The Financial System

• The image shows a person inside a bank branch, engaging in banking activities such as depositing or withdrawing money or applying for a mortgage.

The Financial System

• The financial system enables individuals, businesses, and governments to manage and allocate funds efficiently.
• Financial needs arise because spending plans often don't match available funds, necessitating borrowing and lending.
• The financial system channels savings to those with a need for funds, facilitates payments, provides risk coverage, and transmits monetary policy.
• Key elements include financial institutions, markets, and instruments.

Institutions

• Financial institutions oversee and regulate the financial system.
• In Spain, important regulators include the Bank of Spain, the National Securities Market Commission, and the Directorate General of Insurance and Pension Funds.
• Financial intermediaries connect lenders and borrowers, categorized by their ability to create money.
• Banking intermediaries create bank money, including private banks, savings banks, and credit cooperatives.
• Non-banking intermediaries include ICO, insurance companies, private pension funds, investment firms, leasing companies, and factoring companies.

Financial Markets

• Financial markets enable the exchange of financial assets and price determination.
• There exist varying classifications:
  • Money markets trade short-term, fixed-income assets (less than 1 year).
  • Capital markets trade long-term financial assets (more than 1 year).
  • Primary markets sell newly issued securities.
  • Secondary markets facilitate trading of already-issued securities.
  • Derivative markets trade options and futures for risk management.

Stock Exchange

• Value exchanges are secondary financial markets trading stocks and fixed income securities.
• The Ibex 35 is Spain's main stock index, comprising the 35 most liquid stocks.
• Financial exchanges across the world include:
  • The Dow Jones Industrial Average.
  • Nasdaq 100.
  • Nikkei.
  • FTSE 100
  • Eurostoxx 50.

Financial assets

• A financial asset channels savings into investments, defined by a contract between investor and issuer.
• Key characteristics of assets include:
  • Liquidity.
  • Risk.
  • Return.
• Assets are categorized by return variability.

Money

• Money serves as a medium of exchange, unit of account, and store of value.
• Krugman listed basic functions of money include, medium of exchange, unit of account and deposit of value.
• Others include:
  • Pattern of defered payments
• Historically, money has evolved from barter to commodity money, metallic money, paper money, and electronic money.
• Types of money include:
  • Commodity
  • Metallic
  • Paper
  • Electronic
• Electronic money is also evolving beyond traditional forms to Bitcoin.

Types of Interest

• The cost of money is the interest rate.
• The interest rate reflects the price a borrower pays to a lender for using money.
• Interest is usually annual, but can also be trimestral or semestral.

Demand for Money

• Demand for money is derived from its functions, including transaction, precaution, and speculation
  • Transaction
  • Precaution
  • Speculation
• Demanders of money consider factors such as price level, income level, interest rates, and risk.
• Different definitions of money supply exist, ranging from basic (M1) to broad (M4).

The Monetary Base

• Monetary Policy is the sum of currency in circulation and bank reserves.
• M1 = currency + checkable deposits.
• M2 = M1 + savings deposits.
• M3 = M2 + time deposits.
• Monetary equilibrium occurs when money supply equals money demand, influencing interest rates, economic behavior, and investment decisions.
• A increase in interest rates incentivizes savings, reduces consumption and investment, and can lead to economic slowdown and potentially a recession
• The economic cost is reversed when governments use Quantitative Easing (QE) type controls increasing money supply to lower cost of borrowing, stimulate lending and stimulate investment.

Bank Money

• Bank money in Spain is issued in bills and coins by the Bank of Spain under delegation from the European Central Bank.
• Banks create money by lending deposits, maintaining only a fraction as reserves.
• Banks create lending opportunities through:
  • deposits
  • loans
  • deposits
  • etc

Creation of Bank Money

• Example on how bank money came to be:
  • Deposit funds in Bank A.
  • Bank A has to hold back amount which is now available to lending (e.g: 1000 eur).
  • Which can then be leant to Juan to buy motorcycle (e.g: 900 eur).
  • Business can then choose to deposit the funds in Bank B
  • With coefficient of cash flow being 10%
  • And then Bank B can lend back out (e.g: 810 eur).

Inflation

• Inflation is a sustained increase in the general price level, affecting purchasing power and economic decisions.
• Necessary characteristics of inflation include:
  • Generalized
  • Continued
• Terms related to inflation include deflation, disinflation, and stagflation.
• According to Paul Samuelson and William Nordhaus, There are four main types of inflation based on magnitude:
  • Moderate.
  • Galloping.
  • Hyperinflation.
• According to the rate of level in the consideration period these are different factors affecting the change in level of prices:
  • Monthly
  • Bimanual
  • Yearly Inflation measurements according to form include:
    • general and underlying inflation
    • structural and cyclical inflations

Inflation Calculation

Inflation calculation also includes a basket of family goods based also considering year of reference:

• Includes
  • P1
  • P2
  • P3 ...
  • Pn

Measuring Inflation

• The National Statistics Institute (INE) in Spain calculates inflation using the Consumer Price Index (CPI).
• CPI is a measure used to determine the level of general prices as a whole for consumers.
• Different theories explain demand-pull and cost-push inflation.
  • Demand-pull Inflation
  • Cost-push Inflation

Motives Inflation

• Excessive aggregate demand causes demand-pull inflation:
  • Keynesian explanation.
  • Monetarist explanation.
• Cost-push inflation results from rising production costs like wages and raw materials.

Consequences of Inflation

• Uncertainty about the future leads to affect development of economic and the way it functions.
• Negative affects on economic growth and employees
• Creates a imbalance in competitiveness overall nationally

Injured by Inflation

• Savers
• Collectives
• Exporters

Benefitted By Inflation

• Debtors
• Possesors
• The state
• Importers

Monetary politics

• The European Central Bank (ECB) manages monetary policy for the Eurozone to control inflation and maintain price stability.
• The main objective of these functions is to target 2% inflation in the eurozone

Types of monetary politics

• Expansive
• Restrictive

Monetary Instruments

• The European System of Central Banks makes use of processes in politics and open trades:
  • Open market operations.
  • Standing facilities.
  • Minimum reserves.