Econ 333 Exam 1

1. Means of payment

2. Store or value

3. Unit of Amount Records (Price tags)

Three functions of money

Commodity, representative, and fiat money

What are the three types of money?

commodity money

some item chosen to be money that has intrinsic value (ex: gold, silver)

representative money

some item chosen to be money that itself has no intrinsic value (paper, token) but it is backed by some specific item that does have intrinsic value.

fiat money

some item chosen to be money that itself has no intrinsic value (paper bill, metal coin, electronic balances). Nor is it backed by any item of value. Value based on TRUST

to move money from the savers to the borrowers so the money can be used instead of being stagnant

What is the main objective of the financial system?

savers & buyers

What are the two groups in the financial system?

savers

People who have extra money and no current productive use for it

borrowers

people who have a productive use for money but not enough of it

direct finance

moving money from savers to borrowers is called what?

indirect finance

When money is moved from savers to borrowers is through a mediator or a financial intermediary, it is an

GDP = C + I + G + NX

C- consumption

I- investment

G- government spending

NX - imports/exports

Formula for GDP

macro-economic investment

existing business expanding production & new businesses being formed

• Firms: build new structures, buy machinery & equipment, add to inventory

• People: buy new houses

• Households (normal people)

• Firms (small businesses & large corporations)

• Government

Who can be savers and borrowers?

• Commercial banks are examples of third parties

• Securities firms (Stocks, bonds, Wall Street)

Who are financial intermediaries? (Third parties)

financial instruments (or “vehicle”)

What is a way by which money moves between savers and borrowers?

liquidity

can get their money back when they want it

1. Information

2. Liquidity

3. Risk Sharing

Good financial systems provide

They add value

What do intermediaries do to value?

1. SPREAD RISK among savers. No single saver bears the risk of any single borrower

2. Reduce TRANSACTION COSTS especially the time and trouble it takes for savers and borrowers to find each other

3. Provide ECONOMICS OF SCALE (Pooling Savings)

4. Provide LIQUIDITY

5. Provide INFORMATION SERVICES (fix information problems)

How do intermediaries add value?

2 parties involved in 2 transactions that have different information and one party (the borrower) has better information than the other

asymmetric information

moral hazard

people (borrowers) have an incentive to engage in risky behavior if they don't bear the full cost of that behavior if something goes wrong

Adverse selection

people (borrowers) already inclined towards a risky behavior will be attracted to a situation (savers money) where they don't bear the full cost if something goes wrong

Monitor (asymmetric info)

 

Monitor borrower behavior (moral hazard)

• Ensure repayment (collateral)

 

Screen out risky borrowers and charge appropriate rate (adverse selection)

How do banks help with these information service issues?

1. Payment to savers for bearing risk = letting go of their own money

2. Cost to borrowers for access to money

3. Payment to an intermediary for providing services

4. Relationship between the VALUE OF MONEY AND TIME

What are interest rates?

higher

The longer the time period, the ____ the future value

higher

When interest rate is higher, the future value is

lower

The longer the time period, the ____ the present value

lower

When interest rate is higher, the present value is

discount factor

makes money to be received in the future to have a lower value than today based on how far int eh future payment will occur & chance that you won’t receive the payment

discount bond

saver buys it for a price and gets back a single payment (face value) at some future time (maturity)

interest = coupon rate

For a coupon bond if price = face value, then…

interest > coupon rate

If price < face value, then

interest < coupon rate

If price > face value, then

nominal interest rate

• Posted, observed, market interest rates

• Represent the amount of money get back

real interest rate

• Nominal rates corrected for inflation

• Represent the value of money you get back

the money paid back has less value than the money lent

INFLATION IS BAD FOR SAVERS & LENDERS bc

interactions between savers and borrowers in financial markets e.g. bond market

Where do interest rates come from?

Changes in interactions between savers & borrowers in financial markets

Why do interest rates change?

from interactions between buyers (demand) and sellers (supply) in markets

Where do prices for goods come from?