Study Guide

Topics: Inflation, Economics, Foreign exchange market Pages: 29 (8383 words) Published: June 11, 2013
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Why Study Money, Banking, and Financial Markets?

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n the evening news you have just heard that the Federal Reserve is raising the federal funds rate by 1 of a percentage point. What effect might this have on the 2 interest rate of an automobile loan when you finance your purchase of a sleek new sports car? Does it mean that a house will be more or less affordable in the future? Will it make it easier or harder for you to get a job next year? This book provides answers to these and other questions by examining how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work and by exploring the role of money in the economy. Financial markets and institutions not only affect your everyday life but also involve flows of trillions of dollars of funds throughout our economy, which in turn affect business profits, the production of goods and services, and even the economic well-being of countries other than the United States. What happens to financial markets, financial institutions, and money is of great concern to politicians and can even have a major impact on elections. The study of money, banking, and financial markets will reward you with an understanding of many exciting issues. In this chapter, we provide a road map of the book by outlining these issues and exploring why they are worth studying.

WHY STUDY FINANCIAL MARKETS?
Part 2 of this book focuses on financial markets, 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 crucial 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, and poorly performing financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy.

The Bond Market and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make payments periodically for a specified period of 3

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PART 1

Introduction

Interest Rate (%) 20

15

Corporate Baa Bonds

10

U.S. Government Long-Term Bonds

5 Three-Month Treasury Bills 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

FIGURE 1

Interest Rates on Selected Bonds, 1950–2008
Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

time.1 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 (usually expressed as a percentage of the rental of $100 per year). There are many interest rates in the economy—mortgage interest rates, car loan rates, and interest rates on many different types of bonds. Interest rates are important on a number of levels. On a personal level, high interest rates could deter 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. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions. High interest rates, for example, might cause a...
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