Homework

Question 4,5,6 page 381 of reference book (by Rose and Marquis)

D 1
Reserve multiplier= =
H c+r
M 2 1+ c+ s
M 2multiplier = =
H c +r

a. rr = 0.08 => total reserve ratio r = rd + rr = 0.1+0.08=0.18

D 1
Reserve multiplier= = =0.85
H 1+0.18
M 2 1+1+10
M 2multiplier = = =10.17
H 1+0.18

b. rr = 0.10 => total reserve ratio r = rd + rr = 0.1+0.1=0.2

D 1
Reserve multiplier= = =0.83
H 1+0.2
M 2 1+1+10
M 2multiplier = = =10.00
H 1+0.2

c. rr = 0.12 => total reserve ratio r = rd + rr = 0.1+0.12=0.22

D 1
Reserve multiplier= = =0.82
H 1+0.22
M 2 1+1+10
M 2multiplier = = =9.84
H 1+0.22
 a.

M 2 1+1 .25+9.25
M 2multiplier = = =10
H 1 .25+r

 1.25 + r = 1.15
 r = -0.10 (not valid)

b. banks change excess reserves to $1 per $1,000 of deposit

 rd = 1/1000 = 0.001
in case rr = 0 => r=rr + rd = 0.001

M 2 1+1.25+ 9.25
M 2multiplier = = =9.20
H 1 .25+0.001

in case rr > 0 => r=rr + rd > 0.001

M 2 1+ c+ s
M 2multiplier = = <9.20
H c +r
c = 0.90, s = 8.00, rd = 0.001 , suppose rr = 0.1
a. △M2 = $10 billion => △H=?
M2 1+0.90+8.00 9 .90
M 2multiplier = = =
H 0.90+ rr +0.001 0 .901+ rr

 M2 multiplier = 9.89
△ M2
M 2multiplier =
△H

△M2
 △H= = $1.01 billion
M 2 multiplier

b. c = 1, s = 8.00, rd = 0.001
M2 1+0.90+8.00 9 .90
M 2multiplier = = =
H 0.90+ rr +0.001 0 .901+ rr

 M2 multiplier = 9.083
△ M2
M 2multiplier =
△H

△M2
 △H= = $1.1 billion
M 2 multiplier

c. c = 0.90, s = 10.00, rd = 0.001

 M2 1+0.90+8.00 9 .90
M 2multiplier = = =
H 0.90+ rr +0.001 0 .901+ rr

 M2 multiplier = 11.89
△ M2
M 2multiplier =
△H

△M2
 △H= = $0.841 billion
M 2 multiplier

d. c = 0.90, s = 8.00, rd = 0.003

M2 1+0.90+8.00 9 .90
M 2multiplier = = =
H 0.90+ rr +0.001 0 .901+ rr

 M2 multiplier = 9.87
△ M2
M 2multiplier =
△H

△M2
 △H= = $1.013 billion
M 2 multiplier
 Lecture Diary
Chapter 2: Financial Assets, Money, Financial
Transactions, and Financial Institutions
1. Role of Financial Assets:
The financial system facilitates the transfer of loanable funds from lenders to
borrowers through financial claims like stocks, bonds, and other securities.
This process transforms savings into investments => economic growth.

2. Nature and Characteristics of Financial Assets:

Def: Financial assets are claims against the income or wealth of a firm, household,
or gov, typically represented by certificates, receipts, or digital records (e.g., stocks,
bonds, deposits), usually related to lending of money.
Characteristics:
- Promise future returns (but not a guaranteed form of future income) and act as
a store of value (purchasing power).
- Value depends on the issuer’s promise to pay, not physical attributes.
- Do not depreciate, have low transport/storage costs, and are fungible (easily
substituted or converted).
- Unlike real assets, they have little commodity value.

3. Types of Financial Assets:

- Money: Accepted for payments (e.g., currency, checking accounts).
- Equities: Ownership shares in a firm, claiming profits or asset sale proceeds (e.g.,
common/preferred stock).
- Debt Securities: Priority claims over equities (e.g., bonds, notes, savings
deposits), can be negotiable or non-negotiable.
- Derivatives: Value tied to another asset’s performance (e.g., futures, options,
swaps).

4. Creation of Financial Assets:

Internal Financing: Using current income or accumulated savings.
External Financing: Issuing debt (liabilities) or equities (stocks).
- Borrowing or issuing stock creates financial assets for lenders, recorded as
liabilities on borrowers’ balance sheets.
 - Financial assets enable the acquisition of real assets, increasing societal wealth
and production capacity.
+ Society can increase its wealth: saving and increasing the quantity of its real
assets => produce more goods and services
+ The financial system provides the essential channel for the creation and exchange
of financial assets between savers and borrowers so that real assets can be
acquired
Strong financial system => reduced barriers to external financing, lower cost of
capital, faster economic growth

5. Lending and Borrowing:

- U.S. Economy (2006 Ex): Households (-$546B), nonfinancial businesses (-

$81.5B), and govs were net borrowers; foreign investors (+$946.6B) were net
lenders.
- The financial system enables smooth transitions between borrowing and lending
roles.

6. Money as a Financial Asset:

Def: Money is a financial asset, a claim against public/private institutions, used as a
medium for fund flows.

Types of Money:
- M1 (Narrow Money): Currency + checking account (current account) deposits
(highly liquid) => used to measure amount of money in circulation
- M2 (Broad Money): M1 + savings accounts, small time deposits (less than
$100k), non-institutional money market funds => used to quantify amount of
money in circulation, explain different economic monetary conditions, and forecast
inflation
 - M3: M2 + large time deposits, institutional funds, and other liquid assets
=> measures total money supply
- Fiat Money: Gov-issued currency (legal tender) with value based on trust, not
tied to commodities like gold (ex: A $100 bill)

7. Functions of Money: medium, measure, standard, store

- Unit of Account: Standard for measuring value.
- Store of Value: Reserves purchasing power, though inflation can erode it.
- Medium of Exchange: Eliminates the need for barter’s “coincidence of wants.”

8. Money, Financial Assets, and Inflation:

Inflation: Rising average price levels (measured by CPI, PPI, or GDP deflator),
reducing money’s purchasing power and affecting financial contracts.
Deflation: Falling price levels, increasing purchasing power.
- CPI Formula = (Cost of Current Basket / Cost of Base-Year Basket) × 100.
Ex: U.S. CPI rising from 100 to 125 over five years indicates a 25% cost-of-living
increase and a 20% (1/1.25) drop in the dollar’s purchasing power.
Real values (adjusted for inflation) are critical for accurate financial analysis.

9. Evolution of Financial Transactions:

Direct Finance: Lenders directly provide funds to borrowers, receiving primary

securities (stocks, bonds). Simple but risky and hard to match.
Semidirect Finance: Involves market makers (e.g., brokers, investment bankers)
to reduce search costs, but matching and risk remain.
Indirect Finance: Financial intermediaries (e.g., banks, insurance companies) issue
secondary securities (deposits, policies) to lenders and primary securities to
borrowers, lowering risk and costs.

10. Financial Institutions:

Depository Institutions: Accept public deposits (e.g., commercial banks, credit
unions).
Contractual Institutions: Offer risk-protection contracts (e.g., insurance companies,
pension funds).
Investment Institutions: Pool funds for investment (e.g., mutual funds, money
market funds).
Intermediaries reduce risk and enhance efficiency in fund allocation.

11. Disintermediation:
 - Def: Withdrawal of funds from intermediaries by lenders (SBUs) to lend directly
to borrowers (DBUs), shifting from indirect to direct finance.
- Reintermediation: Reverse flow back to intermediaries when interest rates are
low or financial instruments seem risky.
- New Forms: Banks selling loans, customers seeking alternative financing, or
nonfinancial firms entering financial services.

12. Bank-Dominated vs. Security-Dominated Systems:

- Bank-Dominated: Banks dominate credit and savings (common in economies with
weaker investor protections, e.g., Japan).
- Security-Dominated: Securities (stocks, bonds) dominate, with borrowers selling
directly to the public (common in developed economies, except Japan).
=> Many economies are shifting toward security-dominated systems.

Mixed economy: India

Chapter 5: The Determinants of Interest

Rates: Competing Ideas/Theories
1. Interest Rate:
- Price borrowers pay for loanable funds aka price of credit (annualized %).
+ But unlike other prices in the economy, the rate of interest is really a ratio of two
quantities: the cost of borrowing divided by the amount of money borrowed, usually
expressed on an annual percentage basis.

- Measured in basis points (1 bp = 0.01%) (ex: 10.5% = 10% + 50 bp, or 1050

basic points)
- Opportunity cost of holding (OCH) idle cash = a minimal rate of return.
- Pure/risk-free rate ≈ gov bond rate (opportunity cost of holding cash).
Higher interest rates provide incentives to increase supply of funds, but at same
time they reduce the demand for those funds.

2. Functions of Interest Rates:

- Channels savings into investment for growth.
- Allocates credit to highest-return projects.
- Balances money supply and demand.
- Tool for gov policy (lower rates to stimulate, higher to curb inflation).
+ when slow growth and high unemployment => gov lower interest rate to
stimulate borrowing and investment
+ rapid inflation => gov higher interest rate to slow down borrowing and spending,
encourage saving

3. Classical Theory of Investment Rates (Long-Term):

Equilibrium rate set by supply of savings (households, firms, gov) vs. demand for
investment (businesses).
Supply:
+ Households save due to time preference (current enjoyment or future reward for
waiting); higher rates encourage substitution of saving for consumption
(substitution effect); time and amount of savings; wealth effect (more income =>
more consumption, ex: 1990s – stock market and housing boom, negative personal
saving rates)
+ Business savings: retained earnings = primary fund for investment
+ Gov savings: = budget surplus, determinants: income flows of economy, gov
spending, rates impacting cost of gov debt
Demand: Businesses invest if internal rate of return (IRR) > cost of capital.
+ gross investment = replacement investment (replace obsolete equipment) + net
investment (for new equipment)

Equilibrium: Savings = Investment.

- Limitations: Ignores money creation through loans (repaying loan “destroys”
money), current consumer/gov borrowing instead of traditional business borrowers,
income and wealth are more important than interest rate in determining savings.

4. Liquidity Preference Theory (Short-Term, Keynes): (explain near-term

changes in interest rates, more relevant for policymakers)
Interest rate = payment for giving up liquidity.
Demand for money (cash balances):
- Transactions (Lt = kt × Y): For daily needs, not overly sensitive to interest rates

- Precautionary (Lp = kp × Y): For emergencies, greater demand in times of

economic uncertainty, not overly sensitive to interest rates
Higher levels of income, sales, or prices increase the need for cash balances to
carry out transactions and to respond to future opportunities. However, neither the
precautionary nor the transactions demand for money was assumed to be affected
significantly by changes in interest rates but remained fixed in the short term.

- Speculative: Hold cash if expecting bond prices to rise (interest rates to fall) =>
demand is essentially related to the rate of interest rates and bond prices

Supply: Fixed by central bank (vertical curve).

Equilibrium: Money supply = demand → determines interest rate.

- Limitations: Assumes stable income, which is short-term, does not hold in long-
term; ignores credit demand beyond money.

5. Loanable Funds Theory (Most Practical):

Interest rate balances total demand and supply of loanable funds.
Demand: Households (inelastic), businesses (elastic), gov (inelastic), foreign
borrowers (sensitive to the spread between domestic and foreign interest rates).
Supply: Domestic savings, dishoarding, bank credit creation, foreign lending –
hoarding.

- Equilibrium: Planned savings = investment; money supply = demand; supply of

funds = demand for funds; net foreign demand for funds = net exports.
Interest rates will be stable only when the economy, money market, loanable funds
market, and foreign currency markets are simultaneously in equilibrium.
- Explains short- and long-term rate movements.
6. Shifts in Equilibrium:
- ↑ Demand (e.g., business investment boom) → ↑ interest rates.
- ↑ Supply (e.g., more savings or money creation) → ↓ interest rates.

Conclusion: Interest rates are shaped by savings, investment, money

demand/supply, and credit flows. Classical theory focuses on real factors (long-
term), Liquidity Preference on money (short-term), and Loanable Funds integrates
both (most comprehensive).

The act of increased hoarding of money by the public will result in lower interest
rates, other factors held constant.
 False

Chapter 10: Money Market and Instruments

Introduction
- The money market facilitates short-term borrowing and lending (≤ 1 year) to meet
working capital needs.
+ cash inflows and outflows are rarely in perfect harmony, holding of idle surplus
cash is expensive
- Differs from capital markets due to purpose, maturity, and asset characteristics.

Characteristics of the Money Market

Purpose: Matches temporary cash surpluses with cash deficits.
Investor Priorities:
- Safety and liquidity (first) over return (secondary).
- Funds needed soon → low risk tolerance
+ Maturity:
- Original maturity: ≤ 1 year (overnight to 1 year), time interval between issuance
date and its promised redemption date.
- Actual maturity: Time from now to redemption (some reach maturity every day)

+ Market Efficiency:
- Broad and deep: Absorbs large transactions with minimal price impact (security
prices and interest rates)
- Efficient, constant communication (telephone, computer network) via dealers,
banks, and brokers => alert to any bargains.

Federal funds are mainly deposit balances of commercial banks held at the central
bank and at larger correspondent banks across a country.
Federal funds are often called immediately available funds because of the speed
with which money moves from one bank’s reserve account to that of another.
=> Federal funds: Immediate availability (bank reserves at central/correspondent
banks).

Correspondent banks are used by domestic banks to service transactions

originating in foreign countries, and act as a domestic bank's agent abroad.
This is done because the domestic bank may have limited access to foreign financial
markets and cannot service its client accounts without opening a branch in another
country.

Clearinghouse funds (Alternate structure to the federal funds)

The clearinghouse is a location where checks and other cash items are delivered
and passed from one financial organization to another
Clearinghouse funds are an acceptable means of payment for most purposes
Too slow for the money market, have risk
=> Clearinghouse funds: Slower, riskier, less used in money markets.

5. Wholesale Market:
- Most are Large transactions (millions dollars).
- Dominated by a small no. of major institutions.

Chapter 12: Roles and Services of Central

Banks
Central Bank?
- Gov agency that 1. Monitors financial system; 2. Controls money supply growth.
- “Bankers’ bank” and lender of last resort.
- Communicates with commercial banks and securities dealers.

Primary Goals
- Economic Growth => Max sustainable output & employment
- Price Stability => Low & stable inflation

Core Roles of Roles of the Fed (US

Central Banks Central Bank and other
CBs Today)
1. Control .Collecting and clearing
money supply checks and other means
2. Stabilize of payment
money & .Issuing currency and
capital markets coin
3. Lender of .Maintaining a sound
last resort banking and financial
4. Supervise system
banking system .Providing information to
5. Maintain the public, (Statistical
 payments releases and reports)
system .Influencing currencies
(checks, exchange rates
currency, .Carrying out monetary
digital) policy

How Central Banks Achieve Goals (Transmission Channels)

Monetary Policy Tools

1. Reserve Requirements => % of transaction deposits banks must hold as reserves
2. Open Market Operations (OMO) => Buy/sell treasury bills, bonds, and foreign
currencies to adjust reserves/money supply (give/ take money from commercial
bank)
3. Discount Rate (Bank Rate) => Interest rate charged to banks for borrowing from
central bank (lender of last resort)
4. Moral Suasion => Persuasion to influence bank behavior to achieve certain
outcomes

- Expansionary Monetary Policy: ↑ Money supply or ↓ Interest rates

- Contractionary Monetary Policy: ↓ Money supply growth or↑ Interest rates
=> Key focus of CB monetary policy are interest rates, reserve, and money

Reserve Composition (Example: U.S.)

Legal reserves in the US consist of
1. Required Reserve: the amount of deposits each institution keeps with the Federal
Reserve/ CB Required Reserves = RRd × Transaction Deposits (RRd = Reserve
Requirement Ratio)
2. Plus Excess Reserve: the amount of currency and coin held in its vaults as
protection cushion and to meet unexpected withdrawals
Excess Reserves = EXR × Transaction Deposits (EXR = Bank’s chosen cushion)

Total Legal Reserves = Required Reserves + Excess Reserves

=> Total Legal Reserves = (RRd + EXR) x Transaction Deposits (*)

Transaction Deposits = Checking accounts (no interest, unlimited access)

Savings Accounts = Earn interest, restricted access

Deposit Creation: The Deposit Multiplier

- Banks use excess reserves to make loans → create new deposits.
The deposit multiplier indicates the dollar volume of deposits and loans that the
banking system can create for each new dollar of excess legal reserves
- Deposit Multiplier Formula:

(*) =>

Money Multiplier & Monetary Base

Central bankers are usually more interested in the money multiplier
Defines the relationship between a measure of the money supply that is closely
related to spending and income (M2) in the economy to the total reserve base
- Closely related to deposit multiplier
Currency and coin holdings impact reserves held by depository institutions: If the
public holds less currency, the excess is typically re-deposited

CD = Currency-to-Deposit ratio (public preference for cash)

LA = Liquid Assets-to-Deposit ratio

M2 = Transaction deposits + currency and coins + other liquid assets principally

held by households (savings, time deposits, and shares in money market funds)

Money base:

Central Bank Balance Sheet Ex (Bank of Japan)

- Assets: Govt bonds, loans like T-bills, foreign reserves, loans to banks.
- Liabilities: Currency, bank reserves (monetary base).
- Many central banks engaged in asset purchase programs (QE) → assets ↑ as % of
GDP.

Key Takeaways
- Central banks are independent to effectively manage money & credit.
- Control reserves → deposits → money supply via multipliers.
- Open market operations = most flexible tool.
- Monetary base = foundation of money creation.

Chapter 14: The Commercial Banking Industry

Bank Portfolio Characteristics
Assets
Primary Reserves => Cash + deposits at other banks (liquidity buffer: depositors’
withdrawal and customer demand for loans)
Secondary Reserves => Marketable securities (long-term investment, securities
acquired in the open market)
Loans => Highest revenue source, highest yielding assets
Funding to carry out lending and investing operations comes from wide variety of
fund sources, 2/3 from deposits
Loan Loss Allowance (difference between gross and net loans) => Reserve for loan
default (Provision for Loan Losses)

Liabilities & Funding

+Deposits (~⅔ of funds) => Demand (checking accounts), Savings, Time (CDs)
- Demand deposits: important for transactions, safer than cash
- Savings deposits: low interest rates, low dollar amounts
- Time deposits: fixed maturity, highest rate of return offered
+Principal Nondeposit sources of funds (Borrowings) => Fed funds (Purchases of
reserves from other banks), Repos, Capital notes
+New Sources => Floating-rate CDs and notes in international market, Loan sales,
Securitization (mortgages, auto, credit cards), Standby credit guarantees

Off-Balance Sheet => Standby Letters of Credit (L/C) – Payment guarantees: If the
buyer is unable to make payment on the purchase, the bank will cover the
outstanding amount.
Equity Capital (net worth) supplied by a bank’s stockholders
- ~9–10% of total funds.
- Critical for absorbing losses.
- Minimal capital requirements

Bank Revenues & Expenses

Revenues:
- Interest and fees on loans
- Interest and dividends on investment security holdings
Expenses
- Interest in deposits and other borrowed funds (principal expense for commercial
banks)
- Salaries and wages of employees (also large)
Bank’s expenses have been rising due to 1. greater competition from bank and
nonbank financial insitutions (higher real cost of raising funds), 2. tech upgrade
=> lower interest margin

- [Interest Margin = Net interest income – interest paid] → measures efficiency.

Recently interest expenses have been dropping

- Lower average market interest rates
- Larger banks are evolving from traditional structures into complex banking
companies

- [Noninterest Margin = Noninterest income – noninterest expense] → growing

focus.
+ commercial banks develop more and more new services => higher noninterest
fees
+ however, banks might minimize noninterest expenses: replace labour by
automatic equipment

Managing Bank Performance

- In relative to its goals and to performance of competitors
- Consider: bank size, location, principal service mission (product-line focus)
Key Strategies:
- Loan policies
- Investment portfolio positioning
- Liquidity management (asset conversion/ liability management)
- Focus on large depositors/credit lines
Recently:
- Sources of liquid funds banks borrow daily prolifirate rapidly => challenges for
bank mana
- Bankers rely less on traditional deposits => more on innovative sources of
liquidity, interest sensitive
Performance Metrics:
- Equity-to-Assets Ratio → Risk buffer
- Loan Loss Reserve / NPLs → Credit quality
- Operating Efficiency Ratio = Operating Exp / Income (≤60% = good)

Money Creation by Banks

In form of new checkable deposits, credit card lines, debit cards, other immediately
spendable funds
1. Excess reserves deposited → use for loans → new checkable deposits created.
OR Excess reserves deposited → purchase securities

2. Deposit Multiplier Effect:

- $1 excess reserve → supports multiple dollars in new deposits.
By making loans whenever excess reserves appear, the banking system eventually
creates total deposits and total loans several times larger than the original volume
of new funds received

3. Ex:
Bank A gets $100 deposit → keeps 10% reserve → lends $90
→ Bank B gets $90 → lends $81 → and so on...
→ Total deposits created = $100 × (1/0.1) = $1,000
Implications:
> Banks = major credit creators, one of the most important sources of credit funds
in the global eco
> Instant spending power → needs central bank oversight to avoid inflation.

Key Takeaways
- U.S. banking: fragmented but consolidating into global + community model.
- Banks evolving into universal service providers via convergence & tech.
- Money creation = core economic function, enabled by fractional reserve system.
- Risk management (reserves, capital, provisions) critical to survival.

15.1: International Financial Institutions and

Markets – Summary
1. Major International Financial Institutions
Institution: Established | Main Purpose | Key Features
IMF (International Monetary Fund): 1944 (Bretton Woods) | Foster global monetary
cooperation, financial stability, international trade, growth, and reduce poverty |
186 member countries; Provides temporary loans (in SDRs); Promotes stable
exchange rates & free trade
World Bank Group (1944) | Provide financial & technical assistance to developing
countries for development and poverty reduction | 186 member countries; Five
institutions; Funds via bond sales (AAA rating); Structural Adjustment Loans (SALs),
cofinancing with commercial banks
BIS (Bank for International Settlements): 1930 (Basel, Switzerland) | Central
bank for central banks; promotes monetary & financial cooperation | Forum for
central banks; Research center; Lender of last resort to countries in crisis
WTO (World Trade Organization): 1995 (successor to GATT) | Forum for trade
negotiations & dispute settlement | 164 members (covers >95% world trade);
Uruguay Round → GATT 1994, GATS (goods & trade), TRIPS (intellectual property
rights); Current Doha Round stalled

2. Key IMF Concepts

Special Drawing Rights (SDR): Artificial international reserve asset (basket: USD,
EUR, JPY, GBP, CNY since 2016)
Quotas (~payment by each country): Determine voting power and borrowing limits
Historical Evolution:
- 1944–1971: Fixed exchange rates (Bretton Woods/par value system)
- 1971: End of gold convertibility → floating rates
- 1980s: Debt crisis management
- 1990s–2000s: Asian crisis, transition economies, globalization

3. World Bank Group – Five Arms

IBRD (int bank for reconstruction and dev): Loans to middle-income & creditworthy
low-income countries (186)
IDA (int dev asso): Concessional loans to poorest countries (167)
IFC (int fin corp): Promotes private sector (equity + loans) (179)
MIGA (multilaateral invest guarantee agency): Political risk insurance for foreign
investors (172); additional means with SALs
ICSID (int center for settlement of investment disputs): Settles investment disputes
(143)

4. Regional Development Banks (Examples)

- Inter-American Development Bank
- Asian Development Bank (ADB)
- African Development Bank
-AIIB (Asian Infrastructure Investment Bank) – China-led, 2016, $100B capital, 105+
members (U.S. & Japan not members)
- European Bank for Reconstruction and Development (EBRD)

5. International Financial Markets Covered (Briefly Mentioned)

- Foreign Exchange (Forex) Market
- Eurocurrency Market
- Eurobond Market
- International Stock Markets
Chapter 2: Money and Functions of Money, Inflation
Chapter 5: Competing Theories of Interests (All)
Chapter 10: Money Markets (Excluding instruments)
Chapter 12: Central Banks (All)
Chapter 14: Commercial Banks (Portfolios, Performance Measurement and
Money Creation)
Plus: Issues covered on November 17, 2025 Class.
Chapter 1: Functions and Roles of the
Financial System in the Global Economy
1. Economic Systems:
- Barter to Digital Currency: Economies evolved from barter (using commodities
like livestock, grains, metals) to money-based systems (paper money, credit cards,
digital currencies like Bitcoin since 2008).
- Modern Economic Systems:
- Capitalist/Market Economy: Driven by individuals/firms and market prices.
- Socialist/Centrally Planned Economy: State-controlled with budget-driven
coordination.
- Mixed Economy: Combines state and market coordination.
- Differences lie in ownership of production means and economic activity
coordination.
Differences Capitalism/ Market Communism/ Mixed Economy
Economy Centrally Planned
Economy/ State
Controlled
Economy
Ownership of Individuals and State The State and
Means of firms, directly individuals and
Production and/or indirectly firms
Coordination of Market through Budget through Budget and
Economic price plant managers market
Activities

2. Circular Flow in the Economy:

- Describes the reciprocal flow of income between producers (firms) and
consumers (households).

- Firms provide goods/services and receive payments; households provide factors

of production (labor, capital) and earn income.
- The global economy involves a flow of production and payments, interdependent
with markets.

3. The Financial System:

 - Comprises markets, institutions, laws, and techniques for trading securities,
determining interest rates, and delivering financial services globally.
- Primary Task: Moves loanable funds from savers to borrowers, enabling
investments and economic growth and improved living standards.

Economic system:
Basic functions: allocate resources and produce needed goods and services =>
circular flow of production and income

4. Role of Markets:
- Markets allocate scarce resources (land, labor, capital) and distribute income
through prices, profits, and wages.
- Types of Markets:
- Factor Markets: Allocate production factors (e.g., labor, capital) and distribute
income (e.g., wages, rent).
- Product Markets: Distribute goods/services to consumers, who use most of their
income in this market.
- Financial Markets: Allocate savings to borrowers for spending/investment.

5. Financial Markets and Intermediation:

- Savings and Investment: Financial markets channel savings (household income,
business retained earnings, gov revenues) into investments (e.g., homes, capital
goods, public facilities).
- Financial Intermediation: Facilitates the exchange of current income => future
income, savings => investments, supporting economic growth.
6. Economic Functions of FMIs:
- Savings: Channels savings into low-risk, productive investments.
- Wealth: Stores wealth via financial instruments (e.g., $55 trillion in U.S. financial
assets by domestic nonfinancial businesses; $11 trillion held by international
investors); do not depreciate, often generate income; less risk than other form of
wealth storing
- Liquidity: Provides money (currency, deposits) for immediate spending needs;
lowest rate of return of all financial assets
- Credit: Supplies funds for consumption/investment, with U.S. credit at $3.4
trillion in 2005 and federal debt at $33 trillion currently.
- Payments: Supports transactions via currency, cards, and digital methods.
- Risk Protection: Offers insurance and risk-sharing mechanisms against life,
health, property, and income risks; risk-sharing and risk reduction
- Policy: Enables govs to influence economic stability via central banks; affecting
borrowing and spending plans, growth rates of jobs, production, and prices

7. Types of Financial Markets:

Based on maturity structure: money market and capital market
- Money Market: Short-term loans (≤1 year), e.g., gov borrowing from banks.
- Capital Market: Long-term investments, funded by insurance companies, mutual
funds, etc.
- Open vs. Negotiated Markets: Open markets involve public bidding, sale to
highest bidding; negotiated markets use private contracts.
Based on trading structure: Primary vs. Secondary Markets: Primary markets issue
new securities; secondary markets provide liquidity for trading.
- Spot vs. Futures/Options Markets: Spot markets involve immediate transactions;
futures/options involve future commitments.

8. Factors Unifying Financial Markets:

- Credit: Common commodity linking markets, balancing borrowing costs.
- Speculation and Arbitrage: Maintain market consistency by leveling prices.

9. Dynamic Financial System:

- Rapidly evolving due to global integration, new financial instruments, non-
financial firms entering the sector, deregulation, and harmonized regulations.
- Results in increased competition, new services, higher risks, and mergers among
financial institutions.

Financial Globalization:
 - Integration of financial systems worldwide, driven by innovation and
deregulation, impacting markets and economic stability.

Chapter Review:
- The financial system is critical for allocating savings, enabling investments, and
supporting economic growth.
- It performs essential functions (savings, wealth, liquidity, credit, payments, risk
protection, policy) and operates through diverse markets (money, capital, primary,
secondary).
- The system is dynamic, globally integrated, and influenced by credit, speculation,
and regulatory changes.

This chapter provides foundational knowledge on how financial systems drive

economic activity and improve living standards globally.

Chapter 3: The Financial Information

Marketplace
Overview: This chapter explores the critical role of information in financial decision-
making, sources of financial data, the debate between Efficient Markets Hypothesis
(EMH) and Asymmetric Information Hypothesis (AIH), and social accounting
systems.

1. Importance of Information:
- Reliable financial information is essential for borrowers, lenders, and
policymakers.
- Key data includes security prices/yields, issuer details, economic conditions, and
social accounting.

2. Efficient Markets Hypothesis (EMH):

- Argues all relevant information is quickly reflected in asset prices at low cost.
(financial marketplace contains pockets of inefficiency in information availability and
use of info)
Some market players possess better info (special info, costly for other party,
insiders)
- Forms: (regarding price of current financial assets)
- Weak: Prices reflect past price/volume data.
- Semistrong: Reflects all public information.
- Strong: Reflects all public and private information.
 - repeated research support weak and semistrong forms; strong form debated due
to insider trading, special info.

3. Insider Trading:
- Involves trading with superior internal knowledge (Micheal Milken case)
- Illegal if manipulative; insiders can trade but must disclose.
- Monitored by corporations, exchanges, and regulators.
+ insider trading = firm efficiency (encourage to take risk, managerial incentive),
market efficiency (encourage release of private info, quick price correct, less risk for
investor)

4. Asymmetric Information Hypothesis (AIH):

- Some market players have better information (expertise, experience, location),
leading to inefficiencies.
- Problems:
- Lemons & Plums: Difficulty distinguishing high/low-quality borrowers =>
solution: a mechanism beyond procing to optimally allocate resources
- Adverse Selection: Riskier parties more likely to seek contracts => solution:
enable customer signaling via a conditional price schedule for different account
plans
- Moral Hazard: Post-contract behavior changes to exploit the other party =>
solution: draw contracts with the appropriate incentives
- Solutions: Signaling (Spence) and screening (Stiglitz).

 Only the best-informed traders appear to outperform less-informed

traders
 Investors who purchase market research information do not, on
average, achieve greater net returns than investors who do not

5. Real-World Markets:
- Combine efficiency (well-informed traders) and asymmetry (less-informed
investors).
- Laws (e.g., Sarbanes-Oxley, Regulation FD) aim to improve information flow.

7. Social Accounting:
- National Income and Product Accounts (NIPA): Tracks GDP, income, consumption,
savings.
- Flow of Funds Accounts:
 - Tracks savings and financial asset flows across sectors (households, banks,
gov).
- Steps: Sectoring, balance sheets, sources/uses, matrix.
- Useful for forecasting but limited by intra-sector gaps and market-value bias.

8. Behavioral Finance:
- Experimental studies show best-informed traders outperform; markets efficiently
signal via prices.

Conclusion: Information drives financial markets. While EMH suggests rapid price
adjustment, AIH highlights real-world inefficiencies. Social accounting (NIPA, Flow of
Funds) provides macro-level insights into economic and financial interactions.

Chapter 10: Money Instrument part

Money Market Instruments

1. Treasury Bills (T-Bills)

- Direct gov obligations, zero default risk, issued routinely every week or month.
- Maturities: 4, 13, 26 weeks (regular); irregular for emergencies (one year or less)
- Tax revenues or any other source of gov funds may be used to repay the debt
- Zero (or nearly zero) default risk, High Liquidity, Ready Marketability.
Regular bill - Sold via auction:
- Competitive bids: Large investors (millions of dollars) bid discount rate, compete
for limited supply
- Noncompetitive bids: Small investors (under 1 million) accept auction price.
- Holders: commercial banks & private corporation (as reserve of liquidity),
nonfinancial corporations, state/local govts, central banks.
Irregular-series bills are issued when the Treasury has an emergency cash need
- Strip bills: Package of offered bills, Investor bids for a package of different
maturities
- Cash management bills
o Reopening an issue of bills that were sold in a prior week
o Issued at the actual maturity of the original issue

Dealer Financing in Money Markets

Sources of funds:
1. Demand loans from the largest banks (callable, collateralized => virtually
riskless).
2. Repurchase Agreements (RP or Repos):
- Sell securities with agreement to repurchase later at higher price (fixed price +
interest) => simply a temporary extension of credit collateralized by marketable
securities
 - Term repos (fixed duration – overnight, a few days, 1 month, 3 month, …) or
continuing contracts (flexible, may be terminated by either party on short notice).

2. Commercial Paper (CP)

- Unsecured promissory notes by corporations/banks with maturity 1–270 days.
- Sold at discount, no collateral, higher interest repayment dates than bonds → only
high-credit firms issue (credit ratings from a recognized rating agency) for short-
term obligations (e.g., payroll).

3. Banker’s Acceptance (BA)

- It is an order by the drawer to the bank to pay a specified sum of money on a
specified date to a named person or to the bearer of the draft. Upon acceptance,
which occurs when an authorized bank accepts and signs it, the draft becomes a
primary and unconditional liability of the bank.
- Readily sold in an active market
- A money market instrument used in international trade.
- Short-term, negotiable, sold at discount.

4. Eurocurrency Deposits
- Fixed-rate certificate of deposit (CD), fixed interest rate, in currency outside issuing
country (e.g., USD CD in London).
- Helps hedge currency risk (short-term fluctuations in exchange rates)
Key Takeaways
- Money market = efficient, wholesale, low-risk short-term credit system.
- Dominated by large institutions, gov, and central banks.
- T-bills are cornerstone due to safety and liquidity.
- Repos and dealer networks ensure smooth funding and trading.

Chapter 14: Commercial Banks - Trends part

Introduction
- Commercial banks = dominant private financial institutions in most major
countries
- Offer deposits, loans, and innovative services (investment advice, insurance,
underwriting, financial planning).

The Structure of Commercial Banking

The number of commercial banks
The sizes of commercial banks
o In most other nations the banking system consist of a few large banking
organizations
o The U.S. system is numerically dominated by thousands of small banks
o However they tend to be smaller than banks in other nations
o But most assets are concentrated in a small handful of banks

Consolidation Trend due to Economies of Scale

Mergers & Acquisitions => Fewer, larger banks (14,000 to less than 7,000, largest
bank go from 40% to 76% market share) & more efficient use of resources
Efficiency & Profitability => Larger banks more profitable
Mergers and Creation of New Banks => Two-Tier System Emerging: small number of
Global money-center banks + Community banks serving cities and suburbs
 Consolidation continues but is slowing down in US, because:
 - Under economies of scale: benefits are limited, level off at about $1 billion in
assets, larger banks tend to offer more services and bear more costs

Branch Banking & International Banking

- Branching: Banks follow customers → nationwide networks via mergers.
- International Expansion: - Representative offices - Full branch offices -
Acquisitions & subsidiaries - Joint ventures
> Top Global Banks 1970: Led by US banks (BankAmerica, First National City, etc.,),
Barclays Bank (UK), Banca (Italy), etc.
> Top Global Banks 2020: Led by Chinese banks (ICBC, CCB), JPMorgan Chase (US),
Mitsubishi UFJ (Japan), etc.

Convergence Trend
- Banks increasingly resemble financial-service providers (security firms, insurance
companies)
- Long became universal and merchant banks (Canada, UK, Europe).

Bank Failures & Risks

- Rapid expansion of bank services
- Causes: Excessive risk, competition, economic volatility, fraud.
- Famous cases:
- Lehman Brothers (2008) – Largest bankruptcy ($639B assets).
- Barings Bank – Collapsed due to rogue trader Nick Leeson (speculation)
- Japanese banking fraud scandals.

Technology Revolution
Innovation => Impact
ATMs, POS, ACHs, Internet Banking => Faster, cheaper transactions
Online banking => Convenience, but ↑ identity theft
Automation => ↓ labor costs, ↑ efficiency
=> at least 5% of users abandoned online banking due to security fears.