Chapter 2- Overview of the Financial System

Function: channel funds from lender-savers to borrower-spenders

Principal lender-savers are households

Most important borrower-spenders- business and government

Flow of funds:

Direct finance- borrowers borrow directly from lenders in financial market by selling them

**securities- financial instruments, claim on borrower’s future income or assets

Bond- debt security, promises to make payments for specified time

Stock- security entitles owner a share of company’s profits and assets

Role of financial markets

Structure

Debt and Equity Markets

*Bond or Mortgage

*Stock

Primary and Secondary Market

Primary Market- important assistant, investment bank- underwriting securities

Secondary Market

Examples: New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated
Quotation System),

Brokers- agents of investors who match buyers with sellers of securities

Dealers- link buyers and sellers by buying and selling securities

Important functions:

1. Easy to sell financial instruments to raise cash, more liquid

2. Determine price of security that issuing firm sells in primary market

Secondary markets organized in two ways: Exchanges and Over-the-counter Markets

Exchanges- buyers and sellers meet at central location to conduct trades

Over-the-counter- where dealers are ready to buy and sell securities to anyone willing to accept their
prices

Money Market – short-term debt instruments are traded

-least price fluctuations, least risky investments

FRUNC
*US treasury bills- most liquid, most actively traded

-safest, no possibility of default

*Negotiable Bank Certificates of Deposit-

*Commercial Paper

*Repurchase Agreements-

*Federal funds-

Capital Markets – longer-term debts and equity instruments are traded

*Stocks- equity claims on net income and assets

*Mortgages and mortgage-backed securities- SMCCS

*Corporate Bonds-

*State and Local Government Bonds-

*Consumer and Bank Commercial Loans

Internationalization of Financial Markets

Foreign bonds

Eurobond

Eurocurrencies

Function of Financial intermediaries:

Indirect Finance- process called financial intermediation

*reduce Transaction cost- the time and money spent in carrying out financial transactions

Economies of scale

*promote risk sharing- asset transformation; reduce exposure of investor to risk

Asymmetric information:

Before the transaction results to adverse selection

After. Moral hazard

As we have seen, financial intermediaries play an important role in the economy because they provide
liquidity services, promote risk sharing, and solve information problems, thereby allowing small savers
and borrowers to benefit from the existence of financial markets.

Types of Intermediaries

1. Depository institutions
-commercial banks CT
-thrift institutions: savings and loan associations, mutual savings bank and credit unions
*lia: deposits

2. Contractual savings institutions

-Life insurance companies

-Fire and casualty insurance company

LFP
- Pension funds and government retirement funds

*source of funds: premiums from policies

*assets: municipal bonds, corporate stock and bonds

3. Investment intermediaries

-finance companies, *assets: consumer and business loans

-mutual funds MMF

- Money market mutual funds.

*primary assets: money market instruments

-investment banks

Regulation of Financial system

- increase the information available to investors

- to ensure the soundness of the financial system.

To avoid financial panics, there are 6 types of regulations:

 1. Restrictions on entry
2. Disclosure
3. Restrictions on assets and activities
4. Deposit insurance
5. Limits on competition
6. Restrictions on interest rates

Chapter 3: Money

Functions:

1. as a medium of exchange

Criteria to function as money:

1. Easily standardized
2. Widely accepted
3. Divisible
4. Easy to carry
5. Not deteriorate quickly

-avoids double coincidence of wants on a barter economy, reduce cost

- encourage specialization and division of labor

2. as a unit of account
= N(N-1)/2

-reduces prices needed in the economy, reduce transaction cost

3. as a store of value
- store of value depends on the price level
- inflation

Evolution of Payments system- method of conducting transactions in the economy

Commodity money- made up of metals or valuable commodity

Disadv. Heavy, hard to transport

Fiat money- paper currency, legal tender accepted as payments but not convertible

Adv.lighter than coins and metals

Disadv. Easily stolen and expensive to transport in large amounts, issues of counterfeiting

Checks- instruction from you to banks to transfer money

- no need to carry large amounts

- improve efficiency of payments system
- reduces transportation cost
- written for any amount
- loss from theft is reduced
- convenient receipts for purchases

disadv. Takes time

Electronic payment-

E-money- money in electronic form

1. debit card
2. more advanced, stored-value card, more sophisticated, smart card
3. e-cash

. The Federal Reserve System has defined two different measures of the money supply—M1 and
M2. These measures are not equivalent and do not always move together, so they cannot be used
interchangeably by policymakers. Obtaining the precise, correct measure of money does seem to
matter and has implications for the conduct of monetary policy