Financial system
There are two types of financial institutions:
Direct finance: financial markets
Indirect finance: financial intermediaries
Function of financial markers:
Perform the ESSENTIAL function of channeling funds from economic players that have saved SURPLUS funds to those who have SHORTAGE funds
Savings= income- consumption
-Savers may not have profitable investments
-Individuals with profitable investments may h
Direct finance
borrowers borrow funds directly from lenders in financial markets by selling them SECURITIES
Security assets for the buyers and liabilities for the seller (issues them)
I.E: Ford motor company may issue a bond to finance its expansion
Financial Markets
Promote economic efficiency by producing an efficient allocation of capital, which increases production
Directly improve the well-being of consumers by allowing them to time purchases better.
IE= an individual will have to save over a long period of time
Structure of Financial Markets (direct finance)
Debt and Equity Markets: debt instruments ( maturity- the numbers of years until its expiration date)
Bond or mortgage: (borrower agrees to pay a fixed amount at the regular intervals [principal and interest] until a specified date when the final payment
Secondary markets can be organized in two ways
Exchange and over-the-counter (OTC) markets
Money and capital markets
Exchange and OTC
Exchanges: NYSE, Chicago bond of trade (buyers and sellers meet i na CENTRAL location to conduct business)
OTC markets: foreign exchange, federal funds
NASQAD (dealers at different locations have an inventory of securities)
Money can Capital Markets
Money markets deal in short-term debt instruments (less than a year)
Capital markets deal in longer-term debt and equity instruments
Function of Financial Intermediaries (indirect finance)
LOWER transaction costs
time and money spent in carrying out financial transactions
IE:
Tom: loan of $100 with interest of 10$- lawyer costs $500 makes a lost. Small savers will be frozen out of the market
A bank can get a lawyer for $500 issue 2000 loans
Deal with Asymmetric information problems
Borrowers and lenders have different information. Borrowers know ALL ABOUT THE PROJECT AND THEMSELVES. The lender has no knowledge about the project and the borrower.
Two problems
Adverse selection: (before the transaction) the bad credit risk most actively seeks out a loan and are thus most likely to be selected.
Because of this loans are most likely to be given to the bad credit risk, then lenders may not lend. Even though good c
Example of assymetric info
Aunt Louise good credit risk, conservative chooses good project
Aunt Sheila gambler and bad credit risk, get-rich-schemes.
Who is most likely to call for a loan, Aunt Sheila because she has so much to gain.
You will not want to lend her, because the proba
Moral hazard
This occurs after the transaction
Ensure borrower will not engage in (immoral) stuff that will prevent him or her from repaying the loan.
IE:Uncle Melvin needs $5000 to tutor SAT students. He loves to go to Las Vegas and gamble. How do you know he wont ta
Conclusion
Financial intermediaries allow "small" savers and borrowers to benefit from the existence of financial markets
Regulation of the financial system
To increase the info available to investors
-Reduce adverse selection and moral hazards problems
- Reduce insider trading (SEC)
To ensure the soundness of financial intermediaries
Restrictions on entry (chartering process)
Disclosure of information
Restrictions on assets and activities ( control holding of risky assets
Deposits insurance (avoid banks runs)
Limits on competition(mostly in the past)
-branching
-Restrictions on intere
Broad definition of money
Stored value
Medium of Exchange
Unit of account
Medium of exchange
commodities are exchanged through money for commodity
Unit of account
relative measure of value and we can use it to express the value of services and goods. They are expressed in terms of money
An economy that uses money is highly efficient ecnomy
Store of value
We can transfer purchases into the future
It allows us to take current consumption and transmit it into the future
Why money performs this function the best?
Money provides liquidity, so liquidity the medium of exchange function
Features of money
easy to transport
should not deteriorate
easy divisible
widely acceptable
Evolution of money overtime
payment of system
commodity money: is here some commodity function as money but the commodity has an inartistic value:
ie:gold
Commodity money
Is the commodity function as money but the commodity has an intristic value
ie:gold
Fiat money
Paper currency
Is money because the state declares it that is money
-money issued by the gov
-inflation is a problem: this occurs when there is too much money
Widely acceptable
Measures of Money
M1 and M2
M1
narrow money
normally includes coins and notes in circulation and other money equivalent that are easily convertible into cash
M2
Includes M1 and plus short-term time deposits in banks and 24-hour money market funds