Understanding Money, Banking, and Financial Markets
Understanding Money and Banking
What is Money?
Legal Money: Money issued by an institution that monopolizes the issuance in the form of coins or bills.
Bank Money: Indirect fixed assets and certain financial intermediaries that are generally accepted as payment:
- Demand Deposits: Funds readily available.
- Savings Deposits: Funds held in savings accounts.
- Term Deposits: Borrowed funds for a fixed term, which cannot be withdrawn early without a penalty.
How Financial Intermediaries Create Money
- Bank Intermediaries: Have the ability to create money. Their assets are accepted as means of payment.
- Non-Bank Intermediaries: Perform intermediary functions (e.g., stock exchanges, insurance companies).
Financial Markets
Primary Market: Where financial assets are first traded.
Secondary Market: Where previously issued securities are traded; transactions occur after the initial offering.
Interest Rates and Money Demand
Increased interest rates lead to falling demand for money. The higher the interest, the fewer loans are taken.
Types of Money
Fiat Money: Banknotes and coins that do not base their value on a counterpart (gold, silver, or precious metals), but rather on government backing and public confidence in their future acceptance.
Functions of Money
- Medium of Exchange: Money facilitates exchange by eliminating the need for bartering.
- Unit of Account: Money provides a measure of value for goods and services.
- Store of Value: Money acts as a store of value due to its liquidity.
Financial Concepts and Instruments
Unsystematic Risk
Unsystematic risk stems from internal factors affecting a specific company or sector.
Pension Funds
Pension funds differ in the percentage of resources allocated to equities. Fund E invests only in fixed income, offering low risk and low profitability. Fund A invests up to 80% in equities, offering higher risk and potentially higher profitability.
Expansionary Monetary Policy
This policy increases the money supply, shifting the money supply curve to the right and reducing interest rates.
Monetary Transmission Mechanism Example
Suppose the central bank implements a tight monetary policy to combat inflation. This leads to:
- Reduced bank reserves.
- A multiple contraction of the money supply.
- Higher interest rates and restricted credit volume in the money market.
- Reduced investment and spending on interest-sensitive items like consumer durables and net exports.
Financial Intermediaries, Buyers, and Sellers
Financial Intermediaries: Institutions like commercial banks that accept deposits and lend to households and businesses.
Applicants (Buyers): Entities that borrow money or use checking accounts from financial intermediaries.
Bidders (Sellers): Entities that lend or invest money with financial intermediaries to earn interest.
Reasons for Financial Intermediaries
- Cost of information and investment analysis.
- Diversification.
- Matching supply and demand.
Cash Reserve Ratio
Commercial banks must hold a certain percentage of their deposits as liquid assets or reserves. This percentage is called the cash reserve ratio.
Multiple Expansion of Bank Deposits
The banking system transforms reserves set by the central bank into a larger amount of deposit money.
Financial Assets
A financial asset is a security issued by a company or agency to generate wealth for the acquirer, representing a liability or debt for the issuer.
Profitability, Risk, and Liquidity
Profitability: The benefit or income earned on an investment. Can be implicit or explicit.
Risk: The potential for actual returns to deviate from expected returns.
Liquidity: The ease of converting an asset into cash.
Relationship: Higher risk generally implies higher potential profitability but lower liquidity. Lower risk generally implies lower profitability but higher liquidity.
Fixed Income Assets
Fixed income securities, primarily bonds, represent a portion of debt.
Characteristics: Moderate return, moderate risk, and liquidity that depends on the issuer.
Bond Valuation Example
Condor Airlines issued bonds with the following conditions:
- Life: 8 years
- Principal: $6,000
- Coupon Rate: 7.5%
- Yield: 6%
Bond Definition: A long-term debt instrument with fixed cash payments at a specified maturity date.
Price Calculation:
