EC102: CLASS 9 LT
Christina Ammon
Financial Systems
 Financial systems: the institutions in the economy that
facilitate the flow of funds between and among households
and firm
 Financial markets vs. financial intermediaries
• Bond & Stock markets vs. banks and insurances
 What is the purpose of financial markets& intermediaries?
1. Financing investment
2. Sharing risk
 What is the purpose of intermediaries
• Overcoming asymmetric information
Quiz Question 1
Financial markets allow households to _____ provide resources
for investment, while financial intermediaries allow households
to _____ provide resources for investment.
 A. directly; indirectly
 B. indirectly; directly
 C. productively; unproductively
 D. unproductively; productively
Quiz Question 2
All of the following are examples of financial intermediaries except:
 A. commercial banks.
 B. stock exchanges.
 C. pension funds.
 D. insurance companies.
Essay 7
Basic setup:
 A farmer’s harvest will be worth £200 if she can borrow £100
worth of fertilizer, and £0 otherwise.
 The fertilizer needs to be applied now and harvest will take
place in six months’ time.
 There are N>100 other people in the village, each of whom has
saved £1.
Essay 7 Question a
Is there a role for a financial system in this economy? Briefly
describe a few types of financial arrangements that you might
observe in this economy.
 Without financial systems: Borrow (<)1$ from 100 (+)
villagers
 Possible, but costly
 Financial system allows farmer easier access to savings of
villagers
 If financial markets present: Could issue bonds or stocks
 If financial intermediaries present: villagers deposit savings
and bank gives loan to farmer
Essay 7 Question b
Suppose an enterprising villager starts a new bank (with 0
capital), collects all of the villagers’ savings, and lends the
£100 to the farmer. How will this bank’s balance sheet look
like?
 What does a balance sheet consist of?
 Assets = Liabilities (+equity)
Assets
Liabilities+ Equity
Loans 100$
Deposits: N$
Reserves N$-100$
Equity
Essay 7 Question c
Suppose now that each of the savers faces some chance that
there will be an emergency such as they will absolutely need
access to their £1 three months from now. Is there still a role
for a financial system?
 Without financial markets - will the farmer be able to finance
his investment?
 What about if we only have financial markets?
Essay 7 Question d
Suppose that the probability that any investor faces the
emergency is p. What is the minimum value of N such that
the financial system can viably allow the farmer to buy the
fertilizer?
 Pool of savings: N*1$
 But p*N*1$ will need to be withdrawn in expectation
 Hence the savings to reach the farmer will be (1-p)N$
 Needs to be >=100$
 => need N>100(1-p)
 Similar with financial intermediaries: need to keep p*N*1$ as
reserves
Essay 7 Question e
On the basis of this example, can you see what economists
mean when they say banks are engaged in maturity
transformation?
 Depositors willing to provide short term debt
 Banks take short term debt and issue long term debt for
investment
 Can be problematic!
Quiz Question 5
Falling house prices generate widespread insolvency of financial
institutions by:
 A. reducing the value of collateral assets.
 B.
reducing the value of liabilities.
 C. increasing the value of assets.
 D. increasing capital
Quiz Question 4
To the extent that mortgage defaults contributed to the financial
crisis of 2008–2009, blame for these actions lies with:
 A. homebuyers who borrowed more than they could afford to
repay.
 B. mortgage brokers who encouraged households to borrow
excessively.
 C. financial intermediaries who held large positions in
mortgage-related assets
 D. all of the above
Quiz Question 3
A credit crunch reduces aggregate demand by:
 A. increasing the exchange rate.
 B. increasing interest rates.
 C. reducing consumption and investment spending.
 D. reducing the money supply.