Summary Reading Material (Futurelearn) Global Finance and Growth
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Course
Global Finance and Growth (EBM150A05)
Institution
Rijksuniversiteit Groningen (RuG)
Summary of all the reading material posted on the Future Learn platform. The summary is very useful when studying for the midterms as it contains all exam material. Summary of all six weeks.
1.7 Introduction to Balance Sheets
Balance sheets are organized on double-entry
bookkeeping.
- Central bank: It has the ability to issue the
government’s currency: reserves and currency in
circulation. Commercial banks have an account at
the Central bank.
- Nowadays, Central Bank are formally independent
from the government in their policy. The
government issues debt to pay for government
expenses.
- Financial Institutions. Private financial institutions
can be banks and non-banks. Loans are a banks’
assets, their claim on us. Banks often hold
government bonds as assets. Our money is the
banks’ liability.
o Non-banks. Private equity firms, broker-
dealers, pension funds. Their principal activity
is to manage balance sheets and not to
produce goods/services. Different from bank,
non-banks financial firms have no license to
accept deposits and create new money as
they make loans.
- Firms produce goods and services and finance this
by bank debt and equity liabilities.
- Households. Are the ultimate consumers and hold
large bank deposits.
1.8 Domestic Payments
Largely facilitated by private financial institutions. Similar
to how one bank facilitates transactions between two
customers, the central bank facilitates transactions
between banks. Banks can use their central bank
reserves for transactions.
1.10 Bank Lending
Private banks are responsible for most of the
money creation in the economy.
IOU = I owe you -> is usually an informal
document acknowledging debt. An IOU is not a
negotiable instrument and does not specify
repayment terms such as the time of repayment
⁃ By splitting the two steps we can observe
that banks create money together with
their customers by swapping long term
and short term debt contracts (IOU’s)
Money Supply: The money supply is the entire
stock of currency and other liquid instruments
circulating in a country's economy as of a
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particular time. The money supply can include cash, coins, and balances held in checking and
savings accounts, and other near money substitutes
M1: M1 consists of money commonly used for payment, basically currency in circulation and checking
account balances.M1 is counted as cash + bank deposits
A bank creates money by increasing their balance sheet on both sides and thus increases M1.
M2: M2 includes M1 and, in addition, short-term time deposits in banks and certain money market
funds. M2 includes M1 plus balances that generally are similar to transaction accounts and that, for
the most part, can be converted fairly readily to M1 with little or no loss of principal. M2 is thought to
be held primarily by households.
M3: iM3 includes M2 in addition to long-term deposits. However, M3 is no longer included
1.11 Capital Gains and Losses
Capital gain is a rise in the value of a capital asset (investment or real estate) that gives it a higher
worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be
short-term (one year or less) or long-term (more than one year) and must be claimed on income
taxes.
⁃ Notice how the total wealth in the economy (total assets) increases without something
new actually being produced!
⁃ Indirect Capital gains: ‘Paper’ or ‘virtual’ wealth in the economy has increased by €30.000
as a result of the initial transaction between households 1 and 2. Do keep in mind that
these capital gains are not realized until households 3 and 4 sell their house and cash in
on their capital gain.
Capital Losses: When your house will be less worth. Some agents will go bankrupt if their net worth
or equity becomes negative.
1.12 Textbook Chapter: The Role of a Financial System
1.1. Introduction
The advantages of dealing through intermediaries are similar to
those of dealing in organised markets: lenders and borrowers are
brought together more quickly, more efficiently and therefore more
cheaply than if they had to search each other out. The intermediary
is able, through superior knowledge and economies of scale, to
reduce the risk of the transaction for both parties. Often done by
highly diversified portfolios of assets and liabilities.
1.2 Lenders and Borrowers
The end users in the system. The differences between income and
consumption is saving, these can be used for investment. Many
households save without investing; financial surplus. Lending results from the acquisition of financial
assets which create loans for borrowers. For lenders, liquidity is preferred.
There are different types of risk: default risk (borrower fails to repay when expected), income risk (the
asset fails to yield the return expected), capital risk (the asset’s nominal value differs from what was
expected) and inflation risk (the risk that the price level changes unexpectedly, causing a change int
he real value of assets.
It is usually much more expensive for individuals to borrow funds than it is for firms or public bodies.
Those who spend in excess of their income have a financial deficit.
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Sector deficits and surpluses must sum to zero in a closed economy. Household having surplus, firms
and government deficits.
1.3 Financial Institutions
Mediates between those who have a surplus and those tho have a deficit.
1.3.1. Financial Institutions as firms
Financial institutions hire labour and own or rent specialist premises. They derive revenue from their
outputs from the interest that borrowers pay on the loans made by financial institutions. Most financial
systems tend to be dominated by large institutions (economies of scale).
1.3.2. Financial Institutions as intermediaries
Intermediation means acting as go-between between
two parties. Intermediaries create assets for lenders and
liabilities for borrowers which are more attractive to each
than would be the case if the parties had to deal with
each other directly. They ‘borrow short and lend long’. A
savings institution specialises in taking large number of
small deposits, which it pools and lends as fewer larger
land and for long periods. If pays interest on the
deposits and charges a higher rate of interest on the
loans.
⁃ Risk is reduced and search and transaction
costs lowered.
⁃ Funds are made available to lenders and
borrowers cheaply, readily and with a
minimum of risk.
⁃ Creation of liquidity
For every extra asset created, there is an extra liability. But there is no creation of net wealth. Much
more important is the creation of liquidity:
⁃ People spend more when they know they have liquid assets they could draw on in an
emergency.
⁃ A liquid assets is one that can be turned into money quickly, cheaply and for a known
monetary value. An achievement of a financial intermediary must be that lenders can
recall their loan either more quickly or with a greater certainty of its capital value. It
consists of time, risk and cost.
The reconciliation of intermediaries involves four processes:
⁃ Maturity transformation. Accept funds and transforming into loans of a longer maturity.
The funds accepted by institutions appear as liabilities in their balance sheets (and are
short term drawable) while the loans into which they are transformed appear, on the asset
side (set for longer time). Banks draw on their deposits at the central bank without notice
and can sell bills and other securities for cash quite quickly.
⁃ The advantage of size. Thus a large number of funds which can be spread across
a wide variety of assets.
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⁃ Risk transformation. Diversification and specialist management. The larger the size of the
institution, the larger its pool of funds. Diversifying reduces portfolio risk below average for
the two individual assets.
⁃ Search and transaction costs. The lower costs available through an intermediary result
from the ability to pool funds and to trade in large blocks of securities where dealing
commission is very small.
⁃ Without an intermediary, borrower and lender will be involved in search and
transaction costs and will eat in the return of the lender and costs of the borrower.
Intermediation has cost-reducing benefits.
⁃ Monitoring. Asymmetric information where borrowers are likely to have better information.
Financial markets can alleviate the asymmetry. Asking for information and also
monitoring depositors funds. Some degree of asymmetry is always likely to remain.
1.4 Financial Markets
Markets of foreign exchange bring together buyers and sellers located in countries all over the world.
Financial instruments are traded.
⁃ There is a difference of directly traded instruments and indirectly traded.
⁃ Also between a fixed rate of interest (government bonds) and variable (bank deposits).
⁃ Moreover, the residual maturity is shorter for treasury, interbank loans and deposit ->
called money markets. Capital markets are for longer term capital (company shares, 20
year government and corporate bonds).
⁃ Lastly, primary markets are for a newly issued instrument. Secondary for all the others.
The secondary market is determining the cost of new capital.
New financial innovation tend to fill the gaps between existing ones. Taking us to a ‘complete’ set of
markets.
1.5 The financial system and the real economy
Lenders can store wealth for later consumption: borrowers can buy in advance of their income.
1.5.1. The composition of aggregate demand
One consequence of financial intermediation is that, at any given rate of interest, lenders will be more
willing to lend and borrowers more willing to borrow. Firms are assumed to undertake all those
investment projects which yield an expected rate of return at least equal to the cost of funds (i in
Figure 1.4a). Thus, the flow of real investment spending is negatively related to the cost of funds. In a
world with developed financial system i* and I*.
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