CHAPTER 1: INTRODUCING MONEY AND THE FINANCIAL SYSTEM

LEARNING OBJECTIVES
!! Key components of the financial system !! Identify the five parts of the Financial system
!! The purpose of financial markets and financial institutions !! The process of financial intermediation !! The primary function of a central bank !! Why the money supply is a very important component of the economy

!! The five core principals of Money and Banking

Key components of the financial system

1.! Financial assets !! An asset is anything of value owned by a person or a firm. !! A financial asset is an asset that represents a claim on someone else for a payment. 2. Financial Institutions 3. Central banks and other financial regulators

Financial Assets
!! Economists divide financial assets into those that are securities and those that arent.

!! A security is a financial asset that can be bought and sold in a financial market.

!! Financial markets are places or channels for buying or selling stocks, bonds, and other securities.

Financial Assets
!! Five key categories of financial assets: 1.! Money 2.! Stocks 3.! Bonds 4.! Foreign Exchange 5.! Securitized loans

Financial Assets - Money

!! Money: Anything that is generally accepted in payment for goods and services to pay off debts !! The money supply is the total quantity of money in the economy

Financial Assets - Stocks

!! Stocks are financial securities that represent partial ownership of a firm, also called equities !! Dividend: A payment that a corporation makes to its shareholders

Financial Assets - Bonds

!! Bond: A financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money !! Interest rate: The cost of borrowing funds (or the payment for lending funds), usually expressed as a percentage of the amount borrowed

Financial Assets Foreign Exchange

!! To buy foreign goods and services or foreign assets, a domestic business or a domestic investor must first exchange domestic currency for foreign currency. !! Foreign exchange: Units of foreign currency. !! Bank often engage in foreign currency transactions on behalf of investors and business firms

Financial Assets Securitized Loans

!! Before markets for loans were created, it wasnt possible to sell loans. Loans were financial assets but not securities. !! Securitization: The process of converting loans and other financial assets that are not traded into securities. !! NOTE that what a saver views as a financial asset a borrower views as a financial liability. !! Financial liability: A financial claim owed by a person or a firm.

Financial Institutions
!! The financial system matches savers and borrowers through two channels: (1)! Banks and other financial intermediaries Financial intermediary: A financial firm, such as a bank, that borrows funds from savers and lends them to borrowers (2) Financial markets Funds flow from lenders to borrowers indirectly through financial intermediaries, such as banks, or directly through financial markets, such as the New York Stock Exchange.

Moving Funds through the Financial System

Financial Institutions
!! Financial Intermediaries !! Commercial Bank: A financial firm that serves as a financial intermediary by taking in deposits and using them to make loans
!! Households rely on borrowing money from banks to purchase big ticket items !! Firms rely on banks to meet their short- and long-term needs for credit.

!! Some financial intermediaries, such as saving and loans, savings banks, and credit unions, are legally distinct from banks

Financial Institutions
!! Nonbank Financial Intermediaries
!! Insurance companies Insurance companies collect premiums from customers then invest the premiums to obtain the funds necessary to pay claims and other costs. !! Pension funds Pension funds invest contributions from workers and firms in stocks, bonds, and mortgages to earn the money necessary to make pension benefit payments

Financial Institutions
!! Nonbank Financial Intermediaries
!! Mutual funds A mutual funds obtains money by selling shares to investors and invests the money in a portfolio of financial assets. Portfolio A collection of assets, such as stocks and bonds !! Hedge funds Hedge funds are similar to mutual funds but typically have no more than 99 wealthy investors and make riskier investments. !! Investment banks Investment banks concentrate on providing advice to firms issuing stocks and bonds or considering mergers with other firms

Financial Markets
!! Financial markets are places or channels for buying and selling stocks, bonds and other securities. !! Today, most securities trading takes place electronically between dealers linked by computers and is referred to as over-the-counter trading. !! Primary market A financial market in which stocks, bonds and other securities are sold for the first time. !! Secondary market A financial market in which investors buy and sell existing securities.

The Central Bank and other Financial Regulators

!! Vietnamese agencies that regulate the financial system:
!! The State Bank of Vietnam (Central banks in other countries or the Federal Reserve System in the US) !! State Securities Commission of Vietnam !!

!! The central bank influences three very important variables in the economy:
!! Inflation !! Business cycles !! Interest rates

What is the Federal Reserve?

! The Federal Reserve is the central bank of the United States; usually referred to as the Fed. ! Established by Congress in 1913 to deal with banking problems.

! Original role: Serve as a lender of last resort. !! Topic 1: Insights into State Bank of Vietnam

What Does the Fed Do?

!! The Fed is responsible for monetary policy. Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. !! The Fed Is divided into 12 districts. !! The main policymaking body of the Fed is the Federal Open Market Committee (FOMC). !! Chairman: Ben Bernanke from 2006 present !! The FOMC meets eight times per year. During these meetings, the Fed decides on a target for the federal funds rate. !! Federal funds rate: The interest rate that banks charge each other on short-term loans.

The Federal Reserve System

What does the Financial System Do?

!! The financial system provides three services to savers and borrowers: risk sharing, liquidity and information. !! Risk sharing
!! Risk is the chance that the value of financial assets will change relative to what you expect. !! Diversification: Splitting wealth among many different assets to reduce risk. !! Risk sharing: A service the financial system provides that allows savers to spread and transfer risk.

What does the Financial System Do?

!! Liquidity
!! Liquidity: The ease with which an asset can be exchanged for money. !! Financial markets and intermediaries help make financial assets more liquid.

!! Information
!! Information: Facts about borrowers and about expectations of returns on financial assets. !! Financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds and other securities.

Five Parts of the Financial System

1.! 2.! Money
!! To pay for purchases and store wealth

Financial Instruments
!! To transfer resources from savers to investors and to transfer risk to those best equipped to bear it.

3.! 4.! 5.!

Financial Markets
!! Buy and sell financial instruments

Financial Institutions
!! Provide access to financial markets, collect information and provide services

Central Banks
!! Monitor financial institutions and stabilize the economy

Five Parts of the Financial System

1. Money
!! To pay for purchases !! To store wealth !! Evolved from gold and silver coins to paper money to todays electronic funds transfers !! Traditional Paycheck system vs. ATM Withdrawals !! Mailed transactions vs. E-banking

Five Parts of the Financial System

2. Financial Instruments

!! To transfer wealth from savers to borrowers !! To transfer risk to those best equipped to bear it.

!! once investing was an activity reserved for the wealthy

!! Costly individual stock transactions through stockbrokers !! Information collection was not so easy

!! Now, small investors have the opportunity to purchase shares in mutual funds.

Five Parts of the Financial System

3.

!! To buy and sell financial instruments quickly and cheaply

Financial Markets

!!evolved from coffeehouses to trading places (Stock exchanges) to electronic networks. !!Transactions are much more cheaper now !!Markets offer a broader array of financial instruments than were available even 50 years ago

Five Parts of the Financial System

4.

!! Provide access to financial markets

Financial Institutions.

!! Banks evolved from Vaults and developed into deposits- and loans-agency !! Todays banks are more like financial supermarkets offering a huge assortment of financial products and services for sale.
!! !! !! !! !! Access to financial markets Insurance Home- and car-loans Consumer credit Investment advice

Five Parts of the Financial System

5. Central Banks

!! Monitors financial Institutions !! stabilizes the Economy

!! control the availability of money and credit in such a way as to ensure

1.! low inflation, 2.! high growth, and 3.! the stability of the financial system.

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 allocation resources 5.! Stability improves welfare

Five Core principles of Money and Banking

1.! Time has value
!! Time affects the value of financial instruments !! Interest payments exist because of time properties of financial instruments

2.! Risk requires compensation

!! In a world of uncertainty, individuals will accept risk only if they are compensated in some form.

3.! Information is the basis for decisions

!! The collection and processing of information is the basis of foundation of the financial system.

Five Core principles of Money and Banking

4. Markets determine prices and allocate resources
!! The places where buyers & sellers meet are the core of the economic system

5. Stability improves welfare. !! A stable economy reduces risk and improves everyones welfare