- Study Guide (Course-wide Content)
A. The Modern Financial System
- Financial systems in a modern economy transfer resources over space, time, and sectors. The flow of funds in financial systems occurs through financial markets and financial intermediaries. The major functions of a financial system are to transfer resources, to manage risk, to subdivide and pool funds, and to clear transactions.
- Interest rates are the prices paid for borrowing funds; they are measured in dollars paid back per year per dollar borrowed. The standard way we quote interest rates is in percent per year. People willingly pay interest because borrowed funds allow them to buy goods and services to satisfy current consumption needs or make profitable investments.
- Recall the menu of financial assets, especially money, bonds, and equities.
- Study the monetary transmission mechanism. This refers to the process by which monetary policy undertaken by the central bank, our Federal Reserve, interacts with banks and the rest of the economy to determine interest rates, other financial conditions, aggregate demand, output, and inflation. Make sure you understand each of the five steps (page 453).
- Money is anything that serves as a commonly accepted medium of exchange, or a means of payment. Money also functions as a unit of account. Unlike other economic goods, money is valued because of social convention. We value money indirectly for what it buys, rather than for its direct utility. Money today is composed of currency and checking deposits and is denoted M1.
- People hold money primarily because they need it to pay their bills or buy goods; this is known as the transactions demand. But people keep only a small fraction of their assets in money because money has an opportunity cost: we sacrifice interest earnings when we hold money. Therefore, the asset demand for money is limited.
- Banks are commercial enterprises that seek to earn profits for their owners. One major function of banks is to provide checking accounts to their customers. Banks are legally required to keep reserves on their checking deposits. These can be in the form of either vault cash or deposits at the Federal Reserve.
- Under 100 percent reserves, banks cannot create money, as seen in the simplest goldsmith bank example. For illustrative purposes, we then examined a required reserve ratio of 10 percent. In this case, the banking system as a whole creates bank money in a ratio of 10 to 1 for each dollar of reserves. With fractional-reserve banking, the total value of checking deposits is a multiple of reserves. Remember the formula
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- The most important factors about assets are the rate of return and the risk. The rate of return is the total dollar gain from a security over a specified period of time. Risk refers to the variability of the returns on an investment, often measured by the statistical standard deviation. Because people are risk-averse, they require higher returns to induce them to buy riskier assets.
- Stock markets, of which the New York Stock Exchange is the most important, are places where titles of ownership to the largest companies are bought and sold. The history of stock prices is filled with violent gyrations, such as the Great Crash of 1929 or the sharp bear market of 2008. Trends are tracked using stock-price indexes, such as the Standard and Poor's 500 and the familiar Dow-Jones Industrial Average.
- Modern economic theories of stock prices generally focus on the efficient-market theory. An "efficient" financial market is one in which all information is immediately absorbed by speculators and built into market prices. In efficient markets, there are no easy profits; looking at yesterday's news or at past patterns of prices or business cycles will not help predict future price movements. Thus, in efficient markets, prices respond to surprises. Because surprises are inherently random, stock prices and other speculative prices move erratically, as in a random walk.
- Plant the five rules of personal finance firmly in your long-term memory: (a) Know thy investments. (b) Diversify, diversify—that is the law of the prophets of finance. (c) Consider common-stock index funds. (d) Minimize unnecessary expenses and taxes. And (e) Match your investments with your risk preference.