Money Functions of money –Medium of exchange –Unit of account –Store of value Flavors of money –Commodity money –Banknotes … backed by gold or silver reserves –Fiat money Legal tender... Pay taxes

Measuring Money Liquidity: a measure of the ease with which an asset can be turned into a means of payment (money). Different definitions of money are based upon degrees of liquidity. The Federal Reserve defines monetary aggregates: M1, M2, M3, L.

Link to Current Data

Does money matter? Equation of exchange M V = P Y But … Which measure of M to control? … M2 Can M2 be controlled? Financial innovation  changing velocity Operate via interest rate instead –Open market operations & federal fund rate

Where to Find the Numbers

Financial Intermediaries Indirect Finance –An Institution stands between lender and borrower, e.g., a bank Direct Finance –Borrowers and lenders deal directly with each other, e.g., the bond market Brokers and dealers facilitate transactions

Financial Instruments –Bank Loans –Bonds –Home Mortgages Collateral –Stocks –Asset-backed securities

Financial Instruments Serve as: Means of payment –E.g., Stock options Stores of Value … like all assets Allow for trading of risk E.g., Futures contracts, options, insurance contracts

Value of Financial Instrument Depends on: How much you’ll get paid When you’ll get paid  Present value lower the further in the future Chance you’ll get paid (risk). Conditions under which you’ll get paid e.g., dividends when there’s profit e.g., dividends when there’s profit

Financial Markets: Roles of Financial Markets. Provide liquidity to borrowers and savers. Pool and communicate information about issuer of debt or equity. Allow risk sharing –Construct portfolios of assets … and liabilities Effective Financial Markets Reduce transaction costs. Communicate information accurately. –Asymmetric information problems in finance Adverse Selection … before the deal Moral Hazard … after the deal Protect investors

Structures of Financial Markets Primary vs. Secondary Markets Investment banks/underwriting Stock market/bond market Centralized Exchanges vs. Over-the- counter Markets. Specialists/brokers/dealers Debt vs. Equity Bonds … Stocks Underlying Assets vs. Derivatives Futures/options

Financial Institutions The financial industry –Depository Institutions –Insurance Companies –Pension Funds –Investment Intermediaries – Securities Firms –Finance Companies –Government Sponsored Enterprises