Money and the Financial System

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Money and the Financial System by Mind Map: Money and the Financial System

1. How does the financial system work?

1.1. Savers

1.1.1. Direct finance Borrowers

1.1.2. Indirect finance Financial intermediations Borrowers

1.2. Borrowers

1.2.1. Issue debt or equity to obtain funds Default= the situation when the issuer fails to make a payment promised by a debt security

1.3. (in)direct finance

1.4. Financial intermediations= a company that transfers funds from savers to borrowers

1.4.1. Diversification

1.4.2. Pooling funds

1.4.3. Maturity transformation

1.4.4. Information gathering

1.4.5. Reducing transaction costs

1.5. Financial securities= contracts in which a borrower, who seeks to obtain money from someone, promises to compensate the lender in the future

1.5.1. Debt security= a contract that promises to pay a given amount of money to the owner of the security at specific dates in the future Interest Principal Maturity

1.5.2. Stock Dividend Part owner of a company No maturity

1.6. Financial markets= a place or a mechanism by which borrowers, savers, and financial intermediaries trade securities

1.6.1. Primary market= the market in which a security is initially sold to an investor by a borrower

1.6.2. Secondary market= the market in which a security is sold from one investor to another

1.7. Investors

1.7.1. Risk Expected return= the gain that an investor anticipates making, on average, from a financial security After-tax expected return= the expected return after taxes are paid Market risk= risk that cannot be removed by diversification Idiosyncratic risk= risk that can be eliminated by diversification

1.7.2. Liquidity

1.7.3. Taxes

1.7.4. Maturity

1.7.5. Return Capital gains yield+current yield Current yield= the income the investor receives in some period divided by the value of the security at the beginning of that period Capital-gains yield= the capital gain divided by the value of the security at the beginning of the period

1.7.6. Portfolio

2. What are the applications of the present value?

2.1. Present value= the amount of money you need to invest today to yield a given future amount

2.1.1. Discount factor= the amount by which a future value is divided to obtain its present value Rate of discount= the term i in the discount factor Rate of discount has a relatively greater effect on the present value of long-term securities, rendering them riskier Discounting= the process of dividing a future value by the discount factor to obtain the present value

2.1.2. Present value formula(s) Present value P = F/((1+i)^n) Bonds Consols= a debt security that pays interest forever and never repays principal Pure discount bond/zero bond= a debt security with just one payment Coupon bonds= a security that pays regular interest payments until the maturity date, at which time the face value is repaid Fixed-payment security/annuity= a security in which the dollar payment on the security is the same every year so that the principal is amortized Amoritization= a process in which the principal amount of a security is repaid gradually over time Equity

2.2. Principal= the amount of money invested in a financial security or deposited in a financial intermediary

2.3. Face value= the principal amount repaid by a coupon bond at maturity

2.4. Yield to maturity= average annual return to a security

2.5. Past return= the average annual return that a security or portfolio has produced in the past

2.6. Compounding= earning interest on interest that was earned in prior years

3. What is the term structure of interest rates?

3.1. Term structure of interest rate= the relationship between interest rates with differing times to maturity

3.2. Term spread= the interest rate on a long-term debt security minus the interest rate on a short-term debt security

3.2.1. The term spread is helpful in predicting recessions. The smaller the spread, the greater is the probability of a recession

3.3. Term premium= the difference between the interest rate on a longer-term bond and the average interest rate on shorter-term bonds, which arises from interest-rate risk

3.3.1. Because investors are concerned about interest-rate risk, longer-term interest rates equal average expected short-term interest rates plus a term premium The longer the maturity of the bond, the larger the term premium will be

3.4. expectations theory of long-term interest rates= the theory that a long-term interest rate is equal to the average of current and expected future short-term interest rates on securities maturing on the same date as the long-term security

3.4.1. An investor compares the average interest rate on current and future short-term bonds with the interest rate on a long-term bond, choosing whichever has the higher return Assume zero transactions costs and predictable short-term interest rates

3.5. Securitization= the process by which financial intermediaries that own assets sell them off to another company, which in turn sells bonds to investors

3.6. Short-term or long-term bonds?

3.6.1. The choice of buying short- or long-term bonds depends on transactions costs and uncertainty about future interest rates

3.7. Yield curves= Plots interest rates on different securities of similar default risk for a given day

3.7.1. Flat: at the start of recessions When short-term interest rates are not expected to change

3.7.2. Upward: at the start or in the middle of economic expansions When short-term interest rate are expected to rise

3.7.3. Downward: at the start of recessions When short-term interest rates are expected to decline

3.7.4. Inverted= a downward-sloping yield curve If the term premium is small

3.8. Differences of yield to maturity

3.8.1. Risk: riskier securities must hold more promise

3.8.2. Liquidity: transactions costs are lower on securities that are more liquid

3.8.3. Taxation: corporate and government securities are subject to different levels of taxation

3.8.4. Time to maturity: longer terms must hold more promise

3.9. Interest-rate risk= the risk that a change in the market interest rates will affect the value of financial assets

3.9.1. Interest-rate risk one of main sources of risk to any security

3.9.2. For a given change in interest rates on all bonds, the prices of long-term bonds are affected more than the prices of short-term bonds

4. Economic Interdependence

4.1. International business cycle

4.1.1. refers to fluctuations in economic activity fluctuations can put economies in recessions or expansions indicators for changing economic activity can be consumption, production, incomes, investments, employment, export and import.

4.2. International transmission of financial shocks

4.2.1. Economic interdependence causing the spread of financial shocks: international trading can be affected by changes in one economy which can influence components of an business cycle (import or export rates) Changes in aggregate demand in one country can affect the input or output of another country. Various effects: Trade effects: exports as component of aggregate demand

4.3. Exchange rates are driven by supply and demand which is determined by changes in components of the business cycle.

4.3.1. appreciation of an currency: value increases relatively to other ones. depreciation: value decreases relatively to other ones.

5. Monetary goals and trade-offs

5.1. Stabilization policy can exist of expansionary monetary policy or contractionary monetary policy.

5.1.1. Expansionary: increased money supply, higher output, lower unemployment, inflation rate higher Contractionary: decrease in money supply, output lower, unemployment higher, inflation rate lower

5.2. Various policy lags can influence the effectiveness of monetary policy. The following lags can occur: data lag, recognition lag, decision lag, implementation lag, effectiveness lag.

5.3. The main monetary goals of central banks refer to: A. output. Determining the level of potential output remain the main question. B. Unemployment. Determining the natural rate of unemployment helpes to decide which measures are needed. C. Inflation: brings substantial cost with, striving for an ideal inflation as objective.

6. Monetary control

6.1. Money creation and money destruction is one of the main activities of central banks.Their main asset is their portfolio of securities. Central banks can decide to increase the money supply by influencing bank reserves and engaging in open market operations by buying securities.

6.1.1. Role of banks: moving the money circulation by initiating the money multiplier process. Changing the amount of loans and their investments is one of the main activities bank can carry out. Money supply = money multiplier x monetary base

6.2. The main tools for conducting monetary policy include: open market operations, changes in discount rates and changes in reserve requirements.

6.3. What is the liquidity preference model?

6.3.1. This model states that the money supply and money demand determine the nominal interest rate. It is bases on the thought that there are two basic ways of storing wealth. 1. Money (holding cash) or 2. bonds (investing). The liquidity effects shows the inverse relationship between money supply and the nominal interest rate.

6.4. What causes a shifting demand for money?

6.4.1. 1. Income effect. An higher level of income leads to an increased demand for money at each interest rate. 2. Price level effect: rise in price level leads to an increased demand for money at each interest rate. Though, second round effects show that interest rates can rise. This refers to: 1. the income effect where there is more wealth that leads to higher interest rates. 2. Price level effects that leads to higher interest rates. 3. Expected inflation effect: an higher expected price level leads to higher inflation based on the self-fulfilling prophecy. These effects should lead to a new equilibrium where we would have a lower interest rate. Howerver, due to the second round effects an higher money growth could also cause higher interest rate.

7. What is Money and Banking?

7.1. The Fed monitors banks and determines the money supply

7.2. Most financial formulas are based on the compounding of interest

7.3. More U.S. Currency is held in foreign countries than in the United States

7.4. Interest rates on long-term loans>interest rate on short term loans

7.5. Expected inflation and interest rates affect economic decisions

7.6. Buying stocks is the best way to increase your wealth - and the worst

7.7. Banks and other financial institutions made major errors that led to the financial crisis of 2008

7.8. Recessions cannot be predicted with any degree of accuracy

7.9. To create additional money in the economy, the Fed buys government securities from certain Wall Street firms

7.10. The Fed bases its policy decisions mostly on the output gap and the inflation rate

8. Why do we use money?

8.1. Requirements

8.1.1. Divisible

8.1.2. Uniform

8.1.3. Compact

8.1.4. Storable and durable

8.2. Types

8.2.1. Outside money Fiat money= money that has value mainly because the government decrees that is has value for payment of taxes Commodity money= money whose value is determined by its value as a material

8.2.2. Barter economy=goods and services are directly traded for other goods and services Double coincidence of wants= supplier of good A wants good B and the supplier of good B wants good A

8.2.3. Inside money= created by banks (e.g. checking accounts)

8.3. Functions

8.3.1. Medium of exchange Standard object - exchange goods and services

8.3.2. Unit of account Standard unit – quoting prices

8.3.3. Store of value Store wealth

8.3.4. Standard of deferred payment people buy something one day and pay for it later (with money)

8.4. Monetary aggregate

8.4.1. M1= coins, paper currency, checking accounts, and traveler's check

8.4.2. M2= savings accounts, money market mutual funds, and small time deposits

8.5. Fractional reserve banking= Bank keeps reserves of only a fraction of deposits. Excess reserves can be loaned out to expand the economy

8.5.1. Risk of bank runs

8.5.2. Create money

8.5.3. Make profits

9. Real Interest Rates

9.1. Components

9.1.1. Nominal Interest Rate Amount of interest payed in nominal terms as a percentage of the principal

9.1.2. Real interest rate Nominal interest rate adjusted for inflation

9.1.3. Expected real interest rate Nominal interest rate adjusted for expected inflation

9.1.4. Realized real interest rate Nominal interest rate adjusted for actual inflation

9.1.5. Real present value Present value adjusted for inflation

9.2. Inflation Rate risk

9.2.1. Chance of unexpected inflation occurring, redistributing wealth from borrowers to lenders and impacting real returns

9.3. Measurement

9.3.1. Actual Inflation Rate Data from government statistical agencies

9.3.2. Expected Inflation Rate Forecasts or real interest rates on bonds for expected inflation rate

9.4. Fisher Hypothesis

9.4.1. Expected real interest rates and changes in expected inflation - An increase in the flation rate, in equilibrium, will cause an increase in the nominal interest rate but will not change the expected real interest rate

9.5. Expected Real interest rates & Recession

9.5.1. During recession both demand and supply for onds decrease, but the supply declines more resulting in reduced real interest rates

10. Stocks & Other Assets

10.1. Efficient Market Hypothesis

10.1.1. Idea that stock prices fully reflect all available information

10.2. Predictability

10.2.1. Movement of stock prices is not entirely random possibly because of risk aversion or market inefficiency

10.3. Risk

10.3.1. Unsystematic Risk Risk to a stock that cannot be explained by market movements

10.3.2. Systematic Risk Risk attributable to fluctuations in the stock market

10.3.3. CAPM Models return to a stock by comparing its risk to that of the market average

10.3.4. APT Similar to CAPM but allows for more sources of systematic risk than CAPM

10.4. Fundamental Value

10.4.1. The present value of expected earnings of a company or of all companies in the stock market as a whole

10.5. Expectations

10.5.1. Rational Expectations Investors use all information available leading to stock prices always equaling their fundamental value

10.5.2. Irrational Expectations Stock market goes through periods where prices fluctuate around their fundamental value, creating opportunities for profit

10.6. Dividends

10.6.1. Periodic issues of a companies' profit to shareholders

10.7. Capital Gains

10.7.1. Realized capital gains are the profits made while actually selling the stock and taxed while implicit gains are the unrealized profits from a stock price appreciating but not being sold yet. Realized gains are taxed while implicit gains are not, leading to the Lock-In effect where investors don't want to sell stock as they have to pay taxes.

10.8. Equity Premium

10.8.1. Difference between return on stocks and return on bonds, suggesting that the market prays a premium for equity securities

10.8.2. Equity premium Puzzle Return on equity is far higher than risk analysis would suggest, has not been explained so far

10.9. Other Assets

10.9.1. Real-estate Requires maintenance and upkeep

10.9.2. Precious Commodities Usually underperform compared to stock market except in periods of high inflation

10.9.3. Small Business Investment Requires active role and has a higher risk but also higher potential gains

10.10. Diversification

10.10.1. Spreading wealth in a mix of securities to lower risk and damage as a result of a single security investment failing

11. How do Banks work

11.1. Asymetrical Information

11.1.1. Adverse Selection People or firms that are worse than average risks are more likely to seek a loan

11.1.2. Moral Hazard Existence of a contract that changes the behaviour of a party in a way that harms the other party

11.1.3. Countermeasures Collateral An asset that a borrower promises to give the bank if the borrower is unable to repay the banks loan Net worth maintenance Forcing the borrower to maintain a certain net worth as part of the contract (only lend to people who don't need the loan) Covenants Part of a loan contract that requires the borrower to act in a certain way or spend the loan in a certain way

11.2. Reserves

11.2.1. Excess Reserves Extra reserves that banks are not per se required to hold

11.2.2. Federal funds market & rate The market in which banks that have excess reserves lend them to banks who desire more reserves & the interest rate they charge for it

11.3. Spread

11.3.1. Difference between interest rates in a banks borrowed and lended money, allowing them to profit

11.4. Risk

11.4.1. Credit risk Risk that a bank faces from some of their given loans not being payed back

11.4.2. Interest rate risk Risk that a bank faces as a result of changing interest rates

11.5. Failures of the banking system

11.5.1. Savings and Loans Portfolios that were undiversified geographically and by asset class led to unneccesary risk which caused massive losses when the economy took a downturn, eventually worsened by bailouts as they caused moral hazard problems

11.5.2. Credit Crunch of the 90's Lax lending standards led to risky portfolios, when recession happened banks were quick to diversify and very careful about giving out loans, resulting in further contraction of the economy

11.5.3. 2008 Financial Crisis Risky mortgage loans caused banks to incur massively losses when housing prices began declining, investors worldwide sold off mortgage backed securities causing a near failure of the financial system as asset prices plummeted

12. Economic Growth & The Business Cycle

12.1. Economic Growth - The steady increase of output over time

12.1.1. Labor force - Supply of workers who either have jobs or desire to have them Labor force participation rate Ratio of labor force to working age population Unemployment rate Number of unemployed workers as a fraction of the labor force Labor Productivity Productivity per worker measured as output divided by number of hours worked

12.1.2. Capital Growth Increased availability of capital contributing to economic growth

12.1.3. Total Factor Productivity Factors besides labor and capital contributing to growth

12.2. Business Cycles

12.2.1. Trends Expansion Period of increased output growth Peak End of an expansion where output growth decline begins Recession Period of decreased output growth Through End of a recession where output growth begins to increase Depression A particularly bad recession

12.2.2. Causes & Theories Monetarists Attribute business cycle to changes in the amount of money in the economy Keynesians Attribute business cycle to shifts in aggregate demand Real Business Cycle Theorists Attribute business cycle to sudden changes in productivity

13. Modeling Money

13.1. Equilibrium Models

13.1.1. Partial Equilibrium Model A model wherein some key variables are exogenous

13.1.2. General Equilibrium Model A model wherein all key variables are endogenous

13.1.3. Endogenous Variables A variable determined by something inside the model

13.1.4. Exogenous Variables A variable determined by something outside the model

13.2. Liquidity Preference Model

13.2.1. A model in which money demand and supply determine the nominal interest rate

13.2.2. Liquidity Effect The inverse relationship between money supply and the nominal interest rate

13.3. Real Money Demand Function

13.3.1. The function m(Y,i), which is a useful summary of the relationship between the real demand for money, real income and the nominal interest rate

13.4. Static & Dynamic Models

13.4.1. Static models do not allow variables to change over time while dynamic models allow it

13.4.2. Steady State The long run equilibrium of a model

13.4.3. Shocks A change to a variable that causes other variables to deviate from their long run equilibrium values in the short run or in the long run

13.4.4. Price-level effect The situation where a higher nominal interest rate results from an increase in price level that increases the demand for money

13.4.5. Income effect The situation where a higher nominal interest rate results from an increase in income that increases the demand for money