1. Lecture 1-2: The Financial System
Monetary Economics I
Undergraduate Program
Faculty of Economics and Business
Universitas Gadjah Mada
2021
2. § STUDENTS CAN IDENTIFY THE STRUCTURE AND KEY
COMPONENTS OF FINANCIAL MARKETS
§ STUDENTS CAN ANALYZE THE PROBLEMS THAT
TRANSACTIONS COSTS, ADVERSE SELECTION, AND
MORAL HAZARD POSE FOR THE FINANCIAL MARKET
§ STUDENTS CAN IDENTIFY THE REASONS FOR AND
FORMS OF A GOVERNMENT SAFETY NET IN FINANCIAL
MARKETS
Learning Objectives of Meeting 2
3. Lecture 2: The Financial System
Structure of Financial System
Economic Analysis of Financial Structure
Economic Analysis of Financial Regulation
4. FIRMS
HOUSEHOLDS
LABOR MARKET
GOVERNMENT AND
CENTRAL BANK
FINANCIAL MARKET
GOODS AND
SERVICES MARKET
Payment for Goods
and services
Goods and Services
for consumption
Government purchases
Goods and Services
for investment
Transfer
Taxes
Labor Supply
Wage Payment
Loans
Interest, Dividends
Framework of Macroeconomics
5. FIRMS
HOUSEHOLDS
LABORMARKET
GOVERNMENT AND
CENTRAL BANK
FINANCIALMARKET
GOODSAND
SERVICESMARKET
PaymentforGoods
and services
Goodsand Services
forconsumption
Governmentpurchases
Goodsand Services
forinvestment
Transfer
Taxes
LaborSupply
WagePayment
Loans
Interest,Dividends
Monetary economics ….
§ focuses on the monetary and other
financial markets, the determination of the
interest rate, the extent to which these
influence the behavior of the economic
units and the implications of that influence
in the macroeconomic context.
§ studies the formulation of monetary policy,
with respect to the supply of money and
manipulation of interest rates.
Focus of Monetary Economics
6. Financial Market
FINANCIAL MARKET
Financial market is a market in
which funds are transferred
(direct or indirect) from people
who have an excess of available
funds to people who have a
shortage.
Lender-
Saver
Borrower-
Spenders
Domestic and Foreign:
§ Households
§ Businesses
§ Governments
funds funds
Domestic and Foreign:
§ Households
§ Businesses
§ Governments
Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income.
7. § Financial markets are crucial to promoting a greater
economic efficiency by channeling funds from people who
do not have a productive use for them to those who do.
§ Indeed, well functioning financial markets are a key factor in
producing high economic growth.
§ Activities in financial markets also have direct effects on
personal wealth, the behavior of businesses and consumers,
and the cyclical performance of the economy.
Function of Financial Market
8. Financial Market: Flows of Fund
FINANCIAL MARKET
The arrows show that funds flow from lender-savers to borrower-spenders via two routes:
1. Direct finance: Borrowers borrow funds directly from financial markets by selling securities.
2. Indirect finance: A financial intermediary borrows funds from lender-savers and then uses
these funds to make loans to borrower-spenders.
Lender-
Saver
Borrower-
Spenders
funds funds
Direct finance
Indirect finance
Financial intermediaries
9. Financial Market: Structure
FINANCIAL MARKET
Money
Market
Capital
Market
The money market is a financial
market in which only short-term
debt instruments (generally those
with original maturity terms of less
than one year) are traded.
The capital market is the market in
which longer term debt instruments
(generally those with original maturity
terms of one year or greater) and
equity instruments are traded
2
1
10. Financial Market: Structure
FINANCIAL MARKET
Money
Market
Capital
Market
Equity/Stock
Market
Debt/Bond
Market
Stock market is a financial market in
which claims on the earnings and
assets of corporations (shares of
stock) are traded.
Bond market is a financial market in
which a debt security, that promises
to make periodic payments for a
specified period of time, are traded.
2.1
2.2
2
1
11. Financial Market: Instruments
FINANCIAL MARKET
Money
Market
Capital
Market
Equity/Stock
Market
Debt/Bond
Market
INSTRUMENTS OF BOND
MARKET:
§ Bond
§ Fixed income securities
(e.g. MBS)
INSTRUMENTS OF STOCK
MARKET:
§ Stocks/equities
§ Derivatives (e.g. ETF)
INSTRUMENTS OF MONEY
MARKET:
§ Treasury Bills
§ Certificates of Deposit
§ Commercial Paper
§ Repurchase Agreements
12. Financial Market: Money Market
Money market instruments consist of
§ Treasury Bills is short-term debt instruments of
the government. which are issued in one-, three-,
and six-month maturities to finance the federal
government
§ Certificate of deposit (CD) is a debt instrument
sold by a bank to depositors that pays annual
interest of a given amount and at maturity pays
back the original purchase price.
§ Commercial paper is a short-term debt
instrument issued by large banks and well-
known corporations.
§ Repurchase agreements (repos) are effectively
short-term loans (usually with a maturity term of
less than two weeks) for which Treasury bills
serve as collateral, an asset that the lender
receives if the borrower does not pay back the
loan.
Principal Money Market Instruments
13. Financial Market: Capital Market
Capital market instruments are debt and
equity instruments with maturities of
greater than one year.
§ Stocks are equity claims on the net
income and assets of a corporation
§ Mortgages are loans to households or
firms to purchase land, housing, or
other real structures, in which the
structure or land itself serves as
collateral for the loans.
§ Bond is a debt security that promises
to make periodic payments for a
specified period of time.
Principal Capital Market Instruments
14. Financial Market: Primary Market
FINANCIAL MARKET
Money
Market
Capital
Market
Equity/Stock
Market
Debt/Bond
Market
Primary Market
Secondary Market
Primary Market
Secondary Market
A primary market is a financial market in
which new issues of a security, such as a
bond or a stock, are sold to initial buyers by
the corporation or government agency
borrowing the funds.
15. § The primary markets for securities are not well known to the
public because the selling of securities to initial buyers often
takes place behind closed doors.
§ An important financial institution that assists in the initial sale of
securities in the primary market is the investment bank.
§ The investment bank does this by underwriting securities: It
guarantees a price for a corporation’s securities and then sells
them to the public.
The Primary Market
16. Financial Market: Secondary Market
FINANCIAL MARKET
Money
Market
Capital
Market
Equity/Stock
Market
Debt/Bond
Market
Primary Market
Secondary Market
Primary Market
Secondary Market
A secondary market is a financial market in
which securities that have been previously
issued can be resold.
17. § Securities brokers and dealers are crucial to a well-functioning
secondary market.
§ Brokers are agents of investors who match buyers with sellers
of securities; dealers link buyers and sellers by buying and
selling securities at stated prices.
§ Examples: The New York Stock Exchange and NASDAQ
(National Association of Securities Dealers Automated
Quotation System), foreign exchange markets, futures
markets, and options markets.
The Secondary Market
18. Secondary markets can be organized in two ways:
1. Exchange market: Buyers and sellers of securities (or their
agents or brokers) meet in one central location to conduct
trades.
2. Over-the-counter (OTC) market: Dealers at different locations
who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to
them and is willing to accept their prices.
The Secondary Market
19. The Secondary Market
FUNCTION OF SECONDARY MARKETS
1
Secondary markets determine the
price of the security that the issuing
firm sells in the primary market.
The higher the security’s price in the
secondary market, the higher the
price the issuing firm will receive for
a new security in the primary
market, and hence the greater the
amount of financial capital it can
raise.
2
Secondary markets make it
easier and quicker to sell these
financial instruments to raise
cash; that is, they make the
financial instruments more liquid.
The increased liquidity of these
instruments then makes them
more desirable and thus easier
for the issuing firm to sell in the
primary market.
20. Sources of External Funds for
Nonfinancial Businesses
§ The Bank Loans category is made
up primarily of loans from depository
institutions
§ The Nonbank Loans are primarily
loans by other financial
intermediaries
§ The Bonds category includes
marketable debt securities, such as
corporate bonds and commercial
paper
§ Stock consists of new issues of new
equity (stock market shares).
Sources of External Funds for Nonfinancial Businesses
Financial Market Instruments
21. Household Holdings of Selected
Financial Assets (percentage of
total financial assets held) in
United States (US)
The table reports holdings of
assets, such as stocks and bonds,
that are supplied by financial
markets, and assets, such as bank
deposits and mutual fund shares,
that are supplied by financial
intermediaries.
Financial Market Instruments: US
22. Capital Market Instruments: Indonesia
MARKET VALUE FREQUENCY
Stock Rp 2,228,798 Billion 163,938
Rights Rp 108.59 Billion 31.6
Warrants Rp 2,237.68 Billion 2,511.8
ETFs Rp 194.12 Billion 23.1
Government Bond Rp 10,624,628 Billion 468,387
Corporate Bond Rp 377,544 Billion 37,788
Trading Summary in Indonesia
Stock Exchange
The table reports the value of
capital market instruments in
Indonesia, such as stocks and
bonds, that are supplied by
financial markets.
Trading Summary in Indonesia Stock Exchange 2020
23. Lecture 2: The Financial System
Structure of Financial System
Economic Analysis of Financial Structure
Economic Analysis of Financial Regulation
24. Indirect Finance:
Financial Intermediation
FINANCIAL MARKET
The process of indirect financing using financial intermediaries, called
financial intermediation, is the primary route for moving funds from
lenders to borrowers.
Lender-
Saver
Borrower-
Spenders
funds funds
Financial intermediaries
Indirect finance Indirect finance
26. Depository
institutions
1
Type of Financial Intermediary
DEFINITION: Depository institutions are financial intermediaries that
accept deposits from individuals and institutions and make loans.
EXAMPLE: Commercial banks, savings and loan associations,
mutual savings banks, and credit unions.
PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
27. Contractual
savings
institutions
2
Type of Financial Intermediary
DEFINITION: Contractual savings institutions are financial
intermediaries that acquire funds at periodic intervals on a
contractual basis.
EXAMPLE: Insurance companies and pension funds.
PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
28. Investment
intermediaries
3
Type of Financial Intermediary
DEFINITION: This category of financial intermediary includes
finance companies, mutual funds, money market mutual funds, and
hedge funds.
PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
29. Financial Intermediary: United States
Primary Financial
Intermediaries and Value of
Their Assets
The table describes the value of
assets of the financial
intermediaries in each category.
30. Financial Intermediary: Indonesia
Financial Intermediaries in
Indonesia
The table describes the number of
financial intermediaries in Indonesia
in 2020 (July – temporary figures
based on Indonesia Financial
Service Authority's Database.
TIPE LEMBAGA KEUANGAN JUMLAH LEMBAGA JUMLAH ASET
1 BANK
1.1 BANK UMUM 110 Rp 8,725.91 T
1.1 Bank Persero 4
1.2 BUSN Devisa 41
1.3 BUSN Non Devisa 19
1.4 BPD 27
1.5 Bank Campuran 11
1.6 Bank Asing 8
1.2 BANK: BPR 1520 Rp 148.05 T
2 ASURANSI 139 Rp 1,312.71 T
1.1. Asuransi Jiwa 54
1.2. Asuransi Umum 74
1.3. Reasuransi 6
1.4. Asuransi Wajib 3
1.5. Asuransi Sosial (BPJS) 2
3 DANA PENSIUN 217 Rp 293.60 T
2.1. DPPK-PPMP 151
2.2. DPPK-PPIP 43
2.3. DPLK 23
4 LEMBAGA PEMBIAYAAN 236 Rp 571.94 T
3.1. Perusahaan Pembiayaan 177
3.2. Modal Ventura 57
3.3. PP Infrastruktur 2
5 LEMBAGA KEUANGAN KHUSUS 110 Rp 209.95 T
4.1. LPEI 1
4.2. Pergadaian 85
4.3. Lembaga Penjamin 21
4.4. PT SMF (Persero) 1
4.5. PT PNM (Persero) 1
4.6. PT Danareksa (Persero) 1
6 LEMBAGA KEUANGAN MIKRO 146 Rp 0.61 T
7 FINTECH 147 Rp 3.19 T
31. FINANCIAL MARKET
Why are financial intermediaries and indirect finance so important in
financial markets?
To answer this question, we need to understand the roles of
transaction costs, risk sharing, and information costs in financial
markets.
Lender-
Saver
Borrower-
Spenders
funds funds
Financial intermediaries
Indirect finance Indirect finance
The Importance of Indirect Finance
32. Direct Finance Indirect Finance
Transaction
costs
(i.e.
the
time
and
money
spent
in
carrying
out
financial
transactions)
Financial
Market
Lender
Borrower
Financial
Market
Lender
Borrower
How Financial Intermediaries
Reduce Transaction Costs?
Economies of Scale
Banks achieve economies
of scale in making loans by
using standardized loan
contracts, having specialized
loan officers, and taking
advantage of sophisticated
computer systems
Transaction Costs
33. Direct Finance Indirect Finance
Financial
Market
Lender
Borrower
Financial
Market
Lender
Borrower
High
Transaction
Cost
Low
Transaction
Cost
1. Liquidity Services
A financial intermediary
can provide its customers
with liquidity services,
services that make it
easier for customers to
conduct transactions.
Low Transaction Costs: The Benefit
34. Direct Finance Indirect Finance
Financial
Market
Lender
Borrower
Financial
Market
Lender
Borrower
High
Transaction
Cost
Low
Transaction
Cost
2. Risk Sharing
A financial intermediary
help reduce the exposure
of investors to risk—that
is, uncertainty about the
returns investors will earn
on assets.
Low Transaction Costs: The Benefit
35. § Small investors rarely lend money directly because of
transactions costs.
§ Financial intermediaries can reduce transactions costs partly
because of economies of scale, which refers to the reduction
in average cost that results from an increase in volume.
§ For instance, banks achieve economies of scale in making
loans by using standardized loan contracts, having specialized
loan officers, and taking advantage of sophisticated computer
systems.
Transaction Costs: A Recap
36. Lecture 2: The Financial System
Structure of Financial System
Economic Analysis of Financial Structure
Economic Analysis of Financial Regulation
37. Financial
Markets
Lender
Borrower
Asymmetric information is a situation that
arises when one party’s insufficient
knowledge about the other party involved
in a transaction makes it impossible for
the first party to make accurate decisions
when conducting the transaction
Asymmetric Information
Many financial transactions involve asymmetric information, with one party to the transaction
having better information than the other party.
38. Lender
Borrower
Asymmetric Information
Economists distinguish between two problems arising from asymmetric information: (1)
Adverse selection, dan (2) Moral hazard.
Adverse selection
!"#$%&# '&()*(+',%) !($'#& '&()*(+',%)
Moral Hazard
Transaction
in Financial
Markets
Adverse selection occurs
before the transaction
takes place.
Moral hazard occurs
after the transaction has
taken place.
1 2
39. Asymmetric information results in two problems:
§ Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an
undesirable (adverse) outcome—the bad credit risks—are the
ones who most actively seek out a loan and are thus most
likely to be selected.
§ Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable
(immoral) from the lender’s point of view, because they make it
less likely that the loan will be paid back.
Asymmetric Information
41. § The concepts of asymmetric information, adverse selection,
and moral hazard help explain why governments pursue
financial regulation.
§ The government regulates financial markets for two main
reasons: to increase the information available to investors and
to ensure the soundness of the financial system.
Financial Regulation: A Rationale
47. Two primary methods to handle a failed bank.
1. The payoff method: regulator allows the bank to fail and pays off
depositors up to the insurance limit.
2. The purchase and assumption method: a regulator reorganizes the bank,
typically by finding a willing merger partner who assumes (takes over) all
of the failed bank’s liabilities so that no depositor or other creditor loses a
penny.
Handling A Failed Bank
48. Although a government safety net can help protect depositors
and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net
49. Although a government safety net can help protect depositors
and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
With a safety net, depositors and creditors know they will not suffer losses
if a financial institution fails, so they do not impose the discipline of the
marketplace on these institutions by withdrawing funds when they
suspect that the financial institution is taking on too much risk.
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net
50. Although a government safety net can help protect depositors
and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
Because depositors and creditors protected by a government safety net have little
reason to impose discipline on financial institutions, risk-loving entrepreneurs might find
the financial industry a particularly attractive one—they know they will be able to engage
in highly risky activities.
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net
51. Although a government safety net can help protect depositors
and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Regulators are reluctant to close down large financial institutions and
impose losses on their depositors and creditors because doing so might
precipitate a financial crisis.
Drawbacks of the Government
Safety Net
52. There are eight basic types of financial regulation aimed at lessening
asymmetric information problems and excessive risk taking in the financial
system:
1. Restrictions on asset holdings
2. Capital requirements
3. Prompt corrective action
4. Chartering and examination
5. Assessment of risk management
6. Disclosure requirements
7. Consumer protection
8. Restrictions on competition
Types of Financial Regulation