Chapter 1 & 2

The Economics of Money, Banking, and
Financial Markets
Eighth Canadian Edition
Chapter 1
Why Study Money, Banking,
and Financial Markets?
Copyright © 2023 Pearson Canada Inc. 1-1

Learning Objectives
1. Why study financial markets?
2. Why study financial institutions and banking?
3. Why study money and monetary policy?
4. Why study international finance?
5. How will we study all of these areas?

Why Study Financial Markets?
• Financial Markets: channel funds from those who
do not have a productive use for them to those
that do
• It directly affects our lives, businesses, and
economy
• To learn about bond markets, interest rates, and
stock markets

Flows of Funds Through the Financial System

The Bond Market and Interest Rates
• A security (or a financial instrument) is a claim on
the issuer’s future income or assets
• A bond is a debt security that promises to make
payments periodically for a specified period of
time
• An interest rate is the cost of borrowing, or the
price paid for the rental of funds
– Usually expressed as a percent
– 4% interest on $100 means you must repay $104 when
due
Treasury Bills (T-bills)
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Treasury Bonds

Treasury Bills (T-bills)
 Short-term federal government bonds that provide
no interest, but sold at a discount.
 For example,
 A T-bill with $100 face value was sold at the
following price:
1. $90,
2. $80,
3. $50

Pre-pandemic Canada T-bills (1-year) Rates

Canada Savings Bonds

Interest Rates on Selected Bonds

The Stock Market
• A stock is a share of ownership in a corporation
– Gives claim to the corporation’s earnings and assets
• A stock market is where stocks are bought and
sold
• The value of stocks reflects the current value of a
company, and expectations of future earnings
growth
– Big swings in share price are often major news stories

Stock Prices

Cryptocurrency Crash 2022

Short-selling
Selling short implies establishing a market position by
selling a security one does not own.

The Economics of Money, Banking, and
Financial Markets
Sixth Canadian Edition
Chapter 2
An Overview of the Financial
System

Financial System
Financial Markets, for The bonds market

example The stock market
Financial Institutions, for Commercial banks

example Investment banks
Financial Instruments, Stocks, bonds, checks,

for example and derivatives…

Why Study Financial Institutions and
Banking?
• They play a crucial role in the economy
• Banks and other financial institutions are what
make financial markets work
• In short: they are the entities that move funds from
people who save to people who have productive
investment opportunities

Financial Intermediaries(Institutions)
Institutions that borrow funds from people

who have saved and then make loans to
people who need funds
chartered banks, trust and

Banks: Borrow funds mortgage loan companies,
by accepting deposits and credit unions and
caisses populaires
Other Financial Institutions: insurance

companies, finance companies, pension
funds, mutual funds and investment banks

Flows of Funds Through the Financial System

Debt and Equity Markets
• Bonds - Debt instruments
– A contract between a borrower (who issues the bond)
and lender (who owns it)
– Regularly payments until Maturity (short-term, < 1 year,
intermediate-term, 1-10 years, and long-term, >10 years)
• Equity – Shares in a corporation
– Don’t have maturity dates
– Some make dividend payments
– Equity holders are residual claimants

Primary and Secondary Financial Markets
• Primary Market
– New security issues sold to initial buyers
– Not well known to public; typically private
– Investment banks guarantee prices (called
underwriting)
• Secondary Market
– Previously issued securities can be bought and sold
– Brokers match buyers and sellers with each other
– Dealers offer to buy and sell securities at stated prices

Exchanges and Over-the-Counter Markets
• Two main ways to organize a secondary market:
• Exchanges
– Buyers and sellers meet in one central location
– Toronto Stock Exchange for stocks
– ICE Futures Canada for commodities (wheat, oats)
• Over-the-Counter Markets (OTC)
– Dealers have inventory, ready to buy/sell at stated prices
– Many stocks are traded OTC, but most are on
exchanges
– Canadian government bond market is an OTC market
Money and Capital Markets
• Distinguish markets by maturity of the securities
• Money Markets
– Only short-term debt instruments are traded (<1 year)
– Corporations and banks actively use money markets to
each interest on temporary surplus funds
• Capital Markets
– Market for longer-term debt (>1 year)
• Money markets are more liquid than capital
markets
Money Market Instruments
• Government of Canada Treasury Bills
• Certificates of Deposit
• Commercial Paper
• Repurchase Agreements
• Overnight Funds

Capital Market Instruments
• Stocks
• Mortgages and mortgage-backed securities
• Corporate bonds
• Government of Canada bonds
• Canada Savings bonds
• Provincial and municipal government bonds
• Government agency securities
• Consumer and bank commercial loans
Financial Intermediaries: Indirect Finance
(1 of 2)
• Financial Intermediation
– Indirect financing using financial intermediates (banks)
– Primary route to move funds from lenders to borrowers
– Four main roles of financial intermediates
1. Lowers Transaction Costs
– Economies of scale
– Economies of scope
– Liquidity services

Financial Intermediaries: Indirect Finance
(2 of 2)
2. Improves Risk Sharing

– Asset transformation
– Diversification
3. Help solve Asymmetric Information problems
– Adverse Selection: Potential borrows who are more
likely to default are the ones who most actively seek
out loans
– Moral Hazard: Borrowers might engage in activities
that are undesirable from a lender’s point of view
– Financial intermediates can screen and monitor
borrowers
Types of Financial Intermediaries
• Depository Institutions
– Chartered Banks, Trusts and Mortgage Loan
Companies, Credit Unions and Caisses Populaires
• Contractual Savings Institutions
– Life Insurance Companies, Property and Casual
Insurance Companies, Pension Funds and Retirement
Funds
• Investment Intermediaries
– Finance Companies, Mutual Funds, Money Market
Mutual Funds, Hedge Funds, Investment Banks

Financial Innovation
• Innovation in financial markets is the development
of new financial products and services
– As with innovation in any sector, it is an important force
for good by making the financial system more efficient
• E-Finance: Delivering financial services
electronically
• Creative thinking by financial institutions can
improve efficiency, increase profits, but can also
sometimes result in financial disasters

FinTech
• Fintech stands for Financial technologies.
• It means technologies used and applied in the
financial system, including mobile payments,
money transfers, loans, fundraising, and asset
management.

The China Factor
• China has been at the forefront of fintech growth
and is the largest fintech market in the world. In
terms of investments, according to the Accenture
analysis, the value of fintech deals in China in
2018 was $25.5 billion.

P2P Lending

P2P Lending Crisis in China

Ponzi Scheme

Ponzi Pyramid Schemes

Regulation of Financial Markets
Primary Reasons for Regulation
1. Increase information available to investors
– Reduce adverse selection and moral hazard problems
– Increase efficiency of financial markets
2. Ensure soundness of financial intermediaries
– Restrictions on entry and competition, reporting
requirements, and restrictions on assets and activities
– Deposit insurance

Principal Regulatory Agencies of the
Canadian Financial System (1 of 2)
Table 2-5 Principal Regulatory Agencies of the Canadian
Financial System
Regulatory Agency Subject of Regulation Nature of Regulations
Provincial securities and Organized exchanges and Requires disclosure of information and restricts
exchange commissions financial markets insider trading
Bank of Canada Chartered banks, TMLs, and Examines the books of the deposit taking institutions
CUCPs and coordinates with the federal agencies that are
responsible for financial institution regulation: OSFI
and CDIC
Office of the All federally regulated chartered Sets capital adequacy, accounting, and board-of-
Superintendent of Financial banks, TMLs, CUCPs, life directors responsibility standards; conducts bank
Institutions Canada (OSFI) insurance companies, P&C audits and coordinates with provincial securities
insurance companies, and commissions
pension plans
Canada Deposit Insurance Chartered banks, TMLs, Provides insurance of up to $100 000 for each
Corporation (CDIC) CUCPs depositor at a bank, examines the books of insured
banks, and imposes restrictions on assets they can
hold

Principal Regulatory Agencies of the
Canadian Financial System (2 of 2)
[Table 2-5 Continued]
Regulatory Agency Subject of Regulation Nature of Regulations

Québec Deposit Insurance TMLs and credit cooperatives in Similar role to the CDIC
Board Québec
Canadian Life and Health Life insurance companies Compensates policyholders if the issuing life
Insurance Compensation insurance company goes bankrupt
Corporation (CompCorp)
P&C Insurance Property and casualty insurance Compensates policyholders if the issuing P&C
Compensation Corporation companies insurance company goes bankrupt
(PACIC)

Exploring the Web
• Statistics Canada: CANSIM database
• Federal Reserve Bank of St. Louis: FRED
database
• Bank of Canada website
• Myeconlab: first homework will be assigned this
weekend.
• Economics-games.com

John Maynard Keynes

THE 2/3 GUESSSING GAME (THE
BEAUTY CONTEST GAME)

Rules of the Game
• Each player will be asked to pick an integer between 0 and 100,
inclusive.
• The winner will be the participant whose number is closest to two-
third of the average of all chosen numbers.
• The winner will receive 100 points, while other participants will
receive nothing.
• In case of a tie, the 100 points will be equally divided between
winners.

Rules of the
Game
• Guessing Game
– Who is playing?
– What are they playing with;
i.e., strategies?
– When does each player get
to play?
– How much is the gain (or
loss)?
– What information does each
player know?
• How much are the players in a

game supposed to know about
the rules?
Chapter 2
60

Online Game to Play…..
• Economics-games.com
• Click on the login button on the top right corner
• User ID for the left: _i, where i is the number I assigned to you or
your group earlier.
• User ID for the right: _i, where i is the number I assigned to you or
your group earlier.
• Password: pass

THE GUESSING GAME REVISITED

Why?
• Bounded rationality
– People do not naturally use deep levels of strategic
thinking. They just think 2-3 steps ahead
• Players may be fully rational, however if a player
believes that all other players will say a bigger
number, that player will declare 2/3 of the bigger
number.
– Stock market bubbles

Chapter 1 &amp; 2

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The Economics of Money, Banking, and

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Financial Markets, for The bonds market

Financial Institutions, for Commercial banks

Financial Instruments, Stocks, bonds, checks,

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Institutions that borrow funds from people

chartered banks, trust and

Other Financial Institutions: insurance

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2. Improves Risk Sharing

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Regulatory Agency Subject of Regulation Nature of Regulations

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• How much are the players in a

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