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Chapter 1: Intro to Money & the Financial System

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. in the news…. Subprime lending market meltdown

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Chapter 1: Intro to Money & the Financial System

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  1. 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

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

  3. 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?

  4. 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

  5. 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!

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

  7. 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

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

  9. 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

  10. 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

  11. 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

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