Why Study Financial Markets

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Part II 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.

A security (also called a financial instrument) is a claim on the issuers 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

The Bond Market and Interest Rates period of time.1 The bond market is especially important to economic activity because it enables corporations or 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 corporation to postpone building a new plant that would ensure more jobs.

Because changes in interest rates have important effects on individuals, financial institutions, businesses, and the overall economy, it is important to explain fluctuations in interest rates that have been substantial over the past twenty years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate then fell to 3% in late 1992 and 1993, rose to above 5% in the mid to late 1990s, and then fell to a low of below 2% in the early 2000s.

Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to "the" interest rate. As Figure 1

Interest Rate (%)

FIGURE 1 Interest Rates on Selected Bonds, 1950-2002

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

FIGURE 1 Interest Rates on Selected Bonds, 1950-2002

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

www.federalreserve .gov/releases/

Daily, weekly, monthly, quarterly, and annual releases and historical data for selected interest rates, foreign exchange rates, and so on.

1The definition of bond used throughout this book is the broad one in common use by academics, which covers short- as well as long-term debt instruments. However, some practitioners in financial markets use the word bond to describe only specific long-term debt instruments such as corporate bonds or U.S. Treasury bonds.

The Stock Market

http://stockcharts.com/charts /historical/

Historical charts of various stock indexes over differing time periods.

shows, however, interest rates on several types of bonds can differ substantially. The interest rate on three-month Treasury bills, for example, fluctuates more than the other interest rates and is lower, on average. The interest rate on Baa (medium-quality) corporate bonds is higher, on average, than the other interest rates, and the spread between it and the other rates became larger in the 1970s.

In Chapter 2 we study the role of bond markets in the economy, and in Chapters 4 through 6 we examine what an interest rate is, how the common movements in interest rates come about, and why the interest rates on different bonds vary.

A common stock (typically just called a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The stock market, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial market in America (that's why it is often called simply "the market"). A big swing in the prices of shares in the stock market is always a big story on the evening news. People often speculate on where the market is heading and get very excited when they can brag about their latest "big killing," but they become depressed when they suffer a big loss. The attention the market receives can probably be best explained by one simple fact: It is a place where people can get rich—or poor—quickly.

As Figure 2 indicates, stock prices have been extremely volatile. After the market rose in the 1980s, on "Black Monday," October 19, 1987, it experienced the worst one-day drop in its entire history, with the Dow Jones Industrial Average (DJIA) falling by 22%. From then until 2000, the stock market experienced one of the great bull markets in its history, with the Dow climbing to a peak of over 11,000. With the collapse of the high-tech bubble in 2000, the stock market fell sharply, dropping by over 30% by 2002. These considerable fluctuations in stock prices affect the size of people's wealth and as a result may affect their willingness to spend.

The stock market is also an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A 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.

In Chapter 2 we examine the role that the stock market plays in the financial system, and we return to the issue of how stock prices behave and respond to information in the marketplace in Chapter 7.

The Foreign For funds to be transferred from one country to another, they have to be converted

Exchange Market from the currency in the country of origin (say, dollars) into the currency of the coun try they are going to (say, euros). The foreign exchange market is where this conversion takes place, and so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one country's currency in terms of another's, is determined.

Figure 3 shows the exchange rate for the U.S. dollar from 1970 to 2002 (measured as the value of the American dollar in terms of a basket of major foreign currencies). The fluctuations in prices in this market have also been substantial: The dollar weakened considerably from 1971 to 1973, rose slightly in value until 1976, and then reached a low point in the 1978-1980 period. From 1980 to early 1985, the dollar appreciated dramatically in value, but since then it has fallen substantially.

Dow Jones Industrial Average 12,000

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