Chapter 1: Intro to Money & the Financial System 5 Core Principles of Money & Banking  Time has value  Risk requires compensation  Information is the basis for decisions  Markets set prices and allocate resources  Stability improves welfare 5 Core Principles of Money & Banking  Time has value  Risk requires compensation  Information is the basis for decisions  Markets set prices and allocate resources  Stability improves welfare

in the news… Subprime lending market meltdown  impact on mortgage markets  Impact on financial institutions  impact on the stock market  impact on the economy Subprime lending market meltdown  impact on mortgage markets  Impact on financial institutions  impact on the stock market  impact on the economy

The U.S. dollar  parity with the Canadian $!  Revaluation of the Chinese yuan? Federal Reserve Chair Ben Bernanke  Reduction of federal funds rate Largest since 1984  A re-emergence of stagflation? The U.S. dollar  parity with the Canadian $!  Revaluation of the Chinese yuan? Federal Reserve Chair Ben Bernanke  Reduction of federal funds rate Largest since 1984  A re-emergence of stagflation?

1. Time has value $100 today vs. $100 in one year  Are you indifferent? Forensic economics Value of a financial instrument depends on SIZE and TIMING of payments $100 today vs. $100 in one year  Are you indifferent? Forensic economics Value of a financial instrument depends on SIZE and TIMING of payments

Example: HGTV My House is Worth What?  House purchased 2001: $225,000  Renovations over 5 years: $41,000  Estimated current value: $350,000  Profit: $84,000…..Really? NO! not really! My House is Worth What?  House purchased 2001: $225,000  Renovations over 5 years: $41,000  Estimated current value: $350,000  Profit: $84,000…..Really? NO! not really!

2. Risk requires compensation Risk comes from uncertainty Risk is unavoidable We don’t like it. Risk comes from uncertainty Risk is unavoidable We don’t like it.

To take on risk, we demand compensation  Subprime mortgage rates > prime mortgage rates We pay to avoid certain risks  Auto, life insurance  Low rates on checking, savings accounts To take on risk, we demand compensation  Subprime mortgage rates > prime mortgage rates We pay to avoid certain risks  Auto, life insurance  Low rates on checking, savings accounts

The value of a financial asset depends on the  size,  timing, and  CERTAINTY of its payments. The value of a financial asset depends on the  size,  timing, and  CERTAINTY of its payments.

3. Information is the basis for decisions Rational decisions use all available info Asymmetric info can impede markets Financial institutions play a big role in gathering info Financial regulation demands disclosure of certain info Rational decisions use all available info Asymmetric info can impede markets Financial institutions play a big role in gathering info Financial regulation demands disclosure of certain info

4. Markets set prices and allocate resources Eco 101! Markets set a price that rations scarce resources  Prices send a signal Financial market prices allocate funds Eco 101! Markets set a price that rations scarce resources  Prices send a signal Financial market prices allocate funds

5. Stability improves welfare Back to #2—we do not like uncertainty Financial stability feeds economic growth and standards of living  Role of institutions, Federal Reserve Back to #2—we do not like uncertainty Financial stability feeds economic growth and standards of living  Role of institutions, Federal Reserve