ECON 248

Money & Banking

Dr. Anis Khayati

alkhayati@yahoo.com
Office: 2-84

Mishkin, F. (2010) adapted by Dr. 1

Anis Khayati
 Chapter 1
Why Study Money and Banking?

• This course is about money, banking, and financial

institutions and markets.

• We are going to study macroeconomics with a focus on

monetary issues of the economy.

• This chapter provides an overview of the topics that will

be covered in later chapters.

Mishkin, F. (2010) adapted by Dr. 2

Anis Khayati
 We study money, banking, and financial Markets?

• To examine the role of money in the economy.

• To examine how financial institutions such as

banks and insurance companies work.

• To examine how financial markets (such as bond,

stock and foreign exchange markets) work.

Mishkin, F. (2010) adapted by Dr. 3

Anis Khayati
Six Parts of the Financial System

1. Money: To pay for purchases and store wealth.

2. Financial Instruments (such as loans, stocks & bonds):To transfer

resources from savers to investors and to transfer risk to those best
equipped to bear it.

3. Financial Markets: (such as Bahrain Bourse): To buy and sell

financial instruments.

4. Financial Institutions (such as Banks): To provide access to

financial markets, collect information & provide services.

5. Regulatory Agencies: To provide oversight for financial system.

6. Central Banks (such as CBB): To monitor financial Institutions and

stabilize the economy.

Mishkin, F. (2010) adapted by Dr. 4

Anis Khayati
1. Money
• Money is defined as anything that is generally accepted in
payment for goods and services.

• Has changed from barter to gold/silver coins to paper

currency to electronic funds.

• Cash can be obtained from an ATM anywhere in the

world.

• Bills are paid and transactions are checked online.

• Monetary theory ties changes in the money supply to

changes in aggregate economic activity and the price
level.
Mishkin, F. (2010) adapted by Dr. 5
Anis Khayati
 Money & Business Cycles

• Evidence suggests that money plays an important role in

generating business cycles such as recessions
(unemployment) and expansions (inflation).

• Research shows that Recessions may be caused by

steep declines in the growth rate of money supply.

• Business Cycle: the upward and downward movement of

the aggregate output produced in the economy.

• Recession: Periods of declining aggregate output.

• Expansion: periods of higher aggregate output.

Mishkin, F. (2010) adapted by Dr. 6

Anis Khayati
FIGURE 1: Money Growth (M2 Annual Rate) and the Business Cycle
in the United States, 1950–2008.

Mishkin, F. (2010) adapted by Dr. 7

Anis Khayati
 Money & Inflation

• There is a strong positive association between inflation

and growth rate of money over long periods of time.

• A sharp increase in the growth of the money supply is

likely followed by an increase in the inflation rate.

• Inflation: Continual increase in the ‘aggregate’ price level

• ‘aggregate’ price level: The average price of goods and

services in an economy.

Mishkin, F. (2010) adapted by Dr. 8

Anis Khayati
FIGURE 2: An increase in the growth of the money supply leads to an
increase in the inflation rate.

Mishkin, F. (2010) adapted by Dr. 9

Anis Khayati
FIGURE 3: An increase in the growth of the money supply leads to an
increase in the inflation rate.

Mishkin, F. (2010) adapted by Dr. 10

Anis Khayati
2.Financial Institutions (Banks)
Financial Intermediaries:
• institutions that borrow funds from people who have saved and make
loans to other people.
• they help individuals to earn a safe return on their money with less risk
involved.

• Financial intermediaries are:

– Banks: accept deposits and make loans, Banks make the monetary
system a lot more efficient by reducing our need to carry a lot of cash.
People have tended to use checks instead of cash for large purchases
and bills.

– Other Financial Institutions: insurance companies, finance companies,

pension funds, mutual funds and investment banks.

Mishkin, F. (2010) adapted by Dr. 11

Anis Khayati
 Financial Innovation
• Innovations in banking such as debit cards, direct
deposit, and automatic bill-paying reduce that
inconvenience even further, and also reduce such bank-
related inconveniences of time spent standing in line at
the bank, writing checks, or visiting the ATM.

• Financial innovation refers to technological advances,

which facilitate access to information, trading and means
of payment, and to the:

(1) emergence of new financial instruments and services,

(2) new forms of organization and,
(3) more developed and complete financial markets.

Mishkin, F. (2010) adapted by Dr. 12

Anis Khayati
• To be successful, financial innovation must either reduce
costs and risks or provide an improved service that meets
the particular needs of financial system participants.

• An example of financial innovations is e.finance.

• E-finance is a delivery of financial services electronically

• Banks are important to the study of money and the

economy because they have been a source of rapid
financial innovation.

Mishkin, F. (2010) adapted by Dr. 13

Anis Khayati
3. Financial Instruments

• Financial instruments or “Securities” are traded in

financial markets.

• A security is a claim on the issuer’s future income or

assets e.g., stocks, bonds.

• A bank loan is also a financial instrument.

Mishkin, F. (2010) adapted by Dr. 14

Anis Khayati
4. Financial Markets

Financial markets “Markets” in which funds are transferred

from people who have an excess of available funds to
people who have a shortage of funds.

A markets are mechanisms (or arrangements) that allows

people to easily buy and sell (trade) financial securities
(such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of
value at low transaction costs and at prices that reflect;

e.g., Bahrain Stock Exchange, New York Stock Exchange,

U.S. Treasury's online auction site for its bonds.

Mishkin, F. (2010) adapted by Dr. 15

Anis Khayati
 Financial Markets (cont…)

• Financial markets such as stock market and bond market

are essential because:

1. They promote greater economic efficiency by channeling

funds from who do not have productive use of fund
(savers) to those who do (investors).

2. Activities in financial markets may increase or decrease

personal wealth. While well-functioning financial markets
promote growth, poorly performing financial markets can
be the cause of poverty .

3. Activities in financial markets affect business cycle.

Mishkin, F. (2010) adapted by Dr. 16
Anis Khayati
The Bond Market
• A bond is a debt security that promises to make payments periodically
for a specified period of time.

• An interest rate (the cost of borrowing funds) is determined in the bond

market and has an significant impact on the economy.

- A decline in interest rate may cause consumption and investment to increase;

e.g. expenditure on housing or automobiles may rise.

- An increase in interest rates might encourage consumers to save more

because more can be earned in interest income but discourage investors from
taking loans. Thus, consumption and investment would decrease.

• The bond markets are important because they are the markets where
interest rates are determined .

Mishkin, F. (2010) adapted by Dr. 17

Anis Khayati
FIGURE 4: Rate of money growth is an important determinant of
interest rates

Mishkin, F. (2010) adapted by Dr. 18

Anis Khayati
 The Stock Market
• Common stock represents a share of ownership in a corporation.

• A share of stock is a claim on the earnings and assets of the

corporation.

• Stock Markets are important because:

– Stocks are part of individuals’ wealth, and changes in their value affect
people's willingness to spend.

– Changes in stock prices affect a firm's ability to raise funds, and thus
their ability to finance their investment spending.

• Fear of a major recession causes stock prices to fall, everything

else held constant, which in turn causes consumer spending to
decrease

Mishkin, F. (2010) adapted by Dr. 19

Anis Khayati
5. Government regulatory agencies

– Introduced after the Great Depression.

– Provide wide-ranging financial regulation – rules and

supervision.

– A government examiner looks at the systems a bank uses

to manage its risk.

– The 2007-2009 financial crises has led governments to

consider greater regulation.

Mishkin, F. (2010) adapted by Dr. 20

Anis Khayati
6. Central banks

• A central bank is a governmental body that regulates

financial institutions, controls the supply of money and
credit in the economy, handles the government's
finances, and serves as the bank to commercial banks.

• Commercial banks deposit some of their reserves at the

central bank, and the central bank is the "lender of last
resort" to commercial banks in times of crisis.

• The central bank of Bahrain serves as the federal

regulatory agency to oversee the health of the financial
system.

Mishkin, F. (2010) adapted by Dr. 21

Anis Khayati
• Monetary theory relates changes in the quantity of money to changes
in aggregate economic activity and the price level.

• Monetary policy is the management of the money supply and interest

rates and is conducted by a nation's central bank.

• Fiscal policy involves decisions about government spending and

taxation.

• Budget deficit is the excess of expenditures over revenues for a

particular year.

• Budget surplus is the excess of revenues over expenditures for a

particular year.

• Any deficit must be financed by borrowing

• Budgets deficits can be a concern because deficits can result in
higher rates of monetary growth and they might ultimately lead to
higher inflation.
Mishkin, F. (2010) adapted by Dr. 22
Anis Khayati
 The Foreign Exchange Market
• A market where funds are converted from one currency into
another.

• The price of one currency in terms of another currency is

called the foreign exchange rate which is determined in the
foreign exchange market.

Example: If the price of a euro increases from BD (0.518) to BD

(0.618) (a weaker BD), then..

– a trip to Europe becomes more expensive for Bahrainis.

– the Bahrain’s exports to Europe will be cheaper, and so Europeans

will buy more of them (Businessman better off).The European products
(e.g., Cars) will be costly for Bahrainis (consumer worse off).

Mishkin, F. (2010) adapted by Dr. 23

Anis Khayati
 International Finance
• Financial markets have become increasingly integrated
throughout the world.

• The international financial system has tremendous impact

on domestic economies:

– How a country’s choice of exchange rate policy

effect its monetary policy?

– How capital controls impact domestic financial

systems and therefore the performance of the
economy?

– What should be the role of international financial

institutions like the IMF?

Mishkin, F. (2010) adapted by Dr. 24

Anis Khayati