<ul><li>Lecture 1: Money, Banking & Financial Markets   </li></ul><ul><li>Why Study Financial Markets?   </li></ul><ul><ul...
The Heart Vs Bank Analogy How the Heart Works: Blood Flow Diagram How Blood Flows Through a Healthy Heart .
The Circular Flow Diagram
 
 
 
 
Euro/$ Euro/$ $/Euro $/Euro
<ul><li>Falling Potential Growth Rate </li></ul><ul><li>3.5% to 2.5% </li></ul><ul><li>Less investment spending </li></ul>...
<ul><li>Deflation leads to: </li></ul><ul><li>Households postpone spending </li></ul><ul><li>Rising real interest rates </...
  Federal Reserve Balance Sheet   (January 2010 vs July 2009 vs July 2008)     ($ Billions, H.4.1 Release, Table 10) Asset...
 
 M/M +   V/V =   P/P +   Y/Y  M/M +  0  =   P/P + 3.5% Currency Checking Savings MMA MMMF CD
$53 Trillion unfunded liabilities <ul><li>Bank stock purchases (TARP) </li></ul><ul><li>Stimulus plan </li></ul><ul><li>Mo...
Function of Financial Intermediaries <ul><li>Financial Intermediaries </li></ul><ul><li>Engage in process of  indirect fin...
 
 
 
  UWCU Balance Sheet Assets  Liabilities + NW   Cash  (7.5%)   Deposits  (88%)   Share Draft (15%) Investments  (6%)   Reg...
 
Funding Spread Interest Rate Risk Spread Credit Spread 1-year CD @ 3.0% 5-year loan @ 7.5%
Asymmetric Information:   A situation where one party lacks sufficient information about the other party to make accurate ...
Asymmetric Information Adverse Selection Moral Hazard Stopping “bad credit risks” from  becoming borrowers Stopping borrow...
<ul><li>Financial Intermediaries make   s by     Transactions costs </li></ul><ul><li>Experts on loan contracts </li></u...
Regulation of the Financial System <ul><li>Two Main Reasons for Regulation </li></ul><ul><li>1. Increase information to in...
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Mishkin8 ch1&2-lecture

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Mishkin8 ch1&2-lecture

  1. 1. <ul><li>Lecture 1: Money, Banking & Financial Markets </li></ul><ul><li>Why Study Financial Markets? </li></ul><ul><ul><li>1. Channel funds from savers to investors, thereby promoting economic efficiency </li></ul></ul><ul><ul><li>2. Affect personal wealth and behavior of business firms </li></ul></ul><ul><ul><li>Bond Market </li></ul></ul><ul><ul><li>- where corporations and governments borrow funds </li></ul></ul><ul><ul><li>- where interest rates are determined </li></ul></ul><ul><ul><li>- affects consumers willingness to spend & save </li></ul></ul><ul><ul><li>- affects business spending decisions </li></ul></ul><ul><ul><li>Stock Market </li></ul></ul><ul><ul><li>- affects personal wealth </li></ul></ul><ul><ul><li>- affects business investment decisions </li></ul></ul><ul><ul><li>Foreign Exchange Market </li></ul></ul><ul><li>- used for transfer of funds between countries </li></ul><ul><li>- affects costs of imports & exports for domestic and foreign consumers </li></ul><ul><li>- affects competitiveness of domestic versus foreign businesses </li></ul>
  2. 2. The Heart Vs Bank Analogy How the Heart Works: Blood Flow Diagram How Blood Flows Through a Healthy Heart .
  3. 3. The Circular Flow Diagram
  4. 8. Euro/$ Euro/$ $/Euro $/Euro
  5. 9. <ul><li>Falling Potential Growth Rate </li></ul><ul><li>3.5% to 2.5% </li></ul><ul><li>Less investment spending </li></ul><ul><li>Lower leverage in post-credit era </li></ul><ul><li>Suppressed demand </li></ul><ul><li>Negative demographic trends </li></ul><ul><li>Lower total factory productivity growth </li></ul><ul><li>Below trend growth </li></ul><ul><li>Falling stimulus spending </li></ul><ul><li>Less inventory rebuilding </li></ul><ul><li>Slowing Euro-Zone </li></ul><ul><li>Financial crisis </li></ul><ul><li>Deleveraging households </li></ul><ul><li>Rising savings rates </li></ul><ul><li>Recession Factors: </li></ul><ul><li>Loose monetary policy </li></ul><ul><li>Poor regulation </li></ul><ul><li>Lax bank supervision </li></ul><ul><li>Opaque derivatives </li></ul><ul><li>Shadow banking system </li></ul><ul><li>Lax investor diligence </li></ul><ul><li>Poor governance </li></ul><ul><li>Misaligned incentives </li></ul><ul><li>fraud </li></ul>Maximum Sustainable Growth Rate = 3%
  6. 10. <ul><li>Deflation leads to: </li></ul><ul><li>Households postpone spending </li></ul><ul><li>Rising real interest rates </li></ul><ul><li>Rising debt burdens </li></ul>2.5% Target
  7. 11. Federal Reserve Balance Sheet (January 2010 vs July 2009 vs July 2008) ($ Billions, H.4.1 Release, Table 10) Assets Liabilities + Capital T-Bills (18/18/22) Federal Reserve Notes (879/870/793) T-Notes/Bonds (708/618/402) TIPS (47/48/40) Depository Institution Deposits (1,135/809/23) Federal Agency Debt (161/102/0) Mortgage-Backed Securities (969/526/0) Repurchase Agreements (0/0/117) Reverse Repurchase Agreements (64/66/43) Term Auction Credit (76/274/150) U.S. Treasury, General Account (124/65/4) Primary Credit (18/34/14) U.S. Treasury, Supplementary Financing (5/200/0) Secondary Credit (1/0/0) Seasonal Credit (0/1/1) Asset-backed CP MMMF Liquidity Facility (0/8/0) AIG Credit (25/43/0) Term Asset-back Security loan Facility ((298/26/0) Foreign Official Deposits (3/2/2) Commercial Paper Funding LLC (14/111/0) Money Market Investor Funding (0/0/0) Maiden Lane I, II, III LLC (64/60/29) Capital Paid In (26/25/5) Surplus (25/21/3) Central Bank Liquidity Swaps (6/112/62) Other Capital (1/4/1) Total Assets (2,295/2,074/913) Total Liabilities & Capital (2,295/2,074/913) Italicized accounts represent new policy tools
  8. 13.  M/M +  V/V =  P/P +  Y/Y  M/M + 0 =  P/P + 3.5% Currency Checking Savings MMA MMMF CD
  9. 14. $53 Trillion unfunded liabilities <ul><li>Bank stock purchases (TARP) </li></ul><ul><li>Stimulus plan </li></ul><ul><li>Mortgage bailout plan </li></ul><ul><li>Income-support programs </li></ul><ul><li>Recession-induced falling revenues </li></ul>CBO's Baseline Budget Projection
  10. 15. Function of Financial Intermediaries <ul><li>Financial Intermediaries </li></ul><ul><li>Engage in process of indirect finance </li></ul><ul><li>borrow funds from savers , then lend funds to borrowers </li></ul><ul><li>issue liabilities, then acquire assets </li></ul><ul><li>take deposits, then make loans </li></ul><ul><li>More important source of finance than securities markets </li></ul><ul><li>Needed because of </li></ul><ul><li>risk sharing </li></ul><ul><li>asymmetric information </li></ul><ul><li>transactions costs </li></ul>
  11. 19. UWCU Balance Sheet Assets Liabilities + NW Cash (7.5%) Deposits (88%) Share Draft (15%) Investments (6%) Regular Share (15%) MMA (29%) Loans (82%) CDs (25%) Consumer (20%) IRAs (4%) Mortgage (46%) Student (16%) Borrowings (2.5%) Building (4.5%) Net Worth (9.5%) YOA - COF = NIM + Fee/Other Income - Operating Expense - PLL = Net Income * Required ROA = Asset Growth Rate x Capital Ratio (dependent variable) (choice variable) (current)
  12. 21. Funding Spread Interest Rate Risk Spread Credit Spread 1-year CD @ 3.0% 5-year loan @ 7.5%
  13. 22. Asymmetric Information: A situation where one party lacks sufficient information about the other party to make accurate decisions <ul><li>Adverse Selection </li></ul><ul><li>1. Asymmetric information before transaction occurs </li></ul><ul><li>Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected </li></ul><ul><li> Adverse Selection =>  bankers willingness to lend </li></ul><ul><li>Moral Hazard </li></ul><ul><li>1. Asymmetric information after transaction occurs </li></ul><ul><li>Hazard that borrower has incentives to engage in undesirable ( immoral ) activities making it more likely that won’t pay loan back </li></ul><ul><li> Moral hazard =>  bankers willingness to lend </li></ul><ul><li>Reputation: Declining social stigma regarding bankruptcy =>  M.H. </li></ul>
  14. 23. Asymmetric Information Adverse Selection Moral Hazard Stopping “bad credit risks” from becoming borrowers Stopping borrowers from becoming “bad credit risks” Screening process Monitoring process Loan applicants Approve Deny Loan signing date Performing Non-performing A situation where 1 party has more info than the other party Loan department Collections department potential bad credit risks are the ones who most actively seek out loans the lender runs the risk that the borrower will engage in risky activities that make it less likely that the loan will be paid back “ The business of banking is the business of collecting information” Good C.R. Bad C.R. 2 types
  15. 24. <ul><li>Financial Intermediaries make  s by  Transactions costs </li></ul><ul><li>Experts on loan contracts </li></ul><ul><li>Experts with screening process </li></ul><ul><li>Experts with monitoring borrowers </li></ul><ul><li>Develop high level of lending expertise </li></ul><ul><li>Take advantage of economies of scale (lower average costs) </li></ul><ul><ul><li> number of transactions </li></ul></ul><ul><ul><li> (reduce average costs by spreading fixed costs over many transactions) </li></ul></ul><ul><ul><li> scale of transactions </li></ul></ul><ul><ul><li> (make a few large loans instead of many small loans =>  variable costs) </li></ul></ul><ul><ul><li> scope of operations </li></ul></ul><ul><ul><li> (offering many products and services =>  variable costs) </li></ul></ul>
  16. 25. Regulation of the Financial System <ul><li>Two Main Reasons for Regulation </li></ul><ul><li>1. Increase information to investors </li></ul><ul><ul><li>Decreases adverse selection and moral hazard problems </li></ul></ul><ul><ul><li>SEC forces corporations to disclose information </li></ul></ul><ul><ul><li>SEC prohibits insider trading </li></ul></ul><ul><li>2. Ensuring the soundness of financial intermediaries </li></ul><ul><ul><li>Prevents financial panics </li></ul></ul><ul><ul><li>Six types of regulation: </li></ul></ul><ul><li>1. Chartering – restrictions on entry </li></ul><ul><li>2. reporting requirements – disclosure of appropriate financial statements </li></ul><ul><li>3. restrictions on assets and activities </li></ul><ul><li>4. deposit insurance – up to $100,000 per person </li></ul><ul><li>anti-competitive measures – limits on branching (abolished by 1994 legislation) </li></ul><ul><li>Restrictions on interest rates </li></ul>

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