An Introduction to Money and the Financial System

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Chapter 1

• An Introduction to Money and the Financial System

2
Introduction

• The Five Parts of the Financial System
• The Five Core Principles of Money and Banking

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Five Parts of the Financial System

• Money
• To pay for purchases and store wealth
• Financial Instruments
• Transfer wealth (capital) from savers (people
  with excess capital) to borrowers
• Transfer risk to those best equipped to bear it.
• Insurance, Sub-prime mortgage securities
• Financial Markets
• Buy and sell financial instruments
• Financial Institutions (Intermediaries).
• Provide access to financial markets
• Central Banks
• Monitor financial Institutions and stabilize the
  Economy

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Evolution of Five parts of financial system

• Money has evolved from coins to paper money to
  todays electronic funds transfers.
• Financial instruments where once investing was
  an activity reserved for the wealthy, todays
  small investors have the opportunity to purchase
  shares in mutual funds.
• Financial markets have evolved from trading
  places to electronic networks. Transactions are
  cheaper and markets offer a broader array of
  financial instruments than were available even 50
  years ago.
• Financial institutions Todays banks are more
  like financial supermarkets offering a huge
  assortment of financial products and services for
  sale.
• Central banks what had been government
  treasuries have evolved into the modern central
  bank that controls the availability of money and
  credit in such a way as to ensure low inflation,
  high growth, and the stability of the financial
  system.

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Five Core Principles of Money and Banking

• Time has value
• Risk requires compensation
• Information is the basis for decisions
• Markets determine prices and allocation resources
• Stability improves welfare
• ? TRIMS

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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
• If the interest rate is zero, what does that
  mean?
• If everything else is equal, Long-term government
  bonds offer higher/lower interest rates than
  short-term government bonds.

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Five Core Principles of Money and Banking

• 2. Risk requires compensation
• In a world of uncertainty, individuals will
  accept risk only if they are compensated in some
  form.
• An increase in the perceived risk associated with
  corporate bonds will cause the interest rate on
  corporate bonds to increase/decrease.
• college students pay higher/lower rates for
  credit cards than do individuals with an
  established (and positive) credit history.

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Five Core Principles of Money and Banking

• 3. Information is the basis for decisions
• The collection and processing of information is
  the basis of foundation of the financial system.
• Individuals will devote more/less resources to
  acquiring information when the expected benefits
  from acquiring the information are higher.

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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
• (True/False) most stock and bond prices are
  determined primarily by government pricing
  authorities.

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Five Core Principles of Money and Banking

• 5. Stability improves welfare.
• A stable economy reduces risk and improves
  everyone's welfare.
• (True/False) The rate of economic growth tends
  to be higher in countries that experience high
  and unstable inflation rates.

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Chapter 2

• Money and the Payments System

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A Roadmap

• Money and how we use it
• The Payments System
• The Future of Money
• Measuring Money

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MoneyThe Definition

• Money is an asset that is generally accepted as
  payment for goods and services or repayment of
  debt.

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MoneyCharacteristics

• 1. Means of payment Used in exchange for goods
  services
• 2. Unit of account Used to quote prices
• Store of value Used to move purchasing power
  into the future

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1. Means of payment 2. Unit of account 3.
Store of value

• A student cashes his paycheck and spends all of
  it on groceries. (1/2/3)
• An individual uses money to buy stocks. (1/2/3)
• A firm constructs its current balance sheet,
  expressing all credits and debits in dollars.
  (1/2/3)
• A criminal holds 10,000 in a wall safe to have
  in case he needs to leave the country quickly.
  (1/2/3)
• A student uses money to pay for textbooks.
  (1/2/3)
• A high school student deposits funds from a
  summer job into a savings account that will help
  be used to pay college tuition. (1/2/3)
• A storeowner records all receipts and
  expenditures in dollars. (1/2/3)

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MoneyHow We Pay for Things (I)

• Commodity Money Objects with intrinsic value
• Fiat Money Value comes from government decree
  (or fiat)
• Checks
• Instructions to the bank to shifts funds from
  your account to that of the person or firm
  whose name is written in the Pay to the Order
  of line.
• Are checks money? Yes/No
• ex) 20 dollar bills, gold coins, checking
  deposits,
• U.S. currency, salt, copper

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• Checks are legal proof of payment
• Customers wanted them back
• Starting in 2004
• Banks can transmit digital images
• Substitute checks are proof of payment
• Paper checks are now disappearing

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MoneyHow We Pay for Things (II)

• Credit Cards
• Debit Cards
• Electronic Funds transfers especially
  automated clearing house (ACH transactions)
• Stored Value Cards
• E-Money

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• Debit cards
• Like a check
• Electronic message to your bank to transfer funds
  immediately
• Credit cards
• Deferred payment
• Issuer makes payment for you
• You have to pay it back

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The Future of Money

• Which function of money will be with us for a
  long time?
• Means of payment disappearing
• Unit of account likely to remain
• Store of value disappearing

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Measuring Money

• Changes in the quantity of money are related to
• Interest Rates
• Economic Growth
• Inflation ( change of general price level) CPI
• How do we measure money?
• based upon degree of liquidity.

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Liquidity Definition

• Liquidity a measure of the ease an asset can be
  turned into a means of payment (Money).

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The Liquidity Spectrum
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Measuring Money

• Different Definitions of money are based upon
  degree of liquidity.
• M1 Narrowest definition Only most liquid
  assets
• M2 Broader definition Includes assets not
  used as means of payment.

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Monetary Aggregates
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Measuring Money

• Suppose that the public shifts funds from
  checking accounts to savings accounts. Other
  things equal,
• M1 increases/decreases/remains unchanged.
• M2 increases/decreases/remains unchanged.

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Growth Rates in M1 and M2
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Money Growth (M2) and Inflation
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Money Growth and Inflation

• When inflation is high/low, money growth helps
  forecast inflation.
• When inflation is high/low, the relationship is
  not as close.

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Chapter 2

• End of Chapter