Bowie State University CH4 Financial System Market Economy and Human Body Paper Contribution to the final grade: 3.75% Objectives This discussion is inte
Bowie State University CH4 Financial System Market Economy and Human Body Paper Contribution to the final grade: 3.75%
Objectives
This discussion is intended to help students to achieve the following learning goals:
Interact with other students on the concepts and methods of the financial system and their relationships to the market economy;
Master their understanding of methods and concepts of Module 1;
Share own view of the theme of the discussion; and
Earn the discussion credits.
Description
You have been tasked to discuss the following statement:
“The financial system is to the market economy what the heart is to the human body.”
Each student is required to participate as this discussion gives you the opportunity to earn discussion credits. Participation means posting own threads and reacting to other students postings. You are required to post at least one original message and to respond to at least two of the other students’ postings. Make sure you support your points using economic reasoning and more so the content of the chapters in Module 1. Write clearly and precisely. Postings like, I agree or disagree, yes, no etc. do not count.
Your resources for this discussion include:
PPT slides Chapters 1 4 (See Instructors Lectures under Module1)
Baily, Martin Neil and Douglas J. Elliott (2013). The Role of Finance in the Economy: Implications for Structural Reform of the Financial Sector. Brookings Institution (July 1, 2013).
* I attached the powerpoint slides ECON 321-556
MONEY, BANKING, AND THE FINANCIAL
SYSTEM
Summer 2020
Chapter 1
Introducing Money and The
Financial System
Professor Thaddee Badibanga
References:
– Chapter 1 in HO
– 2018, 2014, and 2012 Pearson Education Slides
LEARNING OBJECTIVES
At the end of this Chapter, each student will be able
to:
Identify the key components of the financial system
Provide an overview of the financial crisis of 2007
2009
Explain the key issues and questions the financial
crises raise
You Get a Bright Idea
but Then What?
Suppose you have a business idea: A smartphone app that
will deliver a textbook chapter to a students phone for a
limited time for a low price.
To get your company off the ground, you may spend a lot of
money before you receive any revenue from sales of this
app.
The role of the financial system is to channel funds from
savers to businesses like you.
But the financial crisis that began in 2007 cut off the flow of
funds that large parts of the U.S. economy needed to thrive.
The result was the worst economic recession since the Great
Depression of the 1930s.
1.1. Identify the key components of the
financial system
3 major components of the financial system:
1. Financial assets
2. Financial institutions
3. The Federal Reserve and other financial regulators
1.1.1. Financial Assets
Asset: anything of value owned by a person or a firm.
Financial asset: asset that represents a claim on someone
else for the payment of money.
Example: A bank checking account
It represents a claim against a bank for payment of money
equal to the dollar value of the account.
Financial asset: can be a security or a no-security.
Security: a financial asset traded in the financial market.
Financial market: place or channel for buying or selling
securities (i.e. stocks, bonds, others).
Checking account: financial asset but not a security (no
tradable in the financial market).
How about a student loan? Is it a security or not?
5 key categories of financial assets:
Money, Stocks, Bonds, Foreign exchange, and Securitized
loans.
1.1.1. Financial Assets
Money
Anything that is generally accepted in payment for goods and
services or to pay off debts.
Money supply: total quantity of money in the economy.
Stock
Financial security that represents partial ownership of a
firm/corporation (also called equities).
Dividend: sum of money paid regularly by a corporation to its
shareholders out of its profits (or reserves).
Bond
Financial security issued by a corporation or a government that
represents a promise to repay a fixed amount of money.
Bond pays interest in dollar fixed amount called coupon.
Interest rate: cost of borrowing funds (or return or payment
received for lending funds).
Usually expressed as a percentage of the amount borrowed or lent.
When a bond matures the seller pays the face value.
1.1.1 Financial Assets
Foreign Exchange
To buy foreign goods, services or assets, a domestic business,
household or investor must exchange domestic currency for
foreign currency.
Foreign exchange: units of foreign currency.
Banks engage in foreign currency transactions on behalf of
households, investors or business firms.
Securitized Loans
Before the creation of markets for loans, loans were financial
assets but not securities (not tradable).
Securitization: process of converting loans and other no
tradable financial assets into securities.
? A loan is a financial liability for a borrower .
Financial liability: financial claim owed by a person or a firm.
Figure 1.1. Moving Funds Through the Financial System
The financial system transfers funds from savers to borrowers.
Borrowers transfer returns back to savers through financial
system.
Savers and borrowers include domestic and foreign households,
businesses, and governments.
1.1.2. Financial Institutions
?Financial Intermediaries
? Commercial bank: financial firm that serves as a financial
intermediary by taking in deposits and using them to
make loans.
Households rely on borrowing from banks to purchase big
ticket items (i.e. house, car, appliances, etc.)
Firms rely on banks to meet their short- and long-term needs
for credit (e.g. inventories, payroll, etc.).
? Nonbank Financial Intermediaries
Some financial intermediaries are legally distinct from
commercial banks although they operate in similar way, they
take in deposit and provide loans.
? Such institutions include savings & loans and credit union
1.1.2. Financial Institutions
? Nonbank Financial Intermediaries (
)
?Savings and Loans (known also as Thrift): financial
institutions specializing in accepting in deposits and making
mortgages and other loans (real estate financing). It can be
a corporation or a mutual.
?Credit Unions: Not-for-profit organizations that accept in
deposits and make loans.
Unlike banks, credit unions provides a safe place for saving
and borrowing at reasonable rates, and returns surplus
income to their members in the form of dividends.
Insurance companies: collect premiums from customers
and invest them to obtain funds necessary to pay for
claims to policyholders and to cover their costs.
1.1.2. Financial Institutions
? Nonbank Financial Intermediaries
Pension funds: invest contributions from workers and firms in
stocks, bonds, and mortgages to earn money necessary to
make pension benefit payments during worker retirement.
Pension funds assets totaled 18 Trillion in assets in 2018.
Mutual funds: obtain money by selling shares to investors
and invest the money in a portfolio of financial assets.
Portfolio: a collection of assets such as stocks and bonds.
Hedge funds: similar to mutual funds but typically have no
more than 99 wealthy investors and make riskier
investments.
Investment banks: provide advice to firms issuing stocks and
bonds or considering mergers with other firms (Goldman
Sachs, Morgan Stanley).
Do not take deposits and rarely lend to households.
Engage also in underwriting by guaranteeing price to a firm issuing
stocks and bonds, and in securitization of mortgage loans.
The Rise of Peer-to-Peer Lending and Fintech
During the financial crisis of 2007?2009, many borrowers
defaulted on their loans.
In response, federal government regulators began pushing
banks to tighten their loan guidelines, making it more
difficult for businesses and households to qualify for loans.
Peer-to-peer lenders, such as LendingClub, Prosper, and
SoFi, began filling the demand for loans with funds from
individuals, businesses and financial firms.
Those lenders are examples of financial technology, or
fintech, because they rely heavily on smartphone
technology in the loan application process.
1.1.2. Financial Institutions
?Financial Markets
Places or channels for buying and selling stocks, bonds, and
other securities.
Traditionally, financial markets have been physical places,
e.g., New York Stock Exchange located on Wall Street in NY.
Today, most securities trading take place electronically
between dealers linked by computers and is referred to as
over-the-counter trading. e.g., NASDAQ (National
Association of Securities Dealers Automated Quotation
System).
Primary market: a financial market in which stocks, bonds,
and other securities are sold for the first time.
Secondary market: a financial market in which investors
buy and sell existing securities.
What Do People Do With Their Savings?
Source: Board of Governors of the Federal Reserve, Flow of Funds
Accounts of the United States, various issues.
1.1.3. The Federal Reserve and Other Financial Regulators
Federal agencies that regulate the financial system include:
Securities and Exchange Commission (SEC):
Regulates financial markets.
Federal Deposit Insurance Corporation (FDIC):
Insures deposits in banks.
Office of the Comptroller of the Currency
Regulates federally chartered banks (CB).
Chartered Bank: financial institution that accepts/safeguards
monetary deposits from individuals /organizations and lends
money.
The Federal Reserve System
The central bank of the US.
The Consumer Finance Protection Bureau (CFPB)
Protects consumers from fraud or deceptive practices in
financial markets.
1.1.3. The Federal Reserve and Other Financial Regulators
Federal Reserve:
The central bank of the U.S., usually referred to as the
Fed.
Established by Congress in 1913 to deal with banking
problems.
Original role: Serves as lender of last resort.
What Does the Federal Reserve Do?
The Fed is responsible for monetary policy.
Monetary policy: actions taken by Fed to manage money
supply and interest rates and to pursue macroeconomic
policy objectives.
1.1.3. The Federal Reserve and Other Financial Regulators
What Does the Federal Reserve Do?
The Fed is responsible for monetary policy (
)
Macroeconomics objectives include:
Full (High levels of) employment,
Low rates of inflation,
High rates of economic growth, and
Stability of financial system.
The Fed is divided into 12 districts (See Figure 1.2).
The Fed is run by the Board of Governors (7 members
appointed by the US President).
One of the 7 is the Chair (Jerome Powell: 2014-2018)
Jerome Powell: 2018- (Trumps appointee)
Figure 1.2. The Federal Reserve System
The Federal Reserve System is divided into 12 districts, each of which has
a District Bank located in the city shown on the map.
Each Federal Reserve Bank is owned by commercial banks in the district.
1.1.3. The Federal Reserve and Other Financial Regulators
What Does the Federal Reserve Do?
The main policymaking body of the Fed is the Federal Open
Market Committee (FOMC):
The FOMC includes 12 members:
7 members of the Board of Governors (appointed each for 14
years),
President of New York Fed, and
4 Presidents out of 11 Presidents of other 11 Fed District Banks.
FOMC meets 8 times a year in Washington D.C. to decide on
monetary policy.
During these meetings, the FOMC decides on a target for the
federal funds rate.
Federal funds rate: interest rate that banks charge each other on
short term loans.
Role of the Financial System
The financial system provides 3 key services to savers
and borrowers: risk sharing, liquidity, and information.
1. Risk Sharing:
Risk: the chance that the value of a financial asset will
change relative to what you expect.
Two ways to reduce a savers risk.
Risk sharing: allows a saver to spread and transfer risk by
holding different assets along with other savers.
Mortgage backed security.
Diversification: splitting wealth among many different
assets to reduce risk.
Role of the Financial System
The financial system provides 3 key services to savers
and borrowers: risk sharing, liquidity, and information.
2. Liquidity
Liquidity: the ease with which an asset can be exchanged for
money.
Financial markets and intermediaries help make financial
assets more liquid.
3. Information
Facts about borrowers and expectations of returns on
financial assets.
Banks collect information on borrowers to determine the
likelihood of repaying their loans.
Financial markets convey information to both savers and
borrowers by determining the prices of stocks, bonds, and
other securities.
Problem1.1.:
Briefly discuss the extent to which securitized loans embody the
key services of risk sharing, liquidity, and information.
Solving the Problem:
Step 1: Review the chapter material.
Step 2: Define securitized loans.
Non-securitized loans: financial assets but not securities. Securitized loans:
loans that have been bundled with other loans and resold to investors (they
are both financial assets and financial securities).
Step 3: Explain whether securitized loans provide risk sharing,
liquidity, and information.
When a mortgage is bundled with other mortgages into mortgage-backed
securities, the buyers jointly share the risk of a default.
A securitized loan can be resold and so has a secondary market, which
makes it liquid.
When loans are securitized, investors rely on the bank or other loan
originator to have gathered the necessary information.
So, securitized loans provide all three of these key services.
1.2. Overview of the financial crisis of 20072009
Origins of the Financial Crisis
Financial crisis: a significant disruption in the flow of funds from
lenders to borrowers.
The financial crisis of 2007-2009 was caused in part by the
housing bubble of 2000-2005.
Bubble: an unsustainable increase in the price of a class of assets
(i.e. houses).
Overly optimistic expectations combined with changes in the
market for mortgages made it easier for families to borrow
money to buy houses.
2 government sponsored enterprises (GSEs), the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan
Mortgage Corporation (Freddie Mac) sold bonds to investors
and used funds to purchase mortgages from banks and to lend to
households who wanted to buy houses.
Investment banks became participants in the secondary mortgage
market, bundling and selling mortgage-backed securities.
1.2. Overview of the financial crisis of 20072009
Origins of the Financial Crisis
Standards for obtaining loans were greatly loosened.
By 2005, many mortgages were being issued to subprime (non
conventional) borrowers with flawed credit histories (high rate of
defaulting) and without down payment.
Borrowers income statements were not documented.
Adjustable-rate mortgages allowed borrowers to start with very
low interest rate but pay higher interest rate down the road
Both borrowers and lenders anticipated higher housing prices,
which would reduce the chance of default.
But decline in housing prices that began in 2006 led to rising
defaults and a sharp decline in the value of many mortgagebacked securities.
1.2. Overview of the financial crisis of 20072009
Figure 1.3 The Housing Bubble
Source: Federal Reserve Bank of St. Louis.
Panel (a) shows that the housing bubble resulted in rapid increases in sales of new houses
between 2000 and 2005, followed by a sharp decrease in sales beginning in July 2005.
Panel (b) shows that home prices followed a similar pattern to home sales.
1.2. Overview of the financial crisis of 20072009
The Deepening Crisis and the Response of the Fed
and Treasury
In October 2008, Congress passed the Troubled Asset Relief
Program (TARP), under which the Treasury provided funds to
commercial banks in exchange for stocks in those banks.
Many policies of the Fed and Treasury during the recession of
20072009 were controversial because they involved:
Partial government ownership of financial firms (i.e. AIG).
Implicit guarantees to large financial firms that they would not
be allowed to bankrupt (Bear Sterns, Merrill Lynch and others
Except for Lehman Brothers).
Unprecedented intervention in financial markets.
Many feared that the Feds actions might reduce its
independence.
1.3. Key issues and questions the financial crisis raises
Our brief account of the financial crisis raises a
number of questions that we will answer in the
following chapters:
17 key issues and questions listed on textbook pages 19
21 (provide a roadmap for the topics in the rest of the
book).
ECON 321-556
MONEY, BANKING, AND THE FINANCIAL
SYSTEM
Summer 2020
Chapter 2
Money and The payment
System
Professor Thaddee Badibanga
References:
– Chapter 2 in HO
LEARNING OBJECTIVES
Upon a successful completion of this chapter, a
student should be able to:
Analyze the inefficiencies of a barter system.
Discuss the four key functions of money.
Explain the role of the payments system.
Explain how the U.S. money supply is measured.
Use the quantity theory of money to analyze the
relationship between money and prices in the long
run.
Key Issue and Question
Key Issue:
By the Federal Reverse Act of 1913, the Fed was granted
independence from the U.S. President and the Congress.
Its role is limited to efficient management of monetary
policy.
But during 2007-2009 financial crisis, the Feds actions
(expansionary monetary policy) led to concerns about
whether it could maintain its independence.
Most candidates in the 2016 presidential race expressed
dissatisfaction with the Fed.
Some critics argued the Fed used its independence to
pursue policies that favored Wall Street (large financial
firms) rather than Main Street (households and small
businesses).
Key Issue and Question
Key Issue:
Most economists believe that there is a connection
between central bank independence and inflation.
High inflation results in high unemployment.
An example of a country without central bank
independence is Zimbabwe:
During 2008, the inflation rate was an almost
unimaginable 15 billion percent.
The central bank began printing Zimbabwean dollar
currency in denominations of $50 billion, then 100
billion, then 100 trillion.
Key Issue and Question
An extraordinary inflation rates contributed to
disastrous decline in production and employment.
In 2009, in attempt to rein inflation, the Zimbabwean
government decided to abandon its own currency
entirely in favor of the US dollar.
Key Question:
Should a central bank be independent of the rest of
government?
2.1. Analysis of the inefficiencies of a barter system
Do we need money? (What is money)
Money: anything that is generally accepted as payment for
goods and services or in settlement of debts.
Barter
Economies can function without money.
Barter: a system of exchange in which individuals trade
goods and services directly for other goods and services.
Four main sources of inefficiency in a barter economy:
1. There must be a double coincidence of wants.
A trader must find a partner who is producing what
theyre looking for and wants what they are producing
2.1. Analysis of the inefficiencies of a barter system
Barter
4 main sources of inefficiency in a barter economy:
1. There must be a double coincidence of wants (… )
Time and effort spent searching for trading partners in a
barter economy increases transactions costs.
Transactions costs: costs of time or other resources that
parties must incur in process of agreeing and carrying out
an exchange of goods and services.
2. Each good has many prices.
If there are N goods to be traded, then the number of prices =
N(N 1)/2.
2.1. Analysis of the inefficiencies of a barter system
Barter
2. Each good has many prices (… )
Suppose N = 5, then the number of price is:
5(5-1)/2 = 10
For an advanced economy like the U.S. with millions of
goods, number of prices can become an obstacle to trade.
3. There is a lack of standardization.
Different sizes and other characteristics for the same good
make price determination a serious issue.
4. It is difficult to accumulate wealth.
Lack of medium for storing value.
2.1. Analysis of the inefficiencies of a barter system
The Invention of Money
In growing an economy, there is an incentive to identify a
specific product that most people will generally accept in
exchange.
Commodity money:
A good used as money that also has value independent of its
use as money.
Example: animal skin (i.e. deerskin), gold, silver,
Money induces Specialization
Specialization: system in which individuals produce only
goods or services for which they have relatively the best
ability.
Once money is inv…
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