Money, Credit and Banking

DEF

A security is a claim on the issuer’s future income or assets.

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

An interest rate is the per-dollar cost of borrowing or the price paid for the rental of funds.

Unexpected changes in interest rates redistribute wealth.

The aggregate price level is the average price of goods and services in an economy.

Usually low inflation is often associated with high unemployment and low growth.

Monetary policy is the management of the money supply and interest rates. (by Federal Reserve System)

Fiscal policy deals with government spending and taxation.

Financial Market:

Type

Debit and Equity Markets:

- Debt instruments(maturity)

- Equities(dividends)

Primary and Secondary Markets:

-Investment banks underwrite securities in primary markets

-Brokers and dealers work in secondary markets.

Exchanges VS. OTC

-Money markets deal in short-term debt instruments (<1 year maturity)

-Capital markets deal in longer-term debt (>10 year maturity) and equity instruments

Function of Financial Markets:

Performs the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds.

Timing of Expenditures: Markets allow participants to give up resource today for future resources or vice versa. (Efficient allocations of funds to good projects)

Direct finance: borrower-spenders borrow funds directly from lender-savers i financial markets by selling their securities.

Problems with Financial Markets:

have many adverse selection problems

Illiquid--Liquidity mismatch: bank’s obligations are short-term or demand able and its assets are usually hard to sell

Credit risk- depends on release of information about credit risk

Interest Rate risk

Bond Finance -using event tree model (compare the event tree for the project to the event tree for the bond)

Financial intermediaries:

institutions that borrow funds from people who have saved and in turn make loans to other people who desire the funds for production or consumption.

Function of financial Intermediaries:

Indirect finance: lower transaction costs (time and money spent in carrying out financial transaction)- (economics of scale; Liquidity services)

Reduce the exposure of investors to risk-- Risk sharing (asset transformation); diversification

Intermediaries provide liquidity transformation.Banks hold many illiquid (hard to sell) long term assets like mortages. Their liabilities are highly illquid (demandable deposits)

Deal with asymmetric information problems:

Adverse Selection (Before transaction): try to avoid selecting the risky borrower by gathering information about them

Moral Hazard(After the transaction): ensure borrower will not engage in activities that will prevent him/her to repay the loan  (sign a contract with restrictive covenants)

Regulation of the financial system:

To increase the information available to investors:

- reduce adverse selection and moral hazard problems via disclosure requirements

- reduce insider trading via prosecutions

To ensure the soundness of financial intermediaries;

- Deposit insurance (avoid bank runs)

-Restriction on entry (chartering process)

-disclosure of information

-restrictions on assets and activities(control holding of risky assets)

-Post-2007: capital planning (stress tests)

Financial Stability Oversight Council (FSOC) (overarching view of financial system)