FIN320 Midterm Study Guide （need to complete within 5 hours）

FIN320_1_Money-Payments-Financial-System.pdf

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Money, Payments, and the Financial System

Professor Lamont Black FIN320 Week 1

Professor Lamont Black

•  Ph.D., Indiana University, in Econ and Finance •  Federal Reserve Economist in DC, 2005-2013 •  Assistant Professor, 2013- •  Academic Director, Center for Financial Services

•  Director of Money and Banking curriculum •  Bike commuter, family

FIN320 •  Textbook with MyEconLab •  Barron’s

•  Syllabus –  Classroom parRcipaRon (10%) –  Online parRcipaRon (10%) –  MyEconLab (10%) –  ArRcle (25%) –  Exams (45%)

•  You will have 50% of your grade aYer week 5

FIN320: Weekly Flowchart

Textbook

Online Par0cipa0on Barron’s

MyEconLab

Classroom Par0cipa0on

1 2 3

Student PresentaRons

•  Volunteer student presentaRons are welcome! – Counts toward classroom parRcipaRon

•  Ideas: 1.  ArRcle topic updates 2.  Financial markets review 3.  Financial markets preview 4.  Overview of a Barron’s arRcle 5.  FOMC preview or FOMC review

Working Together

•  Send me an email or drop by my office to introduce yourself

•  Connect on LinkedIn

•  Choose a topic for your arRcle on D2L •  Form a partnership (up to 3 people) •  Use D2L discussion forum prior to closing

ArRcle Topic and Group

Overview

•  Introducing Money and the Financial System •  Money and the Payments System •  The Stock Market, InformaRon, and Financial Market Efficiency

You Get a Bright Idea…but Then What?

•  “The role of the financial system is to channel funds from households and other savers to businesses. Businesses need access to funds in order to launch, survive, and grow. They depend on funds the way farms depend on water.”

•  The crisis disrupted the flow of funds. •  The Treasury and Fed took acRon to restore the flow of money through banks and markets.

Financial Assets •  A financial asset is a claim on someone else to pay you

money –  A security is tradable on a financial market

•  A liability is the other side of the claim

•  5 Categories of Financial Assets –  Money –  Stocks (equity) –  Bonds (fixed income) –  Foreign exchange (currencies) –  SecuriRzed loans (ABS) –  [Commodi2es]

Financial InsRtuRons

•  The financial system matches savers and borrowers through two channels: (1) financial markets and (2) financial insRtuRons. – E.g., stock exchange vs. a bank

•  Funds flow through financial markets (direct finance) or financial intermediaries (indirect finance).

Figure 1.1 Moving Funds Through the Financial System

The financial system sends funds from savers to borrowers. Borrowers send returns back to savers through the financial system. Savers and borrowers include domes0c and foreign households, businesses, and governments.

Financial InsRtuRons

•  Types of Financial Intermediaries – Commercial Banks – Nonbank Financial Intermediaries

•  Investment Banks •  Insurance Companies •  Pension Funds •  Mutual Funds •  Hedge Funds

•  ConnecRons: 1) P2P lending and 2) Savings 13

Making the ConnecRon: What Do People Do With Their Savings?

“Pension fund reserves” includes IRAs and 401(k) plans, which are tax deferred. Source: Board of Governors of the Federal Reserve, Flow of Funds U.S., various issues.

The Federal Reserve and Other Financial Regulators

•  Who is “in charge” of private markets and insRtuRons? The financial system is different.

•  Primary federal regulators: SEC (markets), FDIC, OCC, and Fed (banks), CFPB

•  The Federal Reserve – Established in 1913 as lender of last resort – The central bank of the U.S. (monetary policy) – Board of Governors and 12 reserve banks – FOMC and the federal funds rate

Figure 1.2 The Federal Reserve System

Source: Board of Governors of the Federal Reserve System.

The Federal Reserve System is divided into 12 districts, each of which has a District Bank located in the city shown on the map.

What Does the Financial System Do?

•  In the financial system, banks and other financial insRtuRons compete to provide financial services to households and firms.

•  3 Key Financial Services – Risk sharing (diversificaRon) – Liquidity (ease of buy/sell) – Informa2on (collecRon and communicaRon)

The Financial Crisis of 2007-2009

•  A significant disrupRon in the flow of funds. •  “Great recession” and slow recovery – Massive unemployment in the U.S.

•  Origins of the Financial Crisis – The housing bubble of 2000-2005 (an unsustainable increase in an asset price)

– Home prices fell 30% from 2006 to 2009

Origins of the Financial Crisis (3 of 3)

Figure 1.3 The Housing Bubble

Source: Federal Reserve Bank of St. Louis. Panel (a) shows that the housing bubble resulted in rapid increases in sales of new houses between 2000 and 2005, followed by a sharp decrease in sales beginning in July 2005. Panel (b) shows that home prices followed a similar paoern to home sales.

Origins of the Financial Crisis

•  Mortgages were the first loans to be securiRzed – Residen2al mortgage-backed securi2es (RMBS) – Created a liquid secondary market

•  GSEs: Fannie Mae and Freddie Mac •  Private-label RMBS (investment banks) •  Subprime borrowers (low credit scores) •  Adjustable-rate mortgages •  Why? AnRcipaRon of increasing housing prices

The Deepening Crisis and the Response of the Fed and Treasury

•  House price declines resulted in defaults •  Spread through the secondary markets (securiRzaRon)

•  Fed began making loans to investment banks •  Fed and Treasury helped JPMorgan Chase buy Bear Stearns

(moral hazard problem?) •  Lehman Brothers bankrupt on Sep 15, 2008 •  Two days later: $85B loan to AIG •  A sharp decline in private lending •  Congress passed Troubled Asset Relief Program (TARP) in

Oct 2008 (equity injecRons in banks) •  A gradual return in the flow of funds. Success?

Money and the Payments System

•  The Federal Reserve: Too independent?

•  Do We Need Money? •  The Key FuncRons of Money •  The Payments System •  Measuring the Money Supply •  The QuanRty Theory of Money: A First Look at the Link Between Money and Prices

Do We Need Money?

•  Money is a means of payment •  Barter’s problem: double coincidence of wants; self-sufficiency

•  High transac/on costs

•  InvenRon of commodity money – Gold, cigareoes,…

•  SpecializaRon and interdependence. GlobalizaRon?

The Key FuncRons of Money

•  Money serves four key funcRons in the economy: – Medium of exchange (payment) – Unit of account (a single price) – Store of value (safe, liquid means of saving)

•  i.e., the “money market” – Standard of deferred payment (exchange over Rme)

•  Different than wealth and income •  Federal Reserve Notes are acceptable, standardized, durable, valuable, divisible

The Mystery of Fiat Money •  History of money – CommodiRes – Coins – Paper backed by gold – Fiat currency – Cryptocurrencies

•  The role of sovereign countries •  Large bills, tax evasion, illegal acRvity •  The cashless society? (Sweden and India)

The Payments System •  Money facilitates transacRons in the economy. The mechanism for conducRng such transacRons is a payments system, which has evolved to electronic funds transfers.

•  In Europe AD 1500, governments and private firms – early banks – began to store gold coins in safe places and issue paper cerRficates.

•  Today, central banks issue paper currency and banks use deposits at the Federal Reserve to seole transacRons with one another.

Technology and the Payments System

•  Checks are promises to pay on demand money deposited with a bank

•  SeLling transac0ons with checks requires verificaRon and processing (transacRon costs) –  Automated Clearing House (ACH)

•  EvoluRon: debit cards, ATMS, credit cards, Apple Pay, PayPal, Venmo, Zelle

•  Increases speed, security, and efficiency

•  Bitcoin and blockchain (distributed ledger)!!

Measuring the Money Supply •  Monetary aggregates are measures of money that include money-like accounts

•  M1 (narrow definiRon – means of payment): currency, checking account deposits, and traveler’s checks

•  M2 (includes short-term investments): M1 + savings accounts, CDs, money market mutual funds

•  Changes in money supply affect prices!

The QuanRty Theory of Money •  More money in circulaRon means higher prices…

•  Infla/on = percentage change in the price level

•  From Fisher: Infla2on = % change in M – % change in Y

Where M is money supply and Y is real GDP

If the Fed allows the money supply to increase at a rate faster than the economy, infla0on will increase (and purchasing power will decrease).

Figure 2.3 The RelaRonship between Money Growth and InflaRon over Time and Around the World

Panel (a) shows the relaRonship between M2 growth and inflaRon for the U.S. from the 1870s to the 2000s. Panel (b) shows the relaRonship between M1 growth and inflaRon for 36 countries during the 1995-2011 period.

The QuanRty Theory of Money •  Hyperinfla2on is extremely high inflaRon

–  Governments spending more than they collect –  Post-WWI Germany, Zimbabwe

•  Defla2on is negaRve inflaRon –  A stalling economy

•  Low, steady inflaRon is ideal for reducing uncertainty in consumpRon and investment decisions

•  Central banks control money supply as a tool for maintaining low, steady inflaRon

•  An independent central bank is important for this goal. 31

The Stock Market, InformaRon, and Financial Market Efficiency

•  Stocks and the Stock Market •  How Stock Prices are Determined •  RaRonal ExpectaRons and Efficient Markets •  Actual Efficiency in Financial Markets •  Behavioral Finance

Equity

•  Equity is ownership •  A stockholder (or shareholder) has a legal claim on the firm’s profits and on its equity

•  Limited liability shields the corporate owners

•  Dividend is a payment to stockholders

•  Market capitaliza2on is the total market value of a firm’s common and preferred stock

The Stock Market •  Stock exchanges (a secondary market for publicly traded companies) – New York Stock Exchange (NYSE) – Chicago Stock Exchange (CHX) – London Stock Exchange (LSE)

•  Stock indexes – Dow – S&P500 – Nasdaq – Stoxx 600, Nikkei

Key U.S. Equity Indexes

•  Stocks are procyclical

Stock Market •  U.S. stocks are in the longest bull market on record (as of August 22, 2018) –  Prior longest was 1982-2000

•  Current bull market began on March 9, 2009 •  S&P500 has nearly quadrupled since boooming on that date during the financial crisis

•  Bear market: Index closes at least 20% down from its previous high close

•  Are we due?

One-period Equity ValuaRon Model

•  Simple model: one-period buy and sell

Pt = Dt+1 e

(1+rE ) + Pt+1 e

(1+rE )

Pt = the current price of the stock Dt+1 = the dividend paid at the end of year 1

rE = the required return on investment in equity Pt+1 = the predicted sale price at the end of the first period

Gordon Growth Model

Pt = Dt (1+g) (rE −g)

= Dt+1

(rE −g)

Dt = the most recent dividend paid g = the expected constant growth rate in dividends rE = the required return on an investment in equity

Dividends are assumed to continue growing at a constant rate forever The growth rate is assumed to be less than the required return on equity

What is Your View of Markets? •  Efficient markets

–  RaRonal expectaRons –  Prices reflect all available informaRon –  A random walk down Wall Street –  Index invesRng –  Eugene Fama (Nobel prize)

•  Behavioral finance

–  Technical analysis (and pricing anomalies) –  Fundamental analysis –  Stock picking –  Managed money –  Robert Shiller (Nobel prize) [bubbles]

TO DO before next class

•  Form a group with an arRcle topic idea

•  Post several Rmes in Online Discussion

•  Complete MyEconLab Week1 and Week2