Chapter 1-3. Topics in Financial Decisions. Financial System and the Economy. Financial system affects the economic performance It consists of

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1 Chapter 1-3 Topics in Financial Decisions Financial system affects the economic performance It consists of 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 1

2 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) 2

3 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 3

4 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 4

5 4 Functions of Money Medium of exchange Unit of account Store of value Standard of deferred payment What is good money?. Criteria: 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 5

6 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: M1: M2 Broader monetary aggregates Figure 2.2 Measuring Monetary Aggregates, February

7 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, Chapter 3 7

8 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 8

9 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 9

10 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 10

11 Goals of Financial Regulation 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 risksharing, liquidity, and information services, as seen in Table