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Money and the Financial System


Every financial transaction has a story.

There is a complex web of interdependent institutions and markets making up the foundation of daily financial transactions:

  1. The Six Parts of the Financial System.
  2. The Five Core Principles of Money and Banking



6 Parts of the Financial System

  1. Money
  • To pay for purchases and store wealth.


  1. Financial Instruments
  • To transfer resources from savers to investors and to transfer risk to those best equipped to bear it.


  1. Financial Markets
  • To buy and sell financial instruments.


  1. Financial Institutions
  • To provide access to financial markets, collect information & provide services.


  1. Regulatory Agencies
  • To provide oversight for financial system.


  1. Central Banks
  • To monitor financial Institutions and stabilize the economy.




  • Money has changed from gold/silver coins to paper currency to electronic funds.
  • Cash can be obtained from an ATM any where in the world.
  • Bills are paid and transactions are checked online.



Financial instruments

  • Transfers resources from savers to investors.
  • Buying and selling individual stocks used to be only for the wealthy.
  • Today we have mutual funds and other stocks available through banks or online.
  • Putting together a portfolio is open to everyone.



Financial Markets

  • Allow the buying and selling of financial instruments easily.
  • Went from being in coffee houses and tavern to well organized markets like the New York Stock Exchange.
  • Now transactions are mostly handled by electronic markets.
  • This has reduced the cost of processing financial transactions making the way for a much broader array of financial instruments available



Financial Institutions

  • Provide all the services of the financial system like providing access to financial markets and gathering information.
  • Banks began as vaults, developed into institutions that accepted deposits and gave loans, and evolved to today’s financial supermarket.






Government regulatory agencies

  • Make sure the elements of the financial system operate safely and reliably.
  • Government regulatory agencies were introduced by federal government after the Great Depression.
  • They provide wide-ranging financial regulation, rules, and supervision; and examine the systems a bank uses to manage its risk.
  • The 2007-2009 financial crises has led governments to greater regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act.


Central banks

  • They monitor and stabilize the financial system.
  • Central banks began as large private banks to finance wars.
  • Central banks control the availability of money and credit to promote low inflation, high growth and stability of financial system.
  • Today’s policymakers strive for transparency in their operations.
  • The financial crisis of 2007-2009 have led the U.S. central bank to try many new policy tools.



Five Core Principles of  Money and Banking

  1. Time has value.
  2. Risk requires compensation.
  3. Information is the basis for decisions.
  4. Markets determine prices and allocate resources.
  5. Stability improves welfare.



Core Principle 1: Time has value

  • Time affects the value of financial instruments.
  • Interest is paid to compensate the lenders for the time the borrowers have their money.
  • Chapter 4 develops an understanding of interest rates and how to use them.


Core Principle 2: Risk requires compensation

  • In a world of uncertainty, individuals will accept risk only if they are compensated.
  • In the financial world, compensation comes in the form of explicit payments: the higher the risk the bigger the payment.



Core Principle 3: Information is the basis for decisions

  • The more important the decision, the more information we gather.
  • Collection and processing of information is the foundation of the financial system.



Core Principle 4: Markets determine prices and allocate resources

  • Markets are the core of the economic system.
  • Markets channel resources and minimize the cost of gathering information and making transactions.
  • In general, the better developed the financial markets, the faster the country will grow.



Core Principle 5: Stability improves welfare

  • A stable economy reduces risk and improves everyone’s welfare.
  • Financial instability in the autumn of 2008 triggered the worse global downturn since the Great Depression.
  • A stable economy grows faster than an unstable one.
  • One of the main roles of central banks is stabilizing the economy.



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