This chapter introduces you to some of the basic terminology of the financial sector and key principles guiding the study of money and banking. This ensures we are all on the same page. If you are already familiar with this stuff, feel free to just skim through it. (That is the great thing about an online course!)
In any market, buyers and sellers meet to exchange and this determines both the price of what is exchanged and the quantity exchanged. Financial markets are no different. In financial markets available funds are exchanged. The sellers have excess funds and the buyers need those funds. The equilibria in these markets determine the price and quantity of financial instruments. If financial markets work well, then useful investment occurs, increasing production and economic efficiency, and this benefits everyone.
Five Parts of the Financial System
Each part of the financial system has a important role to play in the economy:
The Five Core Principles of Money and Banking
Your textbook lays out five key ideas the provide a foundation for studying the financial system. Keeping these principles in mind not only helps you to understand how the financial system works today, but also gives us insight into why things go wrong, and what the consequences might be to future events.
1. Time Has Value
You are not indifferent between getting $100 today versus waiting one year to receive $100. This is certainly not news to you, so on some level you know that the timing of payments is an important part of any financial transaction. Lenders will demand compensation for parting with their money and getting it back slowly over time. Borrowers are will to give this compensation in returns for getting the needed funds today. This is the basis for an interest rate. Furthermore, how long payments are stretched out, and how frequently they occur will be important in determining the value of any financial instrument. Value is based on both the SIZE and the TIMING of promised payments.
2. Risk Requires Compensation
Risk is pretty much unavoidable, and we don't like it. Putting these two realities together means that people are will to pay to avoid risk and that those who assume certain risks will demand compensation. This is the whole basis of the insurance industry. This also explains why Bolivia must pay a higher interest rate on its government debt than the United States. So then the value of a financial instrument is based on the SIZE, TIMING, and CERTAINTY of payments associated with the instruments. We will devote an entrie chapter to understanding risk, and then apply this understanding to the pricing of financial assests such as bonds and stocks.
3. Information Is the Basis for Decisions
At the core of economics is the assumption of rational decision-making. Rational decisions are in part based on using all available information to make a decision. Some decisions are more importants that others: buying a car vs. buying your lunch. Some information is harder to gather than other types. Problems can arise especially when one party to a transaction has more/better information than the other party. This asymmetric information problem is a big motivation for financial intermediation by banks, insurance companies and other institutions. One role of financial institutions and regulation is to gather and disseminate information so that financial markets run smoothly.
4. Markets Set Prices and Allocate Resources
Way back in Eco 101, we learn about the fundamental problem of scarcity and that most of the time markets are an efficient way to allocate scarce resources. A market sets a price that rations scarce resources to those willing and able to pay. In the financial sector markets will determine what investment projects get funded and what capital stock is built.
5. Stability Improves Welfare
This principle is actually closely related to core principle 2. People prefer the known to the unknown, ALL ELSE EQUAL. So when financial institutions offer instruments with stable payments or insurance against variability, and central banks work to create a stable financial system, individuals tend to be better off.
Throughout the semester we will return to these core principles and how they play out in the regulation and structure of the financial system.
FYI: Related Links
note: these links are optional, NOT required
Mulitple Choice Quiz, Chapter 1 Test your understanding with a quiz from the textbook website.