Money and Banking Notes
1) THE FINANCIAL SYSTEM
The financial system exists to transfer investment funds from those who have them in excess to
those who require them.
Lenders are interested in the return on their investment, the risks associated with it (default,
capital, income, liquidity and inflation risks) and the liquidity - the ease with which it can be
converted into cash.
Borrowers care about interest rates, terms and conditions (of debt and equity) and flexibility of
the borrowing. Borrowers include Private Non-Financial Corporations (PNFCs), Monetary and
Financial Institutions (MFIs), the government, households and foreigners.
Markets are where transactions between borrowers and lenders take place. The primary market is
where the issuer of the security (share) lies directly on the other side of the transaction. In the
secondary market, already-lent assets are traded freely between agents. Over-the-counter
transactions are tailored to a particular agent’s requirements (mortgages, for example). Money
markets deal in short-term debt (< 1 year maturity), capital markets in long-term debt (> 1 year).
Banks, or financial intermediaries, play a central role. They reduce transactions costs by dealing
with everyone’s debt at once, diversify risk through borrowing from many small lenders, thereby
reducing the overall risk of default, transform maturities from short-term liabilities to long-term
assets, reconciling the needs of lenders and borrowers, and reduce asymmetric information by
auditing parties to a transaction for credit histories etc. Problems resulting from information
asymmetry: adverse selection, before the transaction (choosing a risky candidate) and moral
hazard, after the transaction, where borrowers’ behaviour can change undesirably.
Instruments are used by banks to effect their operations. Equities provide an annual share of
private profits (dividends) to shareholders and represent ownership of a part of a company. The
price varies with supply and demand. Debt (bonds) involves income being paid per period, the
principal at the maturity date. Interest rates can affect the terms of the debt and returns required,
and regulation seeks to control the terms by which instruments are used in order to protect lenders
(creating problems of moral hazard, compliance costs, entry/exit costs and decreased competition).
2.1) PAYMENT SYSTEMS and BANKS
Kiyotaki develops a barter model (a search economy) with two equilibria: either no one accepts
money (as a means of exchange), or everyone does. As the economy diversifies, money makes
increasing sense. Modern systems are highly developed, containing central banks (CB); in the UK,
the Bank of England monopolises money supply; globally, the BIS monopolises money supply.
Functions of money are as follows: a medium of exchange (facilitating trade and reducing search
costs), deferred payment (allowing for loans and debt), a unit of accounting (by which everything
is valued in the same currency) and a store of value.
1! / !15
