Economics and Financial Markets
Definition of Economics
Economics is the science of managing scarce resources relative to unlimited needs. It addresses the decisions of what, how, and for whom to produce.
The Market
A market is a set of mechanisms that facilitate the exchange of goods or services between buyers and sellers.
Financial Market
A financial market is a market where money, credit instruments, and securities are traded, both at the time of issuance (primary market) and in subsequent trading (secondary market).
Financial System
A financial system encompasses the mechanisms that connect savers and investors, aligning their preferences and needs regarding amount, timing, cost, and risk.
Financial Intermediation
Financial intermediation is the process by which funds are transferred from savers (lenders) to firms (borrowers).
Direct Financing
Direct financing involves firms raising funds directly from households by issuing and selling financial instruments, which become assets for households and liabilities for firms.
Indirect Financing
Indirect financing occurs through financial intermediaries (banks, pension funds, insurance companies, etc.) that channel savers’ funds to various economic agents (households, firms, government).
What is a Bank?
According to Article 40 of the General Banking Law, a bank is a specialized corporation authorized to routinely receive public funds for lending, discounting documents, making investments, undertaking financial intermediation, renting these funds, and performing other legally permitted operations.
SBIF
The Superintendency of Banks and Financial Institutions (SBIF) supervises and controls banks.
Definition of Money
Money is an asset within the financial wealth of individuals and businesses, widely used for transactions.
Functions of Money
- Means of Payment: Money’s primary function is to facilitate transactions, enabling the exchange of goods and services. (General acceptance)
- Unit of Account: Prices of goods are expressed in terms of money. (Homogeneity) Other units of account exist, such as the UF, which is indexed to the price level.
- Store of Value: Money can be used to accumulate assets, save, and transfer resources to the future. Liquidity is essential for this function.
The Process of Bank Money Creation
The following assumptions are made to analyze the process of bank money creation:
- The banking system is in equilibrium, with multiple commercial banks.
- The central bank mandates a statutory reserve ratio as a percentage of deposits for commercial banks.
- Commercial banks aim to maximize profit by lending up to the limit allowed by the reserve requirement.
- Money creation occurs entirely within the banking system, without cash leakage to the public.
Economic Objectives
- Monetary stability
- Normal operation of internal payments
- Normal operation of external payments
Functions of the Central Bank of Chile
- Issuance: The Central Bank has exclusive authority to issue banknotes and coins.
- Regulation of Money and Credit: The Central Bank can provide credit lines, refinancing, and discounts to banking firms and financial companies.
- Fiscal Agent: The Central Bank can act as a fiscal agent for the Ministry of Finance in managing domestic and international credit operations.
Inflation
Inflation is a sustained and permanent increase in the general price level, reducing the purchasing power of money.
Interest Rates
The nominal interest rate indicates the additional money received (or paid) in the future due to saving. The real interest rate accounts for inflation.
Open Market Operations (OMA)
OMA refers to the central bank’s sale of government securities to influence bank reserves, money supply, and interest rates.
Reserve Requirement
The reserve requirement is a mandatory deposit system for banks’ investment funds, with the reserve ratio representing the proportion of reserves to be held for savers.
Discount Rate
The discount rate is the rate at which the central bank lends to commercial banks to cover reserve shortages.