for

bonds, stocks, and foreign exchange)
 Place where people can get rich—or
poor—quickly.
Money, Banking, and Financial Markets- an
Overview
 Banking and Financial markets- use
case
• Use case: Channelize money from savers to borrowers both within country and
across countries. For instance, Banks accept deposits and make loans, average
person interacts with banks most frequently

• Promotes greater economic efficiency and higher economic growth, whereas

when financial markets fail (for instance- GFC-2008) that too has an important
bearing on real economy

• Helps- Monetary policy transmission by RBI : through interest rates, financial

conditions, aggregate demand, output, and inflation
Banking
• Banking: Depository institutions, such as commercial banks- (savings and
loan associations, and credit unions.): heavily regulated by governments to
protect consumers and ensure that the banking system is stable.
Regulated by Banking and regulation act- 1949; need to have a Banking
licence from RBI
NBFCs- Contractual savings institutions such as insurance companies,
finance companies, pension funds, mutual funds, and investment banks
 Provide Special Financial services such as lending, insurance, and
investment banking but that are not regulated as banks.
They raise money by selling securities or borrowing money. They just
need to have a Certificate of registration from RBI
Financial markets
• Financial markets refer broadly to any marketplace where securities
trading occurs, including the stock market, bond market, forex
market, and derivatives market.- regulated exchanges or trade over-
the-counter (OTC).
• SEBI is the regulator
• Our everyday life is surrounded with these institutions and thereby
has a significant bearing on our lives and the economy- business
cycles- credit
Advantages of having Financial
Intermediaries
Financial intermediaries can alleviate the problem of

• Asymmetric information about credit worthiness possibility of

default
• Adverse selection- Borrowers with higher default risks may
disproportionately seek loans and get the loan
• Moral hazard- borrowers may take actions that increase the
likelihood of default:
 Financial market: types and instruments

• Primary: Market in which new issues of a security, such as a bond or a

stock, are sold
• Secondary: in which securities that have been previously issued (and are
thus secondhand) can be resold.
Secondary markets can be organized in two ways: Exchanges (NSE)-
through brokers (zeroda) and over-the-counter (unlisted companies)-
agents e.g- U.S. government bond

• Money market and capital market- Another way of distinguishing between

markets is on the basis of the maturity (benchmark 1 year) of the securities
traded in each market.
Forex market
• Use case: funds to be transferred from one country to another and
forex market is the conversion place.
• A place where exchange rate is determined,
• Affect different economic entities: For example- a weaker rupee
leads to more expensive foreign goods, makes vacationing abroad
more expensive, and raises the cost of indulging your desire for
imported goods and services> increase their consumption of
domestic goods. Chinese manufacturing and exchange rate
• Internationalization of financial markets- removal of capital control
and search for returns and diversification of investments
 Macroeconomic Indicators

Learning goals!

• Will understand GDP as a key indicator of economic health,

its calculation, components, and interpretation.

• We'll also examine limitations and other economic indicators

to provide a comprehensive understanding of economic
activity.

• Focus would be on: Economic Growth, Money Supply,

Inflation and Interest Rates.
What is GDP? And methods to calculate
• Gross Domestic Product (GDP) Current market price of all final goods and services (newly
produced) within a fixed period.

Key Attribute: Flow variable - measures activity over time.

Brief History and need

Simon Kuznets- 1930- national income accounting: 1971 nobel

Used for public information and policy formulation- data in great depression and great
recession

Methods (conceptually from Circular flow income)-

Product method-
Expenditure method
Income method
Expenditure method
• Current spending on all final goods and services
• Y = C + I + G + Net-exports- idea about different components of
GDP, most fundamental equation in Macroeconomics
• Consumption: durable, non-durable and services- largest
component
• Investment: Spending on currently produced capital goods-
fixed, inventory investment, and residential investment
(Purchase of new homes and apartments)- very volatile-
business cycles
• Government expenditure- central, state and local- short and
long-term- transfer payments and interest payments not
included
• Net-exports-
Income Approach
• Factor income- employee compensation: salaries
• Other income- rental, self employment, net-interest
income
• Corporate profits
• Depreciation- net income> Gross Domestic Income +
net factor income> GNI
• GNP and GDP- foreign element
• Personal disposable income- Factoring taxes and
transfer payments
 Rules of computing GDP:
inclusions, exclusions and limitations
• Non-market/black- illegal and tax evasion, meals cooked at
home
• Imputed value is included (housing services, police service)
• Non- perfect measure of non-marketable- national defence,
public administration.
• Value added method- to avoid double counting.
• GDP and happiness- debatable- 1972-spiritual and culture.-
1990s-HDI: Life expectancy, education, and gdp
• Additional- Freedom, safety, environment
• Isn’t it true that GDP includes government production of
bombs and missiles along with salaries paid to prison guards?
• Doesn’t an increase in crime boost sales of home alarms,
which adds to the GDP?
Real VS Nominal GDP
• Nominal GDP is measured in actual market price and Real GDP is
calculated in constant or invariant prices

• Refine GDP to separate the nominal component from real one (eco.
Activity)
• Need- this is the proxy that policymakers use
• Nominal – measured in current prices, can’t provide an accurate
information about economic activity.
• Real variables- measurement of an economic variable in terms of
quantities of actual goods and services. Measured in constant price-base
year.
• Nominal GDP = Real GDP*price level (proxy for inflation)
• Growth rate =
India’s real GDP per capita and Nifty index trend from 1960 and
2000 respectively
GDP per capita
3000

2500

2000

1500

1000

500

0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20
Inflation
• Have you noticed how cost of lunch
have increased over the years? –
Inflation
• Inflation is the tendency of the general
prices to increase over time, eroding
purchasing power.
• What happens to your savings if
inflation is high but your returns on
investments are low?
Measuring Inflation
• GDP deflator (or GDP price index) = nominal GDP in current year/real GDP in current year-
all goods and services produced
• CPI (Consumer Price Index) - cost of living index= nominal expenditure on goods and
services/real expenditure on goods and services*100. Core inflation (CPI-food and energy)
and Head line
• Personal Inflation- conceptually similar (at personal level)
• PPI- or WPI (Wholesale Price Index): at input level

Are these indices always valid? – what if there is improvement in quality (quality adjustment
bias), CPI and difference in consumption patterns;

• Inflation rate- Pt-Pt-1/pt-1= change in index/pt-1 (for policymakers- CPI is of their interest)
Measuring interest rates- cost of borrowing

Definition: The cost of borrowing money

There are many interest rates, depending upon the maturity, risk, tax status, and
other attributes of the loan.

• Prime rate- to prime borrowers (creditworthy)

• Federal funds rate- overnight loans between banks- used for monetary policy
setting
• Federal home lone mortgage rate: cost of financing residential mortgages
• Treasury bill rate- short-term govt bond- proxy for short-term interest rate
movements
• Ten-year Treasury bond rate- 10-year maturity-
Money and money supply
Learn!
• Why do we need to learn about money in the first place:
Monetary policy
Excess money supply may lead to inflation and shortage of it may cause
economic recession.

• Concept and Evolution of “money” from commodities to fiat and how is

it measured?
Money: Meaning, Functions and Role

• Conceptually, anything which is widely accepted in payment for goods or

in discharge of other kinds of business obligation, is called money
(Robertson).
• Crowther: anything that is generally acceptable as a means of exchange
(i.e., as a means of setting debts) and at the same time, acts as a measure
and a store of value.
• During World War II, cigarettes became a de facto currency for soldiers in
prisoner-of-war camps.
• Money eliminates the problem of bartering and double coincidence of
wants.
• Historically, the first forms of money were agricultural commodities, such
as grain or livestock and have been changing from standardized gold-
based, fiat to decentralized.
Everyone values fiat money because they expect everyone else to value it.
Money Supply Determinants
• Central bank: The Reserve Bank of India (RBI)- main source
• High power money (Monetary Base )- Money supplied by central
bank

• However, as a medium of exchange: second major source banking

system of the country- process of borrowing and lending
transactions with public (Credit creation)- credit money
• That means Fed’s policy, behavior of households (which hold
money) and banks (in which money is held) determine money
supply in a country

• M1(total money stock of a country)- high power money and the

credit money
Components of Money Supply in
India- As per third Working Group
• M0 (Reserve Money / High Powered Money): Currency in circulation (with the public + banks) +
Bankers' deposits with RBI + Other deposits with RBI

• M1 (Narrow Money): Currency with the public + Demand deposits with banks (like savings/current
accounts) + Other deposits with RBI

• M2 (M1 + Savings in Post Office Savings Banks):

• M3 (Broad Money, the most commonly used aggregate): M1+Time deposits with banks
(like fixed deposits)

Online data from RBI: Reserve Bank of India – Database

Business Cycle
• Definition: Alternative phases of expansion and
contraction in aggregate economic activity
• Co-movement among economic variables in
each phase of the cycle
• Economic variables- output, employment,
income, sales, inflation, corporate profits, taxes…
• Pro-cyclical-inflation, stocks and
• Countercyclical- unemployment, Short-term
interest rate and term Spread (Long-term
interest rate – Short-term interest rate)
• Understanding Business Cycle can also help you
make better financial decisions
US Real GDP growth, real GDP and
recessions
Unemployment rate, CPI and
recessions
 Phases of business cycle and role of
govt
• Expansion- rising real gdp, inflation, employment… trough to
peak.
Debtors are generally in a good financial condition to repay their
debts and creditors lend money at higher interest rates
• Peak- end of expansion and start of contraction.
• Contraction- fall in real gdp, employment
• Trough- end of contraction and start of expansion.
• Theories explaining business cycle- monetary factors and credit
system- rate of money growth has declined before every
recession but not every decline in the rate of money growth is
followed by a recession, innovation and product cycles.
• Role of govt in stabilizing the economy- in modern economies
Implication of business cycle for
personal finances and financial
strategies
• Impact on different macroeconomic variable on financial
assets- stocks, bonds, gold and personal finances
• Decisions related to personal finance are not taken in
isolation.
• For personal financial planner, it is important to
understand the causes of business cycles, an idea about
the phase and its impact on portfolio so that the adverse
effects of recession could be minimized if not prevented
Monetary policy and its uses
Role of central banks (e.g., the Reserve Bank of India) in adjusting interest rates to manage inflation.

Inflation Targeting:
Many central banks set an explicit inflation target (e.g., 4% ± 2% in India). They adjust policies
to keep inflation within this range.

The three instruments of monetary policy

1) OMO: Buying or selling government securities to control the money supply:

• Selling Securities: Reduces liquidity, curbs spending, and controls inflation.
• Buying Securities: Increases liquidity, stimulates spending, and can increase
inflation.
2) Reserve Requirements (CRR, SLR…) and (3) Discount rate
The three instruments of monetary
policy
Fed controls the money supply indirectly by altering either the monetary
base or the reserve–deposit ratio
1) Open-market operations- purchase and sale of government bonds by
the Central bank through a broker. Most frequently used
2) Reserve requirements: Central bank’s (RBI) regulations that impose on
banks a minimum reserve–deposit ratio. For example, higher reserve–
deposit ratio lowers the money multiplier and the total money supply.
least frequently used
3) Discount rate: interest rate that the Fed charges when it makes loans
to banks. Sometimes banks find themselves with too few reserves to
meet reserve requirements
Goals of Macroeconomic Policy
(fiscal and monetary policy)
• Output:
• Achieve high levels of production.
• Promote rapid economic growth.
• Employment:
• Maintain high employment levels.
• Minimize involuntary unemployment.
• Stable Prices:
• Ensure price stability to avoid inflation or deflation.
Inflation rate and interest rates relationship:
Central banks and inflation targeting

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ce-inflation-and-growth/
Implications of inflation and interest
rate
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king.html

• Inflation and value of savings: can lead to inadequate savings and financial
instability. By factoring in inflation, individuals can ensure their financial goals
align with the realities of the changing economic landscape.
• Inflation and real returns (fixed returns): if you invest in a bond with a fixed
interest rate of 5%, but the inflation rate is 3%, your real return is only 2%.
• Investing in Stocks vs. Bonds (fixed or saving deposits) and Foreign exchange-
• Inflation and the economy: moderate and stable inflation rate is generally
desirable for the economy