Introduction to Money and the Financial System (ECON 2035) - Study Notes

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Chapter 1: Introducing Money and the Financial System

Section 1.1: Key Components of the Financial System

The financial system is essential for the functioning of modern economies, facilitating the transfer of funds between savers and borrowers. Understanding its components helps explain how resources are allocated and risks are managed.

Financial Assets: Anything of value owned by a person or firm. A financial asset represents a claim on someone else for a payment.
Financial Institutions: Entities such as banks and other intermediaries that facilitate the flow of funds.
Regulators: The Federal Reserve and other agencies oversee the stability and integrity of the financial system.

Financial Assets

Financial assets are instruments that allow the transfer of funds and risk between parties. They include securities, bonds, money, stocks, foreign exchange, and securitized loans.

Securities: Financial assets that can be bought and sold in financial markets.
Bonds: Debt securities promising periodic payments for a specified period. Key terms:
- Coupon payment: Interest paid at intervals for the use of borrowed funds.
- Face value: Principal paid at maturity.
- Maturity: Time between issuance and repayment of face value.
Interest Rate: The cost of borrowing or the price paid for the rental of funds. Formula for interest rate on a zero-coupon bond:
Types of Bonds:
- Commercial paper: Short-term debt issued by corporations.
- Treasury bills: Short-term debt issued by the U.S. government.
- Zero-coupon bonds: Sold at a discount, no periodic interest payments.
Money: Anything generally accepted in payment for goods, services, or debts. The money supply is the total quantity of money in the economy.
Stocks (Equities): Securities representing partial ownership of a firm. Dividends are payments to shareholders from profits.
Foreign Exchange: Units of foreign currency. The foreign exchange market converts funds between currencies, and the foreign exchange rate is the price of one currency in terms of another.
Securitized Loans: Loans converted into tradable securities through securitization. A loan is a financial liability for the borrower.

Financial Institutions

Financial institutions match savers and borrowers, either directly or through intermediaries. They play a crucial role in the allocation of resources and risk management.

Banks and Financial Intermediaries: Borrow funds from savers and lend to borrowers.
Indirect Finance: Funds flow from lenders to borrowers through intermediaries.
Direct Finance: Funds flow directly from savers to borrowers via financial markets.

Flows of Funds Through the Financial System

The financial system channels funds from savers (households, businesses, governments, foreigners) to borrowers (spending entities) through both direct and indirect finance.

Types of Financial Intermediaries

Financial intermediaries are classified based on their sources and uses of funds. They include depository institutions, contractual savings institutions, and investment intermediaries.

Depository Institutions (Banks)

Type of Intermediary	Primary Liabilities (Sources of Funds)	Primary Assets (Uses of Funds)
Commercial banks	Deposits	Business and consumer loans, mortgages, government securities, municipal bonds
Savings and loan associations	Deposits	Mortgages
Mutual savings banks	Deposits	Mortgages
Credit unions	Deposits	Consumer loans

Contractual Savings Institutions

Type of Intermediary	Primary Liabilities	Primary Assets
Life insurance companies	Premiums from policies	Corporate bonds and mortgages
Fire and casualty insurance companies	Premiums from policies	Municipal bonds, corporate bonds and stock, government securities
Pension funds, government retirement funds	Employer and employee contributions	Corporate bonds and stock

Investment Intermediaries

Type of Intermediary	Primary Liabilities	Primary Assets
Finance companies	Commercial paper, stocks, bonds	Consumer and business loans
Mutual funds	Shares	Stocks, bonds
Money market mutual funds	Shares	Money market instruments
Hedge funds	Partnership participation	Stocks, bonds, loans, foreign currencies, other assets

Functions of Financial Intermediaries

Financial intermediaries provide several key functions that enhance the efficiency and stability of the financial system.

Lower Transaction Costs: Achieved through economies of scale and liquidity services.
Risk Reduction: Through risk sharing (asset transformation) and diversification.
Dealing with Asymmetric Information:
- Adverse Selection: Avoiding risky borrowers before transactions by gathering information.
- Moral Hazard: Ensuring borrowers do not engage in activities that prevent loan repayment, often through restrictive covenants.
Economies of Scope: Lowering information production costs across services, but may create conflicts of interest.

Structure of Financial Markets

Financial markets are organized to facilitate the trading of debt and equity instruments, and can be classified by the nature of instruments and trading mechanisms.

Debt and Equity Markets:
- Debt instruments: Have a maturity date.
- Equities: Provide dividends to shareholders.
Primary Markets: Where new securities are issued and underwritten by investment banks.
Secondary Markets: Where existing securities are traded by brokers and dealers.
Exchanges: Centralized trading venues (e.g., NYSE).
Over-the-Counter (OTC) Markets: Decentralized markets for instruments like foreign exchange and federal funds.
Money Markets: Deal in short-term debt instruments.
Capital Markets: Deal in longer-term debt and equity instruments.

Internationalization of Financial Markets

Globalization has led to the integration of financial markets across countries, with various instruments facilitating international finance.

Foreign Bonds: Sold in a foreign country, denominated in that country's currency.
Eurobonds: Denominated in a currency other than that of the country in which it is sold.
Eurocurrencies: Foreign currencies deposited in banks outside the home country.
Eurodollars: U.S. dollars deposited in foreign banks or foreign branches of U.S. banks.
World Stock Markets: Help finance corporations and governments globally.

Regulation of the Financial System

Regulation is essential to maintain stability, transparency, and trust in the financial system. It aims to protect investors and ensure the soundness of financial intermediaries.

Increasing Information: Reduces adverse selection, moral hazard, and insider trading.
Ensuring Soundness: Includes restrictions on entry, disclosure, asset holdings, deposit insurance, and competition.

Major Regulatory Agencies

Regulatory Agency	Subject of Regulation	Nature of Regulations
Securities and Exchange Commission (SEC)	Organized exchanges and financial markets	Requires disclosure of information; restricts insider trading
Commodity Futures Trading Commission (CFTC)	Futures market exchanges	Regulates procedures for trading in futures markets
Office of the Comptroller of the Currency	Federally-chartered commercial banks and thrift institutions	Charters and examines books; imposes restrictions on assets
National Credit Union Administration (NCUA)	Federally-chartered credit unions	Charters and examines books; imposes restrictions on assets
State banking and insurance commissions	State-chartered depository institutions and insurance companies	Charter and examine books; impose restrictions on assets
Federal Deposit Insurance Corporation (FDIC)	Commercial banks, mutual savings banks, savings and loan associations	Provides insurance up to $250,000 per depositor; examines books; imposes restrictions
Federal Reserve System	All depository institutions	Examines books; sets reserve requirements

The Federal Reserve System

The Federal Reserve ("the Fed") is the central bank of the United States, established in 1913 to address banking problems. Its original role was as lender of last resort.

Monetary Policy: The Fed manages the money supply and interest rates to pursue macroeconomic objectives.
Structure: Divided into 12 districts; main policymaking body is the Federal Open Market Committee (FOMC).
Federal Funds Rate: The interest rate banks charge each other for short-term loans.

Section 1.2: The Financial Crisis of 2007-2009 - An Overview

Origins of the Financial Crisis

A financial crisis is a significant disruption in the flow of funds from lenders to borrowers. The crisis of 2007-2009 was triggered by the housing bubble and loose lending standards.

Bubble: Unsustainable increase in asset prices.
Subprime Borrowers: Individuals with flawed credit histories received risky loans.
Adjustable-rate Mortgages: Allowed borrowers to pay low initial interest rates.
Mortgage-backed Securities: Investment banks bundled and sold these, spreading risk throughout the financial system.
Defaults and Recession: Falling home prices led to defaults, a severe recession, and rising unemployment.

The Deepening Crisis and Policy Response

Government intervention during the crisis included the Troubled Asset Relief Program (TARP) and controversial policies by the Fed and Treasury.

TARP: Treasury provided funds to banks in exchange for stock.
Controversial Measures: Partial government ownership, implicit guarantees, and unprecedented market intervention.
Concerns: Potential reduction in Fed independence.

Section 1.3: Path Forward

Course Outline

The course covers the following major topics:

Introduction to Money and the Financial System
Interest Rates and the Bond Market
Other Financial Markets (Stocks, Derivatives, Foreign Exchange)
Financial Intermediaries (Banks, Nonbank Institutions)
Monetary Policy and the Federal Reserve
Macroeconomic Activity and Financial Regulation

Additional info: These notes provide foundational knowledge for understanding the financial system, its institutions, and the impact of financial crises, but do not directly address Financial Accounting topics such as transaction analysis, accrual accounting, inventory, or financial statement preparation.