Econ 111 – Monetary Economics

Summer Session I
Tue-Thu, 5:00PM – 7:50PM
Center Hall 216

Dr. Hisham Foad

 Why Take this Class?
• To understand how the financial markets like the bond and stock
markets work

• To articulate why these markets react so strongly to actions taken by

the central bank

• To evaluate the effectiveness of monetary policy in dealing with

economic shocks and inflation

• To analyze the effects of policy on interest rates and how different

interest rates affect different actors in the economy.

• To explain the role of money in the economy and the process by

which banks create money

• To understand how moral hazard and adverse selection in financial

markets led to the current credit crisis

• To evaluate how domestic policy affects exchange rates and capital

flows abroad.
 The Economy
Income Market for Factor Payments
Factors

Labor, Land, and Labor, Land, and

Capital for Sale Capital Purchased

Households
Firms

Goods and
Services
Purchased Goods and
Services for Sale

Consumption Market for Firm Revenue

Goods and
Services
 The Economy
Income Market for Factor Payments
Factors

Private
Savings Financial Interest
Markets
Loans
Interest Public
Savings
Households
Firms
Transfers Transfers
Government
Taxes Taxes

Government
Spending

Consumption Market for Firm Revenue

Goods and
Services
 Features of Financial Markets
• A financial market is any market that matches borrowers and
lenders
– A borrower is anyone who is trading future income in exchange for
current consumption
– A lender is anyone trading current consumption for future income.

• Generally, lenders must be compensated for giving up current

consumption.
• This compensation is represented by the interest rate paid on a loan

• There are many different interest rates in the economy

– Differences due to the length of loans, the risk involved in a loan, and
the tax treatment of interest payments
– Generally, however, all interest rates tend to move in the same
direction.
Three Different Interest Rates
 Stocks vs. Bonds
• Two broad categories of financial markets are the stock and bond
markets
– A stock is an equity security that represents a share of ownership in a
corporation. Ownership of a stock entitles you to a fraction of that
corporations earnings and assets.
– A bond is a debt security in which a loan is paid back to the lender with
specified payments over a specified period of time.

– Both bonds and stocks may be traded in secondary markets (e.g. the
NYSE or the LSE for stocks; various computerized exchanges for
bonds), although the entity first issuing the stocks or bonds does not
receive any additional financing from these trades.

• In general, stock returns are more volatile than bond returns.

– Stocks are effectively loans with no maturity dates.
– Equity holders are residual claimants – corporations must pay off all
debt holders first in the face of bankruptcy
DJIA, 1950-2005
 Monthly Interest Rate/Return

-15
-10
-5
0
5
10
2/1/1999 15

6/1/1999

10/1/1999

2/1/2000

6/1/2000

10/1/2000

2/1/2001

6/1/2001

10/1/2001

2/1/2002

6/1/2002

10/1/2002

2/1/2003

6/1/2003

10/1/2003

2/1/2004

6/1/2004

10/1/2004

2/1/2005

6/1/2005

10/1/2005

2/1/2006

6/1/2006
the 10 year T-bill

10/1/2006

2/1/2007
S&P 500 Monthly Return

6/1/2007
Monthly Interest Rate on

10/1/2007
Monthly Interest Rates vs. Monthly Stock Returns

2/1/2008
 Why Save? Why Borrow?
• What motivates someone to save?
– Generally, we would prefer consumption today over consumption next
year
– However, we would also like to maintain a stable level of consumption
over our lifetimes
– We do this by saving when income is high then borrowing when income
is low.
– Saving can insulate consumption from income fluctuations

• What motivates someone to borrow?

– Since savers will demand positive interest on loans, borrowing money
today implies that you will have more to pay back in the future.
– When will you be willing to do this? When the return on your borrowing
exceeds the amount you have to pay back.
– Ex: You want to borrow $100,000 to open a restaurant that you think
will generate $110,000 in profits next year.
• Would you be willing to borrow at a 5% interest rate?
• Would you be willing to borrow at a 12% interest rate?
 The Importance of Financial Intermediaries
• In reality, borrowers and lenders cannot costlessly find one another
– Borrowers would like to shop around for the best interest rate and may
have a hard time directly finding a lender with enough liquidity for their
needs
– Lenders have to expend resources assessing the risk of borrowers

• Financial intermediaries like banks and mutual funds reduce search

costs by acting as central clearinghouses where borrowers and
lenders indirectly interact
• They can overcome the large fixed costs of risk assessments by
dealing in a large volume of loans
• By making many different loans, they are better diversified against
risk

• However, banks are subject to agency problems in which the

managers of the bank may act to better their own interests at the
expense of the banks creditors and debtors.
 Some Quotes on Money
• "It is well that the people of the nation do not understand
our banking and monetary system, for if they did, I
believe there would be a revolution before tomorrow
morning.”
– Henry Ford

• “The process by which banks create money is so simple

that the mind is repelled.”
• “Money differs from an automobile or mistress in being
equally important to those who have it and those who do
not.”
– John Kenneth Galbraith

• “It’s a kind of spiritual snobbery that makes people think

they can be happy without money.”
– Albert Camus
 The Monetary System
• Money is defined as the set of assets in an
economy that can be readily used to purchase
goods and services

• Money must serve three functions

– Medium of Exchange
– Unit of Account
– Store of Value

• Without money, economic exchange would be

conducted through straight barter
– Requires a Double Coincidence of Wants, which
would greatly limit trade.
Effectively the Same Thing!
 The Evolution of the Monetary System
1. Commodity Money
Commodity Money takes the form of or is backed by a commodity that
has intrinsic value. Examples include gold/silver coins, paper currency
backed by gold, or even cigarettes in prisons.

2. Fiat Money
Fiat money has no intrinsic value and is made viable solely by
government decree. It is not backed by any commodity and only the
collective belief in the government’s stability keeps the monetary system
in operation.

3. Checks
Checks are used to conduct payments within the banking system. Often
payments cancel each other out, reducing the need for physical transfer
of money across locations.

4. Electronic Payments
Since the checks themselves still need to be physically sent and
received, e-payments developed as a means to instantly instruct banks
to make payments.

5. E-Money
Debit cards, gift cards, pre-paid cards, PayPal.
 The Central Bank
• Under a fiat money system, one institution controls
the supply of money in the economy, known as the
Central Bank

• In the U.S., the central bank is called the Federal

Reserve System.
– They are the sole issuers of paper currency and regulate
the private banking system.
– Through several policy tools, the Fed can greatly influence
the supply of money circulating throughout the economy
– Through these actions, the Fed may also influence such
economic variables as the inflation rate, interest rates,
rates of savings, stock market aggregates, exchange
rates, and even unemployment.
 What’s in Money?

More than $2,000 in currency

per person in the US!
 Money and Exchange Rates
• With an increasingly globalized economy, we need
to consider the effects of domestic policy abroad
and the effects of international policy at home

– Why has the dollar been declining in value against the

euro?

– Why has the declining value of the dollar contributed to

higher oil prices?

– Why has the weak dollar helped mitigate the drop in US

housing values but hurt European automakers?