J. K. Dietrich - FBE 524 – Fall 2005 Financial System Overview and the Flow of Funds Week 1 – August 24, 2005

J. K. Dietrich - FBE 524 – Fall 2005

Financial System Overview and the Flow of Funds

Week 1 – August 24, 2005


The Financial System What happened on August 9, 2005?

– What was market reaction?– What are the linkages between those actions and

business conditions? What is occurring in financial markets?

– Interest rates, mortgage borrowing, restructuring of financial firms?

– New financial products? What framework can be used to comprehend these

important changes?


Market Reaction – Summer 2005

2.5

3.0

3.5

4.0

4.5

2005:06 2005:07

FEDFUNDS TBILL TBOND

Fed Funds, T-Bill, and T-Bond Rates Summer 2005


This course

Overview of institutions and markets Major institutions and their regulators Interest rate determination Risk. risk management, and risk premiums Important financial markets in depth Closer scrutiny of the money market and

important factors influencing conditions Detailed review of important credit markets and

the market for equity


Readings in text first two weeks

This evening will we cover Chapters 1 to 3– Chapter 1 - Functions of financial system– Chapter 2 - Markets and funds flows– Chapter 3 - Efficient markets and information

Try to review these and raise any questions by next time, they are introductory

Next week, cover Chapters 14 and 15– Chapter 14 – Banks– Chapter 15 – Non-bank thrift institutions


Stages of financial systems

Each unit is independent, investments accumulate over time, e.g. a farm

Units can accumulate value in monetary asset (e.g. claim on government) in order to save for large investments

Units can borrow and lend individually Financial intermediaries raise funds from

saving units and lend to investing units



Circular Flows

Goods and services– National product accounts, gross domestic product

– Produced by Commerce Department

Income flows– National income accounts

These accounts do not reflect financial market activity

Flow of Funds Accounts of Federal Reserve system track financial flows



Financial Markets

Money and capital markets Open versus negotiated markets

– Competitive market-based funding versus intermediated or bank-dominated funding markets

Primary versus secondary markets Spot versus futures, forward, and option

markets


Balance Sheets and FlowsNon-Bank Balance Sheet

Assets Liabilities and Net Worth

Real Assets BorrowingFinancial Assets

MoneyLendingEquity Net Worth (= Others' Equity)


Sources and uses = flows

Sources and uses are changes in balance sheets

We want to look at both Balance sheets represents stocks, hence total

size, at a point in time Flows represent net changes in stocks (I.e.

new issues minus repayments of financial assets or liabilities)


Balance sheets and portfolios

Assets = Liabilities + (net worth = equity, common stock shares, etc.)

Assets– Financial assets

» Money, loans and bonds, equity investments

– Real assets» Housing, consumer durables including autos» Inventory, plant and equipment


Balance sheets/portfolios (cont’d) Liabilities

– Monetary liabilities (loans, mortgages)– Other financial liabilities

Net worth is composed of equity in real assets and net financial claims on others

Sectors are aggregate balance sheets of similar units– Households, business, government– Financial institutions


Sectoral balance sheets

Balance sheets of Households and Non-profit organizations– 2004 largest real and financial assets– 2004 largest liabilities– 2004 composition of real asset holdings– share of monetary assets

Compare 1980 balance sheets Share changes = growth and change in

portfolio composition


Sectoral balance sheets (cont’d)

Farm + non-farm non-financial non-corporate + non-farm non-financial corporate business

Non-farm non-financial corporate balance sheet– 2004 largest assets– 2004 largest liabilities– 2004 composition of real asset holdings– share of monetary assets

Compare 1980 balance sheets


Wealth and flow of funds

Primary sectors = households, business government

Financial sector– Financial claims - financial liabilities (small

holdings of real assets) Aggregate wealth is real assets since all

financial claims cancel


Wealth Total wealth in 2004 is approximately (billions)

$22,566.2 + $10,479.1 + 6,407.9 = $ 39.5 trillion 2004 GDP is $11,734.9 trillion, so income-capital

ratio is approximately .30 or capital-income ratio 3.4

1980 wealth approximately $ 9,729.7 trillion, GDP $ 2,789.5 trillion, so capital-income ratio is also about 3.5 (about the same)

GDP over assets in 1980 and 2004 around 30% Has tangible wealth composition changed?


Distribution of GDP Employee compensation in 2004 was $6,651, or

56.7% of GDP Business tangible assets were $ 16,887.0 or 40.7%

of “total” tangible assets Roughly gross before tax return on business

investment is:

Gross return illustrates top down approach

%309.16$

)433(.*7.11$

)h1(*K

)w1(*GDPR


Composition of wealth Compare composition of tangible assets

1980 2004Households

Real Estate 78% 83%Durables 21% 16%

Business (corporate + non-corporate)Real Estate 67% 68%P&E 22% 23%Inventories 11% 9%

Think of other economies


The Financial System

Channels savings into investment Financial institutions assist in this process Financial institutions create value for primary

surplus and deficit units through– Increasing economic efficiency– Providing financial servies

The value of flow of funds framework is that we can trace the changing roles of financial institutions


Next time Before next Wednesday, review Chapters 1

to 3 of Money and Capital Markets and identify any questions about this evening’s session

Read Chapters 14 and 15 of Money and Capital Markets

Bring a Wall Street Journal to class every Tuesday

Documents

J. K. Dietrich - FBE 524 – Fall 2005 Financial System Overview and the Flow of Funds Week 1 – August 24, 2005