Money / Banking / Finance Money = TRUST Banking (& Finance) = TRUST When Trust Evaporates … PANIC 1994 Tequila Crisis 1997 Asian Contagion 2001 Enron "Enron proves how meaningless financial statements have become. Until someone makes sure that financial statements have meaning, we will never get this problem behind us." Copyright © 2002 Pearson Education, Inc.

The Drop in East Asian Currencies, January 1997 to April 1998 Copyright © 2002 Pearson Education, Inc.

Topics in Money and Banking Finance affects national and international economies. We’ll study Financial markets: buy and sell financial assets, e.g., stocks, bonds, foreign exchange Financial institutions: banks, insurance companies, mutual funds, pawn shops Money  Prices, Interest Rates, Activity Monetary Policy Five main topics are important in making financial decisions. 1. The financial system and the economy are connected in the United States and around the world. 2. Financial markets, which are markets for buying and selling bonds, stocks, foreign exchange, and other financial instruments, are an important part of the financial system. 3. Financial institutions, such as banks or insurance companies, serve as go-betweens for savers and borrowers. 4. Money influences economic activity, prices, and interest rates. 5. The economic approach helps interpret today’s information and helps predict future events. Copyright © 2002 Pearson Education, Inc. 2

Services Provided by Financial Markets and Institutions Risk sharing Liquidity Information The financial system provides three key financial services: risk sharing, liquidity, and information. 1. Risk sharing gives savers and borrowers ways to reduce the uncertainty. 2. Liquidity is a measure of how easily an asset can be converted to cash. 3. The financial system gathers and communicates information about borrowers’ circumstances. Copyright © 2002 Pearson Education, Inc. 4

Financial Institutions Financial Markets Transfers funds from savers to borrowers International capital market growing rapidly Asset prices communicate information Financial Institutions Intermediaries between borrowers and savers Important source of loans 1. Financial markets such as stock or bond markets provide a means for transferring funds from savers and borrowers. 2. The international capital market has grown rapidly during the past 20 years. 3. Financial markets communicate important information through prices of financial assets. Copyright © 2002 Pearson Education, Inc. 5

Figure 1.1 Sources of Funds for Nonfinancial Businesses Most external funds raised by nonfinancial businesses are loans from financial institutions (mainly banks), with far less reliance on funds raised through bond and stock issues in financial markets. Data are averaged for 1970-2000. Copyright © 2002 Pearson Education, Inc.

Figure 2.1 Money and Exchange 1. Money makes exchange more efficient and allows for specialization. 2. The type of exchange known as barter, where goods and services are exchanged directly for other goods and services is inefficient because it incurs high transactions costs. 3. Voluntary trade may be sidestepped by using government allocation to distribute goods and services, but this is unlikely to be successful because it ignores market forces. Copyright © 2002 Pearson Education, Inc.

Functions of Money Medium of exchange Unit of account Store of value Standard of deferred payment Store of value Why would anyone outside an insane asylum hold his wealth in the form of money??? Money has four key functions that make it the most efficient means of trade: 1. Money acts as a medium of exchange, which is anything that is generally accepted as payment for goods and services or in the settlement of debts. 2. Money is a unit of account, which is a way of measuring value in the economy in terms of money. 3. Money is a store of value, in that it is an asset or a thing of value that can be owned and is, therefore, a component of wealth. 4. Money offers a standard of deferred payment in credit transactions. Copyright © 2002 Pearson Education, Inc. 3

Criteria for Medium of Exchange Acceptable to most traders Standardized quality Durable Valuable relative to its weight Divisible There are five criteria a good must meet to be suitable as a medium of exchange: 1. The good must be acceptable to most traders. 2. It should be of standardized quality. 3. It should be durable. 4. It should be valuable relative to its weight. 5. It should be divisible. Copyright © 2002 Pearson Education, Inc. 4

Figure 2.2 Measuring Monetary Aggregates 1. The narrowest definition of the money supply is M1, which includes currency, traveler's checks, and checking account deposits. 2. M2 includes the assets in M1 plus short-term investment accounts. 3. M3 includes the assets in M1 and M2 plus such less liquid assets as large- denomination time deposits, institutional money market mutual fund balances, term repurchase agreements, and Eurodollars. Copyright © 2002 Pearson Education, Inc.

Selecting Monetary Aggregates M2 currently considered best. Correlates with prices and output Aggregates move broadly together over long time periods. But note a recent relative decline in M1. Sweeps and other financial innovations. 1. In the 1980s and 1990s economists and policymakers have considered M2 the best measure of the money supply. 2. The monetary aggregates move broadly together over long periods of time, although there have been significant differences in their movements during certain periods. Copyright © 2002 Pearson Education, Inc. 7

Figure 2.3 Growth Rates of Monetary Aggregates Monetary aggregates move together broadly over long periods of time. However, their growth rates diverge during some periods. Copyright © 2002 Pearson Education, Inc.