MoneyMoney

Functions of moneyFunctions of money– Medium of exchangeMedium of exchange– Unit of accountUnit of account– Store of valueStore of value

Flavors of moneyFlavors of money– Commodity moneyCommodity money– Banknotes … backed by gold or silver reservesBanknotes … backed by gold or silver reserves– Fiat moneyFiat money

Legal tenderLegal tender

... Pay taxes... Pay taxes

Measuring MoneyMeasuring Money

Liquidity: aLiquidity: a measure of the ease with measure of the ease with which an asset can be turned into a which an asset can be turned into a means of payment (money).means of payment (money).

Different definitions of money are Different definitions of money are based upon degrees of liquidity.based upon degrees of liquidity.

The Federal Reserve defines The Federal Reserve defines monetary aggregates: M1, M2, M3, L.monetary aggregates: M1, M2, M3, L.

Link to Current Data

Does money matter?Does money matter?

Equation of exchangeEquation of exchange

M V = P YM V = P YBut …But …

Which measure of M to control? … M2Which measure of M to control? … M2

Can M2 be controlled?Can M2 be controlled?

Financial innovation Financial innovation changing velocity changing velocity

Operate via interest rate insteadOperate via interest rate instead– Open market operations & federal fund rateOpen market operations & federal fund rate

Where to Find the NumbersWhere to Find the Numbers

http://research.stlouisfed.org/fred2/http://research.stlouisfed.org/fred2/www.economist.comwww.economist.comwww.yardeni.comwww.yardeni.comwww.bea.doc.govwww.bea.doc.govhttp://http://www.gpoaccess.gov/eopwww.gpoaccess.gov/eop//

Financial IntermediariesFinancial IntermediariesIndirect FinanceIndirect Finance

– An Institution stands between lender and An Institution stands between lender and borrower, e.g., a bankborrower, e.g., a bank

Direct FinanceDirect Finance

– Borrowers and lenders deal directly with Borrowers and lenders deal directly with each other, e.g., the bond marketeach other, e.g., the bond market

Brokers and dealers facilitate transactionsBrokers and dealers facilitate transactions

Financial InstrumentsFinancial Instruments

– Bank LoansBank Loans

– BondsBonds

– Home MortgagesHome MortgagesCollateralCollateral

– StocksStocks

– Asset-backed securitiesAsset-backed securities

Financial InstrumentsFinancial Instruments

Serve as:Serve as:

Means of paymentMeans of payment–E.g., Stock optionsE.g., Stock options

Stores of Value … like all assets Stores of Value … like all assets

Allow for trading of riskAllow for trading of riskE.g., Futures contracts, options, insurance E.g., Futures contracts, options, insurance contractscontracts

Value of Financial Instrument Depends on:

How muchHow much you’ll get paid you’ll get paid

WhenWhen you’ll get paid you’ll get paid

Present value lower the further in the futurePresent value lower the further in the future

Chance you’ll get paid (Chance you’ll get paid (riskrisk).).

ConditionsConditions under which you’ll get paid under which you’ll get paid e.g., dividends when there’s profite.g., dividends when there’s profit

Financial Markets: Financial Markets: Roles of Financial Markets.Roles of Financial Markets.

Provide liquidity to borrowers and savers.Provide liquidity to borrowers and savers.Pool and communicate information about issuer of Pool and communicate information about issuer of debt or equity.debt or equity.Allow risk sharingAllow risk sharing– Construct portfolios of assets … and liabilitiesConstruct portfolios of assets … and liabilities

Effective Financial MarketsEffective Financial MarketsReduce transaction costs.Reduce transaction costs.Communicate information accurately.Communicate information accurately.– Asymmetric information problems in financeAsymmetric information problems in finance

Adverse Selection … before the dealAdverse Selection … before the dealMoral Hazard … after the dealMoral Hazard … after the deal

Protect investorsProtect investors

Structures of Financial MarketsStructures of Financial Markets

Primary vs. Secondary MarketsPrimary vs. Secondary MarketsInvestment banks/underwritingInvestment banks/underwriting

Stock market/bond marketStock market/bond market

Centralized Exchanges vs. Over-the-Centralized Exchanges vs. Over-the-counter Markets.counter Markets.

Specialists/brokers/dealersSpecialists/brokers/dealers

Debt vs. EquityDebt vs. EquityBonds … StocksBonds … Stocks

Underlying Assets vs. DerivativesUnderlying Assets vs. DerivativesFutures/optionsFutures/options

Financial InstitutionsFinancial Institutions

The financial industryThe financial industry

– Depository InstitutionsDepository Institutions– Insurance CompaniesInsurance Companies– Pension FundsPension Funds– Investment IntermediariesInvestment Intermediaries– Securities FirmsSecurities Firms– Finance CompaniesFinance Companies– Government Sponsored EnterprisesGovernment Sponsored Enterprises