J. K. Dietrich - FBE 524 – Fall 2005 Financial System Overview and the Flow of Funds Week 1 – August 24, 2005

J. K. Dietrich - FBE 524 – Fall 2005 The Financial System u What happened on August 9, 2005? –What was market reaction? –What are the linkages between those actions and business conditions? u What is occurring in financial markets? –Interest rates, mortgage borrowing, restructuring of financial firms? –New financial products? u What framework can be used to comprehend these important changes?

J. K. Dietrich - FBE 524 – Fall 2005 Market Reaction – Summer 2005

J. K. Dietrich - FBE 524 – Fall 2005 This course u Overview of institutions and markets u Major institutions and their regulators u Interest rate determination u Risk. risk management, and risk premiums u Important financial markets in depth u Closer scrutiny of the money market and important factors influencing conditions u Detailed review of important credit markets and the market for equity

J. K. Dietrich - FBE 524 – Fall 2005 Readings in text first two weeks u This evening will we cover Chapters 1 to 3 –Chapter 1 - Functions of financial system –Chapter 2 - Markets and funds flows –Chapter 3 - Efficient markets and information u Try to review these and raise any questions by next time, they are introductory u Next week, cover Chapters 14 and 15 –Chapter 14 – Banks –Chapter 15 – Non-bank thrift institutions

J. K. Dietrich - FBE 524 – Fall 2005 Stages of financial systems u Each unit is independent, investments accumulate over time, e.g. a farm u Units can accumulate value in monetary asset (e.g. claim on government) in order to save for large investments u Units can borrow and lend individually u Financial intermediaries raise funds from saving units and lend to investing units

J. K. Dietrich - FBE 524 – Fall 2005

Circular Flows u Goods and services –National product accounts, gross domestic product –Produced by Commerce Department u Income flows –National income accounts u These accounts do not reflect financial market activity u Flow of Funds Accounts of Federal Reserve system track financial flows

J. K. Dietrich - FBE 524 – Fall 2005

Financial Markets u Money and capital markets u Open versus negotiated markets –Competitive market-based funding versus intermediated or bank-dominated funding markets u Primary versus secondary markets u Spot versus futures, forward, and option markets

J. K. Dietrich - FBE 524 – Fall 2005 Balance Sheets and Flows

J. K. Dietrich - FBE 524 – Fall 2005 Sources and uses = flows u Sources and uses are changes in balance sheets u We want to look at both u Balance sheets represents stocks, hence total size, at a point in time u Flows represent net changes in stocks (I.e. new issues minus repayments of financial assets or liabilities)

J. K. Dietrich - FBE 524 – Fall 2005 Balance sheets and portfolios u Assets = Liabilities + (net worth = equity, common stock shares, etc.) u Assets –Financial assets »Money, loans and bonds, equity investments –Real assets »Housing, consumer durables including autos »Inventory, plant and equipment

J. K. Dietrich - FBE 524 – Fall 2005 Balance sheets/portfolios (cont’d) u Liabilities –Monetary liabilities (loans, mortgages) –Other financial liabilities u Net worth is composed of equity in real assets and net financial claims on others u Sectors are aggregate balance sheets of similar units –Households, business, government –Financial institutions

J. K. Dietrich - FBE 524 – Fall 2005 Sectoral balance sheets u Balance sheets of Households and Non- profit organizations –2004 largest real and financial assets –2004 largest liabilities –2004 composition of real asset holdings –share of monetary assets u Compare 1980 balance sheets u Share changes = growth and change in portfolio composition

J. K. Dietrich - FBE 524 – Fall 2005 Sectoral balance sheets (cont’d) u Farm + non-farm non-financial non- corporate + non-farm non-financial corporate business u Non-farm non-financial corporate balance sheet –2004 largest assets –2004 largest liabilities –2004 composition of real asset holdings –share of monetary assets u Compare 1980 balance sheets

J. K. Dietrich - FBE 524 – Fall 2005 Wealth and flow of funds u Primary sectors = households, business government u Financial sector –Financial claims - financial liabilities (small holdings of real assets) u Aggregate wealth is real assets since all financial claims cancel

J. K. Dietrich - FBE 524 – Fall 2005 Wealth u Total wealth in 2004 is approximately (billions) $22, $10, ,407.9 = $ 39.5 trillion u 2004 GDP is $11,734.9 trillion, so income-capital ratio is approximately.30 or capital-income ratio 3.4 u 1980 wealth approximately $ 9,729.7 trillion, GDP $ 2,789.5 trillion, so capital-income ratio is also about 3.5 (about the same) u GDP over assets in 1980 and 2004 around 30% u Has tangible wealth composition changed?

J. K. Dietrich - FBE 524 – Fall 2005 Distribution of GDP u Employee compensation in 2004 was $6,651, or 56.7% of GDP u Business tangible assets were $ 16,887.0 or 40.7% of “total” tangible assets u Roughly gross before tax return on business investment is: u Gross return illustrates top down approach

J. K. Dietrich - FBE 524 – Fall 2005 Composition of wealth u Compare composition of tangible assets Households Real Estate 78% 83% Durables 21% 16% Business (corporate + non-corporate) Real Estate 67% 68% P&E 22% 23% Inventories 11% 9% u Think of other economies

J. K. Dietrich - FBE 524 – Fall 2005 The Financial System u Channels savings into investment u Financial institutions assist in this process u Financial institutions create value for primary surplus and deficit units through –Increasing economic efficiency –Providing financial servies u The value of flow of funds framework is that we can trace the changing roles of financial institutions

J. K. Dietrich - FBE 524 – Fall 2005 Next time u Before next Wednesday, review Chapters 1 to 3 of Money and Capital Markets and identify any questions about this evening’s session u Read Chapters 14 and 15 of Money and Capital Markets u Bring a Wall Street Journal to class every Tuesday