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J. K. Dietrich - FBE 524 – Fall 2005
Financial System Overview and the Flow of Funds
Week 1 – August 24, 2005
J. K. Dietrich - FBE 524 – Fall 2005
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?
J. K. Dietrich - FBE 524 – Fall 2005
Market Reaction – Summer 2005
2.5
3.0
3.5
4.0
4.5
2005:06 2005:07
FEDFUNDS TBILL TBOND
Fed Funds, T-Bill, and T-Bond Rates Summer 2005
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
Balance Sheets and FlowsNon-Bank Balance Sheet
Assets Liabilities and Net Worth
Real Assets BorrowingFinancial Assets
MoneyLendingEquity Net Worth (= Others' Equity)
J. K. Dietrich - FBE 524 – Fall 2005
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)
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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?
J. K. Dietrich - FBE 524 – Fall 2005
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 down approach
%309.16$
)433(.*7.11$
)h1(*K
)w1(*GDPR
J. K. Dietrich - FBE 524 – Fall 2005
Composition of wealth Compare composition of tangible assets
1980 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
J. K. Dietrich - FBE 524 – Fall 2005
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
J. K. Dietrich - FBE 524 – Fall 2005
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