A Recap of Money and the Financial

System
 Getting to Know (Building trust)
• Tell me a little bit about yourself.
• How would you describe the strengths you bring to the group?
• What do you consider your past accomplishments or
highlights?
• What are your hobbies, interests, and astrological sign?
• What is your favorite:
• Color
• Music
• Car
• Food
• Star / TV Star
• What are your goals for this class?

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 Teaching Strategy
 The objective of the class is to emphasize the key
concepts and reinforce what you have studied.
 It will be difficult to follow the class without
familiarity with the days reading materials.
 Ask questions: easiest way to clarify doubts.
 Do not miss classes.
 Review after each class.

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 Intro - Every financial transaction has a story –
1/3college student bought coffee at the
• This morning, a typical American
local café, paying for it with an ATM card. Then she jumped into her
insured car and drove to the university, which she attends thanks to her
student loan. She may have left her parents’ home, which is mortgaged,
a few minutes early to avoid construction work on a new dormitory,
financed by bonds issued by the university. Or perhaps she needed to
purchase this book online, using her credit card, before her first money
and banking class began.
• Beneath the surface, the financial transactions embedded in this story—
even the seemingly simple ones—are quite complicated. If the café
owner and the student use different banks, paying for the coffee will
require an interbank funds transfer. The company that insures the
student’s car has to invest the premiums she pays until they are needed
to pay off claims. The student’s parents almost surely obtained their
home mortgage through a mortgage broker, whose job was to find the
cheapest mortgage available. And the bonds the university issued to
finance construction of the new dormitory were created with the aid of
an investment bank.
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 Intro - Every financial transaction has a story – 2/3

• This brief example hints at the complex web of interdependent

institutions and markets that is the foundation for our daily
financial transactions. The system is so efficient that most of us
rarely take note of it. But a financial system is like air to an
economy: If it disappeared suddenly, everything would grind to a
halt.
• In the autumn of 2008, USA came closer to such a financial
meltdown than at any time since the 1930s. In the earlier episode,
the collapse of the banking system led to the Great Depression. In
the recent crisis, some of the world’s largest financial institutions
failed. Key markets stopped functioning. Credit dried up, even for
sound borrowers. As a result, vibrant companies that relied on
short-term loans to pay their employees and buy materials faced
potential ruin. Even some fundamental ways that we make
payments for goods and services were threatened.
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 Intro - Every financial transaction has a story – 3/3

• Gasping for air in this financial crisis, the global economy during
2008 and 2009 sank into the deepest, broadest, and longest
downturn since the 1930s. Around the world, tens of millions of
people lost their jobs. In the United States, millions lost their
homes and their life’s savings. Others became unable to borrow to
buy a home or go to college. And the weakness added to financial
fragility elsewhere, especially in Europe, where the viability of the
euro, the world’s leading currency after the U.S. dollar, was
threatened. The chances are good that you know someone—in
your neighborhood, your school, or your family—whose life was
changed for the worse by the crisis.
• So, what happens in the financial system—whether for good or for
bad—matters greatly for all of us. To understand the system—
both its strengths and its vulnerabilities—let’s take a closer look.

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 Money, Banking, Financial Systems
Vocabulary
Money Mobile Banking
Income Close Loop System
Wealth Mobile Banking
Fiat Money Interoperability
Credit Money ATM Interoperability
Commodity Money
Switch
Financial Instruments
1LINK
Securities
Financial Markets MNET
Financial Institutions Payment Gateways
Regulatory Agencies Loans
Central Banks Debt
ATM Card Credit Card
Debit Card Mortgage Loan
Electronic Money Bonds
Electronic Wallet Coupon Bonds
Easy Paisa
Fixed Income Securities
Branchless Banking
Money Market
Financial Inclusion
Equities 1-7
Why you need to be familiar with
Money & Banking?
 Individuals financial decisions
 Buying a car
 Being a homeowner
 Going to the job market
 Understanding what’s going on
 The economy
 Functioning of the economy in the short-run
 Growth of the economy in the long-run

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 Introduction
• Every financial transaction has a story.
• There is a complex web of interdependent
institutions and markets making up the
foundation of daily financial transactions.
• The Six Parts of the Financial System.
• The Five Core Principles of Money and
Banking.

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 Six Parts of the Financial System
1. Money
To pay for purchases and store wealth.
2. Financial Instruments
To transfer resources from savers to investors and to transfer risk to those who are best
equipped to bear it. Stocks, mortgages, and insurance policies are examples of financial
instruments.
3. Financial Markets
To buy and sell financial instruments quickly and cheaply.
4. Financial Institutions
Provide a myriad of services, including access to the financial markets and collection of
information about prospective borrowers to ensure they are creditworthy. Banks,
securities firms, and insurance companies are examples of financial institutions.
5. Regulatory Agencies
To provide oversight for financial system, are responsible for making sure that the
elements of the financial system, including its instruments, markets, and institutions,
operate in a safe and reliable manner
6. Central Banks
To monitor financial Institutions and stabilize the economy.

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Six Parts of the Financial System
1. Money
• Money has changed from gold/silver coins to paper
currency to electronic funds.
• Cash can be obtained from an ATM any where in
the world.
• Bills are paid and transactions are checked online.
• To pay their bills, people once wrote checks and put
them in the mail, then waited for their monthly
bank statements to make sure the transactions had
been processed correctly.
• Today, payments can be made automatically, and
account holders can check the transactions at any
time on their bank’s website or on their smartphone.
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Different ways of defining Money
• He makes a lot of money.
• Income
• She is worth a lot of money.
• Wealth
• They Spend a lot of money
• Economic activity
• Money (money supply)—anything that is generally
accepted in payment for goods or services or in the
repayment of debts (Mishkin, 2007)

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Functions of Money
• Medium of Exchange
– Standardized
– Widely accepted
– Divisible
– Portable
– Durable
• Unit of Account—a measure of economy value
• Store of Value—stable purchasing power and highly
liquid, however can lose value (Inflation)

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 Efficiency of Money

Standard of
Medium of
Store of Value Unit of account Deferred
Exchange
Compensation
• Facilitates trade • Stores • Facilitates price • Can be used to
• Fulfills double purchasing determination denominate a
coincidence of power over debt
wants time
 Money Another View
• Economists use liquidity to define money. Liquidity is people can easily convert an
asset into cash with little transaction costs. For example, if you take all your assets and
list them in terms of liquidity, then liquidity forms a scale, Cash is the most liquid asset
because a person already has money and does not need to convert it to money.
• Subsequently, a savings account is almost as good as cash because customers can arrive
at a bank or ATM and convert their deposits into cash quickly with little transaction
costs.
• Nevertheless, cars and houses are the least liquid assets because owners require time
and high transaction costs to convert these assets into cash.

Ranking Assets by liquidity 1-15

Six Parts of the Financial System
2. Financial instruments
• or Securities, as they are often called, have evolved
just as much as currency.
• Buying and selling individual stocks used to be
only for the wealthy.
• Today we have mutual funds and other stocks
available through banks or online.
• Putting together a portfolio is open to everyone.

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Six Parts of the Financial System
3. Financial Markets
• Once financial markets were located in coffeehouses and
taverns.
• Then organized markets were created, like the New York
Stock Exchange.
• Now transactions are mostly handled by electronic markets.
• This has reduced the cost of processing financial
transactions.
• There is a much broader array of financial instruments
available.

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Six Parts of the Financial System
4. Financial Institutions
• Banks began as vaults, developed into institutions,
to gradually they developed into institutions that
accepted deposits and made loans, are now today’s
financial supermarket.
• They offer a huge assortment of financial products
and services.
• Walk in to a bank and you will discover financial
products and services for sale, from access to the
financial markets to insurance policies, mortgages,
consumer credit, and even investment advice.

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Six Parts of the Financial System
5. Government regulatory agencies
• Government regulatory agencies were introduced by
federal government (refers to USA) after the Great
Depression.
• Government regulatory agencies provide wide-ranging
financial regulation - rules and supervision.
• Financial regulation—rules for the operation of
financial institutions and markets
• Supervision —oversight through examination and
enforcement.
• Government regulatory agencies examine the systems a
bank uses to manage its risk.
• The 2007-2009 financial crises has led governments to
consider greater regulation. 1-19
Six Parts of the Financial System
6. Central banks
• Central banks began as large private banks to
finance wars.
• Central banks control the availability of money
and credit to ensure low inflation, high growth and
stability of financial system.
• Today’s policymakers strive for transparency in
their operations.

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 Five Core Principles of
Money and Banking
1. Time has value.
2. Risk requires compensation.
3. Information is the basis for decisions.
4. Markets determine prices and allocation
resources.
5. Stability improves welfare.

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 Five Core Principles of
Money and Banking
A. Core Principle 1: Time has value
• Time affects the value of financial
instruments.
• Interest is paid to compensate the lenders
for the time the borrowers have their
money.
• Later we will gain an understanding of
interest rates and how to use them.

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Five Core Principles of Money and
Banking
B. Core Principle 2: Risk requires compensation
• In a world of uncertainty, individuals will accept risk only if they
are compensated.
• Dealing effectively with risk requires that you consider the full
range of possibilities in order to eliminate some risks, reduce
others, pay someone to assume particularly onerous risks, and just
live with what’s left. Needless to say, no one will assume your
risks for free, which brings us to the second core principle of
money and banking: Risk requires compensation
• In the financial world, compensation comes in the form of explicit
payments: the higher the risk the bigger the payment.
• Bearing in mind that time has value and risk requires
compensation, we can begin to see the rationale behind the
valuation of a broad set of financial instruments. For example, a
lender will charge a higher interest rate on a loan if there is a
chance that the borrower will not repay. 1-23
 Five Core Principles of
Money and Banking
C. Core Principle 3: Information is the basis for
decisions
• The more important the decision, the more information we
gather.
• Collection and processing of information is the foundation
of the financial system.
• The lender doesn’t know much about the borrower and
wants to make sure the loan will be repaid. When lenders
fail to assess creditworthiness properly, they end up with
more borrowers who are unable to repay their loans in the
future. Large mistakes like these were a key factor in the
wave of U.S. mortgage delinquencies and defaults that
preceded the financial crisis of 2007–2009.
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Five Core Principles of Money and Banking
D. Core Principle 4: Markets determine prices and allocate
resources.
• Markets are the core of the economic system.
• Markets channel resources and minimize the cost of gathering
information and making transactions.
• Fair, Efficient, rules, authorities to police them.
• The better developed the financial markets, the faster the
country will grow.
Ex. To see how prices in the financial markets allocate capital,
think about a large firm wishing to finance the construction of a
new factory costing several hundred million dollars. To raise the
funds, the firm can go directly into the financial markets and issue
stocks or bonds. The higher the price investors are willing to pay in
the market, the more appealing the idea will be, and the more
likely it is that the firm will issue securities to raise the capital for
the investment. 1-25
 Five Core Principles of
Money and Banking
E. Core Principle 5: Stability improves
welfare.
• A stable economy reduces risk and improves
everyone's welfare.
• Financial instability in the autumn of 2008
triggered the worse global downturn since the
Great Depression.
• A stable economy grows faster than an unstable
one.
• Volatility creates risk, reducing volatility
reduces risk.
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What is Money and Banking?
• A means and method of allocating and reallocating
resources
• The means is what we call Money
• The method is called Banking or the Financial
System
• The Financial system
• Financial Markets
• Financial intermediaries
• The role of money in the economy

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Money and Business Cycles
• Evidence suggests that money plays an important
role in generating business cycles
• Recessions (unemployment) and booms (inflation)
affect all of us
• Monetary Theory ties changes in the money supply
to changes in aggregate economic activity and the
price level

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What do banks do?
• Take deposits from general public (legal
definition)
• Make loans
• Provide payment services
• Deposits short‐term, often on demand
• Loans more long‐term
• Need to keep liquid reserves

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Reasons for intermediation
• Economies of scale and scope in lending
• Transaction costs
• Costs of information gathering
• Repackaging, diversification
• Monitoring services
• Dealing with adverse selection, moral
hazard, excessive optimism, lack of self‐
control

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 What makes banks different from
other intermediaries?
• Bank deposits major part of money supply
• Crucial in the transmission of monetary policy to the
real economy
• Crucial for the financing of small and medium sized
firms
• Information contained in the customer relationship

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 Financial intermediary
Financial firms that borrow funds from savers or from other
financial firms and invest them in loans or securities:

Mainly investing in loans: Mainly investing in securities:

•Banks •Investment firms
•Finance companies •Pension funds
•Credit companies •Insurance companies
•Government lenders •Mutual funds

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Asymmetric Information – the real evil?
• Asymmetric information occurs when one party knows
more about an economic transaction or asset than the other
party does.
• Adverse selection occurs before a transaction takes place. If
unmitigated, lenders and insurers will attract the worst risks.
• Moral hazard occurs after a transaction takes place. If
unmitigated, borrowers and the insured will take advantage
of lenders and insurers.

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 Summary
1. A healthy and constantly evolving financial system is the foundation for
economic efficiency and economic growth. It has six parts:
a. Money is used to pay for purchases and to store wealth.
b. Financial instruments are used to transfer resources and risk.
c. Financial markets allow people to buy and sell financial instruments.
d. Financial institutions provide access to the financial markets, collect
information, and provide a variety of other services.
e. Government regulatory agencies aim to make the financial system operate
safely and reliably.
f. Central banks stabilize the economy.
2. The core principles of money and banking are useful in understanding all
six parts of the financial system.
a. Core Principle 1: Time has value.
b. Core Principle 2: Risk requires compensation.
c. Core Principle 3: Information is the basis for decisions.
d. Core Principle 4: Markets determine prices and allocate resources.
e. Core Principle 5: Stability improves welfare.
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Info Slides

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The Generic Macro Model
 Agents: who make economic decisions
 Households: Maximize utility
 Firms: Maximize profits
 Government: Taxes, Public goods, Policies
 Rest of the world: Trade
 Market: where agents interact
 Equilibrium
 where the market ‘tends’ to go (uniqueness)
 and ‘tends’ to stay put (stability)

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Gross Domestic Product
Firms hire factors of production from households. The blue flow, Y,
shows total income paid by firms to households.

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Gross Domestic Product
Households buy consumer goods and services. The red flow, C, shows
consumption expenditures.

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Gross Domestic Product
Households save, S, and pay taxes, T. Firms borrow some of what
households save to finance their investment.

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Gross Domestic Product
Firms buy capital goods from other firms. The red flow represents this
investment expenditure by firms.

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Gross Domestic Product
Governments buy goods and services, G, and borrow or repay
debt if spending exceeds or is less than taxes.

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Gross Domestic Product
The rest of the world buys goods and services from us, X, and
sells us goods and services, M. Net exports are X – M.

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Gross Domestic Product
And the rest of the world borrows from us or lends to us depending on
whether net exports are positive or negative.

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Gross Domestic Product
The blue and red flows are the circular flow of expenditure and income.
The green flows are borrowing and lending.

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Gross Domestic Product
The sum of the red flows equals the blue flow.

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National Income Accounting
And, therefore, Y = C + I + G + X – M.

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 A Few Definitions
Aggregate Output
Gross Domestic Product (GDP) = Value of all final goods and services
produced in domestic economy during year
Aggregate Income
Total income of factors of production (land, capital, labor) during year
Distinction Between Nominal and Real
Nominal = values measured using current prices
Real = quantities, measured with constant prices
Aggregate Price Level
nominal GDP
GDP Deflator =
real GDP
$10 trillion
GDP Deflator = = 1.11
$9 trillion
Consumer Price Index (CPI) price of “basket” of goods and services
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 A Few Definitions
Growth Rates and the Inflation Rate
xt  xt 1
Growth Rate   100
xt 1

$9.5 trillion  $9 trillion

GDP Growth Rate  100  5.6%
$9 trillion

113  111
Inflation Rate  100  1.8%
111
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