Chapter 1: Intro to Money & the Chapter 1: Intro to Money & the Financial SystemFinancial SystemChapter 1: Intro to Money & the Chapter 1: Intro to Money & the Financial SystemFinancial System

• 5 Core Principles of Money & Banking Time has value Risk requires compensation Information is the basis for decisions Markets set prices and allocate

resources Stability improves welfare

• 5 Core Principles of Money & Banking Time has value Risk requires compensation Information is the basis for decisions Markets set prices and allocate

resources Stability improves welfare

in the news…in the news…in the news…in the news…• Subprime lending market meltdown

impact on mortgage markets Impact on financial institutions impact on the stock market impact on the economy

• Subprime lending market meltdown impact on mortgage markets Impact on financial institutions impact on the stock market impact on the economy

• The U.S. dollar parity with the Canadian $! Revaluation of the Chinese yuan?

• Federal Reserve Chair Ben Bernanke Reduction of federal funds rate• Largest since 1984

A re-emergence of stagflation?

• The U.S. dollar parity with the Canadian $! Revaluation of the Chinese yuan?

• Federal Reserve Chair Ben Bernanke Reduction of federal funds rate• Largest since 1984

A re-emergence of stagflation?

1. Time has value1. Time has value1. Time has value1. Time has value

• $100 today vs. $100 in one year Are you indifferent?

• Forensic economics

• Value of a financial instrument depends on SIZE and TIMING of payments

• $100 today vs. $100 in one year Are you indifferent?

• Forensic economics

• Value of a financial instrument depends on SIZE and TIMING of payments

Example: HGTVExample: HGTVExample: HGTVExample: HGTV

• My House is Worth What? House purchased 2001: $225,000 Renovations over 5 years: $41,000 Estimated current value: $350,000 Profit: $84,000…..Really?• NO! not really!

• My House is Worth What? House purchased 2001: $225,000 Renovations over 5 years: $41,000 Estimated current value: $350,000 Profit: $84,000…..Really?• NO! not really!

2. Risk requires compensation2. Risk requires compensation2. Risk requires compensation2. Risk requires compensation

• Risk comes from uncertainty

• Risk is unavoidable

• We don’t like it.

• Risk comes from uncertainty

• Risk is unavoidable

• We don’t like it.

• To take on risk, we demand compensation Subprime mortgage rates > prime

mortgage rates

• We pay to avoid certain risks Auto, life insurance Low rates on checking, savings

accounts

• To take on risk, we demand compensation Subprime mortgage rates > prime

mortgage rates

• We pay to avoid certain risks Auto, life insurance Low rates on checking, savings

accounts

• The value of a financial asset depends on the size, timing, and CERTAINTY

of its payments.

• The value of a financial asset depends on the size, timing, and CERTAINTY

of its payments.

3. Information is the basis for 3. Information is the basis for decisionsdecisions3. Information is the basis for 3. Information is the basis for decisionsdecisions

• Rational decisions use all available info

• Asymmetric info can impede markets

• Financial institutions play a big role in gathering info

• Financial regulation demands disclosure of certain info

• Rational decisions use all available info

• Asymmetric info can impede markets

• Financial institutions play a big role in gathering info

• Financial regulation demands disclosure of certain info

4. Markets set prices and allocate 4. Markets set prices and allocate resourcesresources4. Markets set prices and allocate 4. Markets set prices and allocate resourcesresources

• Eco 101!

• Markets set a price that rations scarce resources Prices send a signal

• Financial market prices allocate funds

• Eco 101!

• Markets set a price that rations scarce resources Prices send a signal

• Financial market prices allocate funds

5. Stability improves welfare5. Stability improves welfare5. Stability improves welfare5. Stability improves welfare

• Back to #2—we do not like uncertainty

• Financial stability feeds economic growth and standards of living Role of institutions, Federal

Reserve

• Back to #2—we do not like uncertainty

• Financial stability feeds economic growth and standards of living Role of institutions, Federal

Reserve