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Unformatted text preview: Chapter 1: The Financial System Money, Banking, and Financial Markets The Financial System Learning Objectives This chapter introduces you to: • Financial markets and their functions • Asymmetric information problems • Banks and their economic function • How finance contributes to economic growth • Financial crises • Key economic measures CHAPTER 1 The Financial System The Financial System Overview • A well-functioning financial systems channels savings to investors helping an economy to grow. • A malfunctioning financial system can damage an economy. – The collapse of the stock market and banking system caused the Great Depression. – A financial crisis beginning in 2007 plunged the U.S. economy into a recession, doubling the unemployment rate. CHAPTER 1 The Financial System The Financial System Financial Markets Financial markets are comprised of the people and firms that trade financial assets. • Two types of financial assets: – Currencies – Securities • Bonds • Stocks CHAPTER 1 The Financial System The Financial System Bonds A bond is a debt security or fixed-income security. • A bond is a security that promises fixed payments at future dates. • The coupon payment is interest paid at specified intervals for the use of the borrowed funds. • The face value is the principal paid when a bond matures. • Maturity is the life of a bond: the time between the original sale and payment of the face value. CHAPTER 1 The Financial System The Financial System Bonds: An example For a $100, 10-year bond with a 6% coupon: • The face value is $100. • The maturity is 10 years. • The coupon or interest payment is $6 annually. • The coupon or interest payment is payment for the use of the $100, just like any loan. CHAPTER 1 The Financial System The Financial System Bond Characteristics • Bonds with maturities less than one year: –Commercial paper – issued by corporations –Treasury bills – issued by the U.S. government CHAPTER 1 The Financial System The Financial System Bond Characteristics • Zero-coupon bonds: – No specified coupon or interest payment – Sold at a discount from face value – The interest rate is the annualized percentage difference between face value and the purchase price. CHAPTER 1 The Financial System The Financial System Bond Characteristics • Default risk – A payment is not made in two ways: • Failure to make a coupon payment. • Failure to pay face value at maturity. • Varies for different bonds • The interest rate paid on a bond increases with the risk of default. CHAPTER 1 The Financial System The Financial System Stocks Stock or equity is an ownership share in a corporation. – Sto kholders share a orporatio ’s profits. – Profits are u ertai , so a sto k’s retur is uncertain. • Stockholders vote on corporate policies. • Bondholders have no vote on corporate policies. CHAPTER 1 The Financial System The Financial System Economic Functions of Financial Markets • To match savers and investors: – Savers have surplus funds to lend. – Investors borrow to increase productive capacity of economy. • To share risk or diversification: – Diversification involves holding a variety of different assets to reduce risk. CHAPTER 1 The Financial System The Financial System Case Study: The Perils of Employee Stock Ownership • Employee pension plans – 401(k) plans: – Usually include mutual funds that hold a diversified collection of stocks and/or bonds. • Enron, an energy company, encouraged employees to invest in company stock instead. – 58% of all 401(k) funds in Enron stock – Employees lost everything due to 2001 bankruptcy • Pension Reform Act of 2006 restricts companies from promoting employee stock ownership in pensions. CHAPTER 1 The Financial System The Financial System Asymmetric Information Asymmetric information exists when one party to a transaction knows more than the other party. This is a potential problem for all financial transactions. • Adverse selection is a problem that occurs prior to a transaction. • Moral hazard occurs after the transaction. CHAPTER 1 The Financial System The Financial System Adverse Selection Adverse selection is the problem that those most eager to borrow money are the greatest risks. • Adverse selection makes lenders reluctant to lend. • Good borrowers may be unable to obtain funding, hurting the economy. CHAPTER 1 The Financial System The Financial System Moral Hazard Moral hazard occurs when borrowers engage in activities contrary to the purpose of the loan. • Borrowers may use funds for unintended purposes. • Borrowers may take excessive risks. CHAPTER 1 The Financial System The Financial System Banks A bank is a financial institution or financial intermediary. – A mutual fund is a financial institution that sells shares to savers and purchases securities from many firms. • Banks raise funds by accepting deposits. • Banks use the funds to make loans to businesses and individuals. – Bank loans are private loans – negotiated between one lender and one borrower. CHAPTER 1 The Financial System The Financial System Types of Banks • Savings and Loan Associations accept deposits and primarily make mortgage loans. • Commercial banks accept deposits, make loans for a variety of purposes and some also deal in securities markets. • Investment banks are not really banks. They help companies raise funds by issuing new securities. CHAPTER 1 The Financial System The Financial System Banks versus Financial Markets • Banks and financial markets both channel funds from savers to investors. • Channeling funds through financial institutions, like banks, is indirect finance. • Channeling funds through financial markets by buying securities directly is direct finance. CHAPTER 1 The Financial System The Financial System Why Banks Exist • Asymmetric information is a problem for direct finance. • Bank finance is more costly than direct finance – banks charge higher rates of interest on loans. • Banks reduce adverse selection and moral hazard. CHAPTER 1 The Financial System The Financial System Why Banks Exist • Banks reduce adverse selection by screening potential borrowers. – Ba k loa offi ers assess a orrower’s risk. • Banks reduce moral hazard by monitoring borrower behavior. – Covenants are agreements about how a borrower should behave. They reduce moral hazard. • Medium and small firms and individuals need bank financing as only well-known entities can use direct financing. CHAPTER 1 The Financial System The Financial System The Financial System and Economic Growth • Economic growth means increases in real GDP, standards of living, and productivity. – A well-developed financial system increases economic growth. – Economic growth is growth of real gross domestic product (real GDP). CHAPTER 1 The Financial System The Financial System Saving and Growth • Countries that save more invest more and have higher standards of living in the long run. • Underdeveloped financial systems make it difficult for investors to raise funds. • Government regulation reduces asymmetric information and improves the functioning of the financial system. • Deposit insurance encourages savers to channel funds through banks. CHAPTER 1 The Financial System The Financial System Financial Development and Economic Growth • Studies find that strong financial systems increase growth. – Stock market capitalization, the value of all corporate stock as a percentage of GDP, increases as country income increases. – Total bank loans as a percentage of GDP are also high in high income countries. CHAPTER 1 The Financial System The Financial System Figure 1.3 Financial Development and Economic Growth, 1996-2007 (A) Stock Market Capitalization (B) Bank Loans Percent 100 of GDP 90 Percent 100 of GDP 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 Low Lower Upper High income middle middle income (Nigeria, income income (Germany, Pakistan) (India, (Mexico, United Indonesia) Turkey) States) Low income Lower Upper High middle middle income income income This figure compares financial development in four group of countries, from the quarter with the lowest real GDP per capita to the quarter with the highest. Examples of countries in each group appear in parentheses in Panel (A). Richer countries have higher levels of stock market capitalization ad bank loans than poorer countries. Source of data: World Bank The Financial System Case Study: Unit Banking and Economic Growth • A unit banking restricts a bank to a single location with no branches. • Proponents of unit banking feared that large banks would become too powerful and exploit customers. • Problems of unit banking: – No economies of scale – No diversification – all business in one town – Unit banks are local monopolies • Unit banks provide less funding to business than branched banks and unit banking states had lower manufacturing employment and wages. CHAPTER 1 The Financial System The Financial System Case Study: Microfinance • Microfinance or microlending provides small loans to help poor people start businesses. – Serves people not served by banks. • The Grameen Bank in Bangladesh, founded by Muhammad Yunus, lends to multiple entrepreneurs together. Credit is cut off if anyone defaults, reducing moral hazard. • Microfinance reduces poverty and improves growth. • Microfinancial institutions (MFIs) now exist in many countries and commercial banks are entering this loan market. CHAPTER 1 The Financial System The Financial System Markets Versus Central Planning Centrally planned or command economy • Government chooses investment projects. • Fi a ial arkets do ’t exist i o a d economies. • Government choices were poor. • Growth in command economies lags far behind growth in market economies. CHAPTER 1 The Financial System The Financial System Case Study: Investment in the Soviet Union • The Soviet Union was a centrally planned economy of Russia and 14 other countries. • Soviet planners allocated twice as high a percentage of GDP to investment as in Western economies. • Planners made poor choices and the Soviet Union collapsed due to lagging economic growth. CHAPTER 1 The Financial System The Financial System Financial Crises • A financial crisis is a major disruption of the financial system. –A financial crisis often involves are sharp drop in asset prices and failures of financial institutions. –Financial crises often reduce output and increase unemployment. CHAPTER 1 The Financial System The Financial System The 2007 Financial Crisis • • • • Many defaults on subprime mortgages. Stock prices fell 55% from 2007 to 2009. The economy suffered a severe recession. Unemployment rose from under 5% to over 10%. CHAPTER 1 The Financial System The Financial System Policy Responses • The government became partial owner in many of the largest banks. • The Federal Reserve expanded the money supply massively through loans to financial institutions. • The Fed pushed short-term interest rates to close to zero. CHAPTER 1 The Financial System The Financial System Financial Crises • Economies can experience financial crises in which asset prices plummet and financial institutions fail. • Crises can reduce output and increase unemployment. • A major crisis in the United States began in 2007. CHAPTER 1 The Financial System The Financial System Chapter Summary Financial markets: • Financial markets are markets for currencies and for securities. • Bonds provide fixed monetary payments at specified times. – Issuing bonds is a method of borrowing money. • Stocks are shares of ownership in corporations and share corporate profits. CHAPTER 1 The Financial System The Financial System Chapter Summary Functions of financial markets: • Allocate funds from savers to investors. • Financial markets help savers diversify to reduce risk. CHAPTER 1 The Financial System The Financial System Chapter Summary Asymmetric information: • Since sellers of securities (investors) know more than buyers (savers), financial markets may malfunction. • Adverse selection – riskiest borrowers are most anxious to sell securities • Moral hazard – borrowers may misuse funds they have borrowed from savers CHAPTER 1 The Financial System The Financial System Chapter Summary Banks: • Financial institutions such as banks and mutual funds help channel funds from savers to investors. • Banks are financial institutions that accept deposits and use funds to make private loans. • Banks gather information to overcome asymmetric information problems. • Banks lend to those who cannot sell securities. CHAPTER 1 The Financial System The Financial System Chapter Summary Finance and economic growth: • Saving spurs growth if funds are invested productively. • Richer countries have deeper financial systems. • Poor policies inhibit growth while good policies increase growth. • Markets allocate funds more efficiently than central planning. CHAPTER 1 The Financial System The Financial System Appendix: Measuring Output and the Price Level • Nominal Gross Domestic Product (Nominal GDP) – the total value of all goods and services produced in the economy in a given period (usually one year) • Aggregate price level – a weighted average of the prices of goods and services CHAPTER 1 The Financial System The Financial System Appendix: Measuring Output and the Price Level • Consumer price index – an average of prices paid by consumers • GDP deflator – the average of prices for all goods and services produced in the economy • The aggregate price level is an average of all prices in the economy. CHAPTER 1 The Financial System The Financial System Inflation Rate and Real GDP • The inflation rate – the percentage change in prices over a period of time, typically one year. • Real GDP is a measure of output not distorted by inflation real GDP = nominal GDP aggregate price level CHAPTER 1 The Financial System Chapter 2: Money and Central Banks Money, Banking, and Financial Markets Money & Central Banks Learning Objectives This chapter introduces you to: • The concept and types of money • How money is measured and used to make payments • Liquidity • Our central bank, the Federal Reserve System, and the key functions of central banks • The rest of the book CHAPTER 2 Money and Central Banks Money & Central Banks What Is Money? Money is often used to refer to income and wealth. • Money is a class of assets used to buy goods and services. • I o e is a pe so ’s a ual ea i gs. • Wealth is the alue of a i di idual’s assets less liabilities. CHAPTER 2 Money and Central Banks Money & Central Banks Functions of Money • Money serves three functions: – As the medium of exchange people use money to buy goods and services. – As the unit of account prices of goods and services are quoted in terms of money. – As a store of value people can hold wealth in the form of money. • The amount of wealth people hold as money is called money demand. CHAPTER 2 Money and Central Banks Money & Central Banks Money versus Barter Barter is the direct exchange of goods and services, which is how exchange occurs when there is no money. • Barter exchange has several problems: – Barter requires a double coincidence of wants. – With barter there are multiple prices for each good. – It may be difficult to store wealth with barter. CHAPTER 2 Money and Central Banks Money & Central Banks Double Coincidence of Wants • Barter requires that two parties have something to trade, that each party wants what the other person is offering, and that each feels the values of the traded goods or services are equal. • A medium of exchange solves this problem since the purchase and sale are separated, with each transaction being conducted using money. CHAPTER 2 Money and Central Banks Money & Central Banks Case Study: Barter in the Pacific Islands • Europeans who visited the Pacific Islands in the 19th century experienced difficulties with barter. – An opera singer was paid in livestock and fruits that she could not take to Paris and so she left her payment on the island. – Another man traveled with knives, cloth, and liquor (which made his suitcase very heavy) to trade for meals. • These Europeans were accustomed to money. CHAPTER 2 Money and Central Banks Money & Central Banks Barter Prices & the Unit of Account • With barter, prices are quoted in terms of other goods, such as shoes or bread, resulting in many sets of prices that make comparisons difficult. • With money serving as the unit of account, all prices are quoted in terms of the money, making comparisons of prices quoted by different sellers very easy. CHAPTER 2 Money and Central Banks Money & Central Banks A Store of Value • Storing wealth under barter can be difficult as many goods and services cannot be easily saved. • Money is a store of value that is easily saved to make future payments. – In developed economies there are many assets that are more attractive stores of value than money. – In countries suffering high inflation, foreign currency is often the most popular store of value. CHAPTER 2 Money and Central Banks Money & Central Banks Types of Money • There are two types of money: – Commodity money exists when a good that has intrinsic value serves as the medium of exchange. – Fiat money has no intrinsic value but has been declared money by government decree or fiat. CHAPTER 2 Money and Central Banks Money & Central Banks Commodity Money • Commodity money is a valuable good that serves the key functions of money. • Examples of commodity money: – Seashells – Animal skins – Tobacco – Precious metals, especially gold and silver CHAPTER 2 Money and Central Banks Money & Central Banks Commodity Money • Coins – Made from precious metals with standard weights and purities – First appeared in China in 1000 BCE and in Greece in 700 BCE • Paper money – Originally backed or redeemable for commodities – Jevons, WS, 1875. Money and the mechanism of exchange. London: Kegan Paul, Trench – Appeared in China in the year 1000 and in CHAPTER 2 Money and Central Banks Europe between 1500 and 1700 Money & Central Banks Fiat Money • Fiat money: – Has no intrinsic value. – Cannot be redeemed for anything except itself. – Is used because it is generally acceptable everyone uses and accepts it. CHAPTER 2 Money and Central Banks Money & Central Banks From Commodity to Fiat Money • When governments realized paper money was rarely redeemed, they began issuing more paper money than they had of the commodity that backed it. • Once paper money was generally accepted, governments stopped backing it with commodities. – Now governments could print money without limit. CHAPTER 2 Money and Central Banks Money & Central Banks Case Study: The History of the U.S. Dollar • The Continental dollar was a fiat currency. – So much was printed to pay for the war that it became almost worthless. • After the revolution the new country minted gold and silver coins. – The First and Second Banks of the United States, our first central banks, issued paper money redeemable for gold or silver. • To pay for the Civil War the government issued fiat u e alled G ee a ks ausi g high i flatio . CHAPTER 2 Money and Central Banks Money & Central Banks Case Study: The History of the U.S. Dollar • The return to commodity money occurred in 1879 when the gold standard was reestablished, with an ounce of gold worth $20.67. • In 1914 the Federal Reserve began operations and its notes had only 40% gold backing. • In 1933 President Roosevelt suspended the gold standard. CHAPTER 2 Money and Central Banks Money & Central Banks Case Study: The History of the U.S. Dollar • In 1934 Roosevelt restored the gold standard with a devalued dollar. Foreign governments could exchange dollars for gold at $35 per ounce. Private ownership of monetary gold was prohibited. • I the Fed’s gold ese e e ui e e t as reduced to 25%, and it was ended in 1965. • In 1971 President Nixon broke all ties to gold. The dollar once again became a fiat currency. CHAPTER 2 Money and Central Banks Money & Central Banks Alternatives to a National Currency • Dollarization is ...
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