Exam 1 Study GuideChapter 1—The financial system• The financial system is circular/continuous• Broad—two part systemo Financial markets Channels for buying and selling financial securitieso Two party system Only within/between the buyers and sellers• Financial intermediaries (institutions)o Indirect three-party system Someone in between the buyer and sellero Example Commercial banks: deposits (lending to bank) Investment banks/firms: no deposits. New capital Mutual finds, pension funds, hedge funds, and insurance firms (invest premium into three parties) Banks can give lenders interests or services (ex. Writing checks, paying bills, etc.)• Players of systemo Government agencies Federal, state, and local Taxes—decrease in tax revenues recently (ex. Gas taxes)o Businesses (large and small) Small business owners pay taxes as individualso Households “retail/small” investors Lower, middle, and upper class• Investments= future, uncertainties• Financial system purpose; provides channels for transferring funds between lenders and borrowerso Savers—supply fundso Buyer—demand funds• Financial Assetso An asset is anything of value owned by a person or a firm, while a financial asset is a financial claim (which means that if you own a financial asset, you have a claim on someone else to pay you money) Example: a bank checking account is a financial asseto Economists divide financial assets into those that are securities and those that aren’t. A security is tradable (bought and sold in financial market)o Five key financial assets Money• Anything that people are willing to accept in payment for goods and services or to pay off debts• Money supply: total quantity of money in the economy Stocks (equities)• Represent partial ownership of a corporation• When Microsoft sells additional stock, it is doing the same thing that the owner of a small firm does when she takes on a partner: increasing the funds available to the firm, its financial capital, in exchange for increasing the number of the firm’s ownerso Firms keep some of their profits as retained earnings and pay the remainder to shareholders in the form of dividends, which are payments corporation typically make every quarter Bonds• When issued, you are lending the corporation or the government a fixed amount of moneyo The interest rate is the cost of borrowing funds (or the payment for lending funds) Bonds typically pay interest in fixed dollar amounts called coupons• Bonds can be bought and sold in the financial markets like bonds Foreign exchange• Many goods and services purchased in a country are produced outside that country—so country must convert exchange• The most important buyers and sellers of foreign exchange are large bankso Banks engage in foreign currency transactions on behalf of investors who want to buy foreign financial assets.o Banks also engage in foreign currency transactions on behalf of firms that import and export goods Securitized Loans• Loans that banks could sell on financial markets became securities, so the process of converting loans into securities is known as securitization.o Example: a bank might grant a mortgage, and bundle it together with similar mortgages granted by other banks (mortgage backed security) that will function like a bond What a saver (can be a household, firms, or the government) views as a financial asset a borrower (can either be a household, firms, or the government) views as a financial liability• Financial Liability—financial claim owed by a person or a firmo Ex. If you take out a car loan from a bank, the loan is an asset from the viewpoint of the bank because it represents a promise by you to make a certainpayment to the bank every month until the loan is paid off, on the other hand, the loan a is a liability to you, the borrower, because you owe the bank the payments specified in the loan• What does the financial system doo Economists believe there are three key services that the financial system provides to savers and borrowers: (firms provide these services in different ways, which makes different financial assets and liabilities more or less attractive to individual savers and borrowers) Risk sharing• Risk is the chance that the value of the financial assets will change relative to what you expecto One advantage of using the financial system to match individual savers and borrowers is that it allows the sharing or risko One way to decrease risk is the splitting of wealth into many assets, known as diversification The financial system provides risk sharing by allowing savers to hold many assets Liquidity• The ease with which an asset can be exchanged for money• Savers view liquidity of financial assets as a benefito More liquid assets can be quickly and easily exchanged for money, while less liquid—or illiquid—assets can be exchanged for money only after a delay or by incurring costs• In general, we can say that assets created by the financial system, such as stocks, bonds, or checking accounts, are more liquid than are physical assets, such as cars, machinery, or real estate.• Financial markets and intermediaries help make financial assets more liquid Information• Facts about borrowers and expectations of returns on financial assets• Financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds, and other securitieso Ex. When the price of your shares of apple rises, you know that other investors must expect that apple’s profits will be higher: this information can help you decide whether to continue investing in apple stock.•• Money—human creationo We can always createo Allows us to do: Medium of exchange (fair trade) Constantly evaluating because everything has different values• Need to figure out relationshipso There is no gold system/ gold standard anymore Dollar bill isn’t backed by anythingo Value of money is created when you believe the exchange is fair• Market is based on what we believe; expectations are extremely important• Main Government Regulatorso The Federal Reserve (The Fed) Do not take deposits Fed’s Dual mandate “Low inflation and low unemployment” Center bank of the United states—12 locations countrywide Lender of last resort (bank borrow to pay depositors) Conduct monetary policy (hard currency) in supply• Does not
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