Lesson 1: Introducing Money and the Financial System

Upon completion of this lesson, you should be able to do the following:
  • Explain the purpose of financial markets and financial institutions.
  • Describe the process of financial intermediation.
  • Identify the primary functions of a central bank.
  • Why the money supply is a very important component of the economy.

Introduction

This lesson introduces the financial system and the role of money in an economy. Money and the financial system are intertwined and cannot be separated. They both influence and affect the whole economy, such as the inflation rate, business cycles, and interest rates. Understanding how the financial markets and money influences the economy, can help consumers, investors, savers, and government officials to make better informed decisions.

Purpose of Financial Markets and Institutions

First, you need some definitions. A financial market is where buyers and sellers come together to buy and sell bonds, stocks, and other financial instruments. The buyers of financial securities are investing their savings, while sellers of financial securities are borrowing funds. The financial market can be a physical place like the New York Stock Exchange where buyers and sellers come face-to-face or the market can be like the NASDAQ where buyers and sellers are connected together by computer networks. A financial institution is a business that links savers and borrowers. The most common is banks. For example, if you deposited $100 into your savings account, the bank will lend this $100 to a borrower and the borrower will pay interest to the bank. In turn, the bank will pay you interest on your account. The bank's profits are the difference between the interest rate charged to the borrower and the interest rate paid on your savings account.

Why would you want to deposit money at a bank instead of directly buying securities through the financial markets? A bank, being a financial institution, can provide three benefits to the depositor.

  • Information about borrowers - banks collect information about borrowers, and will only lend to borrowers who have a low chance defaulting on their loans. This is a bank's specialty, rating its borrowers.

  • Lower investment risk - the bank lowers your investment risk. The bank will lend to a variety of borrowers, such as for house mortgages, business loans, credit cards, etc. If one business bankrupts or a couple of customers do not pay their credit cards, this does not financially hurt the bank. The bank is earning interest income on its other investments.

  • Liquidity - A bank deposit has liquidity. If you have an emergency and need your bank deposit, you can readily convert your bank deposit into cash.  Liquidity means that an asset can easily be exchanged for goods and services without high transaction costs. Liquidity is a very important concept in defining money. For example, take all your assets and list them in terms of liquidity.

 

Your Assets
"Most Liquid Assets" "Least Liquid Assets"

Cash Savings Account Stock/Bonds Car House

Money and the Central Bank

Money or the money supply is defined as anything that is accepted for payment of goods and services or paying off debts. In developing countries, money is essentially cash. In countries with sophisticated financial markets like the United States, the definition of money can be very complicated. Money includes cash and checking account balances, but what about assets like savings accounts and government securities? These assets are so easily converted into cash with little transaction costs, that essentially this could be included in the definition of money. An asset like a $50,000 home is not included in the definition of money. The house can be converted into cash, but it could take time and there is a high transaction cost. To get money quickly, the house may have to be sold for a lower value than its worth.

Every country uses some form of money and therefore every country has a government institution that measures and influences the money supply. This institution is referred to as the central bank. For example, the central bank in the United States is the Federal Reserve System, or commonly referred to as the "Fed." The Federal Reserve regulates banks, grants loans to banks, and can influence the money supply. However, the money supply and the financial markets are intertwined. When the Fed influences the money supply, it also indirectly influences the financial markets. Therefore, when the Fed influences the financial markets, the Fed can indirectly affect the interest rates, exchange rates, inflation, and the output growth rate of the U.S. economy. When the Fed uses its management of the money supply to influence the economy, economists call this monetary policy. This whole course is to explain how the Federal Reserve System can influence the economy through the financial markets. This analysis can also be extended to any central bank in the world.

The central bank can influence three very important variables in the economy.

  1. Inflation is a sustained rise in the average prices for goods and services in an economy. Increasing the money supply leads to inflation. For example, if you place a $100 in a shoe box and bury it in your yard for one year. That $100 is losing value, because, on average, all the prices for goods and services in the United States are increasing approximately 2% each year. After one year, that $100 will buy on average, 2% less goods and services.

  2. Business cycles mean the economy is experiencing strong growth. The most common measure of the business cycle is the Gross Domestic Product (GDP). GDP is the total value of goods and services produced in an economy in one year. When businesses are rapidly increasing production, the economy has more goods and services being produced. GDP grows rapidly and the economy is in a business cycle. It is easier for people to find a job, so the number of unemployed people decreases (i.e. the unemployment rate decreases). The opposite can also occur. GDP can grow slowly or actually decrease, so businesses are slowing the production of goods and services. The economy has fewer goods and services being produced and it becomes difficult for people to find jobs. The unemployment rate increases and the economy is in a recession. If the money supply grows too slowly or even contracts, it can cause the economy to enter a recession. If the money supply grows too fast, then inflation results.  Economists distinguish two types of GDP.

    1. Nominal GDP - has no adjustment for inflation. When more goods and services are produced in a year or inflation causes prices to increase, then nominal GDP increases.

    2. Real GDP - removes the effect of inflation. When real GDP increases, it means more goods and services are being produced and inflation has no effect on real GDP. Economists define many variables in terms of real or nominal, such as interest rates and wage rates.

  3. Interest rates are the cost of borrowing money. Americans borrow money to buy cars, houses, stereos, and computers. Corporations and businesses borrow money to build factories, buy machines, and expand production. Governments borrow money when they spend more than what they collect in taxes. There are many ways to borrow money, so there are many different types of interest rates. Usually economists refer to "the interest rate," because interest rates tend to move together. The growth rate of the money supply is related to (nominal) interest rates.

 

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