FSU ECO 3223 - Ch. 1 Why Study Money, Banking, and Financial Markets?

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August 30, 2012Financial MarketsFinancial markets: markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of fundsStocks and bondsDirect finance: borrower and lender interact directlyFinancial IntermediationNot a financial marketIndirect financeBanks — move around money and collect fees for doing soDepositors are the source of bank’s fundsUses of fundsSources of fundsLoansBonds-Create income (try to sell as highly as possible)Deposits-Create expense (want to buy as cheaply as possible)Money: a universally accepted object that can be used to buy goods and services and can repay loansLabor Theory of Money: (Marx) think of money in terms of the labor required to earn it, not just what it can buy2004-2006: Housing BubbleAsset bubbles: when the price of an asset rises above its fundamental valueThere is always a rational price that makes sense, when the price increases above that, there is a bubble (irrational pricing)Causes of the Housing Bubble:1) Low interest rates  builders increase production of homes (increased home supply), people buy homes (increased home demand)Alan Greenspan = Chairman of the FedSustained economic growth between 1900-2000 bc of low interest rates and technology boom2) Financial innovationMortgage lenders paid on commission  lenders relaxed the rules and created mortgage products to make it easier to make the loan  get more commissionAdjustable Rate Mortgage (ARM)  lender can increase or decrease mortgage rate based on changes on the interest rateLenders expected interest rates to continue to decrease, but in 2008, interest rates rose and the lender was forced to increase mortgage payment  hurt borrowersAlso made it easier to access mortgage lender (i.e. internet)3) High inflow of foreign capital in US economy (financial capital)Look for low risk and high return = US attractive to foreignersFurther lowered interest rates in the US*4) Mortgage-backed securities  most deadly feature of housing bubble and making the crisis go globalBanks have a limit to the number of loans they can make, but these mortgage-backed securities allowed banks to over-extend their ability to make loansPeople who bought mortgage-backed securities, also lost money  made things go globalIf banks are in trouble, the entire economy is in troublei.e. Bailouts via the Fed and Treasury Dept.When large banks go under, smaller banks go under  everyone invested in large bank goes bankrupt  ripple effectThe Fed lowered interest rates, and provided liquidity to financial market = successfulThe federal government provided a stimulus package, fiscal bailout = failedForeclosure: cannot make mortgage payment, so bank evicts residents, and owns property  banks do not want to do this because it creates costs for them, but are forced to do soIn the global economy, everyone is suffering (i.e. Euro is extremely fragile)In 2007, the bubble burstReal Potential GDP = $14.5 trillionReal: adjusted for inflationPotential GDP: how much we can producei.e. Production Possibilities CurveActual GDP = 13.5 trillion  due to recessionDebt deflationHouseholdAssetsLiabilitiesCashStocksBondsReal estateCarCredit cardsConsumer loansMortgage loansOther debtsTotal: $500,000New Total: $200,000Total: $400,000Net worth/liquidity: $100,000New net worth/liquidity: -$200,000During recessions, the market value of assets decrease bc directly linked to market value; liabilities remain the same = net worth decreasesOutput gap = $1 trillion, about $3,200 per person a yearUnemployment = 8.3%; ideal = 5-6%Federal debt (in reality, the money taxpayers owe) = $15.9 trillionCitizens’ fault  ask the government to spend money via programsIf government does not raise taxes, it borrows via treasury bonds = increases debtInterest on federal debt = $500 billion  get the money to pay interest rates by borrowing more = increases debtCongress gives Treasury the authority to raise money in bond market, and anyone can buy a treasury bondThe Chinese have loaned a lot of money to US and expect to be repaidThe average Chinese family has savings rate of 50%The Bond Market and Interest RatesSecurity: (financial instrument) a claim on the issuer’s future income or assets (i.e. bonds and stocks)Bond: a debt security that promises to make payments periodically for a specified period of time (like renting money)Seller = borrowerBuyer = lenderInterest rate: the cost of borrowing or the price paid for the rental of fundsAAA = the highest credit rating a borrower can achieve; if lower, then have to pay a higher interest rateFigure 1 Interest Rates on Selected Bonds, 1950-2011Trends move together, but with a spread (no such thing as one interest rate)Largest peak at around 1980-85 = 2 severe oil crises and chairman of Fed tried to decrease inflation (interest rates peaked)From 1990-95: all dipped, but Three-Month Treasury Bills (short-term) paid lower interest rates than others = risk and term structure of interest ratesSeptember 4, 2012The Stock Market/Equity MarketCommon stock: represents a share of ownership in a corporationShare of stock: a claim on the residual earnings and assets of the corporationEquity = ownershipSee return on investment through:1) Dividends (money given to shareholders from company for buying their stock)2) Capital gain (make profit) or capital lossStock Prices as Measured by the Dow Jones Industrial Average, 1950-2011*Not adjusted for inflation1985-1995 = technology boomTechnology helps the stock market because makes businesses more efficient  decrease costs  increase profits  increase stock pricesBefore technology boom, we did not have the info to detect economic changes, so the market did not react as quicklyDecrease in early 2000s = 9/11Decrease in 2006-07 = housing crisisWhy Study Financial Institutions and Banking?Financial intermediaries: institutions that borrow fund from people who have saved and make loans to other peopleBanks: accept deposits and make loansBank is not the lender; the lender is the depositor; the bank is the intermediaryCommercial banks are most important in our economy1) Make consumer loans (i.e. car, student loans)2) Make mortgage loans3) Make business loans  makes commercial banks unique***Conduit for monetary policyOther financial institutions: insurance companies, finance companies, pension funds, mutual funds and investment companiesInsurance companies:Collect


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FSU ECO 3223 - Ch. 1 Why Study Money, Banking, and Financial Markets?

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