Chapter One

1. Chapter One Why Study Money, Banking, and Financial Markets ?

2. We study money because : • 1. Its growth rate may be a driving force behind inflation . • 2. Money plays an important role in generating the business cycle i.e. upward and downward movement of aggregate output in the economy 3. Money plays an important role in the fluctuation of interest rate . Therefore :

3. To see how money create inflation , we need to study the monetary policy . • Also, we will study the link between the money and the business cycle when we study the monetary policy . • Also, we will analyze the relationship between money and interest rate when we examine the behavior of interest rate . • In a later chapter, we will study how central bank can affect the quantity of money in the economy .

4. Why do we study Banking ? • Banks are important to our study of money in the economy because : • 1. They provide a channel for linking those who • wants to save with those who wants to invest. • 2. They play an important role in determining • the quantity of money in the economy. For this reason we will study how banks decide to make loans and how money supply is determined .

5. Why do we study financial markets ? • Financial Marketsare markets in which funds are transferred from people who have excess of available funds to people who have a shortage of funds . Examples Bond market or stock market. • These markets are important in channeling funds from people who do not have a productive use for them to those who do . This process results in greater efficiency .

6. Bond Market and interest rates • The Bond Market is important to economic activities because it enables corporations or governments to borrow to finance their activities • The interest rate is the cost of borrowing money or the price paid for the rental funds . • Interest rates have an impact on the overall health of the economy because they affect consumers willingness to spend or save and business investment decisions . Note : We will discuss the fluctuations in interest rate in chapters 4 through 6 .

7. The Stock Market • The Stock Market : Is the financial market where the shares of different corporations are traded . • Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities • Higher price for a firm’s shares means that it can raise a larger amount of funds which can be used to buy production facilities and equipment . • Note : in chapter 2 , we will examine the role of the stock market in the financial system .

8. 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 dollar ) into the currency of the country they are going to ( say euros ) . • The Foreign Exchange Market is where this conversion takes place . It is important because it moves funds between countries and it is the place where the foreign exchange rate is determined . In chapter 17 we will study how exchange rates are determined in the foreign exchange market .

9. Why Study Financial Markets ? • 1. Channels funds from savers toinvestors,thereby promoting economic efficiency. • 2. Affect personal wealth and behavior of business firms .

10. Why Study Financial Institutions and Banks ? • 1. Financial Intermediation helps get funds from savers to investors . • 2. Banks play an important role in the creation of Money . • 3. Financial Innovation .

11. Chapter 2 An Overview of the Financial System

12. Function of Financial Markets • Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds • Promotes economic efficiency by producing an efficient allocation of capital, which increases production • Directly improve the well-being of consumers by allowing them to time purchases better

13. Structure of Financial Markets • Debt and Equity Markets • Primary and Secondary Markets • Investment Banks underwrite securities in primary markets • Brokers and dealers work in secondary markets • Exchanges and Over-the-Counter (OTC) Markets • Money and Capital Markets • Money markets deal in short-term debt instruments • Capital markets deal in longer-term debt and equity instruments

14. Internationalization of Financial Markets • Foreign Bonds—sold in a foreign country and denominated in that country’s currency • Eurobond—bond denominated in a currency other than that of the country in which it is sold • Eurocurrencies—foreign currencies deposited in banks outside the home country • Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks • World Stock Markets

15. Function of Financial Intermediaries: Indirect Finance • Lower transaction costs • Economies of scale • Liquidity services • Reduce Risk • Risk Sharing (Asset Transformation) • Diversification • Asymmetric Information • Adverse Selection (before the transaction)—more likely to select risky borrower • Moral Hazard (after the transaction)—less likely borrower will repay loan

16. Function of Financial Markets • The basic function of financial market is to move the funds from those who have surplus funds ( Savers – Lenders) to those who have shortages of funds ( borrowers or spenders ) . • The fund can be transferred either through : 1. Direct Finance ( Financial Market ) 2. Indirect Finance (Financial Intermediaries)

17. Direct Finance • Borrowers borrow money directly from the lenders in the financial market by selling securities (Bonds).

18. Indirect Finance • Funds can move from lenders to borrowers by a second route through the financial intermediaries who borrow funds from the lenders-savers and then make loans to borrowers or spenders .

19. Structure of Financial Market • There are two ways a firm or an individual can obtain funds in the financial market . • 1. By issuing Debt Instruments ( Bonds ) • 2. By issuing Equity Instruments ( Common Stock )

20. Bonds • Pay fixed interest rate and has a maturity date . • Bonds, can be classified as : • 1. Short-Term Bonds: maturity less than one year • 2. Intermediate-Term Bond (maturity 1-10 years ) • 3. Long-Term Bond: maturity more than 10 years

21. Money Market • Financial Market in which only Short-Term Debt Instruments are traded . Such as : • U.S. Treasury bills • Negotiable bank certificates of deposit • Commercial Paper • Banker’s acceptance , etc.

23. Capital Market • Financial market in which Intermediate as well as Long-Term instruments are traded . • Example : • Corporate Stocks • Corporate Bonds • Government Bonds • Bank commercial loans . etc.

24. Primary Market • Is a financial market in which new issues of securities such as Bonds or Stocks are sold to initial buyers by corporation or government agency borrowing the funds .

26. Secondary Market • Is a financial market in which the securities that have been previously issued can be sold . • The secondary market can be divided into two types : 1. Organized Exchange Market 2. Over-the-counter (OTC) Market

27. Organized Exchange Market • Is a financial market where buyers and sellers of securities meet at one central location to conduct trade. Example : • New York Exchange Market . • Tokyo Exchange Market … etc.

28. Over-the-counter Market • Is a financial market where dealers at different locations buy and sell securities over the counter . Example : • The current financial market in Saudi Arabia .

29. Function of Financial Intermediaries • The Basic function of financial intermediaries is to move funds from lenders to borrowers through the indirect finance .

32. Types of Financial Intermediaries • 1. Depository Institutions such as Banks . • 2. Contractual Saving Institution such as Life Insurance Company . • 3. Investment Intermediaries such as Mutual Funds or Money Market Mutual Funds .

34. I. Depository Institutions • Example : • A. Commercial Banks . • B. Saving & Loan Associations . • C. Mutual Saving Banks . • D. Credit Union .

35. Commercial Banks • Raise Funds by issuing Deposits accounts Such as -Demand deposits - Saving Deposits - Time Deposits • And then use these funds to : - Make consumer loans - Make Business loans - and buy securities .

36. Saving & Loan Associations • Before 1980 they Raise Funds by making Saving deposits only • And use the funds to make Mortgage loans only . • Since 1980 they open all kinds of deposits • And make consumers & business loans and buy securities .

37. Mutual Saving Banks • Since 1980 they raise funds by opening all kinds of deposits and make consumers and business loans and buy securities . • The difference between Mutual Saving banks and Saving & Loans Association is that Mutual Saving banks function as mutual which means cooperation where depositors own the bank .

38. Credit Union • Raise Funds as deposits from the union’s members or employees of particular firm • And use the Fund to make consumer loans only to its members .

39. II. Contractual Savings Institutions • Example: • 1. Life Insurance Company . • 2. Pension Funds . • 3. Fire & Casualty Insurance companies . • They raise funds on a contractual basis and use these funds by investing them in Long-term securities such as corporate bonds and stocks .

40. III. Investment Intermediaries • Such as : • 1. Mutual Funds • 2. Money-Market Mutual Funds • 3. Finance Companies

41. Mutual Funds • Raise Funds by issuing shares to many individuals . • And use the Fundsto buy stocks and bonds of long-term securities

42. Money-Market Mutual Funds • Raise Funds by issuing shares to many individuals . • And use the Fund to buy money market instruments such as commercial papers, Treasury bills ,etc. that are both safe and very liquid .

43. Finance Companies • Raise Funds by selling commercial papers , stock, and bonds . • And use the Funds to make consumers and business loans .

44. CHAPTER 3 What is Money?

45. Definition of Money • Economists define money as : • “ Anything that is generally accepted in payment for goods or services or in the repayment of debts .

46. Barter Economy • Is an economy where one good is being exchanged directly for another good .

47. Wealth and Money • Wealth is much broader concept than money. It includes money plus all other assets owned by theindividual such as Bonds , Stock, Land, Furniture, Cars, Houses, etc.

48. Income VS. Money • Income is a Flow of earning per unit of time ( day, week, month, year, etc. ) . • Money is a Stock , i.e. certain amount at a given point in time .

49. Functions of Money • 1. Act as a medium of exchange . • 2. Act as a unit of Account . • 3. Act as a store of value .

50. 1. Money act as a medium of Exchange • This means that money is used to pay for goods and services. • Goods Money Goods • The use of money as a medium of exchange promotes economic efficiency by reducing the transaction cost .