Lesson 1: Introducing Money and the Financial System |
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Upon completion of this lesson, you should be able to do the following:
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IntroductionThis lesson introduces the financial system and the role of money in an economy. Money and the financial system are intertwined and cannot be separated. They both influence and affect the whole economy, such as the inflation rate, business cycles, and interest rates. Understanding how the financial markets and money influences the economy, can help consumers, investors, savers, and government officials to make better informed decisions. Purpose of Financial Markets and InstitutionsFirst, you need some definitions. A financial market is where buyers and sellers come together to buy and sell bonds, stocks, and other financial instruments. The buyers of financial securities are investing their savings, while sellers of financial securities are borrowing funds. The financial market can be a physical place like the New York Stock Exchange where buyers and sellers come face-to-face or the market can be like the NASDAQ where buyers and sellers are connected together by computer networks. A financial institution is a business that links savers and borrowers. The most common is banks. For example, if you deposited $100 into your savings account, the bank will lend this $100 to a borrower and the borrower will pay interest to the bank. In turn, the bank will pay you interest on your account. The bank's profits are the difference between the interest rate charged to the borrower and the interest rate paid on your savings account. Why would you want to deposit money at a bank instead of directly buying securities through the financial markets? A bank, being a financial institution, can provide three benefits to the depositor.
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Your Assets | |||||
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Money and the Central BankMoney or the money supply is defined as anything that is accepted for payment of goods and services or paying off debts. In developing countries, money is essentially cash. In countries with sophisticated financial markets like the United States, the definition of money can be very complicated. Money includes cash and checking account balances, but what about assets like savings accounts and government securities? These assets are so easily converted into cash with little transaction costs, that essentially this could be included in the definition of money. An asset like a $50,000 home is not included in the definition of money. The house can be converted into cash, but it could take time and there is a high transaction cost. To get money quickly, the house may have to be sold for a lower value than its worth. Every country uses some form of money and therefore every country has a government institution that measures and influences the money supply . This institution is referred to as the central bank. For example, the central bank in the United States is the Federal Reserve System , or commonly referred to as the " Fed ." The Federal Reserve regulates banks, grants loans to banks, and can influence the money supply. However, the money supply and the financial markets are intertwined. When the Fed influences the money supply, it also indirectly influences the financial markets. Therefore, when the Fed influences the financial markets, the Fed can indirectly affect the interest rates, exchange rates, inflation, and the output growth rate of the U.S. economy. When the Fed uses its management of the money supply to influence the economy, economists call this monetary policy. This whole course is to explain how the Federal Reserve System can influence the economy through the financial markets. This analysis can also be extended to any central bank in the world. The central bank can influence three very important variables in the economy.
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