Lecture Notes on Mishkin Chapter 3 ("What is Money") Econ 330: Money, Banking, and Financial Institutions

Department of Economics, Faculty of Economics The University of Lampung Odd Semester (September – December 2010)

Last Updated: September- December , Anno 2010

Latest Course Offering: Odd Semester 2010

Course Instructor: Dr. Yoke Muelgini, M.Sc

ESP 330 email: ekonomimoneter@ymail.com

·         Economists' Meaning of Money

·         Functions of Money

·         Evolution of Payment Systems

·         Measuring Money

·         Reliability of Monetary Data

·      Basic Concepts and Key Issues From Mishkin Chapter 3

Economists' Meaning of Money

1. Basic Definition

Money is anything that is generally accepted in payment for goods and services and for the repayment of debts, as a matter of social custom.

It follows that money is defined more by its function (what purposes it serves) than by its form (coin, paper, gold bars, etc.).

Moreover, the stress on "generally accepted" in this definition indicates that money is largely a social convention in the sense that what actually constitutes money in a society depends on what people in the society are generally willing to accept as money.

An interesting question is how this "general acceptance" comes to be established!

Note on Terminology:

Money must be distinguished from both "wealth" and "income."

The wealth of an agent at any given point in time is the current market value of the total collection of assets currently owned by that agent. Money holdings might constitute part of an agent's wealth, but the agent would presumably own other types of assets as well (e.g., land, equipment,...). On the other hand, income is a flow of value accrued over some specified period of time.

Example: A student works part time as a teaching assistant, earning $900 per month, and has a checking account balance of $400. He also owns a car worth $1100 and books worth $500. Consequently, ignoring for simplicity the student's "human capital" (e.g., his embodied labor skills, valued by estimating the capitalized stream of all of his potential future wage earnings), one has:

·         Money holdings = $400

·         Wealth = Market value of his asset holdings consisting of (money holdings, car, books) = ($400 + $1,100 + $500) = $2,000

·         Income = $900 per month

As illustrated by this example, income is a flow variable in the sense that it measures an amount of value accrued over a specified period of time (e.g., a month). In contrast, money and wealth are both stock variables in the sense that they measure an amount of value at a given point in time.

2. Types of Money

·         Commodity Money: Commodity money is any commodity (economic good) that is used as money, i.e., that is generally accepted as a means of payment for goods and services and for the repayment of debts.

Commodity Money Examples from the Past:

Cattle, skins, furs, corn, gold, silver, and copper.

·         Fiat Money: Fiat money is any paper money that is "unbacked" and "legal tender." A money is unbacked if it is not collateralized by any valuable commodity. That is, no one is obliged by law to convert the money into coins, precious metals, or any other type of physical good or service. A money is legal tender for a country if, by law, the citizens of the country must accept the money for repayment of debts.

Fiat Money Example:

In the United States, the Federal reserve notes (dollar bills) issued by the Federal Reserve System (the central bank of the US) are paper money that is unbacked legal tender, hence fiat money. The general acceptance of dollar bills in the US as payment for goods and services depends upon the persistence of a widely shared trust among citizens that any person who accepts dollars now in exchange for goods or services will be able to exchange these dollars later for other goods and services.

Note: Under the Coinage Act of 1965, legal tender in the United States consists of all currency (coins and paper money) issued by the U.S. government. This includes Federal reserve notes as well as other older paper money issued by the U.S. government, such as United States notes first authorized and issued in 1862 during the Civil War (1861-1866).

·         Electronic Means of Payment (EMOP): A means of payment that permits payments to be transmitted using electronic telecommunications.

EMOP Examples:

One example is the Fed's use of Fedwire, a telecommunications system that permits all financial institutions that maintain accounts with the Fed to wire (transfer) funds to each other without having to send checks.

Other examples include private EMOP systems such as CHIPS and SWIFT (used by banks, money market mutual funds, securities dealers, and corporations to wire funds) and ACHs (automatic clearing houses) used for smaller wire transfers, e.g., from employers to their employees.

Interesting EMOP observation:

As noted by Mishkin, in the United States, even though an EMOP is used by fewer than 1 percent of the number of payments made, over 80 percent of the dollar value of payments made is through EMOP transfers.

·         Electronic Money (e-Money): E-money is money that is stored electronically rather than in paper or commodity form. Once established, e-money cuts way down on transactions costs; but it can be expensive to set up an e-money system, and concerns have been raised about record-keeping, security, and privacy (as well as the elimination of "float" for consumers!).

e-Money Examples:

·         Debit Cards: Charged expenses are immediately deducted from some corresponding bank account -- there is no float (time between purchase and deduction) as with credit cards and paper checks;

·         Stored-Value Cards: Charged expenses are immediately deducted from a fixed amount of digital cash stored on the card;

·         Electronic Cash: A form of e-money that can be used to purchase goods and services on the Internet;

·         Electronic Checks: A process by which users of the Internet can pay their bills directly over the Internet without having to send a paper check.

Functions of Money

Money performs three basic functions in an economy: (1) It serves as a unit of account; (2) it serves as a medium of exchange; and (3) it serves as a store of value.

·         Unit of Account: A unit in terms of which a single price for each good and service can be quoted.

Example:

In the US, the price of an apple is given as dollars per apple, the price of a gallon of milk is given as dollars per gallon of milk, etc. That is, each good or service on sale at an outlet is generally offered at a single quoted "dollar price" -- that is, a price quoted in terms of dollars.

In reality, however, any particular good or service (e.g., apples) has a huge array of different prices that could be quoted for it, one for each other good or service in the economy (e.g., pounds of bread per apple, cans of beer per apple, hours of doctor visits per apple, etc.)

Without a money unit to provide a single accepted unit of account, sellers would have to quote prices of items in terms of whichever goods or services they were willing to accept in return at the time the items were purchased. That is, as clarified further below, the payment system would be a "barter" payment system.

·         Medium of Exchange: An accepted means of payment for trade of goods and services.

As noted above, the existence of a money unit permits each item for sale to have a single price quoted for it in terms of the money unit. But this is not enough to ensure the item will actually be sold to buyers for money units.

Sellers have to be willing to accept the money units from buyers in return for giving up the item, which requires a trust on the part of sellers that others will in turn be willing to accept these money units from them at a later time in return for goods and services. That is, the money units have to act as a medium of exchange in the economy before one can conclude that they indeed constitute money in the economy.

·         Store of Value: A repository of purchasing power for future use.

Money can be held for future use, allowing for the ability to save (store value) over time. All assets act as stores of value to some extent, but money by definition is the most liquid, i.e., the most easily converted into a medium of exchange, since by definition it already is a medium of exchange!

On the other hand, money is by no means a risk-free store of value. The real purchasing power of money depends on the inflation rate, that is, on the rate at which the general price level is changing. If the inflation rate is positive (prices are increasing), any money held loses purchasing power over time. If the inflation rate is negative (prices are decreasing), any money held gains purchasing power over time.

To the extent that the inflation rate is unpredictable, inflation reduces the ability of money to act as a reliable store of value and as a method of deferred payment in borrowing-lending transactions. A positive inflation rate is bad for lenders and good for borrowers since the dollars lent out are worth more than the dollars later paid back. Conversely, a negative inflation rate is good for lenders and bad for borrowers.

In extreme cases in which the inflation rate exceeds 50 percent per month -- a situation referred to as hyperinflation -- the entire monetary system generally breaks down and is replaced by barter. This has devastating effects on an economy.

Mishkin notes that Post-WWI Germany suffered a hyperinflation in which the inflation rate at times exceeded 1000 percent per month. More recently, various Latin American economies experienced hyperinflations during the 1980s. For example, as discussed by Mishkin in Chapter 28, in the first half of 1985 Bolivia's inflation rate was running at 20,000 percent and rising.

Evolution of Payment Systems

Tracing the historical evolution of payment systems in various economies is a fascinating and complex task. Although highly simplified, the following three-stage process captures the general way in which this evolution has occurred in many parts of the world.

·         Autarky: Each family or tribal group produces all of what they consume, with the outputs of production being shared in accordance with some kind of group distribution rule determining who gets what and in what amount. No trade takes place and there is no use of money.

·         Barter Payment System: Within family or tribal groups, and possibly between such groups, people trade goods and services for other goods and services. There is no use of money.

·         Monetary Payment System: People trade goods and services in return for money.

A barter payment system has several problems that make it extremely inefficient relative to a monetary payment system if a large number of goods and services are produced in an economy:

·         Double Coincidence of Wants: Under a barter payment system, a double coincidence of wants is needed before any trade can take place. That is, two individuals seeking to trade must have exactly the goods or services that each other wants. The requirement of having a double coincidence of wants before exchange can take place discourages both specialization in labor (generally referred to as "division of labor") and specialization in production; for the fewer the types of goods and services one produces for sale, the fewer the types of goods and services one can expect to be able to trade for. The need for double coincidence of wants in barter payments systems thus tends to reduce productive efficiency.

·         Multiple Prices for Each Good or Service: Under a barter payment system, many different prices must be maintained for each good and service, making informed decisions about what to buy (and from whom to buy it) extremely difficult. Specifically, an exchange ratio ("goods price") is needed for every distinct pair of items to be traded.

For example, given two items (say apples and beer), one needs one goods price (apples per beer or beer per apples, either one will do). For three items (say apples, beer, and cars), one needs three goods prices (e.g., apples per beer, apples per car, and beer per cars). But for four items one needs six prices, for five items one needs ten prices, and so it goes. As the number of items keeps increasing, the number of needed goods prices increases dramatically.

More precisely, given a barter economy with n goods, the number of needed goods prices is n[n-1]/2, which is the number of distinct ways that n items can be selected 2 at a time without consideration of order. An equivalent formula for calculating the needed number of goods prices in a barter economy with n goods is the sum of numbers between 1 and n-1, inclusive; i.e., (n-1) + (n-2) + ... + 1. Can you explain why?

·         High Transactions Costs: Under a barter payment system, the above two problems result in high transaction costs, that is, large amounts of resources (time, effort, shoe leather,...) being spent on trying to exchange goods and services.

As previously discussed, the use of money dramatically cuts down on the transactions costs arising from barter, so it is not surprising that barter payment systems have tended to evolve into monetary payment systems.

The nature of the monies used in monetary payment systems continues to evolve over time.

The first monies were commodities, that is, they were economic goods such as cattle, tobacco, and gold which had a direct use value (e.g., for eating, smoking, jewelry). Their direct use value made them useful as mediums of exchange because people were willing to accept them as means of payment even if they, themselves, had no direct use for them.

Different types of commodities have different kinds of drawbacks for use as commodity money. For example, gold and silver are durable and can be molded into portable coins of standard size for ease of use in trade, but they tend to lose commodity value when subdivided into very small quantities for everyday transactions. On the other hand, tobacco is not very durable and its quality is highly variable, but it can be subdivided into small amounts without loss of commodity value.

To avoid various difficulties associated with the direct use of commodity monies in trade, private banks along with governments began to issue paper notes (claims against themselves) that were backed (collateralized) by the commodity money they replaced, usually gold or silver coin. That is, the issuers of these paper notes normally promised to redeem their notes in gold or silver coins on demand. This paper form of money was therefore simply a way to cut down on the transactions costs associated with the use of commodity monies without actually eliminating these commodity monies.

As trade continued to expand, however, the power to issue notes was increasingly transferred to governments and the link with commodity monies became increasingly tenuous. Eventually paper notes evolved into fiat monies, i.e., unbacked paper monies officially designated as legal tender. Moreover, the link between the precious metal content of coins and the face value of coins also became tenuous. Indeed, coins in use today are often referred to as token coins because the amounts of silver and other precious metals they contain are far below their face values.

As Mishkin details, the use of fiat money in trade is itself subject to several difficulties: in particular, expense of transport, and risk of theft. Attempts to combat these difficulties led to the invention of checkable demand deposits. More recent innovations include electronic means of payments (EMOPs), which permit value to be transmitted electronically, and electronic monies (e-monies), which permit value to be stored electronically.

In summary, the nature of monies used in monetary payment systems has tended to evolve over time from commodity money, to fiat money, to checkable demand deposits, to EMOPs, and most recently to e-monies. At this point in time, all of these forms of money are used to varying extents in different parts of the world. Whether the earlier forms of money will ever be entirely eliminated by the later forms remains to be seen.

Measuring Money

In the U.S. today, dollar bills and coins are together referred to as currency. As will be clarified later in the course, dollar bills (Federal Reserve notes) are issued by each of the twelve banks constituting the Federal Reserve System (Fed), the central bank of the US. Coins are also put into circulation by the Fed, but they are minted by the U.S. Treasury (part of the Executive Branch of the U.S. Federal government).

In value terms, however, currency represents only a small part of what is used in the U.S. today as money. For this reason, the Fed makes use of various broader measures of the money supply.

Accurate measurement of the money supply is important for the following reasons:

·         Changes in the money supply are thought to have rather immediate effects on short-term interest rates (e.g., the Federal funds rate), intermediate-run effects on key macro variables such as real GDP, and longer-run effects on other key macro variables such as the aggregate price level and the inflation rate.

·         The Fed has some ability to manipulate and control the money supply (hence short-term interest rates) through open-market operations, i.e., sales and purchases of government bonds to and from the private sector. Thus, by appropriately managing the money supply (and short-term interest rates), the Fed can exert some longer-run control over key macro variables.

NOTE: Monetary policy refers to the efforts of central banks such as the Fed to control key macro variables through the management of the money supply and (short-term) interest rates.

·         Without an accurate measurement of the money supply, however, it is difficult for the Fed to judge the effectiveness of its monetary policy. To judge this effectiveness, the Fed must first be able to measure the extent to which it has succeeded in changing the money supply in accordance with its plans. Second, the Fed must be able to measure the extent to which these changes in the money supply have had intended effects on key macro variables.

There are two basic ways of measuring money: the "theoretical approach" and the "empirical approach."

The Theoretical Approach to Money Measurement:

The theoretical approach to money measurement tries to use economic theory to decide which assets should be included in the measure of money. In particular, the theoretical approach focuses on the relative "moneyness" of assets -- in particular, the degree to which assets function as mediums of exchange.

Traditionally, advocates of this theoretical approach have argued that only those assets that clearly function as a medium of exchange should be counted in the measure of money. Unfortunately, however, many assets function as a medium of exchange to some degree and the appropriate cut-off point is not clear.

More recently, however, economists have argued for a "weighted aggregate" approach to the measure of money.

In the latter approach, all assets functioning to some degree as a medium of exchange are included in the measure of money. However, each of these assets is weighted, with assets that function more as a medium of exchange receiving a relatively larger weight. This eliminates the need to specify a sharp threshhold determining which assets are included or excluded from consideration. However, one is still left with the problem of how to select specific weight magnitudes for the included assets.

The verdict on the reliability and usefulness of these newer weighted-aggregate measures is still out.

The Empirical Approach to Money Measurement:

The empirical approach to the measurement of money takes a more pragmatic view and argues that the decision about what to call money should be based on which measure of money works best in helping to predict the movements of key macro variables.

Unfortunately for the empirical approach, experience has shown that different measures may work better for predicting different variables at any given point in time. For example, the measure that works best for predicting recessions may not be the measure that works best for predicting exchange rates. Morever, the usefulness of any one measure for predicting any one variable tends to vary over time. What works in one period may not work well in the next.

Actual Practice in the United States:

Over the years the Fed has devised a range of different measures of money that combine aspects of the theoretical and empirical points of view. The three measures of money most commonly used by the Fed -- M1, M2, and M3 -- are explained by Mishkin in Table 1.

These measures, generally referred to as monetary aggregates, are "nested" in the sense that each aggregate is broader than its predecessor. For example, M2 includes all assets in M1 together with several additional assets not included in M1.

The narrowest monetary aggregate, M1, conforms to the theoretical point of view in that it only contains highly liquid assets that are directly usable as mediums of exchange (currency, traveler's checks, demand deposits, and other checkable deposits). However, the continual introduction of new forms of money-like instruments has driven the Fed to make additional use of broader monetary aggregates such as M2 and M3 in order to improve its prediction of and control over key macro variables.

Question: Why might you guess that, the narrower the measure of money, the more "unstable" will be its relationship to key macro variables such as GDP and inflation?

As seen in Mishkin's Figure 1, the monetary aggregates M1 and M2 have tended to move together over time, but there have been occasions in which they have moved in substantially different directions. These differences in movement underscore the difficulty of obtaining useful empirical measures of money.

Reliability of Monetary Data

Estimates of the various monetary aggregates are frequently revised by large amounts for two reasons.

·         First, small depository institutions are only required to report the amount of their deposits infrequently, forcing the Fed to estimate these amounts between the reporting dates.

·         Second, the monetary aggregates are based on "seasonally adjusted" data, meaning that corrections are made for systematic peaks and dips in money use due to such time-dependent events as regular holidays and seasonal changes in weather. The appropriate extent of these seasonal adjustments often only becomes clear after the fact, requiring revisions to the adjustments made at the time of the event.

The revisions made in monetary aggregate estimates can be considerable from one month to the next. However, when averaged over time, these revisions tend to average out to zero.

For example, for the initial and revised monthy estimates of the growth rate of M2 depicted in Mishkin's Table 2, in some months the initial rate estimates are too high and need to be revised downward, and in other months the initial rate estimates are too low and need to be revised upwards. However, the average of the initial rate estimates across all 12 months is approximately the same as the average of the revised rate estimates across all 12 months, implying that the revisions (error corrections) made in the initial rate estimates tend to average out to zero.

A useful conclusion to draw from these observations is that one should probably not pay too much attention to reported monthy movements in monetary aggregates. It is far more meaningful and useful to consider the trends in these monetary aggregates, i.e., to consider the average movements in these monetary aggregates over longer periods of time.

Basic Concepts and Key Issues From Mishkin Chapter 3

Basic Concepts:

Money

Wealth

Income

Stock Variable

Flow Variable

Commodity Money

Paper Money (Backed or Unbacked)

Legal Tender

Fiat Money

U.S. Federal Reserve System

Electronic Means of Payment

Electronic Money

Unit of Account

Medium of Exchange

Store of Value

Hyperinflation

Payment System

Autarky

Barter Payment System

Monetary Payment System

Double Coincidence of Wants

Monetary Policy

Currency

Monetary Aggregates (M1, M2)

Key Issues:

The Definition (Abstract Meaning) of Money

Types of Money

Functions of Money

Evolution of Payment Systems

Efficiency of Barter vs. Monetary Payment Systems

Difficulties Encountered in Attempts to Measure the Money Supply

Measuring the Money Supply: Actual Practice in the U.S.

Reliability of U.S. Monetary Data

Copyright © 2010 Yoke Muelgini. All Rights Reserved. 

Lecture Notes on Mishkin Chapter 2: "What is Money" Econ 330: Money, Banking, and Financial Institutions

Department of Economics, Faculty of Economics The University of Lampung Odd Semester (September – December 2010)

Last Updated: September- December , Anno 2010

Latest Course Offering: Odd Semester 2010

Course Instructor:  Dr. Yoke Muelgini, M.Sc

ESP 330 email: ekonomimoneter@ymail.com

• Six Basic Functions of Financial Markets: A More Detailed Consideration
• Additional Distinctions Among Securities Markets
• Asymmetric Information Problems Arising in Financial Markets
• Financial Regulation
• Basic Concepts and Key Issues from Mishkin Chapter 2 (Part B)

Six Basic Functions of Financial Markets:

A More Detailed Consideration

1. Borrowing and Lending

One key function of financial markets is to facilitate the financing of new borrowing. Financial markets bring savers (agents with excess funds relative to their desired expenditures) together with would-be borrowers (agents who are short of funds relative to their desired expenditures). The borrowers issue new liabilities against themselves in return for receiving the excess funds of savers.

In general, there is a mismatch of income and spending needs between households and businesses in an economy that creates an opportunity for borrowing and lending. In the aggregate, the household sector tends to have on hand more funds than it currently wishes to consume (i.e., savings), and the business sector tends to have fewer funds on hand than it wishes to invest. Financial markets provide a mechanism by which the household sector can lend its savings to the business sector for investment purposes.

             SAVINGS                INVESTMENT
HOUSEHOLD  --------->  BUSINESS   ------------>   PROJECTS

SECTOR                 SECTOR

There are two central mechanisms for the transfer of funds from savers to borrowers to facilitate new acts of borrowing: indirect finance; and direct finance.

Indirect Finance:

Funds are channeled indirectly from savers to borrowers in intermediation financial markets by means of financial intermediaries (FIs). The FIs purchase new financial assets issued by borrowers, which the FIs pay for by selling to savers new financial assets issued by themselves. Consequently, the FIs hold claims against the ultimate borrowers whereas the savers hold claims only against the FIs.

Indirect Finance Examples: A bank purchases a home mortgage loan contract from a consumer using funds collected from its depositors (i.e., purchasers of its deposit accounts); A pension fund buys newly issued commercial paper from a corporation using the premiums collected from participants in its pension fund (i.e., purchasers of its pension fund shares).

Direct Finance:

Savers directly finance new acts of borrowing by purchasing newly issued financial assets from the borrowers who are issuing them. Consequently, the savers directly hold claims against these borrowers.

Direct Finance Examples: A corporation buys commercial paper newly issued by another corporation; A household buys a newly issued Treasury bill at a U.S. Treasury auction.

Important Note: Transactions involving the purchase of existing financial assets (e.g., households purchasing corporate stock shares from other households) do not involve any new borrowing. Such transactions simply reallocate among savers the existing volume of claims against borrowers without creating any new claims in net terms. Consequently, given any particular purchase of a financial asset, it can represent an instance of indirect finance, direct finance, or neither.

As pointed out by Mishkin, studies show that firms in major developed countries have traditionally relied more on indirect than on direct financing to obtain their borrowed funds. The reasons for this will be explored in later parts of the course.

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2. Price Determination

Intermediation Financial Markets:

Financial intermediaries pool the funds of many small savers to lend money to individual borrowers.

Interest is paid to savers in exchange for use of their funds for lending, while borrowers pay interest on their loans.

The difference between the rate paid by borrowers and the (generally lower) rate paid to savers can be considered a "price" for the services provided by the financial intermediary to both the borrower and lender.

The goal of intermediaries is generally to borrow funds from savers at low rates and to lend funds to borrowers at high rates -- "borrow low, lend high."

             INTEREST                     INTEREST

             ON SAVINGS                   ON LOANS

   SAVERS  <------------   FINANCIAL    <----------   FIRMS

                          INTERMEDIARY

             "BORROW LOW"                "LEND HIGH"

Auction Securities Markets:

In auction markets, brokers receive bid and asked prices from buyers and sellers and facilitate exchange by matching received bid prices with received asked prices of equal or lesser value so that exchanges can take place. In some cases, only bids are received (so that effective asked prices are zero) and items are simply sold to the highest bidders.

Example: Treasury Auctions

For example (see Fedpoint 41: Treasury Auctions), the U.S. Government regularly auctions newly issued Treasury bills, notes, and bonds ("treasuries") to finance the Federal government debt. Most newly issued treasuries are bought by "primary dealers" -- financial institutions that are active in buying and selling U.S. government securities and that have established business relations with the New York Fed. A much smaller volume of newly issued securities is purchased by individual investors who buy them directly from the Treasury Department at auction instead of in a secondary (resale) market.

A modern auction process for bills, notes, and bonds begins with a public announcement by the Treasury: e.g., "The Treasury will auction $11,000 million of 91 day bills to refund $9,000 million of maturing securities and to raise about $2,000 million in new cash."

Bids are then accepted for up to thirty days in advance of the auction. All bids are confidential and are kept sealed until the auction date. Two types of bids can be submitted: non-competitive tenders (usually submitted by small investors and individuals) submitted in dollar amounts (e.g., $1 million); and competitive bids (usually submitted by primary dealers for their own accounts) submitted in terms of both desired unit price (equivalently, yield to maturity or discount rate) and desired dollar amounts.

On the day of the auction, officials at the Treasury Department first subtract from the public securities offering the total dollar amount of securities bid by non-competitive bidders (who automatically receive securities) in order to determine the total dollar amount of securities available to competitive bidders. For example, if $1 billion in non-competitive tenders is received in an $11 billion public offering of securities, $1 billion in securities will be awarded to non-competitive bidders and $10 billion in securities will be awarded to competitive bidders.

The Treasury officials then work their way down the list of competitively bid unit prices, starting with the highest, accepting the dollar-amount bids for securities submitted with these prices until all securities available for competitive bidders (e.g., $10 billion) have been awarded. Any remaining competitive bids are then rejected. For 2-year and 5-year notes, a single-price auction scheme is used to set the actual price of each security: specifically, all non-competitive bidders and all accepted competitive bidders are awarded their dollar-amount bids at a uniform unit price equal to the unit price bid by the marginal (last) accepted competitive bidder. For all other securities, a more complicated multiple-price auction scheme is used -- see the Fedpoint 41 publication, cited above, for details.

Over-the-Counter Securities Markets:

In over-the-counter securities markets (e.g., Nasdaq), dealers make the market for particular types of securities (e.g., stocks) by posting their own bid prices (offers to buy) and asked prices (offers to sell) for units of the security. The difference between any particular dealer's asked price and bid price for units of a security -- called the dealer's bid-asked spread -- constitutes the dealer's anticipated gross profit margin on trades in this security. For obvious reasons, bid-asked spreads are always positive. An individual (or institution) wishing to buy or sell a security in an over-the-counter market generally makes use of a broker. The broker seeks out the best available bid or asked price posted by the dealers making a market in this security and then executes the individual's desired trade.

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3. Information Aggregation and Coordination

Intermediation Financial Markets:

It is difficult to get information about the credit worthiness of individuals or small businesses, as well as to seek out potential borrowers or lenders.

The specialized information gathering resources and skills of financial intermediaries help to reduce the costs of acquiring information about potential borrowers and lenders. In addition, financial intermediaries act as a coordination device by providing a centralized facility to which would-be lenders and borrowers can direct their demands and supplies for funds.

Securities Markets:

Financial assets sold in securities markets (i.e., in auction markets, over-the-counter markets, or organized exchanges) are financial assets that have been transformed into relatively liquid marketable assets by means of various legally enforceable guarantees provided either by the original issuer of the asset or by other parties.

Many investment advisory firms provide publicly attainable ratings for securities based on the perceived trustworthiness of these guarantees. For example, Moody's Investors Service and the Standard and Poor's Corporation provide default risk information by rating the quality of corporate and municipal bonds, and Merrill Lynch continually announces buy and sell recommendations for various stocks. These ratings reduce the need for participants in securities markets to acquire detailed information, themselves, about the original issuers of the assets.

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4. Risk Sharing

Risk refers to the degree of uncertainty concerning an asset's return.

Risk Diversification:

Financial markets permit savers to diversify their asset portfolios by purchasing financial assets from many different borrowers who face separate types of risks.

In this way, even if some assets in the portfolio generate low rates of return, these low rates may be offset by high rates of return earned by other assets in the portfolio.

                       -----------------ASSET A (ISSUED BY

                      |                 AN HC CORPORATION)

      ASSET           |

      PORTFOLIO   ---->---------------- ASSET B (ISSUED BY

      OF AN           |                 A ROW CORPORATION)

      HC SAVER        |

                       ---------------- ASSET C (ISSUED BY

                      |                 THE HC GOVERNMENT)

                      |

                        ETC.

Risk Pooling:

Conversely, financial markets permit borrowers to transfer their risk to lenders by issuing financial assets to a pool of savers that then collectively shares the risk (e.g., default) burden.

                                   ------------  SAVER A

                                   |

                                   |

      FINANCIAL ASSET       ------->------------  SAVER B

      ISSUED BY CORPORATION        |

                                   |

                                   |------------  SAVER C

                                   |

                                    etc.

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5. Liquidity

The liquidity of an asset refers to the ease with which that asset can be converted into a means of payment for goods and services.

Securities markets enhance the opportunity for savers to save their assets in relatively liquid form while still generating a stream of returns. If a saver were to lend to a personal acquaintance rather than lending through a securities market, he or she would typically lose out on the liquidity offered by lending through a securities market because personal loan agreements are generally not liquid. That is, it would generally be difficult to sell such a loan contract to a third party in return for cash in advance of the maturity of the loan.

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6. Efficiency

Financial markets reduce transactions and information costs.

Securities markets provide centralized or decentralized means for individual savers to purchase financial assets from borrowers. Since the financial assets sold in securities markets are subject to general legal restrictions (e.g., information disclosure laws), individual savers do not need to engage, themselves, in the design and enforcement of contracts with individual borrowers.

The manner in which transactions and information costs are reduced in intermediation financial markets is more complicated, involving a consideration of asymmetric information, monitoring, and enforcement. These issues are introduced in preliminary fashion below and taken up in much greater detail in later parts of the course.

Additional Distinctions Among Securities Markets

In Notes on Mishkin Chapter 2: Part A, financial markets were classified into four basic structural types: auction markets; over-the-counter markets, organized exchanges, and intermediation financial markets. It was also pointed out that the first three types of markets are generally referred to as securities markets.

Mishkin points out several additional important ways to distinguish among the structure of securities markets that primarily concern the properties of the securities being exchanged.

Note on Terminology: Mishkin interchangeably uses the term "security" and "financial instrument," and we will do likewise.

Primary versus Secondary Markets:

Primary markets are securities markets in which newly issued securities are offered for sale to buyers. Secondary markets are securities markets in which existing securities that have previously been issued are resold. The initial issuer raises funds only through the primary market.

Debt Versus Equity Markets:

Debt instruments are particular types of securities that require the issuer (the borrower) to pay the holder (the lender) certain specied payments at regularly scheduled intervals until a specified time (the maturity date) is reached, regardless of the success or failure of any investment projects for which the borrowed funds are used.

Debt instrument holders do not normally participate in the management of the debt instrument issuer. In cases of bankruptcy, holders of debt instruments have first claim on any remaining assets of the debt instrument issuer. An example of a debt instrument is a 30-year mortgage.

In contrast, an equity is a security that confers on the holder an ownership interest in the issuer. There are two general categories of equities: "preferred stock" and "common stock."

Common stock shares issued by a corporation are claims to a share of the assets of a corporation as well as to a share of the corporation's net income -- i.e., the corporation's income after subtraction of taxes and other expenses, including the payment of any debt obligations. Thus, the return that common stock shareholders receive depends on the economic performance of the issuing corporation.

Holders of a corporation's common stock shares participate in any upside performance of the corporation in two possible ways: by receiving a share of net income in the form of dividends; and/or by enjoying an appreciation in the price of their stock shares.

However, the payment of dividends is not a contractual or legal requirement. Even if net earnings are positive, a corporation is not obliged to distribute dividends to shareholders. For example, a corporation might instead choose to keep its profits as retained earnings to be used for new capital investment (self-financing of investment rather than debt or equity financing). Moreover, in case of bankruptcy, the claims of common stock share holders against any remaining assets of the company are subordinate to the claims of all debt instrument holders.

On the other hand, corporations cannot charge losses to their common stock shareholders. Consequently, these shareholders at most risk losing the purchase price of their shares, a situation which arises if the market price of their shares declines to zero for any reason. An example of a common stock share is a share of IBM.

In contrast, preferred stock shares are usually issued with a par value (e.g., $100) and pay a fixed dividend expressed as a percentage of par value. Preferred stock is a claim against a corporation's cash flow that is prior to the claims of its common stock shareholders but is generally subordinate to the claims of its debt instrument holders. In addition, like debt holders but unlike common stock shareholders, preferred stock shareholders generally do not participate in the management of issuers through voting or other means unless the issuer is in extreme financial distress (e.g., insolvency). Consequently, preferred stock combines some of the basic attributes of both debt and common stock and is often referred to as a hybrid security.

Money versus Capital Markets:

The money market is the market for shorter-term securities, generally those with one year or less remaining to maturity.

Examples: U.S. Treasury bills; negotiable bank certificates of deposit (CDs); commercial paper, Federal funds; Eurodollars.

Remark: Although the maturity on certificates of deposit (CDs) -- i.e., on large time deposits at depository institutions -- can run anywhere from 30 days to over 5 years, most CDs have a maturity of less than one year. Those with a maturity of more than one year are referred to as term CDs. A CD that can be resold without penalty in a secondary market prior to maturity is known as a negotiable CD.

The capital market is the market for longer-term securities, generally those with more than one year to maturity.

Examples: Corporate stocks; residential mortgages; U.S. government securities (marketable long-term); state and local government bonds; bank commercial loans; consumer loans; commercial and farm mortgages.

Remark: Corporate stocks are conventionally considered to be long-term securities because they have no maturity date.

Domestic Versus Global Financial Markets:

As Mishkin notes in Chapter 2, financial markets are becoming increasingly international in nature, in the sense that various types of financial assets issued by one country may be purchased by nationals of another country.

Eurocurrencies are currencies deposited in banks outside the country of issue. For example, eurodollars, a major form of eurocurrency, are U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks. That is, eurodollars are dollar-denominated bank deposits held in banks outside the U.S.

An international bond is a bond available for sale outside the country of its issuer.

Example of an International Bond: a bond issued by a U.S. firm that is available for sale both in the U.S. and abroad.

A foreign bond is an international bond issued by a country that is denominated in a foreign currency and that is for sale exclusively in the country of that foreign currency.

Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in Japanese yen and that is for sale exclusively in Japan.

A Eurobond is an international bond denominated in a currency other than that of the country in which it is sold. An example would be a bond issued by a U.S. borrower, denominated in U.S. dollars, and sold outside the U.S.

Example of a Eurobond: Bonds sold by the U.S. government to Japan that are denominated in U.S. dollars.

Asymmetric Information in Financial Markets

Asymmetric information in a market for goods, services, or financial assets refers to differences ("asymmetries") between the information available to buyers and the information available to sellers. For example, in markets for financial assets, asymmetric information may arise between lenders (buyers of financial assets) and borrowers (sellers of financial assets).

Problems arising in markets due to asymmetric information are typically divided into two basic types: "adverse selection;" and "moral hazard." This section explains these two types of problems, using financial markets for concrete illustration.

1. Adverse Selection

Adverse selection is a problem that arises for a buyer of a good, service, or asset when the buyer has difficulty assessing the quality of this item in advance of purchase. Buyers might then offer to buy the item at a price equal to the average (expected) quality of the item. But this encourages sellers of high-quality items to EXIT the market and sellers of low-quality items to ENTER the market, lowering the average quality of items for sale.

Consequently, adverse selection is a problem that arises because of different ("asymmetric") information between a buyer and a seller before any purchase agreement takes place.

An Illustration of Adverse Selection in Loan Markets:

In the context of a loan market, an adverse selection problem can arise between lenders (i.e., buyers of newly issued financial assets) and borrowers (i.e., sellers of newly issued financial assets). In particular, if a lender sets contractual terms in advance in an attempt to protect himself against the consequences of inadvertently lending to high risk borrowers, these contractual terms might have the perverse effect of encouraging high risk borrowers to self-select INTO the lender's loan applicant pool while at the same time encouraging low risk borrowers to self-select OUT of this pool. In this case, the lender's pool of loan applicants is adversely affected in the sense that the average quality of borrowers in the pool decreases.

Suppose, for example, that 50% of potential borrowers in the population at large are high risk, in the sense that there is a high probability they would default on their loan payments, and 50% are low risk in the sense that there is a low probability they would default on their loan payments. A banker is willing to loan to high risk borrowers at an 11% interest rate and to low risk borrowers at a 5% interest rate. Thus, the "risk premium" required by the bank is 6%.

Prior to making a loan to any individual, the bank has no way of knowing whether the individual is a high risk or a low risk borrower. However, the bank knows that the two types of individuals (high risk and low risk) are equally represented in the population.

Consequently, prior to actually making any loans, the bank concludes there is a 50-50 chance that any given would-be borrower is high risk or low risk. It might therefore seem reasonable to the bank to charge an interest rate that is an average of the rates for high and low risk borrowers, so the bank sets its loan interest rate at 8%.

Unfortunately for the bank, high risk borrowers will view 8% as a great rate since they know the riskiness of their projects actually warrants a higher rate -- indeed, they would be required to pay 11% if the bank knew their true quality. Consequently, high risk borrowers have an incentive to apply for loans from the bank. On the other hand, low risk borrowers will view 8% as an unnecessarily high and costly rate, and they might turn elsewhere for funds or abandon their intended investment projects altogether.

Consequently, although high risk and low risk borrowers are equally represented in the population at large, when the bank offers a loan rate of 8% the percentage of high risk borrowers attracted to the bank's pool of loan applicants will tend to rise above 50% and the percentage of low risk borrowers in this pool will tend to fall below 50%.

Being rational, the bank might be able to predict this eventuality in advance, in which case the bank might conclude it should set an interest rate higher than 8% to compensate for the fact that more than 50% of its loan applicant pool will be high risk. However, the effect of any such increase will only be to further compound the adverse selection problem, because low risk borrowers will have an additional incentive to select out of the bank's loan applicant pool. Indeed, all low risk borrowers may eventually be driven out of this pool altogether, leaving only high risk borrowers who are each charged a rate of 11%. To the extent that profits could also have been made on low risk borrowers at a rate as low as 5%, the bank will then be missing out on good profit opportunities.

Potential solutions to adverse selection problems in the context of financial markets will be taken up in later parts of the course.

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2. Moral Hazard

Moral hazard is said to exist in a market if, after the signing of a purchase agreement between the buyer and seller of a good, service, or financial asset:

·         the seller changes his or her behavior in such a way that the probabilities (risk calculations) used by the buyer to determine the terms of the purchase agreement are no longer accurate;

·         the buyer is only imperfectly able to monitor (observe) this change in the seller's behavior.

For example, a moral hazard problem arises if, after a lender purchases a loan contract from a borrower, the borrower increases the risks originally associated with the loan contract by investing his borrowed funds in more risky projects than he originally reported to the lender.

This is precisely the type of moral hazard problem that arose in the savings and loan debacle in the United Stated during the 1980s. In essence, the government, through the agency of a regulatory body called the Federal Savings and Loan Insurance Corporation (FSLIC), fully insured the majority of the deposit accounts held by savings and loan (S and L) associations. When the ceiling on depositor interest rates was lifted in the mid 1980's -- so that S and L's now had to offer higher interest rates to depositors to compete for funds -- the S and L's then had every incentive to move into riskier lending at higher charged interest rates in an attempt to maintain their profit margins (borrow low-lend high). This, in turn, significantly increased their probability of bankruptcy, and hence the risk to taxpayers --- the ultimate underwriters of FSLIC insurance.

Potential solutions to moral hazard problems will be taken up in later parts of the course.

Financial Regulation

As noted by Mishkin, government regulates financial markets for three main reasons:

·         Efficiency: to increase the information available to investors;

·         Stability: to ensure the soundness of the financial system;

·         Optimality: and to improve the control of monetary policy.

Discussion of these forms of regulation will be taken up in later sections of the course, particularly in Section 3. It may be useful, however, to give a few preliminary remarks here on the specific types of regulations imposed in securities markets and intermediation financial markets.

Securities Markets:

A key problem in securities markets is that small investors cannot easily judge the risks associated with the purchase of bonds and stock shares issued by firms. As previously noted, various private investment advisory firms have formed in response to this problem who collect information on the quality of bonds and stock shares. Nevertheless, these private firms cannot always collect truthful information, and the amount and type of information they do collect is geared more to their own individual profitability than to the welfare of society at large.

For these reasons, government policy makers have argued for the need for government regulations requiring issuers of bonds and stock shares to disclose information about their financial condition. For example, the Securities and Exchange Commission (SEC), established by the Securities Act of 1933, requires corporations issuing securities to represent these securities truthfully and restricts "insider trading," i.e., trading by the largest corporate shareholders on the basis of privileged (non-public) information.

Intermediation Financial Markets:

Adverse selection and moral hazard problems are endemic in intermediation financial markets.

As noted above, the quality of loan application pools may be degraded as a consequence of efforts by financial intermediaries to protect themselves against the risk of making loans to default-prone borrowers.

In addition, financial intermediaries are subject to two different forms of moral hazard. On the one hand, the financial intermediary has to worry about moral hazard problems arising from changed behavior by its borrowers after loan contracts have been made. On the other hand, the financial intermediary has to assure its own creditors (e.g., depositors) that it will not engage in behavior that endangers the soundness of the creditors' claims against it. If creditors lose faith in the soundness of the financial intermediary for any reason, valid or not, this can result in a financial panic in which many creditors desperately attempt to withdraw their funds from the financial intermediary all at the same time, which could bankrupt the financial intermediary.

In an attempt to alleviate these and other problems perceived to arise in intermediation financial markets, the government in the past has imposed five basic types of regulations on financial intermediaries:

·         Entry Restrictions: Restrictions on who is allowed to set up a financial intermediary (i.e., chartering and licensing restrictions);

·         Information Reporting: Restrictions regarding the reporting requirements for financial intermediaries;

·         Risk Reduction: Restrictions on participation in activities perceived to be risky (e.g., stock purchases);

·         Insurance Provision: Restrictions forcing financial intermediaries to participate in government-backed insurance programs;

·         Restrictions on Competition: For example, branching restrictions imposed on banks to protect small banks from competition, and ceiling restrictions on allowable interest rates on deposit accounts in order to lessen competition for funds on the basis of interest rates, etc.

The effectiveness of these and other forms of government regulations, and the extent to which they have been successfully or unsuccessfully challenged, will be taken up in Section 3 of the course.

Basic Concepts and Key Issues from Mishkin Chapter 2

Basic Concepts: Mishkin Chapter 2

Borrowing and Lending

Direct Finance

Indirect Finance

Risk

Risk Sharing

Risk Pooling

Liquidity

Primary Market

Secondary Market

Debt Market

Equity Market

Money Market

Capital Market

Negotiable (i.e., can be resold without penalty)

Eurocurrency

Eurodollar

International bond

Foreign bond

Eurobond

Asymmetric Information

Moral Hazard

Adverse Selection

Financial regulation

Financial Exchange vs. Instances of Finance

Direct vs. Indirect Finance

Distinctions Among Securities Markets by Asset Characteristics

Moral Hazard Problems in Financial Markets

Adverse Selection Problems in Financial Markets

Reasons for Financial Regulations in Various Types of Financial Markets

Copyright © 2010 Yoke Muelgini. All Rights Reserved.