– Banks held stocks and the stock values decreased. • Japan had relied on banks to allocate its saving[r]
(1)Money, Prices, and the Financial System
(2)1 Describe the role of financial intermediaries such as
commercial banks in the financial system
2 Differentiate between bonds and stocks and show why
their prices are inversely related to interest rates
3 Explain how the financial system improves the
allocation of saving to productive uses
4 Discuss the three functions of money and how the
money supply is measured
5 Analyze how the lending behavior of commercial
(3)Money in Economics
• The term "money" in economics has a specific
meaning different from every day use
• To an economist:
– Your paycheck is income
– The income you don't spend is saving
– The increase in the value of your stock is a capital
gain
– When your house appreciates, your wealth
(4)The Allocation of Saving
• A successful economy allocates its saving to the
most productive investments
• The interest on deposits is one important reason
people put their saving in banks
• The financial system improves the allocation of
saving:
– Provides information to savers about the possible
uses of their funds
(5)Banking System
• Financial intermediaries are firms that extend
credit to borrowers using funds raised from savers
– Thousands of commercial banks accept deposits
from individuals and businesses and make loans
– Banks and other intermediaries specialize in
evaluating the quality of borrowers
• Principle of Comparative Advantage
• Banks have a lower cost of evaluating opportunities
than an individual would
• Banks pool the saving of many individuals to make
(6)Banking System
• Banks gather information about potential
investments
– Evaluate the options
– Direct saving
– Service provided to depositors
• Banks provide access to credit for small
businesses and homeowners
– May be the only source of credit for some
(7)The Banking System
• Having bank deposits makes payments easier
– Checks
– ATMs
– Debit card
(8)Japanese Banking Crisis, 1990s
• Japanese banks fell into severe trouble
– Property values decreased and some loans on real
estate went into default
– Banks held stocks and the stock values decreased
• Japan had relied on banks to allocate its saving
– Thin financial markets
– Borrowers had difficulty obtaining credit
– Small- and medium-sized businesses suffered
(9)Bonds
• A bond is a legal promise to repay a debt • Each bond specifies
– Principal amount, the amount originally lent
– Maturation date, the date when the principal
amount will be repaid
• The term of a bond is the length of time from issue to
maturation
– Coupon payments, the periodic interest payments
to the bondholder
– Coupon rate, the interest rate that is applied to the
(10)Bonds
• Corporations and governments issue bonds • The coupon rate depends on
– The bond's term
• 30 days to 30 years; longer term, higher coupon rate
– The issuer's credit risk
• Probability the issuer will default on repayment • Higher risk, higher coupon rate
– Tax treatment for the coupon payments