Chapter 1: Introducing Money and the Financial System – Key Concepts and Components

Chapter 1: Introducing Money and the Financial System

Section 1.1: Components of the Financial System

The financial system is fundamental to the functioning of modern economies, facilitating the flow of funds between savers and borrowers. Understanding its components is essential for analyzing macroeconomic activity and financial stability.

Why Study Financial Markets?

• Financial markets play a crucial role in the allocation of resources and the stability of economies.

• Events such as the 2007-2009 financial crisis and the COVID-19 pandemic have demonstrated the profound impact of financial markets on economic agents worldwide.

• Financial markets are where funds are transferred from those with surplus funds (savers) to those with a deficit (borrowers).

Main Components of the Financial System

• Financial assets: Anything of value owned by a person or firm. A financial asset specifically represents a claim on someone else for a payment.

• Financial institutions: Entities such as banks, the Federal Reserve, and other regulatory bodies that facilitate the functioning of financial markets.

Financial Assets

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

Securities

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

• A bond is a debt security that promises to make payments periodically for a specified period of time.

• The interest rate is the cost of borrowing or the price paid for the rental of funds.

Bond Terminology

• A coupon bond pays interest at specified intervals for borrowed funds.

• Face value is the principal paid when a bond matures.

• Maturity is the time between the original sale and the payment of the face value.

Example: $100, 10-Year Bond with 6% Coupon

• Face value: $100

• Maturity: 10 years

• Annual coupon payment: $6

• Coupon payment is payment for the use of funds, similar to a loan.

Short-Term Financial Assets

• Commercial paper: Issued by corporations, short-term debt instrument.

• Treasury bills: Issued by the U.S. government, short-term debt instrument.

• Zero-coupon bonds: No specified coupon payment; sold at a discount from face value. The interest rate is the annualized percentage difference between face value and purchase price.

Other Financial Assets

• Money: Anything generally accepted in payment for goods and services or to pay off debts.

• Money supply: The total quantity of money in the economy.

• Stocks: Financial securities representing ownership in a firm (also called equities).

• Dividends: Payments made by corporations to shareholders from profits.

Foreign Exchange

• Foreign exchange: Units of foreign currency.

• Foreign exchange market: Where funds are converted from one currency to another.

• Foreign exchange rate: The price of one currency in terms of another.

Securitized Loans

• Traditionally, banks made loans intending to collect payments directly.

• Now, loans are often sold on financial markets through securitization.

• Securitization: The process of converting loans and other financial assets that are not tradable into tradable securities.

• A financial liability is a financial claim owed by a borrower.

Financial Institutions

Financial institutions are essential for matching savers and borrowers, operating through direct and indirect channels.

Channels of Fund Flow

• Banks and financial intermediaries: Financial firms that borrow funds from savers and lend them to borrowers.

• Direct finance: Funds flow directly from savers to borrowers.

• Indirect finance: Funds flow through financial intermediaries, such as banks.

Types of Financial Intermediaries

• Commercial banks: Take deposits and make loans.

• Savings banks and credit unions: Similar to commercial banks but legally distinct.

• Investment banks: Assist firms in underwriting stocks and bonds.

• Insurance companies: Collect premiums and invest to pay claims.

• Pension funds: Collect contributions and pay benefits during retirement.

• Mutual funds: Pool money from investors to invest in a portfolio of assets.

• Hedge funds: Similar to mutual funds but typically for wealthy investors and make riskier investments.

Functions of Financial Intermediaries

• Reduce transaction costs (time and money spent carrying out financial transactions).

• Achieve economies of scale and provide risk-sharing (asset transformation and diversification).

• Address asymmetric information problems:

  • Adverse selection: Screening risky borrowers before transactions.

  • Moral hazard: Ensuring borrowers do not engage in undesirable activities after receiving funds.

Summary Table: Types of Financial Intermediaries

Type	Primary Liabilities (Sources of Funds)	Primary Assets (Uses of Funds)
Commercial Banks	Deposits	Business and consumer loans, mortgages, securities, bonds
Savings Banks	Deposits	Mortgages, consumer loans
Credit Unions	Deposits	Consumer loans, mortgages
Insurance Companies	Premiums	Bonds, stocks, government securities
Pension Funds	Contributions	Corporate bonds, stocks
Mutual Funds	Shares sold to investors	Portfolio of stocks, bonds
Hedge Funds	Partnership participation	Stocks, bonds, currencies, other assets

Additional info:

• Financial intermediaries allow small savers and borrowers to benefit from financial markets.

• They help reduce risk and improve efficiency in the allocation of resources.