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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 2
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
Example
At 6% interest rate, 4 year loan of $10,000 for a car
Requires 48 monthly installments of $235 each
Total repayment = $235 x 48 = $11,280
$11,280
>
$10,000
(Total repayment)
(Amount of loan)
Reason: you are compensating the lender for the time during which you use the funds
2. Risk Requires Compensation
In a world of uncertainty, individuals will accept risk only if they are compensated in some
form.
The world is filled with uncertainty; some possibilities are welcome and some are not
To deal effectively with risk we must consider the full range of possibilities:
Eliminate some risks,
Reduce others,
Pay someone else to assume particularly onerous risks, and
Just live with what's left
Investors must be paid to assume risk, and the higher the risk the higher the required payment
Car insurance is an example of paying for someone else to shoulder a risk you don't want to
take. Both parties to the transaction benefit
Drivers are sure of compensation in the event of an accident
The insurance companies make profit by pooling the insurance premiums and investing them
Now we can understand the valuation of a broad set of financial instruments
E.g., lenders charge higher rates if there is a chance the borrower will not repay.
3. Information is the basis for decisions
We collect information before making decisions
The more important the decision the more information we collect
The collection and processing of information is the basis of foundation of the financial system.
Some transactions are arranged so that information is NOT needed
Stock exchanges are organized to eliminate the need for costly information gathering and thus
facilitate the exchange of securities
One way or another, information is the key to the financial system
4. Markets set prices and allocate resources
Markets are the core of the economic system; the place, physical or virtual,
Where buyers and sellers meet
Where firms go to issue stocks and bonds,
Where individuals go to purchase assets
Financial markets are essential to the economy,
Channeling its resources
Minimizing the cost of gathering information
Making transactions
Well-developed financial markets are a necessary precondition for healthy economic growth
The role of setting prices and allocation of resources makes the markets vital sources of
information
Markets provide the basis for the allocation of capital by attaching prices to different stocks or
bonds
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Money & Banking ­ MGT411
VU
Financial markets require rules to operate properly and authorities to police them
The role of the govt. is to ensure investor protection
Investor will only participate if they perceive the markets are fair
5. Stability improves welfare
To reduce risk, the volatility must be reduced
Govt. policymakers play pivotal role in reducing some risks
A stable economy reduces risk and improves everyone's welfare.
By stabilizing the economy as whole monetary policymakers eliminate risks that individuals
can't and so improve everyone's welfare in the process.
Stabilizing the economy is the primary function of central banks
A stable economy grows faster than an unstable one
Financial System Promotes Economic Efficiency
The Financial System makes it Easier to Trade
Facilitate Payments - bank checking accounts
Channel Funds from Savers to Borrowers
Enable Risk Sharing - Classic examples are insurance and forward markets
1. Facilitate Payments
Cash transactions (Trade "value for value"). Could hold a lot of cash on hand to pay for things
Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs
Make transactions easier.
2. Channel Funds from Savers to Borrowers
Lending is a form of trade (Trade "value for a promise")
Give up purchasing power today in exchange for purchasing power in the future.
Savers: have more funds than they currently need; would like to earn capital income
Borrowers: need more funds than they currently have; willing and able to repay with interest in
the future.
Why is this important?
A) Allows those without funds to exploit profitable investment opportunities.
Commercial loans to growing businesses;
Venture capital;
Student loans (investment in human capital);
Investment in physical capital and new products/processes to promote economic growth
B) Financial System allows the timing of income and expenditures to be decoupled.
Household earning potential starts low, grows rapidly until the mid 50s, and then declines with
age.
Financial system allows households to borrow when young to prop up consumption (house
loans, car loans), repay and then accumulate wealth during middle age, then live off wealth
during retirement.
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Money & Banking ­ MGT411
VU
Figure: Channel Funds from Savers to Borrowers
$
Consumption
Dissavings
Dissavings
Income
Time
Retirement
Begins
3. Enable Risk Sharing
The world is an uncertain place. The financial system allows trade in risk. (Trade "value for a
promise")
Two principal forms of trade in risk are insurance and forward contracts.
Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to
replace lost income to provide for their family.
What are your options to address this risk?
Summary
Five Core Principles of Money and Banking
Time has Value
Risk Requires Compensation
Information is the basis for decisions
Markets set prices and allocate resources
Stability improves welfare
Financial System Promotes Economic Efficiency
Facilitate Payments
Channel Funds from Savers to Borrowers
Enable Risk Sharing
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY