Monetary Economics I

Lecture 1-2: The Financial System

Undergraduate Program
Faculty of Economics and Business
Universitas Gadjah Mada

2021
Learning Objectives of Meeting 2

§ STUDENTS CAN IDENTIFY THE STRUCTURE AND KEY

COMPONENTS OF FINANCIAL MARKETS

§ STUDENTS CAN ANALYZE THE PROBLEMS THAT

TRANSACTIONS COSTS, ADVERSE SELECTION, AND
MORAL HAZARD POSE FOR THE FINANCIAL MARKET

§ STUDENTS CAN IDENTIFY THE REASONS FOR AND

FORMS OF A GOVERNMENT SAFETY NET IN FINANCIAL
MARKETS
Lecture 2: The Financial System

Structure of Financial System

Economic Analysis of Financial Structure

Economic Analysis of Financial Regulation

Framework of Macroeconomics

Goods and Services

for consumption FIRMS
GOVERNMENT AND
Goods and Services
CENTRAL BANK for investment
Wage Payment
Government purchases Interest, Dividends

GOODS AND
FINANCIAL MARKET LABOR MARKET
SERVICES MARKET
Loans

Transfer

Payment for Goods Labor Supply

and services

Taxes HOUSEHOLDS
Focus of Monetary Economics

Monetary economics ….

§ focuses on the monetary and other

financial markets, the determination of the
interest rate, the extent to which these
influence the behavior of the economic
units and the implications of that influence
in the macroeconomic context.
Goods and Services
for consumption FIRMS
GOVERNMENT AND
Goods and Services
CENTRAL BANK for investment
Wage Payment
§ studies the formulation of monetary policy,
Government purchases Interest, Dividends
with respect to the supply of money and
GOODS AND
SERVICES MARKET
FINANCIAL MARKET LABOR MARKET manipulation of interest rates.
Loans

Transfer
Payment for Goods Labor Supply
and services

Taxes HOUSEHOLDS
Financial Market

Lender- funds FINANCIAL MARKET funds Borrower-

Saver Spenders

Domestic and Foreign: Financial market is a market in Domestic and Foreign:

§ Households which funds are transferred § Households
§ Businesses (direct or indirect) from people § Businesses
§ Governments who have an excess of available § Governments
funds to people who have a
shortage.

Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income.
Function of Financial Market

§ Financial markets are crucial to promoting a greater

economic efficiency by channeling funds from people who
do not have a productive use for them to those who do.
§ Indeed, well functioning financial markets are a key factor in
producing high economic growth.
§ Activities in financial markets also have direct effects on
personal wealth, the behavior of businesses and consumers,
and the cyclical performance of the economy.
Financial Market: Flows of Fund

Lender- funds FINANCIAL MARKET funds Borrower-

Saver Spenders

Financial intermediaries
Direct finance
Indirect finance

The arrows show that funds flow from lender-savers to borrower-spenders via two routes:
1. Direct finance: Borrowers borrow funds directly from financial markets by selling securities.
2. Indirect finance: A financial intermediary borrows funds from lender-savers and then uses
these funds to make loans to borrower-spenders.
Financial Market: Structure

FINANCIAL MARKET
Money Capital
1 Market Market 2

The money market is a financial The capital market is the market in

market in which only short-term which longer term debt instruments
debt instruments (generally those (generally those with original maturity
with original maturity terms of less terms of one year or greater) and
than one year) are traded. equity instruments are traded
Financial Market: Structure

FINANCIAL MARKET
Money Capital
1 Market Market 2

Stock market is a financial market in

Equity/Stock which claims on the earnings and
2.1
Market assets of corporations (shares of
stock) are traded.

2.2 Debt/Bond Bond market is a financial market in

which a debt security, that promises
Market
to make periodic payments for a
specified period of time, are traded.
Financial Market: Instruments

FINANCIAL MARKET
Money Capital
Market Market

INSTRUMENTS OF STOCK
MARKET:
INSTRUMENTS OF MONEY Equity/Stock
MARKET: § Stocks/equities
Market
§ Treasury Bills § Derivatives (e.g. ETF)

§ Certificates of Deposit
INSTRUMENTS OF BOND
§ Commercial Paper
MARKET:
Debt/Bond
§ Repurchase Agreements
Market § Bond
§ Fixed income securities
(e.g. MBS)
Financial Market: Money Market

Money market instruments consist of

§ Treasury Bills is short-term debt instruments of
the government. which are issued in one-, three-,
Principal Money Market Instruments
and six-month maturities to finance the federal
government
§ Certificate of deposit (CD) is a debt instrument
sold by a bank to depositors that pays annual
interest of a given amount and at maturity pays
back the original purchase price.
§ Commercial paper is a short-term debt
instrument issued by large banks and well-
known corporations.
§ Repurchase agreements (repos) are effectively
short-term loans (usually with a maturity term of
less than two weeks) for which Treasury bills
serve as collateral, an asset that the lender
receives if the borrower does not pay back the
loan.
Financial Market: Capital Market

Principal Capital Market Instruments

Capital market instruments are debt and
equity instruments with maturities of
greater than one year.
§ Stocks are equity claims on the net
income and assets of a corporation
§ Mortgages are loans to households or
firms to purchase land, housing, or
other real structures, in which the
structure or land itself serves as
collateral for the loans.
§ Bond is a debt security that promises
to make periodic payments for a
specified period of time.
Financial Market: Primary Market

FINANCIAL MARKET
Money Capital
Market Market

Primary Market
Equity/Stock
A primary market is a financial market in Market
which new issues of a security, such as a Secondary Market
bond or a stock, are sold to initial buyers by
the corporation or government agency
borrowing the funds. Primary Market
Debt/Bond
Market
Secondary Market
The Primary Market

§ The primary markets for securities are not well known to the
public because the selling of securities to initial buyers often
takes place behind closed doors.
§ An important financial institution that assists in the initial sale of
securities in the primary market is the investment bank.
§ The investment bank does this by underwriting securities: It
guarantees a price for a corporation’s securities and then sells
them to the public.
Financial Market: Secondary Market

FINANCIAL MARKET
Money Capital
Market Market

Primary Market
Equity/Stock
A secondary market is a financial market in Market
which securities that have been previously Secondary Market
issued can be resold.

Primary Market
Debt/Bond
Market
Secondary Market
The Secondary Market

§ Securities brokers and dealers are crucial to a well-functioning

secondary market.
§ Brokers are agents of investors who match buyers with sellers
of securities; dealers link buyers and sellers by buying and
selling securities at stated prices.
§ Examples: The New York Stock Exchange and NASDAQ
(National Association of Securities Dealers Automated
Quotation System), foreign exchange markets, futures
markets, and options markets.
The Secondary Market

Secondary markets can be organized in two ways:

1. Exchange market: Buyers and sellers of securities (or their
agents or brokers) meet in one central location to conduct
trades.
2. Over-the-counter (OTC) market: Dealers at different locations
who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to
them and is willing to accept their prices.
The Secondary Market
FUNCTION OF SECONDARY MARKETS

Secondary markets make it Secondary markets determine the

1 easier and quicker to sell these 2 price of the security that the issuing
financial instruments to raise firm sells in the primary market.
cash; that is, they make the
financial instruments more liquid. The higher the security’s price in the
secondary market, the higher the
The increased liquidity of these price the issuing firm will receive for
instruments then makes them a new security in the primary
more desirable and thus easier market, and hence the greater the
for the issuing firm to sell in the amount of financial capital it can
primary market. raise.
Financial Market Instruments

Sources of External Funds for Nonfinancial Businesses Sources of External Funds for
Nonfinancial Businesses

§ The Bank Loans category is made

up primarily of loans from depository
institutions
§ The Nonbank Loans are primarily
loans by other financial
intermediaries
§ The Bonds category includes
marketable debt securities, such as
corporate bonds and commercial
paper
§ Stock consists of new issues of new
equity (stock market shares).
Financial Market Instruments: US

Household Holdings of Selected

Financial Assets (percentage of
total financial assets held) in
United States (US)

The table reports holdings of

assets, such as stocks and bonds,
that are supplied by financial
markets, and assets, such as bank
deposits and mutual fund shares,
that are supplied by financial
intermediaries.
Capital Market Instruments: Indonesia

Trading Summary in Indonesia Stock Exchange 2020

MARKET VALUE FREQUENCY Trading Summary in Indonesia

Stock Rp 2,228,798 Billion 163,938 Stock Exchange
Rights Rp 108.59 Billion 31.6
The table reports the value of
Warrants Rp 2,237.68 Billion 2,511.8 capital market instruments in
ETFs Rp 194.12 Billion 23.1 Indonesia, such as stocks and
Government Bond Rp 10,624,628 Billion 468,387 bonds, that are supplied by
Corporate Bond Rp 377,544 Billion 37,788 financial markets.
Lecture 2: The Financial System

Structure of Financial System

Economic Analysis of Financial Structure

Economic Analysis of Financial Regulation

Indirect Finance:
Financial Intermediation

Lender- funds FINANCIAL MARKET funds Borrower-

Saver Spenders

Indirect finance Indirect finance

Financial intermediaries

The process of indirect financing using financial intermediaries, called

financial intermediation, is the primary route for moving funds from
lenders to borrowers.
Type of Financial Intermediary

Lender- funds FINANCIAL MARKET funds Borrower-

Saver Spenders

Depository Contractual savings Investment

1 2 3
institutions institutions intermediaries
Type of Financial Intermediary
DEFINITION: Depository institutions are financial intermediaries that
accept deposits from individuals and institutions and make loans.

EXAMPLE: Commercial banks, savings and loan associations,

Depository mutual savings banks, and credit unions.
1
institutions
PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
Type of Financial Intermediary
DEFINITION: Contractual savings institutions are financial
intermediaries that acquire funds at periodic intervals on a
contractual basis.

Contractual EXAMPLE: Insurance companies and pension funds.

2
savings
institutions PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
Type of Financial Intermediary
DEFINITION: This category of financial intermediary includes
finance companies, mutual funds, money market mutual funds, and
hedge funds.

Investment
3
intermediaries
PRIMARY ASSETS AND LIABILITIES OF DEPOSITORY
INSTITUTION
Financial Intermediary: United States

Primary Financial
Intermediaries and Value of
Their Assets
The table describes the value of
assets of the financial
intermediaries in each category.
Financial Intermediary: Indonesia
TIPE LEMBAGA KEUANGAN JUMLAH LEMBAGA JUMLAH ASET
1 BANK
1.1 BANK UMUM 110 Rp 8,725.91 T
1.1 Bank Persero 4
1.2 BUSN Devisa 41
1.3 BUSN Non Devisa 19
1.4 BPD 27
1.5 Bank Campuran 11
1.6 Bank Asing 8
1.2 BANK: BPR 1520 Rp 148.05 T
2 ASURANSI 139 Rp 1,312.71 T Financial Intermediaries in
1.1. Asuransi Jiwa
1.2. Asuransi Umum
54
74
Indonesia
1.3. Reasuransi 6
1.4. Asuransi Wajib 3 The table describes the number of
1.5. Asuransi Sosial (BPJS) 2
3 DANA PENSIUN 217 Rp 293.60 T financial intermediaries in Indonesia
2.1. DPPK-PPMP
2.2. DPPK-PPIP
151
43
in 2020 (July – temporary figures
2.3. DPLK
4 LEMBAGA PEMBIAYAAN
23
236 Rp 571.94 T
based on Indonesia Financial
3.1. Perusahaan Pembiayaan 177 Service Authority's Database.
3.2. Modal Ventura 57
3.3. PP Infrastruktur 2
5 LEMBAGA KEUANGAN KHUSUS 110 Rp 209.95 T
4.1. LPEI 1
4.2. Pergadaian 85
4.3. Lembaga Penjamin 21
4.4. PT SMF (Persero) 1
4.5. PT PNM (Persero) 1
4.6. PT Danareksa (Persero) 1
6 LEMBAGA KEUANGAN MIKRO 146 Rp 0.61 T
7 FINTECH 147 Rp 3.19 T
The Importance of Indirect Finance

Lender- funds FINANCIAL MARKET funds Borrower-

Saver Spenders

Indirect finance Indirect finance

Financial intermediaries

Why are financial intermediaries and indirect finance so important in

financial markets?
To answer this question, we need to understand the roles of
transaction costs, risk sharing, and information costs in financial
markets.
Transaction Costs

money spent in carrying out financial Direct Finance Indirect Finance

Transaction costs (i.e. the time and

Lender Lender

How Financial Intermediaries

Financial Financial Reduce Transaction Costs?
Market Market Economies of Scale
transactions)

Banks achieve economies

of scale in making loans by
using standardized loan
contracts, having specialized
loan officers, and taking
Borrower Borrower advantage of sophisticated
computer systems
Low Transaction Costs: The Benefit

Direct Finance Indirect Finance

Lender Lender
High Transaction Cost

Low Transaction Cost

1. Liquidity Services
A financial intermediary
can provide its customers
Financial Financial
with liquidity services,
Market Market services that make it
easier for customers to
conduct transactions.

Borrower Borrower
Low Transaction Costs: The Benefit

Direct Finance Indirect Finance

Lender Lender
High Transaction Cost

Low Transaction Cost

2. Risk Sharing
A financial intermediary
help reduce the exposure
Financial Financial
of investors to risk—that
Market Market is, uncertainty about the
returns investors will earn
on assets.

Borrower Borrower
Transaction Costs: A Recap

§ Small investors rarely lend money directly because of

transactions costs.
§ Financial intermediaries can reduce transactions costs partly
because of economies of scale, which refers to the reduction
in average cost that results from an increase in volume.
§ For instance, banks achieve economies of scale in making
loans by using standardized loan contracts, having specialized
loan officers, and taking advantage of sophisticated computer
systems.
Lecture 2: The Financial System

Structure of Financial System

Economic Analysis of Financial Structure

Economic Analysis of Financial Regulation

Asymmetric Information
Many financial transactions involve asymmetric information, with one party to the transaction
having better information than the other party.

Lender

Asymmetric information is a situation that

arises when one party’s insufficient
Financial knowledge about the other party involved
Markets in a transaction makes it impossible for
the first party to make accurate decisions
when conducting the transaction

Borrower
Asymmetric Information
Economists distinguish between two problems arising from asymmetric information: (1)
Adverse selection, dan (2) Moral hazard.

Lender

Adverse selection Transaction Moral Hazard

in Financial
!"#$%&# '&()*(+',%) Markets !($'#& '&()*(+',%)

1 Adverse selection occurs Moral hazard occurs

2 after the transaction has
before the transaction
takes place. Borrower taken place.
Asymmetric Information

Asymmetric information results in two problems:

§ Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an
undesirable (adverse) outcome—the bad credit risks—are the
ones who most actively seek out a loan and are thus most
likely to be selected.
§ Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable
(immoral) from the lender’s point of view, because they make it
less likely that the loan will be paid back.
Asymmetric Information Problems
Financial Regulation: A Rationale

§ The concepts of asymmetric information, adverse selection,

and moral hazard help explain why governments pursue
financial regulation.

§ The government regulates financial markets for two main

reasons: to increase the information available to investors and
to ensure the soundness of the financial system.
Financial Regulation: A Rationale

Lender

Asymmetric Information
Financial
Market
Asymmetric Information

Bank Panic

Borrower
Financial Regulation: A Rationale

Lender

Asymmetric Information
Financial
Market
Asymmetric Information

Bank Panics

Borrower Uncertainty about the health of the banking system in general can lead
to runs on both good and bad banks, and the failure of one bank can
hasten the failure of others (referred to as the contagion effect).
Government Safety Net

Lender

Asymmetric Information
Financial
Market
Asymmetric Information

Bank Panics

Borrower

Government Safety Net

Government Safety Net

Lender

Asymmetric Information
Financial
Market
Asymmetric Information

Bank Panics

Borrower

A government safety net for depositors can short-circuit runs on banks and
bank panics, and by providing protection for the depositor, it can overcome
depositors’ reluctance to put funds into the banking system.
Government Safety Net

Lender

Asymmetric Information
Financial
Market
Asymmetric Information

Bank Panics

Borrower

Government Safety Net

1. Deposit insurance
2. Lender of last resort
Handling A Failed Bank

Two primary methods to handle a failed bank.

1. The payoff method: regulator allows the bank to fail and pays off
depositors up to the insurance limit.
2. The purchase and assumption method: a regulator reorganizes the bank,
typically by finding a willing merger partner who assumes (takes over) all
of the failed bank’s liabilities so that no depositor or other creditor loses a
penny.
Drawbacks of the Government
Safety Net

Although a government safety net can help protect depositors

and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net

Although a government safety net can help protect depositors

and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
With a safety net, depositors and creditors know they will not suffer losses
if a financial institution fails, so they do not impose the discipline of the
marketplace on these institutions by withdrawing funds when they
suspect that the financial institution is taking on too much risk.
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net

Although a government safety net can help protect depositors

and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
Because depositors and creditors protected by a government safety net have little
reason to impose discipline on financial institutions, risk-loving entrepreneurs might find
the financial industry a particularly attractive one—they know they will be able to engage
in highly risky activities.
§ “Too Big to Fail”
Drawbacks of the Government
Safety Net

Although a government safety net can help protect depositors

and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing.
§ Moral Hazard and the Government Safety Net
§ Adverse Selection and the Government Safety Net
§ “Too Big to Fail”
Regulators are reluctant to close down large financial institutions and
impose losses on their depositors and creditors because doing so might
precipitate a financial crisis.
Types of Financial Regulation

There are eight basic types of financial regulation aimed at lessening

asymmetric information problems and excessive risk taking in the financial
system:
1. Restrictions on asset holdings
2. Capital requirements
3. Prompt corrective action
4. Chartering and examination
5. Assessment of risk management
6. Disclosure requirements
7. Consumer protection
8. Restrictions on competition
THANK YOU