Transcript Financial System Overview and the Flow of Funds

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
Fed Funds, T-Bill, and T-Bond Rates Summer 2005
4.5
4.0
3.5
3.0
2.5
2005:06
FEDFUNDS
J. K. Dietrich - FBE 524 – Fall 2005
2005:07
TBILL
TBOND
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 Flows
Non-Bank Balance Sheet
Assets
Real Assets
Financial Assets
Money
Lending
Equity
J. K. Dietrich - FBE 524 – Fall 2005
Liabilities and Net Worth
Borrowing
Net Worth (= Others' Equity)
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 Nonprofit 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 noncorporate + 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
J. K. Dietrich - FBE 524 – Fall 2005
1980 balance sheets
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:
GDP * (1  w ) $11.7 * (.433)
R

 30%
K * (1  h)
$16.9
 Gross
return illustrates top down approach
J. K. Dietrich - FBE 524 – Fall 2005
Composition of wealth
 Compare
composition of tangible assets
1980
2004
Households
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
J. K. Dietrich - FBE 524 – Fall 2005