01 Introduction: Money and the

Financial System
Introduction
 Financial crises > Money and Banking
 Basic Question
 What is Money?
 What is Banking?
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 Money is anything that is widely used for making payments
and accounting for debts and credits.
 direct barter
 Indirect barter

 Medium of Exchange
 Store of value
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 What is the best form of money?
 Stable Value
 Supply cannot be manipulated like fiat money which causes the boom and
bust cycles in the economy

 Durability
 Gold and silver will not rot which makes them a great store of value

 Fungible and divisible

 They can be divided into small, interchangeable amounts which make them
ideal for trade.
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 What is the best form of money?
 Portable
 Their high concentration of value allows you to carry and store substantial
value
 Proven
 Gold and silver have been used as money for over 6000 years of recorded
history.
 Use value
 Both gold and silver have tremendous use value in industry. The highest use
value though is in their role as money
Introduction
 THE FIVE CORE PRINCIPLES OF MONEY AND
BANKING

 TIME has value:

 A dollar today is worth more than a dollar a year from now. Why is
this?
 RISK requires compensation.
 For securities like stocks and bonds, the higher the risk, the higher the
return has to be. For individuals, minimizing the risk of such things as
accidents, illness, and theft is worth the expense of monthly insurance
premiums.
Introduction
 THE FIVE CORE PRINCIPLES OF MONEY AND
BANKING

 INFORMATION is the basis for decisions

 Banks and other financial institutions that make loans gather a considerable
amount of information about their potential borrowers before advancing
them money.
 MARKETS set prices and allocate resources
 Financial institutions and markets, by connecting savers with borrowers,
allow for people's leftover money (savings) to be channeled into
productive investment in capital
 STABILITY improves welfare
Introduction
 THE FIVE PARTS OF THE FINANCIAL SYSTEM

 MONEY - Anything generally accepted as payment. It's

useful because you can buy things with it, either now or later
(non-perishable, store of wealth).
 Main types of money: bank deposits, cash.

 FINANCIAL INSTRUMENTS - A financial

instrument is a formal obligation that entitles one party
to receive payments and/or a share of assets from another
party.
E.g.: loans, stocks, bonds. Even an ordinary bank loan is a
financial instrument. Security is a name that commonly
refers to financial instruments that are traded on.
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 THE FIVE PARTS OF THE FINANCIAL SYSTEM

 FINANCIAL MARKETS - Places or networks where financial instruments

can be sold quickly and cheaply. E.g.: New York Stock Exchange, U.S. Treasury's
online auction site for its bonds, KSE

 FINANCIAL INSTITUTIONS - Firms that provide savers and borrowers

with access to financial instruments and financial markets.Among other services,
they allow individuals to earn a decent return on their money while at the same time
avoiding risk.

 CENTRAL BANKS - A central bank is a large financial institution that

handles the government's finances, regulates the supply of money and credit in
the economy, and serves as the bank to commercial banks.
Introduction
 Difference between saving and investment??

 Meaning
Saving money means keeping aside a part of your income regularly in order to deal with unexpected
expenses. Investment means putting your saved money in various products in order to earn returns and
grow your wealth.
 Time
Savings are usually used to meet your short term needs. People save in order to deal with emergency
situations and meet unexpected expenses. However, investment generally entails a longer horizon of six
months or more. It is designed to provide returns and grow your money over a period of time.
 Risk and reward
Another difference between savings and investment is the risk they bear and returns they offer. While
savings stored in a safety vault are very safe, they will not generate any returns over the years. Even if
money is kept in a savings account, it will provide a negligible rate of return. On the other hand, money
invested in various products like stocks, mutual funds, gold, etc. is subject to more risks, but has the
potential to grow over time. If invested wisely, your money can grow manifold over years.
 Liquidity
When it comes to liquidity, your savings are the most liquid assets, as they can be accessed at any time.
However, this is not the case with investments. It takes a few days for the money to reach your bank
account after you decide to sell your investments.
Introduction
 FUNCTIONS OF MONEY
 Medium of exchange:
 A medium of exchange should possess the following characteristics:
 Transportability
 Divisibility
 High market value in relation to volume and weight
 Reconcilability
 Resistance to counterfeiting
 Unit of account:
 It is possible to divide a certain amount of money in smaller units
 It is interchangeable
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 Store of value:
 Money must have a stable value: (In reality this is often not the case,
the process of money slowly losing its value over time is called inflation)
 It must be very hard, preferably even impossible, to counterfeit
money
 Money is more liquid

 Standard of Deferred Payment:

 Buying now and paying later
 This function may seem obscure, but it is a direct result of the store
of value and unit of account functions.
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 Evolution of the Payments System and the
Form of Money:
1. Barter: exchange goods for goods, no money
2. Commodity money: gold or silver or another
valuable commodity (has value to everyone and
thus universally acceptable)---Heavy and Hard to
transport
3. Metallic Money
4. Paper currency
5. Credit Money
6. Near Money:liquid assets that can be converted to cash very
quickly, such as a bank deposit or bill of exchange
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What backs money?

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 What backs money?
 Earlier it used to be Gold
 Credit ratings
 Tax Collection

 Confidence/Trust in government
 Legal stipulation that dollars and coins printed by the U.S.
government must be accepted as payment.
 Change in purchasing power over a short period of time.
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 Money in Circulation:
 What do we count?

• Liquidity:
 The ease with which an asset can be sold or redeemed for a known
amount of cash at short notice and at low risk of loss of nominal value

• Monetary Aggregate:
 A grouping of assets sufficiently liquid to be defined as a measure of
money
Introduction
 The Monetary Base
 M1:
 1) Currency -Minted coins and paper currency not deposited in financial
institutions
 2) Checkable (transaction) deposits -Checkable Deposits
 3) Traveler’s checks - Purchased from a bank and signed when making purchases

• The currency includes only paper money and coins in the hands of the nonbank public and does not include cash
that is held in ATMS or banks vaults.
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 The Monetary Base
 M2:
 M1 plus savings and small-denomination time deposits and balances of individual
and broker-dealer money market mutual funds.
 This category includes household savings accounts and small denomination (usu
100,000$) certificates of deposit (CDs) which have a scheduled maturity date

M2 = M1 + savings deposits and small denomination time deposits + overnight repurchase agreements + overnight
Eurodollars deposits + retail money market mutual funds + money market deposit accounts
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TIME DEPOSITS AND DEMAND

DEPOSITS
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 The Monetary Base
 M3:
 M3 adds primarily large denomination time certificates of deposits
 Deposits/Repurchase agreements/Eurodollars with set maturities and
denominations greater than or equal to $100,000.
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 What is a bank?
 BANK is a financial institution that accepts deposits and makes
loans. Banks are critical to our economy. The primary function
of banks is to put their account holders' money to use by
lending it out to others who can then use it to buy homes,
businesses, send kids to college

 Banks create money in the economy by making loans. The

amount of money that banks can lend is directly affected by the
reserve requirement set by the Federal Reserve
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 How do banks create money??
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 Why does it work
 Banking is all about trust
 What is Bank run??
 if everyone came to withdraw their money at the same time, there
wouldn't be enough
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 How do banks make money?
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 Checking accounts