MONEY & BANKING (Eco 340)
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapter 1 ("An Introduction to Money and the Financial System")
Last revised 23 Jan. 2009.

In these notes:
I. Quick introduction to money and banking
II. The Five Core Principles of Money and Banking ("TRIMS") 
III. The Five Parts of the Financial System


I. QUICK INTRODUCTION TO MONEY AND BANKING

With the world now in its worst economic and financial crisis since the Great Depression, the study of money and banking takes on great urgency.  That study begins with a couple of very basic definitions -- What is money?  What is banking?  (And why do we study them together?)  Let's start with an example...

Q: Why isn't it a good idea for me to try to pay my home heating bill by giving economics lectures to people at the power company?

A (the obvious answer, but not the full answer): The power company might not want my lecturing services. But, suppose for a minute that the company did. Then we'd have a "double coincidence of wants" - I want their heating services, and they want my lecturing services, and a trade could be arranged. Still, that probably wouldn't be very efficient, since I already have a job and not much free time. There's a much easier way to pay my bill - I can pay with money.
--Paying with money is more convenient and less time-consuming.

MONEY (anything that is generally accepted as payment) is more efficient than BARTER (trading goods/services for goods/services). Barter requires a double coincidence of wants (you want the good/service that the other guy has to offer, and he wants the good/service that you have to offer); money does not, because everybody can find some use for money.

Q: Given that I'm paying the power company with money, why would it probably be a waste of time to drive down to their office (which is 40 miles away) and pay in cash?

A: Because it's inconvenient and I don't need to. It's much easier to write a check and mail it in, or to have money debited from my bank account (e.g., pay by phone, automatic monthly debit).
-- Since the funds in your checking account balance are easily available for spending (through an ATM withdrawal, a debit card, online bill payments, etc.), they count as money, too.
--BANK DEPOSITS, followed by CASH IN CIRCULATION, are the main form of money in our society.
---Banks make the monetary system a lot more efficient by reducing our need to carry a lot of cash. People have long tended to use checks instead of cash for large purchases and bills. Innovations in banking like debit cards, direct deposit, and automatic bill-paying reduce that inconvenience even further, and also reduce such bank-related inconveniences of time spent standing in line at the bank, writing checks, or visiting the ATM.
----So, then, MONEY may be the common thread in our economy, but BANKS make the supply of money a lot more plentiful than it would otherwise be. Banks also make the "payments system" a lot more efficient.

Definition: A BANK is a financial institution that accepts deposits and makes loans.

II. THE FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. TIME has value. A dollar today is worth more than a dollar a year from now. Why is this? (Several reasons: inflation erodes the buying power of money over time; having the money now means you can spend it now; having the money now means you can invest it and turn it into more money.) The reason we focus on is the interest that you can earn on your money when you set it aside.  The longer you set it aside, the more interest you earn.  Later, we'll relate this principle to the concept of present discounted value of future payments, or what they're worth today taking into account the interest you could be earning in the interim.
--An important aspect of the time value of money is that interest compounds over time. Ex. in book: a $10,000 car loan, at 6%. If you repaid the entire loan in one lump sum a year later, you'd pay $10,600 (original amount plus $600 interest). But in the example, the loan is to be paid off in monthly payments over four years, or 48 monthly payments of $235, and the total repayment is $11,280. Why? Interest compounds, or accumulates, from month to month.

2. RISK requires compensation. For securities like stocks and bonds, the higher the risk, the higher the return has to be. For individuals, minimizing the risk of such things as accidents, illness, and theft is worth the expense of monthly insurance premiums. (A note on usage: "Risk" refers to your potential losses, financial and otherwise, not merely to the probability of unwanted events. For example, fire insurance might not reduce the likelihood of your house burning down, but it will compensate you for the damage from your house burning down.)

3. INFORMATION is the basis for decisions. This rather general sentence relates to money, banking, and finance because we live in a world of imperfect information. It is hard for financial transactions to take place when one or both parties lack adequate information about the other, because one party could easily end up getting burned. As a result, banks and other financial institutions that make loans gather a considerable amount of information about their potential borrowers before advancing them money. The collection and provision of company financial information by government agencies like the Securities and Exchange Commission can aid the growth of financial markets by making them more transparent, thus reducing the information barrier for potential investors. Recent advances in computer and communications technology have greatly helped the spread of financial information, thereby paving the way for the growth of important new financial markets like the junk-bond market.

4. MARKETS set prices and allocate resources. Financial institutions and markets, by connecting savers with borrowers, allow for people's leftover money (savings) to be channeled into productive investment in capital (e.g., new technology, machinery, buildings). Financial markets for assets like stocks and bonds allow some companies, especially well-established companies, to obtain funds for new capital investment more cheaply than they could borrow from a bank.  Other, less-established companies that cannot get approved for a bank loan can raise money by selling bonds in the junk-bond market (though at higher rates of interest, because these bonds are riskier, and risk requires compensation).

5. STABILITY improves welfare (i.e., well-being).
--Imagine that your next job pays you $3,500 a month (or $42,000 a year). Now imagine that your boss proposes to change your monthly pay to $1,000 times the roll of a die. That is, you'd have an equal chance of receiving $1,000, $2,000, $3,000, $4,000, $5,000, and $6,000, and the average of those numbers (or the expected value of your monthly pay) would still be $3,500. Would you do it? Most people would say no way.
--Real-life example: Professors at the college are officially paid on a nine-month schedule (i.e., nothing in June, July, and August), but we have the option of being paid the same amount stretched out over 12 months. I don't know of a single person who chose the 9-month option. Even though it's not really risky, because the irregularity is known in advance, it could be hard to manage.
--In the interest of stability in the financial sector, governments have created central banks to try to guard against bank failures and financial panics. (Most people think the bubble-and-bust economic fluctuations of 2003-2008 were not desirable.)  The tasks of central banks have grown in recent years, as they are now expected to keep inflation low and stable, and also to avoid or minimize recessions.
--Bank deposit insurance is another example of a government intervention for the sake of financial and social stability.

A handy device for memorizing those five principles is the (inelegant) acronym "TRIMS" - for Time, Risk, Information, Markets, Stability. They're worth memorizing, as we will be returning to them again and again in this course.

III. THE FIVE PARTS OF THE FINANCIAL SYSTEM

. . . are money; financial institutions (including banks); financial instruments (including loans, stocks, and bonds); financial markets (like the New York Stock Exchange); and central banks (like the Federal Reserve System).

The way these five parts fit together can be represented, however crudely, as a pyramid/triangle, with money at the base (a modern economy is monetary, or money-based, economy), central banks at the top, and the other three in the middle. I drew it with financial institutions occupying all of one side, and on the other side financial markets on top of financial instruments. (Check your notes.)

The five parts of the financial system, in a bit more detail:

1. MONEY - anything generally accepted as payment. It's useful because you can buy things with it, either now or later (non-perishable, store of wealth. Contrast with, say, fish).
--Main types of money: bank deposits, cash.

2. FINANCIAL INSTRUMENTS
--defn.: A financial instrument is a formal obligation that entitles one party to receive payments and/or a share of assets from another party.
---Exs.: loans, stocks, bonds. Even an ordinary bank loan is a financial instrument. Securities is a name that commonly refers to financial instruments that are traded on . . .

3. FINANCIAL MARKETS
--defn.: places or networks where financial instruments can be sold quickly and cheaply.
---Exs.: New York Stock Exchange, U.S. Treasury's online auction site for its bonds.

4. FINANCIAL INSTITUTIONS
--defn.: firms that provide savers and borrowers with access to financial instruments and financial markets. Among other services, they allow individuals to earn a decent return on their money while at the same time avoiding risk.
---Exs.: banks, insurance companies, mutual funds, brokerage houses.

5. CENTRAL BANKS
--defn.: A central bank is a large financial institution that handles the government's finances, regulates the supply of money and credit in the economy, and serves as the bank to commercial banks. (That last part means that commercial banks deposit some of their reserves at the central bank, and the central bank is the "lender of last resort" to commercial banks in times of crisis.)
---Exs.: the Federal Reserve System of the U.S., the European Central Bank (ECB; for countries using the Euro).