Financial System Overview and the Flow of Funds

1. Financial System Overview and the Flow of Funds Week 1 – August 24, 2005

2. The Financial System • What happened on August 9, 2005? • What was market reaction? • What are the linkages between those actions and business conditions? • What is occurring in financial markets? • Interest rates, mortgage borrowing, restructuring of financial firms? • New financial products? • What framework can be used to comprehend these important changes?

3. Market Reaction – Summer 2005

4. This course • Overview of institutions and markets • Major institutions and their regulators • Interest rate determination • Risk. risk management, and risk premiums • Important financial markets in depth • Closer scrutiny of the money market and important factors influencing conditions • Detailed review of important credit markets and the market for equity

5. Readings in text first two weeks • This evening will we cover Chapters 1 to 3 • Chapter 1 - Functions of financial system • Chapter 2 - Markets and funds flows • Chapter 3 - Efficient markets and information • Try to review these and raise any questions by next time, they are introductory • Next week, cover Chapters 14 and 15 • Chapter 14 – Banks • Chapter 15 – Non-bank thrift institutions

6. Stages of financial systems • Each unit is independent, investments accumulate over time, e.g. a farm • Units can accumulate value in monetary asset (e.g. claim on government) in order to save for large investments • Units can borrow and lend individually • Financial intermediaries raise funds from saving units and lend to investing units

8. Circular Flows • Goods and services • National product accounts, gross domestic product • Produced by Commerce Department • Income flows • National income accounts • These accounts do not reflect financial market activity • Flow of Funds Accounts of Federal Reserve system track financial flows

10. Financial Markets • Money and capital markets • Open versus negotiated markets • Competitive market-based funding versus intermediated or bank-dominated funding markets • Primary versus secondary markets • Spot versus futures, forward, and option markets

11. Balance Sheets and Flows

12. Sources and uses = flows • Sources and uses are changes in balance sheets • We want to look at both • Balance sheets represents stocks, hence total size, at a point in time • Flows represent net changes in stocks (I.e. new issues minus repayments of financial assets or liabilities)

13. Balance sheets and portfolios • Assets = Liabilities + (net worth = equity, common stock shares, etc.) • Assets • Financial assets • Money, loans and bonds, equity investments • Real assets • Housing, consumer durables including autos • Inventory, plant and equipment

14. Balance sheets/portfolios (cont’d) • Liabilities • Monetary liabilities (loans, mortgages) • Other financial liabilities • Net worth is composed of equity in real assets and net financial claims on others • Sectors are aggregate balance sheets of similar units • Households, business, government • Financial institutions

15. Sectoral balance sheets • Balance sheets of Households and Non-profit organizations • 2004 largest real and financial assets • 2004 largest liabilities • 2004 composition of real asset holdings • share of monetary assets • Compare 1980 balance sheets • Share changes = growth and change in portfolio composition

16. Sectoral balance sheets (cont’d) • Farm + non-farm non-financial non-corporate + non-farm non-financial corporate business • Non-farm non-financial corporate balance sheet • 2004 largest assets • 2004 largest liabilities • 2004 composition of real asset holdings • share of monetary assets • Compare 1980 balance sheets

17. Wealth and flow of funds • Primary sectors = households, business government • Financial sector • Financial claims - financial liabilities (small holdings of real assets) • Aggregate wealth is real assets since all financial claims cancel

18. Wealth • Total wealth in 2004 is approximately (billions) $22,566.2 + $10,479.1 + 6,407.9 = $ 39.5 trillion • 2004 GDP is $11,734.9 trillion, so income-capital ratio is approximately .30 or capital-income ratio 3.4 • 1980 wealth approximately $ 9,729.7 trillion, GDP $ 2,789.5 trillion, so capital-income ratio is also about 3.5 (about the same) • GDP over assets in 1980 and 2004 around 30% • Has tangible wealth composition changed?

19. Distribution of GDP • Employee compensation in 2004 was $6,651, or 56.7% of GDP • Business tangible assets were $ 16,887.0 or 40.7% of “total” tangible assets • Roughly gross before tax return on business investment is: • Gross return illustrates top downapproach

20. Composition of wealth • Compare composition of tangible assets1980 2004Households Real Estate 78% 83% Durables 21% 16%Business (corporate + non-corporate) Real Estate 67% 68% P&E 22% 23% Inventories 11% 9% • Think of other economies

21. The Financial System • Channels savings into investment • Financial institutions assist in this process • Financial institutions create value for primary surplus and deficit units through • Increasing economic efficiency • Providing financial servies • The value of flow of funds framework is that we can trace the changing roles of financial institutions

22. Next time • Before next Wednesday, review Chapters 1 to 3 of Money and Capital Markets and identify any questions about this evening’s session • Read Chapters 14 and 15 of Money and Capital Markets • Bring a Wall Street Journal to class every Tuesday