Money and Banking Chapter 1,2,3,4

Six Parts of the financial system

1-Money 2-Financial Instruments 3-Financial Markets 4-Financial Institutions 5-Regulatory Agencies 6-Central Banks

Financial Instruments

Example: Checks, bonds, securities -Transfers resources from savers to investors -Buying and selling stocks used to be only for the wealthy -Mutual funds and stocks available through banks or online, portfolio making is open to everyone.

Financial Markets

-Allow the buying and selling of financial instruments easily. -Went from being in coffee houses and taverns to the well-organized NYSE. -Now transactions are mostly electronic, which has made the costs of processing financial transactions cheaper and more financial instruments available.

Financial Institutions

-Provide all the services of the financial system like providing access to financial markets and gathering information -Banks began as vaults, became institutions that accepted deposits and gave loans, then today's financial supermarket

Government Regulatory Agencies

-Make sure the elements of the financial system operate safely and reliably -Introduced after the great depression -Provide regulation, rules, and supervision, and examines how banks manage their risk After 2007-2009 crisis, implemented the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Central Banks

-Monitor and stabilize financial systems. -Central banks began as large private banks to finance wars. -Central banks control the availability of money and credit to promote low inflation, and stability. -Policymakers strive for transparency. -The 2007 crisis led to new policy tools.

Five Core Principles of Money and Banking

1-Time has value 2-Risk requires compensation 3-Information is the basis for decisions 4-Markets determine prices and allocate resources 5-Stability improves welfare

Time has value

Interest is paid to compensate the lenders for the time the borrowers have their money.

Risk requires compensation

Individuals will only take a risk if they are compensated. Compensation comes in the form of explicit payments

Information is the basis for decisions

-The more important a decision, the more info is gathered -Collection and processing of information is the foundation of the financial system

Markets determine prices and allocate resources

-Markets channel resources and minimize the cost of gathering information and making transactions. -The better developed the financial markets the faster the country will grow.

Stability improves welfare

-A stable economy reduces risk and improves everyone's welfare, and grows the economy -One of the main roles of central banks is stabilizing the economy -Financial instability caused 2008

Income

Flow of earnings overtime

Wealth

The value of assets minus liabilities

Three characteristics of money

1-Means of payment 2-Unit of account 3-Store of value Number one is the most important

Means of payment

-People insist on payment in money -Money is easier and finalizes payments so there is no further claim on buyers and sellers. -The increase in the number of transactions and the number of buyers and sellers requires something like "money" to make transactions smoother.

Unit of Account

-Money is used to quote prices and record debts, it is a standard of value -Prices provide the information needed to ensure resources are allocated to their best prices -Using dollars makes relative price comparisons easier

Store of value

-A means of payment has to be durable and capable of transferring purchasing power from one day to the next. -Paper currency does degrade but it is accepted at face value in transactions. -Other forms of wealth are also a store of value stocks, bonds, houses etc.

Why is money a good store of value?

Because it is liquid

Liquidity

A measure of the ease with which an asset can be turned into a means of payment, the more costly it is to convert an asset into money, the less liquid it is.

Financial institutions use:

-Market liquidity: The ability to sell assets for money -Funding liquidity: The ability to borrow money to buy securities or make loans.

The payments system

-A web of arrangements that allow for the exchange of assets. The efficiency of the economy depends on the payment system.

Possible methods of payment:

1-Commodity and Fiat Monies 2-Checks 3-Electronic payments

Fiat moneys

a government-issued currency that is not backed by a commodity such as gold.

Commodity Monies

Commodity monies are things with intrinsic value, like silk and salt.

What does a commodity money need to be succesful

-Usable by most people -Can be made into standard quantities -Durable -Easily transportable -Divisible into smaller units

Common commodity money

Gold

Who printed the first paper money

In 1661, Stockholm Banco issued Europe's first paper money.

What happened to the first paper money?

The King of Sweden printed too many to try to finance a war and the bank failed

What did the U.S issue in 1775 and what happened?

The continental congress issued "continentals" to finance the revolutionary war, but they printed too much and it became worthless.

Why is today's paper money called fiat money?

Because its value comes from a government decree, or fiat

Why do we accept these fiat money?

Because the U.S gov. stands behind its paper money.

What must fiat currency do to be credible?

limited in circulation and volume

Check

A check is an instruction to the bank to take funds from your account and transfer them to another account. It is not a final payment like currency, it sets in motion a series of transactions

The path of a paper check

1-Hand check to a merchant in exchange for groceries. 2-Merchant deposits check or image into the merchant's bank and the merchant's account is credited 3-Merchant's bank sends an electronic image of the check to the local Federal Reserve Bank. 4-Federal Reserve Credit's the merchant's bank reserve account and Debit's your bank's reserve account. 5-Federal Reserve returns an electronic image of the check to your bank 6-Your bank debits your checking account by the amount of the check.

Electronic payments take the form of

-Credit and debit cards -Electronic funds transfers -E-money

Goal of Electronic payment digital systems

To improve reliability, ensure security, and prevent use for criminal purposes.

What is needed to make financial markets run smoothly

Market liquidity and Funding liquidity

What did the 2007-2009 financial crisis lead to

A sudden loss in liquidity.

What did financial institutions believe before the crisis?

They believed markets would be liquid, and relied on short-term borrowing to hold long-term financial instruments.

What is the liquidity spiral?

What is the future of the three functions of money>

-Means of payment: disappearing due to the ease of electronic transactions. -Unit of account: likely to remain, will always be needed to quote values and prices -Store of value: disappearing due to liquidity of financial instruments.

Changes in the quantity of money are related to

-Interest Rates -Economic Growth -Inflation

What do we need to know to find the value of a means of payment

how much of it is circulating, defining money means defining liquidity

Money aggregates (Measures of money)

M1- Narrowest definition, only the most liquid of assets M2- Broader definition, includes assets not used as means of payment

Examples of M2

-Small denomination time deposits -Savings deposits and money-market deposit accounts -Retail money market mutual fund shares

Which M do we use to understand inflation?

Until the early 1980’s we used M1. But with changes in accounts, M2 became more useful.

How useful is M2 in tracking inflation?

-When the quantity of money grows quickly, it produces high inflation. -Positive correlation up until 1980. From 1990-2019 – virtually no correlation.

Why does M2 no longer predict inflation?

-Maybe the relationship only applies at high levels of inflation. -Maybe it only shows up over longer periods of time. -Maybe we need a new measure of money.

Computing CPI Inflation

(Cost of basket in current year/ Cost of basket in base year)X100

Computing Inflation rate

[(CPI in current year-CPI in base year)/ CPI in base year] x 100

Direct finance

Borrowers sell securities directly to lenders in the financial markets. Provides financing for governments and corporations.

Indirect Finance

An institution stands between lender and borrower Ex: a loan from a bank to buy a car.

Role of financial system

facilitate production, employment, and consumption

Financial Instruments definition

The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions.

Three functions of financial instruments

1-Act like a means of payment.(Employees take stock options as pay for working.) 2- Stores of value 3-Transfer of risk, futures and insurance contract allows one person to transfer risk to another 1 AND 2 are like money, 3 is not.

Leverage

The use of borrowing to finance part of an investment

What does more leverage lead to

greater risk that an adverse surprise will lead to bankruptcy.

When losses are experienced, firms try to:

deleverage to raise net worth

What happened when institutions deleveraged

prices fell, losses increased, and net worth fell

How do you fix the issue of complexity in financial instruments.

Standardization of financial instruments overcomes potential costs of complexity.

Counterparty

The person or institution on the other side of the contract.

What mechanism exists regarding counterparties

Mechanisms exist to reduce the cost of monitoring the behavior of counterparties.

Asymmetric information

Borrowers have some information they don't disclose to lenders.

Underlying instruments

Used by savers/lenders to transfer resources directly to investors/borrowers. Example, stocks and bonds

Derivative Instruments

where values and payoffs are "derived" from the behavior of the underlying instruments. Examples are futures, options, and swaps. Used to shift risk anong investors

Four characteristics that influence the value of a financial instrument:

1- Size of payment, larger is more valuable 2-Timing of payment, sooner is more valuable 3-Likelihood of payment, higher likelihood is more valuable 4- Conditions under which payments are made, made when we need them is more valuable.

Which financial instruments are used as stores of value?

1-Bank loans 2-Bonds 3-Home mortgages, home buyers usually use their home as collateral for their loan. 4-Stocks 5-Asset-backed securities, shares in the returns or payments arising from specific assets, like student loans or a mortgage.

Which financial Instruments are used primarily to transfer risk?

1-Insurance contracts 2-Futures contracts 3-Options 4-Swaps

What is the primary purpose of insurance contracts?

To assure that payments will be made under particular and often rare circumstances

What is a futures contract?

An agreement between to parties to exchange a commodity or asset at a fixed price on a set future date. A price is always specified

What type of instrument is a futures contract?

A derivative instrument

What type of instrument is an option?

A derivative instrument

What is an option

Give the holder the right, not obligation to buy or sell an asset at a predetermined price on either a specific date at any time within a specified period.

What are swaps?

Agreements to exchange two specific cash flows at certain times in the future.

What are a few varieties of swaps?

Ones that reflect differences in maturity, payment frequency, and underlying cash flows.

What are financial markets?

Places where financial instruments are sold.

What are the roles of financial markets?

1-Market liquidity: Ensure owners can buy and sell cheaply 2-Information: Information about issuers of financial instruments 3-Risk sharing: Provide individuals a place to buy and sell risk.

What is the structure of financial markets?

1-Distinguish between primary or secondary markets 2-Categorize by the way they trade 3-Group based on the type of instrument they trade.

Primary vs. secondary markets

A primary financial market is one in which a borrower obtains funds from a lender by selling newly issued securities. Secondary financial markets are those where people can buy and sell existing securities.

Historical Secondary-Market trading methods for stocks.

1-Centralized exchanges: buyers and sellers meet in a central physical location 2-Over the counter markets (OTS's)- decentralized markets, where dealers stand ready to buy and sell securities electronically

Recent secondary market trading for stocks.

Electronic communication networks (ECN's)- don't require a broker or dealer.

Why has the pace of structural change in secondary stocks accelerated dramatically?

1-Technological advances make physical location less important. 2-Increased globalization encouraged more cross-border exchanges

What are the benefits of decentralized electronic exchanges?

-Customers can see their orders -Orders happen quickly? -24/7 trading -Low cost -Reduces operational risk, like when the NYSE was inaccessible for days after 9-11

What are the risks of decentralized electronic exchanges?

-Trading algorithim is prone to errors -High Frequency traders can purchase or sell thousands of stocks in seconds.

Debt markets

Markets for loans, mortgages, and bonds

Equity markets

Markets for stocks

Derivative markets

the markets where investors trade instruments like futures, options, and swaps

What is the difference between a debt or equity market and a derivative market?

In debt and equity markets, claims are bought and sold for immediate cash payments. In derivative markets, investors make agreements that are settled later.

How do you categorize a debt instrument by the loan's maturity?

If repaid in less than a year: traded in money markets If maturity is more than a year: traded in bond markets

Shadow banks

-Provide services that compete with banks but do not accept deposits. -Take on more risk than traditional banks and are less transparent.

Financial institutions

Firms that provide access to the financial markets, both to savers who wish to purchase financial instruments directly and to borrowers who want to issue them.

What is the role of financial institutions

reduce transaction costs reduce information costs Give savers ready access to their funds

Two broad categories of intermediaries

1-Depository institutions:Take deposits and make loans, what people think of as banks 2-Non-Depository institutions: Include insurance companies securities firms, etc.

What facets constitute the structure of the Financial Industry(6)

1-Depository Institutions 2-Insurance companies 3-Pension funds 4-Securities firms 5-Finance companies 6-Government-sponsored enterprises

Depository institutions

take deposits and make loans

Insurance companies

accept premiums, which they invest, in return for promising compensation to policy holders under certain events.

Pension funds

invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers.

Securities firms

include brokers, investment banks, underwriters, mutual fund companies private equity firms, and venture capital firms.

Finance companies

raise funds directly in the financial markets in order to make loans to individuals and firms.

Government-sponsored enterprises

federal credit agencies that provide loans directly for farmers and home mortgagors.