Chapter 2

Financial Assets, Money,

Financial Transactions,
and Financial Institutions

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives

To learn about the important channels

through which funds flow from lenders and
borrowers and back again within the global
system of money and capital markets.

To discover the nature and characteristics of

financial assets how they are created and
destroyed by decision makers within the
financial system.

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 Learning Objectives

To explore the critical roles played by money

within the financial system and the linkages
between money and inflation in the prices of
goods and services.

To examine the important jobs carried out by

financial intermediaries in lending and
borrowing and in creating and destroying
financial assets.

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 The Role of Financial Assets
The financial system is the mechanism
through which loanable funds reach
borrowers
Operation of the financial market
Money exchanged for financial claims
Stocks
Bonds
Other securities
Transforms savings into investment
Permits the economy to grow

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The Nature and Characteristics of
Financial Assets
A financial asset
A claim against the income or wealth of a
business firm, household, or unit of
government
Represented usually by a certificate
receipt, computer record file, or other legal
document
Usually related to the lending of money
Examples include stocks, bonds,
deposits, and others
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Characteristics of Financial Assets

Financial assets are sought after

because they promise future returns to
their owners and serve as a store of
value (purchasing power).

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 Characteristics of Financial Assets

Financial asset value based on faith that issuer

honors contractual promise to pay

Financial assets characteristics

Do not depreciate like physical goods

Physical condition or form usually not relevant in
determining market value
Have little or no value as a commodity
Cost of transportation and storage is low
Financial assets are fungible can easily be
changed in form and substituted for other assets
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 Types of Financial Assets
Money
Financial asset accepted in payment for purchases
of goods and services
Examples are currency and checking

Equities
Ownership shares in a business firm
Claims against the firms profits
Claims against proceeds from the sale of its assets
Examples are common stock and preferred stock

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 Types of Financial Assets
Debt Securities
Priority claim over the holders of equities to the
assets and income of an economic unit
Can be negotiable or nonnegotiable
Examples include bonds, notes, accounts payable,
and savings deposits
Derivatives
Market value tied to or influenced by the value or
return on a financial asset
Examples include futures contracts, options, and
swaps

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How Financial Assets Are Created
Internal financing to acquire assets
Use current income
Use accumulated savings

External financing to acquire assets

Raise funds by issuing financial liabilities
(debt)
Raise funds by issuing stock
(equities)
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Balance Sheets of Units in a
Simple Financial System

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 Unit Balance Sheets Following the
Equipment Purchase and Debt Issuance

2-13
Unit Balance Sheets Following Equipment
Purchase and Stock Issuance

2-14
 Financial Assets and the Financial System

The act of borrowing or of issuing new stock

simultaneously gives rise to the creation of
an equal volume of financial assets.

All financial assets are recorded as a liability

or claim on some other economic units
balance sheet.
Volume of financial assets for lenders
= Volume of liabilities issued by borrowers

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Financial Assets and the Financial System

For the balance sheet of any economic unit,

Total assets = Total liabilities + Net Worth

Where
Assets = Real assets + Financial assets

For the whole economy and financial system,

Total financial assets = Total liabilities

So, for the economy as a whole,

Total real assets = Total net worth
2-16
 Financial Assets and the Financial System

Society can increase its wealth

Saving and increasing the quantity of its real
assets
Real assets enable the economy to produce more
goods and services

The financial system provides the essential

channel
Necessary for the creation and exchange of
financial assets
Exchange is between savers and borrowers so
that real assets can be acquired

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 Financial System Matters
Strong financial system helps society
Reducing barriers to external financing
Lowering cost of capital
Accelerating economic growth

Nations with more fully developed financial

systems
Tends to grow faster
Tends to enjoy a higher standard of living

2-18
 Lending and Borrowing in the
Financial System
Economists John Gurley and Edward Shaw pointed
out that each business firm, household, or unit of
government active in the financial system must
conform to:

R - E = FA - D

Where
R = Current income receipts
E = Expenditures out of current income
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding

2-19
 Lending and Borrowing in the
Financial System
So, for any given time period, each
economic unit must fall into one of three
groups:
Deficit-budget unit (DBU):
E > R, so D > FA (net borrower of funds)

Surplus-budget unit (SBU):

R > E, so FA > D (net lender of funds)

Balanced-budget unit (BBU):

R = E, so D = FA (neither net lender nor
borrower)
2-20
 Lending and Borrowing in the
Financial System
The U.S. Economy in 2006
($ Billions)
Major Sectors Net Acquisitions Net Net Lender(+)
of the of Financial Increase in or Net
Economy Assets Liabilities Borrower (-)
Households $865.1 $1,411.1 $ - 546.0
Nonfinancial business 599.0 680.5 + 87.5
firms
State and local 80.0 144.0 - 64.0
governments
Federal government - 13.6 634.6 - 648.2
International sector:
foreign investors 1491.9 545.3 + 946.6
and borrowers
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
2-21
 Lending and Borrowing in the
Financial System

The global financial system permits

businesses, households, and
governments to adjust their financial
position from that of net borrower
(DBU) to net lender (SBU) and back
again, smoothly and efficiently.

2-22
 What is Money?

All financial assets are valued in terms of

money, and flows of funds between lenders
and borrowers occur through the medium of
money.

Money itself is a financial asset, because all

forms of money in use today are claims
against some public or private institution.

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 Alternative Definitions of Money

M1 = cash and checking account

deposits (Narrow Money)
M2 = M1 + savings accounts & money
market accounts (Broad Money)
M3 = M2 +large deposits and other
large, long-term deposits.
 Alternative Definitions of Money

M1 (Narrow Money)
Physical Currency (notes/bills and coins) plus
demand deposits, which are checking
accounts.
This is used as a measurement for
economists trying to quantify the amount of
money in circulation.
The M1 is a very liquid measure of the money
supply, as it contains cash and assets that
can quickly be converted to currency.
 Alternative Definitions of Money
M2 (Broad Money)
M1 + small time deposits (less than $100,000),
savings deposits, and non-institutional
money-market funds.
Economists use M2 when looking to quantify
the amount of money in circulation and trying
to explain different economic monetary
conditions.
M2 is a key economic indicator used to
forecast inflation.
 Alternative Definitions of Money

M3
M2 + all large time deposits, institutional
money-market funds, short-term repurchase
agreements, along with other larger liquid
assets.

This measure of money is used by

economists to estimate the entire supply of
money within an economy.
 Fiat Money
Fiat money is money whose value is not derived from
any intrinsic value or guarantee that it can be
converted into a valuable commodity (such as gold).
Instead, it has value only by government order (fiat).
Usually, the government declares the fiat currency
(typically notes and coins from a central bank), to be
legal tender, making it unlawful to not accept the fiat
currency as a means of repayment for all debts,
public and private.
 Historic Volume of Money
8000

7000

6000

5000

4000

3000

2000

1000

0
2000 2001 2002 2003 2004 2005 2006 2007

M1 M2
Source: http://www.federalreserve.org/releases/H6/hist/h6hist1.txt

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 The Functions of Money
In the past, money was generally considered to have
the following four main functions, which are summed
up in a rhyme found in older economics textbooks:
"Money is a matter of functions four, a medium, a
measure, a standard, a store.
 The Functions of Money
Money serves as a unit of account.

Money serves as a store of value

Reserve of future purchasing power
Value of money can fluctuate with inflation

Money serves as a medium of exchange

Buyers and sellers no longer need to have an
exact coincidence of wants

2-31
 The Value of Money and Other Financial
Assets and Inflation
Inflation
Rise in the average price level of all goods
and services
Lowers purchasing power of money
Can damage value of financial contracts
Deflation
The opposite of inflation
Fall in the average price level of all goods
and services
2-32
 The Value of Money and Other Financial
Assets and Inflation

Inflation is commonly measured

using price indices, such as:
the Consumer Price Index (CPI),
the Producer Price Index (PPI), or
the Gross Domestic Product (GDP)
deflator Index.

2-33
 The Value of Money and Other Financial
Assets and Inflation

Suppose the U.S. CPI rises from 100 to 125

over a five-year period.
Over the five-year period, the cost-of-living
index climbed
125 100 0.25 or 25% ...
100

and the U.S. dollars relative purchasing

power fell
1
100 0.8 .
125
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 Impact on Purchasing Power

Changes in purchasing power can be

dramatic
Due to inflation

Need to think in terms of real values

Purchasing power adjusted
Nominal values can be misleading

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 The Evolution of Financial
Transactions
The transfer of funds from savers to
borrowers can be accomplished in at
least three different ways

Direct Finance
Semidirect Finance
Indirect Finance

2-36
 The Evolution of Financial
Transactions

Direct Finance Direct lending gives rise

to direct claims against borrowers
Flow of funds and other financial services
(loans of spending power for an
agreed-upon period of time)
Borrowers Lenders
(DBUs) (SBUs)
Primary Securities
(stocks, bonds, notes, etc., evidencing
direct claims against borrowers)

Simple Difficult to match & risky

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 The Evolution of Financial
Transactions
Semidirect Finance Direct lending with the
aid of market makers who assist in the sale
of direct claims against borrowers
Primary Securities Primary Securities
(direct claims (direct claims
against Security against
borrowers) borrowers)
Borrowers brokers, Lenders
dealers, & (SBUs)
(DBUs) investment Flow of funds
Proceeds of
bankers and other
security sales and other financial services
financial services (loans of spending
(less fees and commissions) power)
Lower search (information) costs
Risky & matching is still required 2-38
Major Financial Institutions

2-39
 The Evolution of Financial
Transactions
Indirect Finance Financial intermediation of
funds
Primary Securities
(direct claims against ultimate
borrowers in the form of loan
contracts, stocks, bonds, notes,
etc.)
Secondary Securities
(indirect claims against ultimate
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)

Financial intermediaries
Ultimate (banks, savings and loan associations, Ultimate
borrowers insurance companies, credit unions, lenders
(DBUs) mutual funds, finance companies, (SBUs)
pension funds)
Flow of funds and other Flow of funds and other
financial services financial services
(loans of spending power) (loans of spending power)
Low risk & affordable 2-40
Classifying Financial Institutions

Depository institutions
Bulk of their loanable funds from deposit
accounts sold to the public
Commercial banks, savings and loan
associations, savings banks, credit unions
Contractual institutions
Funds from offering legal contracts to
protect the saver against risk
Insurance companies, pension funds

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 Classifying Financial Institutions

Investment institutions
Sell shares to the public
Invest the proceeds in stocks, bonds, and
other assets
Mutual funds, money market funds, real
estate investment trusts

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 The Disintermediation of Funds
Disintemediation process
Withdrawal of funds from a financial
intermediary by the ultimate lenders
(SBUs)
Lending of those funds to ultimate
borrowers (DBUs)
Disintermediation shifts funds
Away from indirect finance
To direct finance

2-43
The Disintermediation of Funds

Financial Disintermediation

Primary Securities

Ultimate Financial Ultimate

borrowers intermediaries lenders
(DBUs) (SBUs)

Loanable funds

2-44
 The Disintermediation of Funds
Disintermediation is not a foregone
conclusion
Reintermediation
Reversal of flow of funds
Back to a safe haven of financial
intermediaries
Interest rates are low or declining
Or riskiness of financial instruments appear
to be rising

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 New Forms of Disintermediation
Initiation by financial intermediaries
Banks sell off loans
Difficulty in raising capital
Initiation by borrowing customers
Customer learn alternate financing
conduits
Nonfinancial retail and industrial firms
attempting to draw financial services
customers
Raise funds in the open market

2-46
Bank-Dominated Versus Security-
Dominated Financial Systems

Bank-dominated financial systems

Banks and other similar institutions
dominate
Supply of credit
Attracting savings
Common in economies with less
protection of investor rights or less well-
defined rules

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 Bank-Dominated Versus Security-
Dominated Financial Systems

Security-dominated financial systems

Traditional intermediaries are less
important
More borrowers sell securities to the public
Many economies are gradually moving
toward a more security-dominated financial
system

2-48
 Markets on the Net
Answers.com at
http://www.answers.com/topic/disinter
mediation
Bondsonline at www.bondsonline.com
Encarta at encarta.msn.com
Encyclopedia.com at encyclopedia.com
Federal Reserve Bank of Atlanta at
www.frbatlanta.org
Federal Reserve Bank of New York at
www.ny.frb.org
2-49
 Markets on the Net

Federal Reserve Bank of St. Louis at

research.stlouisfed.org/fred2
Moodys Investor Service at
www.moodys.com
Money Magazine at money.cnn.com
New York Stock Exchange at
www.nyse.com
RePEc at ideas.repec.org
2-50
 Markets on the Net

Standard & Poors Corporation at

www.standardandpoor.com
The Bond Market Association at
www.investinginbonds.com
U.S. Bureau of Economic Analysis at
www.bea.gov
U.S. Bureau of Labor Statistics at
www.stats.bls.gov
Wikipedia at en.wikipedia.org
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 Chapter Review

Introduction: The role of financial

assets
The creation of financial assets
Characteristics of financial assets
Different kinds of financial assets
How financial assets are born
Financial assets and the financial
system
2-52
 Chapter Review

Lending and borrowing in the financial

system
Money as a financial asset
What is money?
The functions of money
The value of money and other financial
assets and inflation

2-53
 Chapter Review

The evolution of financial transactions

Direct finance
Semidirect finance
Indirect finance and financial
intermediation
Relative size and importance of major
financial institutions
Classification of financial institutions

2-54
 Chapter Review

Disintermediation of funds
New types of disintermediation
Bank-dominated versus security-
dominated financial systems

2-55