LECTURE 01
With respect to learning outcomes, you should be able to:
a. Demonstrate the importance of the circular flow of income to the national economy;
b. Demonstrate the important role of the financial system for an efficient flow of funds; What are the key activities
c. Explain direct and indirect financing and their respective benefits;
d. Distinguish between various types of financial markets according to function.
• Circular Flow of Income: Five Sector Model
• Circular Flow of Income Model: Leakages and Injections
Leakage: Withdrawals from the flow of income.
• (e.g.) savings, net tax payments, and imports.
Injection: Introduction of income into the flow.
• (e.g.) investment, government spending and exports.
• Financial institutions (FIs) play the role of intermediaries.
• Financial system endeavours to transfer funds from savers to borrowers.
• Budget of each economic actor
• Each actor is constrained by their income
• Balanced budget
• Surplus budget = Revenue> ex
• Deficit budget = revenue < ex
• Main Economic Policies
• Fiscal policy: deals with government actions regarding spending and taxation; or
• Monetary policy: deals with central bank actions regarding the money supply and interest rates.
• Both are employed to achieve policy goals.
• Inflation (i.e., stable prices)
• Full employment (i.e., NAIRU)
• Economic growth
• However, the ‘Treasury View’ prevails.
• Monetary Policy
• Primary objective is ‘inflation targeting’.
• Specifically, to keep consumer price inflation to 2–3 per cent, on average, over the medium term.
• Central Banks tend to implement monetary policy via:
i. open market operations;
ii. discount rate; and
iii. reserve requirements.
, • Role of the Financial System
The role of the financial system is:
i. To facilitate the flow of funds (direct financing and indirect financing)
ii. To provide ways of dealing with incentive problems
iii. To facilitate financial market efficiency
iv. To provide the means to transfer and manage risk
v. To provide the mechanism to settle transactions (i.e., payments system)
vi. To facilitate the flow of funds (direct financing and indirect financing)
• Financial market (direct financing)
• Financial institutions (indirect financing)
• i. Flow of Funds: Financial Claims
• Financial claims are written promises (e.g. IOU)
• An agreement is made to:
i. pay a specific sum of money (the principal)
ii. plus interest for the privilege of borrowing money
iii. over a period of time (maturity of the loan).
• Financial claims are issued by deficit spending units (DSUs). These are considered liabilities.
• Financial claims are then purchased by surplus saving units (SSUs). These are considered
assets.
• ii. Managing Incentive Problems
• The three main incentive problems are:
• Information asymmetry
i. occurs when buyers and sellers do not have access to the same information.
• Adverse selection
i. occurs before a financial transaction takes place which can result in undesirable
(i.e., adverse) outcomes.
• Moral hazard
i. occurs after the transaction takes place. Engagement of behaviour different to what
was agreed to.
• iii. Financial Market Efficiency
• The three main financial market efficiency areas are:
i. Allocational Efficiency:
a. funds are allocated to their highest value use.
ii. Informational Efficiency:
a. market prices reflect all relevant information about securities.
With respect to learning outcomes, you should be able to:
a. Demonstrate the importance of the circular flow of income to the national economy;
b. Demonstrate the important role of the financial system for an efficient flow of funds; What are the key activities
c. Explain direct and indirect financing and their respective benefits;
d. Distinguish between various types of financial markets according to function.
• Circular Flow of Income: Five Sector Model
• Circular Flow of Income Model: Leakages and Injections
Leakage: Withdrawals from the flow of income.
• (e.g.) savings, net tax payments, and imports.
Injection: Introduction of income into the flow.
• (e.g.) investment, government spending and exports.
• Financial institutions (FIs) play the role of intermediaries.
• Financial system endeavours to transfer funds from savers to borrowers.
• Budget of each economic actor
• Each actor is constrained by their income
• Balanced budget
• Surplus budget = Revenue> ex
• Deficit budget = revenue < ex
• Main Economic Policies
• Fiscal policy: deals with government actions regarding spending and taxation; or
• Monetary policy: deals with central bank actions regarding the money supply and interest rates.
• Both are employed to achieve policy goals.
• Inflation (i.e., stable prices)
• Full employment (i.e., NAIRU)
• Economic growth
• However, the ‘Treasury View’ prevails.
• Monetary Policy
• Primary objective is ‘inflation targeting’.
• Specifically, to keep consumer price inflation to 2–3 per cent, on average, over the medium term.
• Central Banks tend to implement monetary policy via:
i. open market operations;
ii. discount rate; and
iii. reserve requirements.
, • Role of the Financial System
The role of the financial system is:
i. To facilitate the flow of funds (direct financing and indirect financing)
ii. To provide ways of dealing with incentive problems
iii. To facilitate financial market efficiency
iv. To provide the means to transfer and manage risk
v. To provide the mechanism to settle transactions (i.e., payments system)
vi. To facilitate the flow of funds (direct financing and indirect financing)
• Financial market (direct financing)
• Financial institutions (indirect financing)
• i. Flow of Funds: Financial Claims
• Financial claims are written promises (e.g. IOU)
• An agreement is made to:
i. pay a specific sum of money (the principal)
ii. plus interest for the privilege of borrowing money
iii. over a period of time (maturity of the loan).
• Financial claims are issued by deficit spending units (DSUs). These are considered liabilities.
• Financial claims are then purchased by surplus saving units (SSUs). These are considered
assets.
• ii. Managing Incentive Problems
• The three main incentive problems are:
• Information asymmetry
i. occurs when buyers and sellers do not have access to the same information.
• Adverse selection
i. occurs before a financial transaction takes place which can result in undesirable
(i.e., adverse) outcomes.
• Moral hazard
i. occurs after the transaction takes place. Engagement of behaviour different to what
was agreed to.
• iii. Financial Market Efficiency
• The three main financial market efficiency areas are:
i. Allocational Efficiency:
a. funds are allocated to their highest value use.
ii. Informational Efficiency:
a. market prices reflect all relevant information about securities.
