Chapter 1-3
Topics in Financial Decisions
• Financial system affects the economic performance
• It consists of
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Financial markets
Financial institutions
Money
How does each of the above affect the economy?
Financial System and the Economy
• Savers and borrowers
– 3 groups of potential savers and borrowers are households, businesses, and governments
• Financial instruments
– Assets & liabilities
• Financial system
– A network of markets and institutions to bring savers and borrowers together
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What does financial system do?
• Risk sharing
– Borrowers & savers reduce the uncertainty to which they are exposed
• Liquidity
– A measure of how readily one asset can be converted to cash
• Information
– The financial system gathers information about borrowers’
circumstances so individual savers do not need to search for prospective borrowers
• The financial system as a share of GDP is small but serves important functions!
Financial Markets
• Transfers funds from savers to borrowers
• International capital market (lending & borrowing across national boundaries) is growing rapidly
• Asset prices communicate information
Financial Institutions
• Intermediaries between borrowers and savers • Think about banks
– Deposit insurance crisis (1980’s and early 1990’s) and recent reforms
• Loans from financial institutions account for the majority of funds borrowers raise (Stock and bond markets is relatively small)
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Figure 1.1 Sources of Funds for Nonfinancial
Businesses: Markets Versus Institutions
Money
• Defined as anything that people are willing to accept in payment for goods & services or to pay off debts.
• Money supply: total quantity of money in the economy
Money in the U.S.
• Federal Reserve System
– The central bank in the United States
– Collects data on various measures of the money supply
• Monetary policy
– The management of the money supply and its links to prices, interest rates, and other economic variables
• Monetary theory – Explores the relationships linking changes in the money supply to changes in economic activity and prices
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Chapter 2
Why do we need money?
• 3 methods to facilitate specialization include – barter, government allocation, and money
• Money is great
– (duh!)
– No high trading costs of barter or – No problem of misallocations of government allocation
Figure 2.1 Methods of Exchange
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4 Functions of Money
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Medium of exchange
Unit of account Store of value
Standard of deferred payment
What is good money?
• .
• Criteria:
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Acceptable to most traders
Standardized quality
Durable
Valuable relative to its weight
Divisible • Not everything can be used as money
– Your used car, Britney CDs, fish, cigarettes
• Seashells, gold and silver, paper money
Payments Systems
• Commodity money
– Physical goods (precious metals) • Fiat money
– Money authorized by a central bank, legal tender
– doesn’t have to be exchanged for gold or commodity money
– Public acceptance is key
• Checks
– Promises to pay definitive money on demand, drawn on money deposited in a financial institution
– Costly (check or cash?)
• Electronic funds
– Computerized payment‐clearing, debit cards, ATM, stored‐value cards, e‐cash
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Measuring the Money Supply
• To understand money’s role as an economic variable, we need to measure it.
• Definitions of the money supply
– Strict definition: medium of exchange
– Broader definition: also includes other assets that could be changed to medium of exchange
– Based on different liquidity: the cost at which an asset can be converted into definitive money.
Monetary Aggregates
• The Federal Reserve has developed 3 definitions of money that include assets broader than currency, called monetary aggregates:
¾M1: ¾M2
¾Broader monetary aggregates
Figure 2.2 Measuring Monetary Aggregates, February 2006
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Selecting Monetary Aggregates
• M2 currently considered best.
• Aggregates move broadly together over long time periods.
• Some significant differences in monetary aggregate movements have occurred during certain periods
• The different monetary aggregates give a different picture of movements in the money supply over time.
Figure 2.3 Growth Rates of M1
and M2, 1960‐2006
Chapter 3
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Financial System
• We use it every day
• Provides channels to transfer funds from savers to borrowers. – Savers = suppliers of funds.
– Borrowers = demanders of funds.
• Two components
– Financial markets
• issue claims on borrowers directly to savers.
– Financial intermediaries • act as go‐betweens by holding a portfolio of assets and issuing claims to savers.
Figure 3.1 Moving Funds Through the Financial System
Figure 3.2 Key Services Provided by the Financial System
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Key Services Provided by the Financial System
• Risk sharing by allowing savers to hold many assets, diversification
– Invest in downtown arena vs. mutual fund
• Liquidity, which is the ease with which an asset can be exchanged for money
– Invest in a house vs. stock
• Information about borrowers and returns on financial assets
– Lend to me vs. invest in Google
– Asymmetric information
Financial Markets
• Primary markets: – newly issued claims are sold to initial buyers.
– IPO
– Function: matching savers and borrowers
• Debt vs. Equity
– Debt: matures in certain amount of time, fixed payment
– Equity: no maturity, variable payments (dividend)
• Secondary markets – previously issued claims are bought and sold.
– Function: • Risk‐sharing: buy different stocks
• Liquidity: frequently traded, easily sold
• Information services: price as public info
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Types of Secondary Financial Markets
• Maturity: money and capital markets
– Longer than 1 year: capital market
– Shorter: money market: less risky, liquid and lower info cost
• Trading places: auction (NYSE) and over‐the‐counter markets (NASDAQ)
• Settlement: cash (now) or derivative (future)
Financial Intermediaries’ Tasks
• Match savers and borrowers
– Earn interest rate differences
• Provide risk‐sharing, liquidity, and information services
– Bank diversifies for you (the depositors)
– deposits are liquid
– Collects information
Competition and Change
• Financial innovation results from:
– Changes in cost of providing services
– Changes in demand
• Financial integration: ease of communication
– Regional markets are integrated into national
– Globalization: integration of international markets
• Funding investment • International capital flows
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Goals of Financial Regulation
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Provision of information
Maintenance of financial stability
Controlling the money supply
Encouraging particular activities (like home ownership)
• Regulation affects the ability of financial markets and institutions to provide risk‐
sharing, liquidity, and information services, as seen in Table 3.1
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