Unit.1: Introduction to Money, Markets and Democracy
Defining Financial Markets
Types of Instruments
To define "financial markets", let's break that phrase down into its components. First, there's
"markets". What is a market? It's an arena in which buyers and sellers interact to trade goods and
services. Next, there's "financial", which refers to instruments such as currencies, bonds, money
market securities, stocks, derivatives, mutual funds, and hedge funds. Putting the two words
together, "financial markets" simply refers to the arena in which those instruments are bought
Function and Influence of Financial Markets
What are the role(s) of the financial markets?
What influences are there on financial markets?
Many people view financial markets as casinos where people bet on the future direction of stocks
and currencies. But while markets can be used to speculate, they dont chiefly exist to facilitate
gambling. Their role is to provide the following:
1. Bring savers/investors and managers/entrepreneurs together.
2. Risk management
3. Price discovery and dissemination
Financial markets have grown in influence over the last two decades. Financial markets used to
only be followed by a few and were relegated to the business pages. But things have definitely
changed. Financial markets are more prominent as we hear about them in magazines, on cable
TV channels and in everyday conversation.
Stock ownership has increased among the public and pension plans are more dependent on
stocks. Financial markets are increasingly replacing banks in deciding which businesses get
financing. Plus, they are a key mechanism by which corporations are held accountable to society.
Not only that, financial markets influence government policy.
The guiding question of the course is:
DO THE FINANCIAL MARKETS, IN ALL THEIR GROWING MIGHT, SERVE THE
Some say yes that financial markets serve the public interest as markets efficiently bring savers-
investors together with entrepreneurs-managers; they democratize ownership of resources and
keep governments accountable. Others say no. Naysayers claim the markets are irrational, create
economic turbulence, advantage corporate and the financial elites, and foster inequality. Understanding Money, Origins of Money and
the Barter System
To comprehend the markets, we must start by
analyzing money. After all, every financial
instrument is denominated in money. Plus,
financial instruments are nothing more than
claims on a set of cash flows.
The first thing to realize is how money was
invented. Out of a desire to increase productivity,
human beings adopted the division of labour. That is, people specialized in certain tasks, instead
of producing all the goods they desired on their own. Specialization led people to engage in
exchanges. If you fished all day, for example, youd want to trade your fish for some clothes.
Exchange initially was done through barter. Barter is the exchange of goods and services.
Surprising as it may seem, the barter system functioned well enough until economies grew more
Problems with Barter
There exist a number of problems with using the barter system. The problems include:
1. Double coincidence of wants dilemma it is hard to find someone who has what you
want and wants what you have. Say you had fish to trade and wanted meat. Now the
person selling meat would have to desire fish for you to make a trade. If the person
selling meat wants sugar, you wont be able to trade for meat.
2. Indivisibility dilemma it is hard to break up some goods into portions. For example:
imagine one-eighth (1/8) of a cow is worth one hat. Whod want 1/8 of a cow, unless
it was dead?
3. Perishability dilemma it is hard to accumulate a stock of commodities due to
spoilage, wear, and tear. If you specialize in oranges, then youd have to trade your
oranges within a limited space of time, otherwise theyd go bad and youd have
nothing to trade.
4. Portability dilemma it is hard to carry some commodities to market. If you
specialize in raising cows, it might be difficult to carry them around all the time to
5. Valuation dilemma it is hard to keep track what things are worth, there being no
consistent frame of reference. Imagine 1 cup is worth 3 newspapers, and 4 cups are
worth 12 pens. You have newspapers to trade and want pens. How many newspapers
do you need to get 2 pens? This takes some mental effort to figure out. But its
precisely the sort of mathematical problem one would constantly be faced in a barter
Invention and Definition of Money To facilitate trade, people agreed to consistently use a particular object as a medium of exchange.
Money can be defined as any class of objects that people agree to use as a mode of accepting
payment for goods and services. Today, money is government certified paper and coins. But,
money used to be cattle, cod, shells, dried leather, salt, gold and/or silver.
Unit.2: Regulating the Supply of Money; Central Banking
Money can be defined as any socially agreed upon
class of objects that is always accepted as
payment. Money is designed to facilitate
exchanges of real goods. One of the key issues
that arise is: How much money should circulate?
If too little money is circulating, it becomes hard
to do transactions. If too much money is
circulating, then inflation occurs.
Two ways of regulating the money supply include
a RESERVE BASED SYSTEM and a FIAT
SYSTEM. In the reserve based system, the money
supply is proportionate to the value of some
reserve asset. If gold is used as a reserve asset,
then we have a GOLD STANDARD; such a
system existed in the 19th and early 20th centuries. If another major currency is used as the
reserve asset, then we have a CURRENCY BOARD. A currency board is currently in use in
Hong Kong. It was also used by Argentina between April 1991 and December 2001.
The gold standard was used from 1717 in U.K and 1834 in the U.S. In Canada, it was adopted
with establishment of the Canadian dollar in 1858. The gold standard reached its zenith during
the so-called classical gold standard period from 1870-1914. During \
world War I, the gold standard regime was suspended. It was then briefly reinstated after the war
ended, but abandoned again in the wake of the 1930s depression. A variation on the gold
standard was in place from 1945-1971 known as Bretton Woods. Under this system, the US
government anchored its dollar to gold at $35 per ounce and other governments could trade their
US dollars for gold at that rate.
The Classical gold standard required that adjustments be made through the trade balance. That is,
countries that imported more than they exported (trade deficit) had to send gold to other
countries to pay for the imbalance. At the same time, countries that exported more than they
imported (trade balance) received gold from other nations to settle their accounts. This made
national economies subject to external shocks. A country that ran a trade surplus would suddenly
find itself with more gold, and hence more money in circulation. This might cause an
unsustainable boom. Conversely, if a country ran a trade deficit, it would lose gold, which would
cause less money to circulate. The result would be a recession or depression. The historical