Money banking and the financial system 1e by hubbard and OBrien chapter 01

R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Introducing Money and the Financial System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1.1 Identify the key components of the financial system 1.2 Provide an overview of the financial crisis of 2007–2009 1.3 Explain the key issues and questions the financial crisis raises © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Introducing Money and the Financial System CAN THE FED RESTORE THE FLOW OF MONEY? •During the economic crisis that began in 2007, the financial system was disrupted as it hadn’t been since the 1930s •Large sections of the U.S economy were cut off from the flow of funds they needed to thrive •Some government intervention was necessary to pull the economy out of a deep recession •During the recession, more than million jobs were lost, GM declared bankruptcy, and some Wall Street investment houses disappeared •An Inside Look at Policy on page 20 reviews options the Fed considered to support the economy in late 2010 © 2012 Pearson Education, Inc Publishing as Prentice Hall Learning 1.1 Objective Identify the key components of the financial system © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Three major components of the financial system: Financial assets An asset is anything of value owned by a person or a firm A financial asset is an asset that represents a claim on someone else for a payment Financial institutions The Federal Reserve and other financial regulators Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Financial Assets Economists divide financial assets into those that are securities and those that aren’t A security is a financial asset that can be bought and sold in a financial market Financial markets are places or channels for buying or selling stocks, bonds, and other securities Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Financial Assets Five key categories of financial assets: Money Stocks Bonds Foreign exchange Securitized loans Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Financial Assets Money Money Anything that is generally accepted in payment for goods and services or to pay off debts The money supply is the total quantity of money in the economy Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Financial Assets Stocks Stocks are financial securities that represent partial ownership of a firm; also called equities Dividend A payment that a corporation makes to its shareholders Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall of 38 Financial Assets Bonds Bond A financial security issued by a corporation or a government that represents a promise to repay a fixed amount of money Interest rate The cost of borrowing funds (or the payment for lending funds), usually expressed as a percentage of the amount borrowed Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 38 What Does the Federal Reserve Do? • The Fed is responsible for monetary policy Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives • The Fed is divided into 12 districts (See Figure 1.2) • The main policymaking body of the Fed is the Federal Open Market Committee (FOMC) • Chair, Ben Bernanke from 2006 – present • The FOMC meets eight times per year During these meetings, the Fed decides on a target for the federal funds rate Federal funds rate The interest rate that banks charge each other on shortterm loans Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 24 of 38 Figure 1.2 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.• Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 25 of 38 What Does the Financial System Do? The financial system provides three services to savers and borrowers: risk sharing, liquidity, and information Risk Sharing Risk is the chance that the value of financial assets will change relative to what you expect Diversification Splitting wealth among many different assets to reduce risk Risk sharing A service the financial system provides that allows savers to spread and transfer risk Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 26 of 38 Liquidity Liquidity The ease with which an asset can be exchanged for money Financial markets and intermediaries help make financial assets more liquid Information Information Facts about borrowers and about expectations of returns on financial assets Financial markets convey information to both savers and borrowers by determining the prices of stocks, bonds, and other securities Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 27 of 38 Solved Problem 1.1 The Services Provided by Securitized Loans Briefly discuss the extent to which securitized loans embody the key services of risk sharing, liquidity, and information Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 28 of 38 Solved Problem 1.1 The Services Provided by Securitized Loans Solving the Problem Step Review the chapter material Step Define securitized loans Non-securitized loans are financial assets but not financial securities Securitized loans are loans that have been bundled with other loans and resold to investors; they are both financial assets and financial securities Step Explain whether securitized loans provide risk sharing, liquidity, and information 1.When a mortgage is bundled together with other mortgage-backed securities, the buyers jointly share the risk of a default 2.A securitized loan can be resold and so has a secondary market, which makes it liquid •When loans are securitized, investors rely on the bank or other loan originator to have gathered the necessary information So, securitized loans provide all three of these key services Key Components of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 29 of 38 Learning 1.2 Objective Provide an overview of the financial crisis of 2007–2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 30 of 38 Origins of the Financial Crisis Bubble An unsustainable increase in the price of a class of assets • Overly optimistic expectations, and more importantly, changes in the mortgage market for made it easier for families to borrow money to buy houses • Two government-sponsored enterprises (GSEs), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), sold bonds to investors and used the funds to purchase mortgages from banks • Investment banks became significant participants in the mortgage market, bundling and selling mortgage-backed securities The Financial Crisis of 2007–2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 31 of 38 Origins of the Financial Crisis Standards for obtaining loans were greatly loosened By 2005, many mortgages were being issued to subprime borrowers with flawed credit histories Adjustable-rate mortgages allowed borrowers to pay a very low interest rate Both borrowers and lenders anticipated higher housing prices, which would reduce the chance of default Unfortunately, the decline in housing prices that began in 2006 led to rising defaults and a sharp decline in the value of many mortgage-backed securities The Financial Crisis of 2007–2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 32 of 38 Origins of the Financial Crisis Figure 1.3 The Housing Bubble Panel (a) shows that housing bubble resulted in rapid increases in both sales of new houses and housing prices between 2000 and 2005, followed by sharp decreases in sales and prices from early 2006 through early 2009 and then a slow revival Panel (b) shows that home prices followed a similar pattern to home sales. The Financial Crisis of 20072009 â 2012 Pearson Education, Inc Publishing as Prentice Hall 33 of 38 The Deepening Crisis and the Response of the Fed and Treasury In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury provided funds to commercial banks in exchange for stock in those banks Many policies of the Fed and Treasury during the recession of 2007–2009 were controversial because they involved: • Partial government ownership of financial firms • Implicit guarantees to large financial firms that they would not be allowed to go bankrupt • Unprecedented intervention in financial markets Many feared that the Fed’s actions might reduce its independence The Financial Crisis of 2007–2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 34 of 38 Learning 1.3 Objective Explain the key issues and questions the financial crisis raises © 2012 Pearson Education, Inc Publishing as Prentice Hall 35 of 38 Our brief account of the financial crisis raises a number of questions that we will answer in the following chapters The 17 key issues and questions listed on textbook pages 17 – 19 provide a roadmap for the topics in the rest of the book Key Issues and Questions from the Financial Crisis © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 38 AN INSIDE LOOK AT POLICY Fed Ready to Help Economy, but Options Are Limited Wall Street Journal, Bernanke Prepared to Take New Steps Key Points in the Article • Fed Chairman Ben Bernanke expressed doubts about the effectiveness of the actions the Fed usually takes to spur the economy, such as lowering the discount rate, lowering the federal funds rate, or lowering reserve requirements • He outlined three other possible options: Announce the Fed’s intention to keep short-term interest rates low The Fed could lower the interest rate it paid banks on required reserves (from 0.25 percent) The Fed could buy additional securities with the proceeds of maturing mortgage securities © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 38 AN INSIDE LOOK AT POLICY The Fed was very aggressive in using its discount window to pump reserves into the banking system in 2008 and 2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 38 ... located in the city shown on the map. Key Components of the Financial System â 2012 Pearson Education, Inc Publishing as Prentice Hall 25 of 38 What Does the Financial System Do? The financial system. .. Introducing Money and the Financial System CAN THE FED RESTORE THE FLOW OF MONEY? •During the economic crisis that began in 2007, the financial system was disrupted as it hadn’t been since the 1930s •Large... of the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall 21 of 38 The Federal Reserve and Other Financial Regulators Federal agencies that regulate the financial system: