Part – I : Introduction

Chapter 1: Why Study Financial

Markets and Institutions?
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Recapitulation of the Last Class on 21st
August, 2020

• Why Study Financial Markets and Institutions?

– Debt Market and Interest rates
– The Stock Market
• Importance of interest rate in financial market
• Fluctuations and trend of interest rate
• Relationship between interest rate and economic growth
• Stock market trends and economic growth in India
• Supply leading and demand following hypothesis.

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Why Study Financial Markets
and Institutions?
Why Study Financial Markets?
– Debt Market and Interest rates
– The Stock Market
– The Foreign Exchange market

• The Foreign exchange market is more volatile than the

Stock market.
• The causes of these volatility are many domestic and
international factors.

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Why Study Financial Markets and Institutions?
The Foreign Exchange Market
• What have these fluctuations in exchange rate mean to
the public and business?
• A change in the exchange rate have a direct effect on
the consumer as it affect the cost of imports.
• When rupee depreciates, Indian consumer purchase
from foreign countries reduces, purchases of domestic
produced goods increases and various other direct
effects.
• Conversely, a strong rupee (rupee appreciation) means
exports reduces (as foreign consumer purchase from
India reduces) and hurts Indian business, reduces
production and employment.

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Trend in Exchange rate wit US
Dollar (2003 to 2020)

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Trend in Exchange rate wit US
Dollar (2003 to 2020)

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Trend in Exchange rate wit US
Dollar (Last 5 Years)

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Why Study Financial Markets and Institutions?
The Foreign Exchange Market
• The above figures states that rupee has depreciated
over these years with volatility.
• When rupee depreciates, it is expected that export
increases due to more demand from foreigners (foreign
imports increases) and hence export leading hypothesis
proved.
• When we look at the economic growth of India in past
decades, it is supporting the hypothesis at large.
• But both producer and consumer are not happy in the
short run.

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Why Study Financial Markets and Institutions?
The Foreign Exchange Market
• But when rupee appreciates, Indian imports for foreign
goods become cheaper.
• Hence, parts and raw materials imports for the business
become affordable.
• Production of goods increases and possibly cost of
production decreases and hence price should become
cheaper ceteris paribus.
• In the long run both producer and consumer become
happy.
• As the foreign exchange market is becoming popular both
for Academics and financial investors, we will study this in
details in chapter 14 and 15

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Why Study Financial Markets and Institutions?
Financial Institutions
• The second major focus of the course in Financial
Institutions.
• Financial institutions are what make financial markets
work.
• Without them, financial markets would not able to move
such a huge amount of funds from people who save to
people who have productive investment opportunities.
• Thus they play a crucial role in improving the productivity
and efficiency of the economy.

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Why Study Financial Markets and Institutions?
Financial Institutions
• What we are dealing is the subject matter of Financial
Economics which studies;
1. Money and Banking
2. Financial Markets and Institutions
3. Monetary System

• Hence, Financial Economics studies The financial

System.

• What is Financial System?

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Why Study Financial Markets and Institutions?
Financial Institutions

• Financial System includes:

1. Financial Institutions (Banks: Commercial Banks,
Central Bank, Investment Banks, Insurance companies)
2. Financial Markets (Stock Market)
3. Financial Instruments/ Financial Assets

• Financial Economics deals with how financial system

affects the economy (macro economy).

• What is all about Macro Economy?

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Why Study Financial Markets and Institutions?
Financial Institutions
• We are going to study how Financial Institutions affect
the macroeconomic variables / system.
 They includes;
• GDP (Output)
• Employment (Jobs)
• Wages (salary)
• Government Expenditures and Taxes
• Imports and Exports
• Interest rates

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Structure of the Financial
System
– The financial system is complex comprising with
many different types of institutions.
– All are heavily regulated by the Government.
– Financial intermediaries are connecting institution
between savers and investors.
– Why are financial intermediaries are so crucial?
– Why do they give credit to one party and not to
others?
– Why do they have complicated legal documents?
– Why are they so heavily regulated?

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Financial Institutions

• Financial institutions (intermediaries) that borrow funds

from people who have saved and make loans to other
people
• Banks—institutions that accept deposits and make
loans.
• Many Indian keep their savings in the form of saving
account and other types of bank deposits.
• Because banks are largest financial intermediaries in the
country, then deserve careful study.

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Financial Institutions

• However, Banks are not only important financial

institutions.
• Indeed, in recent years, other financial institutions such
as insurance companies, financial companies, pension
funds,, mutual funds and investment banks have been
growing at the equal speed.
• Hence, they also needs careful study. We will study both
banks and other financial institutions in part 6 and 7 of
the book.

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Monetary System

• Money referred as money supply is defined as anything that

is generally accepted as medium of exchange or means of
payment.
• Money is linked to changes in economic variables that effects
all of us and are important to the health of the economy.
• Evidence suggests that money
plays an important role in generating
business cycles
• Recessions (unemployment) and booms (inflation) affect all
of us
• Monetary Theory ties changes in the money supply to
changes in aggregate economic activity and the price level

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Money growth and business
cycle

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GDP and Inflation

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Money and Inflation

• The aggregate price level is the

average price of goods and services in an economy
• A continual rise in the price level (inflation) affects all
economic players
• Data shows a connection between the money supply
and the price level

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Macroeconomic Variables
interrelationships
• Interest rates are the price of money
• Prior to 1980, the rate of money growth and the interest
rate on long-term Treasure bonds were closely tied
• Since then, the relationship is less clear but still an
important determinant of interest rates

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Macroeconomic Variables
interrelationships

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What is the link between growth,
inflation and interest rates?
• In a fast-growing economy, incomes go up quickly and more
and more people have the money to buy the existing bunch
of goods. As more and more money chases the existing set
of goods, prices of such goods rise. In other words, inflation
(which is nothing but the rate of increase in prices) spikes.
• To contain inflation, a country’s central bank typically nudges
up the interest rates in the economy. By doing so, it
incentivizes people to spend less and save more because
saving becomes more profitable as interest rates go up. As
more and more people choose to save, money is sucked out
of the market and inflation rate moderates.

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What happens when growth rate
decelerates or contracts?
• When growth contracts, as is happening in the current financial
year, or when its growth rate decelerates, as was happening
right through 2019, then typically, people’s incomes also get hit.
As a result, less and less money is chasing the same quantity of
goods. This results in either the inflation rate decelerating (that
is, prices grow at 1% instead of 5%; also called “disinflation”) or
it actually contracts (also called “deflation”; that is, prices
reduce by 1% instead of growing at 5%).
• In such situations, a central bank nudges down the interest
rates so as to incentivize spending and by that route boost
economic activity in the economy. Lower interest rates imply
that it is less profitable to keep one’s money in the bank or any
similar saving instrument. As a result, more and more money
comes into the market, thus boosting growth and inflation.

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