Chapter 2 (contd.)
The Financial System
Note: Here we discuss the financial system
• Healthy leads to economic growth
• Unhealthy leads to problems
a) The financial system and economic growth
• Eg. Flower shop- expansion leads to growth
• If the financial system is not efficient leads to no economic growth
B) What happens when the financial system works
Note: However when the system breaks down
1) Asian Crisis- “Asian flu”(Mid 1990s)
Indonesia, Malaysia, singapore, south korea, Thailand
Huge investment in real estate (Value increases). Huge supply ( value
October 1997 – huge withdrawal of funds by foreigners
#2: Saving + Loan Crisis in 1980’s (Canada)
S+L Companies began to fail
Why? Inflation rate was high so interest rates rose as well. This meant that S&L
institutions had to pay high interest rates/amounts on deposit accounts, but their long-
term mortgage loans were fixed at low interest rates.As a result, the S&Ls lost huge
amounts of money. THUS, the financial system can fail if financial intermediaries do not
transfer funds efficiently.
• Borrow short (current interest rates)
• Lend Long (Interest Revenue)(Fixed interest rates)
#3: Financial Crisis of 2008
1. An efficient financial system enables people to borrow or lend easily at low cost.
2. More efficient financial systems exist in countries with faster economic growth.
3. When the financial system is inefficient, the economy does not work as well.
5 Determinants of Investors Decisions
1) Expected Return = (Probability of Return1 x Return1) + (Probability of Return x
Return is made up of : Current Yield + Capital Gains
• a) Current Yield % (Dividends or Interest / initial Equity Value)
• b) Capital Gains Yield (Capital gain or loss / initial equity value) 2) Risk:Amount of uncertainty about the return on a security
1. default by issuer
2. unexpected change in dividends
3. change in price of security
4. unexpected change in inflation
3) Liquidity: How easy to buy/sell security in the secondary market
- Depends on Transaction cost
• Liquid Asset ( Low cost)
• IlliquidAsset ( High cost
4) Taxability: Marginal Rate of Taxation
Assume 40% Marginal tax rate.
If a security pays 6%, Then his Return = (1-0.4) x 6% = 3.6%
Investor must Consult Tax Advisor
Young People: Long Time (Borrower pays higher interest for longer period of time)
Older People: Shorter Period of Time
Chapter 3: Money & Payments
Note: Money Supply = The total amount of Money in Circulation.
It is directly related to the level of price
Policy makers must measure the Money Supply and its growth rate
I) How we use Money
A: Medium of Exchange (Exchange Money for goods & services).
Historically we used gold and silver. It was later replaced by IOU notes (Ming
Dynasty). This was the introduction to the Banking System.
B) Money serves as Unit of Account: Prices are denoted in terms of money.
• When the Banking System fails, the Barter System prevails.
• Choose another currency = USD dollars
C) Store of Value: The function that money serves when people keep money for some
period instead of spending or investing it.
When people save money = Store of Value
Inflation can eat into share of value
D) Standard of Deferred Payments Money serves as a standard of deferred payment because loans are repaid in terms of
Recap: How We Use Money
1. Medium of Exchange: For something to serve as a medium of exchange, it must
be widely accepted in that role. Ideally, the medium of exchange is homogeneous,
durable, easy to transport, and exists in small denominations.
2. Unit ofAccount: Money serves as a unit of account when prices of goods are
quoted in terms of money. Except barter and times of hyperinflation, money is the
unit of account.
3. Short-term Store of Value: Money serves as a short-term store of value because
people do not want to run to the bank whenever they want to buy something, so
they keep some money in their wallets. Doi