US and Global Financial Institutions
Financial Systems
Overview 101
Lesson Overview
Economic System
• System Basics
Banking
• Banking System Basics
• Impacts on Money Creation
• Impacts on Capital Flows in the Intl. Economy
Security Markets
• Security Mkt Basics
• Impacts on the Intl. Economy
Currency Exchanges
• Currency Exchange Basics
• Impact on the Intl. Economy
2-2
Economics
Microeconomics is the study of how individual
households and firms make decisions and how
they interact with one another in markets.

Prices and selection of products
Macroeconomics is the study of the economy as a
whole. Its goal is to explain the economic
changes that affect many households, firms, and
markets at once.



Inflation
Unemployment
Economic Growth
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
• Two types of “actors”:

households

firms
• Two markets:

the market for goods and services

the market for “factors of production”
THINKING LIKE AN ECONOMIST
4
FIGURE 1: The Circular-Flow Diagram
Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services
Firms
Households
Firms:
 Buy/hire factors of production,
use them to produce goods and
services
 Sell goods & services
THINKING LIKE AN ECONOMIST
5
The Circular-Flow Diagram: Economic System Model
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
THINKING LIKE AN ECONOMIST
Spending
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
6
Circular Flow Issues
• Doesn’t account for…
 Taxes
 Intl.
Trade
 Intl.
Monetary Flows
THE MARKET FORCES OF SUPPLY AND DEMAND
7
Financial System
• …the group of institutions in the
economy that help to match one
person’s savings with another person’s
investment.
 Financial
Markets: Direct match between
savers and borrowers
• ie. Stock and bond markets
 Financial
Intermediaries: Indirectly match
savers and borrowers
• ie. banks and mutual funds,
THE MARKET FORCES OF SUPPLY AND DEMAND
8
Banking System
• How does a bank work?
• Where does money come from?
• Where does it go?
THE MARKET FORCES OF SUPPLY AND DEMAND
9
Banking Money Creation with
Fractional-Reserve
• This T-Account
shows a bank
that…
First National Bank
Assets
 accepts
deposits, Reserves
$10.00
 keeps a portion
as reserves,
Loans
 and lends out
$90.00
the rest.
• It assumes a
reserve ratio
of 10%.
Total Assets
$100.00
Liabilities
Deposits
$100.00
Total Liabilities
$100.00
The Money Multiplier
in the Money
SupplyBank
=
First Increase
National Bank
Second National
$190.00!
Assets
Liabilities
Reserves
$10.00
Deposits
$100.00
Loans
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
$100.00
Assets
$81.00
Total Liabilities
$100.00
Total Assets
$90.00
Total Liabilities
$90.00
THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds.
• The market for loanable funds is the
market in which those who want to save
supply funds and those who want to
borrow to invest demand funds.
Supply and Demand for Loanable
Funds
• Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
• The supply of loanable funds comes from
people who have extra income they want to
save and lend out.
• The demand for loanable funds comes from
households and firms that wish to borrow to
make investments.
Supply and Demand for Loanable
Funds
• Interest rate
 the
price of the loan
 the
amount that borrowers pay for loans
and the amount that lenders receive on
their saving
 in
the market for loanable funds, the real
interest rate
Supply and Demand for Loanable
Funds
• Financial markets work much like other
markets in the economy.
• The equilibrium of the supply and
demand for loanable funds determines
the real interest rate.
Figure 1 The Market for Loanable
Funds
Interest
Supply
Rate
5%
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
Intl. Capital Flows
Open-Economy Macroeconomics:
Basic Concepts
• An open economy interacts with other
countries in two ways.
 It
buys and sells goods and services in
world product markets.
 It
buys and sells capital assets in world
financial markets.
The Flow of Financial Resources: Net
Capital Outflow
• Net capital outflow refers to the
purchase of foreign assets by domestic
residents minus the purchase of
domestic assets by foreigners.
• A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in
the Ford Motor corporation.
The Flow of Financial Resources: Net
Capital Outflow
• When a U.S. resident buys stock in
Telmex, the Mexican phone company,
the purchase raises U.S. net capital
outflow.
• When a Japanese residents buys a
bond issued by the U.S. government,
the purchase reduces the U.S. net
capital outflow.
The Flow of Financial Resources: Net
Capital Outflow
• Variables that Influence Net Capital
Outflow
 The
real interest rates being paid on foreign
assets.
 The
real interest rates being paid on
domestic assets.
 The
perceived economic and political risks
of holding assets abroad.
 The
government policies that affect foreign
ownership of domestic assets.
Figure 3 How Net Capital Outflow
Depends on the Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
World Financial Centers - Securities
Financial Markets
• The Stock Market
 Stock
represents a claim to partial ownership
in a firm and is therefore, a claim to the profits
that the firm makes.
 The sale of stock to raise money is called
equity financing.
• Compared to bonds, stocks offer both higher risk
and potentially higher returns.
 The
most important stock exchanges in the
United States are the New York Stock
Exchange, the American Stock Exchange, and
NASDAQ.
 What about the primary Korean markets?
Financial Markets
• The Stock Market
 Most
newspaper stock tables provide the
following information:
• Price (of a share)
• Volume (number of shares sold)
• Dividend (profits paid to stockholders)
• Price-earnings ratio
Financial Markets
• Reading the stock page…
Financial Markets
•
•
•
•
•
•
•
•
•
Columns 1&2 52-Week Hi-Lo Range
Column 3 Company Name and Type of Stock: If there are no special symbols or letters
following the company name, it is common stock (shares without a fixed rate of return of
investment.) Other types of stock are “pf“ or preferred, etc.
Column 4 Ticker symbol: This alphabetic symbol is a unique stock identifier.
Column 5 Dividend Payment: This indicates the annual dividend payment per share.
Column 6 Percent Yield: This figure represents the dividend return an investor can
expect on each share of stock. It is calculated by dividing the annual dividend each share
pays by its current market value, and is expressed as a percentage.
Column 7 Price-Earnings Ratio (PE): This calculation is one way of evaluating a stock's
relative performance and value. It is computed by dividing the stock's price by the
company's per-share earnings for the most recent four quarters. Higher Price-Earnings
multiples suggest the investors are more optimistic about a stock's prospects than
comparable lower-PE stocks, but the reason for high and low PEs also include the
company's growth outlook, the industry the company is engaged in, company accounting
policies, and whether the firm is a startup or a more established business.
Column 8 Trading Volume: This figure shows a total number of shares traded for the
day, listed in hundreds.
Column 9 Hi/Lo: This indicates the trading price range of the security during the day's
trading.
Column 10 Close and Net Change:
Financial Markets
• The Bond Market


A bond is a certificate of indebtedness that
specifies obligations of the borrower to the holder
of the bond.
Characteristics of a Bond
• Term: The length of time until the bond matures.
• Credit Risk: The probability that the borrower will fail to
pay some of the interest or principal.
• Tax Treatment: The way in which the tax laws treat the
interest on the bond.

Bonds can be from companies (private/public) or
the government (local-municipal, regional,
provincial or national) levels

Municipal bonds are federal tax exempt.
World Trade Flows
The Flow of Goods: Exports, Imports,
Net Exports
• Net exports (NX) are the value of a
nation’s exports minus the value of its
imports.
• Net exports are also called the trade
balance.
The Flow of Goods: Exports, Imports,
Net Exports
• Factors That Affect Net Exports
 The
tastes of consumers for domestic and
foreign goods.
 The
 The
prices of goods at home and abroad.
exchange rates at which people can
use domestic currency to buy foreign
currencies.
The Flow of Goods: Exports, Imports,
Net Exports
• Factors That Affect Net Exports
 The
incomes of consumers at home and
abroad.
 The
costs of transporting goods from
country to country.
 The
policies of the government toward
international trade.
The Equality of Net Exports and Net
Capital Outflow
• For an economy as a whole, NX and
NCO must balance each other so that:
NCO = NX
• Why?
When a nation is running a trade surplus (NX>0), it is
selling more goods/services to foreigners than it is buying.
What is it doing with the foreign currency received? Must be
buying foreign assets. Capital is flowing out of the country
(NCO>0).
When a nation is running a trade deficit (NX<0), it is
buying more goods and services from foreigners than it is
selling. How is it financing the purchase? It must be selling
assets abroad. Capital is flowing into the country (NCO<0).
THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATES
• International transactions are influenced
by international prices.
• The two most important international
prices are the nominal exchange rate
and the real exchange rate.
Nominal Exchange Rates
• The nominal exchange rate is the rate at
which a person can trade the currency
of one country for the currency of
another.
Real Exchange Rates
• The real exchange rate is the rate at
which a person can trade the goods and
services of one country for the goods
and services of another.
Figure 1 The Market for Loanable
Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Why does demand slope
downward? Why is the Equil.
Qty vertical?
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
The Effects of Government Budget Deficit
1. A budget deficit reduces
the supply of loanable funds . . .
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
r
2. . . . which
increases
the real
interest
rate . . .
S
(b) Net Capital Outflow
Real
Interest
Rate
S
B
r2
A
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
5. . . . which
causes the
real exchange
rate to
appreciate.
E1
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange