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Chapter 2
Financial Assets, Money,
Financial Transactions, and
Financial Institutions
2-3
 Learning Objectives 
• To learn about the channels through which funds flow between
lenders and borrowers within the global system of money and
capital markets.
• To discover the nature and characteristics of financial assets –
how they are created and destroyed by decision-makers within
the financial system.
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 Learning Objectives 
• To explore the critical roles played by money within the
financial system and the linkages between money and
inflation in the prices of goods and services.
• To examine the important functions carried out by financial
intermediaries in lending and borrowing and in creating and
destroying financial assets.
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Introduction: The Role of Financial
Assets
• The financial system is the mechanism through which loanable
funds reach borrowers.
• Through the operation of the financial markets, money is
exchanged for financial claims in the form of stocks, bonds,
and other securities, thereby transforming savings into
investment so that the economy can grow.
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The Creation of Financial Assets
A financial asset is …
• a claim against the income or wealth of a business firm,
household, or unit of government,
• represented usually by a certificate, receipt, computer record
file, or other legal document,
• and usually created by or related to the lending of money.
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Characteristics of Financial Assets
• Financial assets are sought after because they promise future
returns to their owners and serve as a store of value
(purchasing power).
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Characteristics of Financial Assets
• They do not depreciate like physical goods, and their physical
condition or form is usually not relevant in determining their
market value.
• They have little or no value as a commodity and their cost of
transportation and storage is low.
• Financial assets are fungible – they can easily be changed in
form and substituted for other assets.
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Different Kinds of Financial Assets

Any financial asset that is generally accepted in payment for
purchases of goods and services is money. Currency and
checking accounts are forms of money.
 Equities represent ownership shares in a business firm and are
claims against the firm’s profits and against proceeds from the
sale of its assets. Common stock and preferred stock are
equities.
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Different Kinds of Financial Assets


Debt securities entitle their holders to a priority claim over the
holders of equities to the assets and income of an economic
unit. They can be negotiable or nonnegotiable. Examples
include bonds, notes, accounts payable, and savings deposits.
Derivatives have a market value that is tied to or influenced by
the value or return on a financial asset. Examples include
futures contracts, options, and swaps.
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How Financial Assets Are Born
• To acquire assets, households and business firms may use
current income and accumulated savings – internal financing.
• An economic unit may also raise funds by issuing financial
liabilities (debt) or stock (equities), provided that a buyer can
be found – external financing.
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Balance Sheets of Units in a Simple Financial System
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Unit Balance Sheets Following the Purchase of
Equipment and the Issuance of a Debt Security
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Unit Balance Sheets Following the Purchase of
Equipment and the Issuance of Stock
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Financial Assets and the Financial
System
• The act of borrowing or of issuing new stock simultaneously
gives rise to the creation of an equal volume of financial
assets.
• All financial assets are recorded as a liability or claim on some
other economic unit’s balance sheet.
 Volume of financial assets created for lenders
= Volume of liabilities issued by borrowers
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Financial Assets and the Financial
System
• For the balance sheet of any economic unit,
Total assets = Total liabilities + Net worth
where assets = real assets + financial assets
• For the whole economy and financial system,
Total financial assets = Total liabilities

So, for the economy as a whole,
Total real assets = Total net worth
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Financial Assets and the Financial
System
• So, society increases its wealth only by saving and increasing
the quantity of its real assets, for these assets enable the
economy to produce more goods and services in the future.
• However, the financial system provides the essential channel
necessary for the creation and exchange of financial assets
between savers and borrowers so that real assets can be
acquired.
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Lending and Borrowing in the Financial
System
• Economists John Gurley and Edward Shaw pointed out that
each business firm, household, or unit of government active in
the financial system must conform to:
R – E = FA – D
where
R
E
FA
D
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=
=
=
=
Current income receipts
Expenditures out of current income
Change in holdings of financial assets
Change in debt and equity outstanding
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Lending and Borrowing in the Financial
System
• So, for any given time period, each economic unit must fall
into one of three groups:
 Deficit-budget unit (DBU):
E > R, so D > FA (net borrower of funds)

Surplus-budget unit (SBU):
R > E, so FA > D (net lender of funds)

Balanced-budget unit (BBU):
R = E, so D = FA (neither net lender nor borrower)
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Lending and Borrowing in the Financial
The U.S. System
Economy in 2003
($ Billions)
Major Sectors
of the
Economy
Net Acquisitions
Net
Net Lender (+)
of Financial Increase in
or Net
Assets
Liabilities Borrower (-)
Households
Nonfinancial business
firms
State and local
governments
Federal government
International sector:
foreign investors
and borrowers
$770.9
$912.6
$ - 141.7
709.3
540.1
+ 169.2
70.0
141.6
- 71.6
- 3.0
421.5
- 424.5
810.5
234.6
+ 575.9
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
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Lending and Borrowing in the Financial
System
• The global financial system permits businesses, households,
and governments to adjust their financial position from that of
net borrower (DBU) to net lender (SBU) and back again,
smoothly and efficiently.
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What is Money?
• All financial assets are valued in terms of money, and flows of
funds between lenders and borrowers occur through the
medium of money.
• Money itself is a financial asset, because all forms of money in
use today are claims against some public or private institution.
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Alternative Definitions of Money
M3
M2
M1
The most
liquid forms
of money,
namely
currency and
checkable
deposits.
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+
Household
holdings of
savings
deposits,
small time
deposits, and
retail money
market
mutual funds.
Institutional
money funds and
certain managed
liabilities of
depositories,
namely large
+ time
deposits,
repurchase
agreements, and
Eurodollars.
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Alternative Definitions of Money
Billions of Dollars
Money Supply Measures
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
September 2004
September 2001
$6.3 trillion
$5.3 trillion
$9.3 trillion
$7.8 trillion
Euros & Repos
Institutional MMFs
Large Time Deposits
Retail Money Funds
Small Time Deposits
$1.3 trillion
$1.2 trillion
Checkable Deposits
Currency
Savings Deposits
M1
M2
M2
M1
M3
Source: http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html
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The Functions of Money



Money serves as a standard of value (or unit of account) for all
goods and services.
Money serves as a medium of exchange, such that buyers and
sellers no longer need to have an exact coincidence of wants in
terms of quality, quantity, time, and location.
Money serves as a store of value – a reserve of future
purchasing power. However, the value of money can
experience marked fluctuations.
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The Functions of Money

Money functions as the only perfectly liquid asset in the
financial system. It exhibits price stability, ready marketability,
and reversibility.
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The Value of Money and Other Financial
Assets and Inflation
• Inflation refers to a rise in the average price level of all goods
and services.
• Inflation lowers the value or purchasing power of money and
is a special problem in the money and capital markets because
it can damage the value of financial contracts.
• The opposite of inflation is deflation, where the average level
of prices for goods and services actually declines.
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The Value of Money and Other Financial
Assets and Inflation
• Inflation is commonly measured using price indices, such as:
- the Consumer Price Index (CPI),
- the Producer Price Index (PPI), or
- the Gross Domestic Product (GDP) Deflator Index.
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The Value of Money and Other Financial
Assets and Inflation
• Suppose the U.S. CPI rises from 100 to 125 over a five-year
period.
 Over the five-year period, the cost-of-living index climbed
125  100  0.25 or 25% ...
100
and the U.S. dollar’s relative purchasing power fell to
1
100  0.8 .
125
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The Evolution of Financial Transactions
• Financial systems change constantly in response to shifting
demands from the public, the development of new technology,
and changes in laws and regulations.
• Over time, the ways of carrying out financial transactions have
evolved in complexity.
• In particular, the transfer of funds from savers to borrowers
can be accomplished in at least three different ways.
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The Evolution of Financial Transactions

Direct Finance – Direct lending gives rise to direct claims
against borrowers.
Flow of funds
Borrowers
(DBUs)
(loans of spending power for an
agreed-upon period of time)
Lenders
(SBUs)
Primary Securities
(stocks, bonds, notes, etc.,
evidencing direct claims against
borrowers)
 Simple  Difficult to match & risky
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The Evolution of Financial Transactions

Semidirect Finance – Direct lending with the aid of market
makers who assist in the sale of direct claims against
borrowers.
Primary Securities
Primary Securities
(direct claims
against
borrowers)
(direct claims
against
borrowers)
Borrowers
(DBUs)
Proceeds of
security sales
Security
brokers,
dealers, &
investment
bankers Flow of funds
(less fees and commissions)
Lenders
(SBUs)
(loans of
spending power)
 Lower search (information) costs
 Risky & matching is still required
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The Evolution of Financial Transactions

Indirect Finance – Financial intermediation of funds.
Secondary Securities
Primary Securities
(indirect claims against ultimate
(direct claims against
ultimate borrowers in the
form of loan contracts,
stocks, bonds, notes, etc.)
Ultimate
borrowers
(DBUs)
borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts, etc.)
Financial intermediaries
(banks, savings and loan associations,
insurance companies, credit unions,
mutual funds, finance companies,
pension funds)
Ultimate
lenders
(SBUs)
Flow of funds
Flow of funds
(loans of spending power)
(loans of spending power)
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 Low risk & affordable
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Relative Size and Importance of
Major Financial Institutions
Total Financial Assets Held by U.S. Financial Institutions
($ billions at year-end)
1970
1980
Financial intermediaries:
Commercial banks
$489 $1,248
S&L assoc. and savings banks
252
794
Life insurance companies
201
464
Private pension funds
110
413
Investment co. (mutual funds)
47
64
State & local gov’t pension funds
60
198
Finance companies
63
199
Property-casualty insurance co.
50
174
Money market funds
––
74
Credit unions
18
72
Mortgage companies
––
16
Real estate investment trusts
4
6
Other financial institutions:
Security brokers and dealers
16
36
1990
2000 2004Q1
$3,340
1,358
1,357
1,629
602
820
611
534
498
202
49
13
$6,488
1,219
3,204
4,587
4,457
2,290
1,138
872
1,812
441
36
62
$8,044
1,557
3,849
4,260
4,890
2,303
1,401
1,069
1,972
635
32
133
262
1,221
1,725
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Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts
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Classification of Financial Institutions
• Depository institutions derive the bulk of their loanable funds
from deposit accounts sold to the public.
- Commercial banks, savings and loan associations, savings banks,
credit unions.
• Contractual institutions attract funds by offering legal
contracts to protect the saver against risk.
- Insurance companies, pension funds.
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Classification of Financial Institutions
• Investment institutions sell shares to the public and invest the
proceeds in stocks, bonds, and other assets.
- Mutual funds, money market funds, real estate investment trusts.
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Portfolio (Financial-Asset) Decisions by
Financial Institutions
Portfolio decisions – deciding what financial assets to buy or sell
– are affected by:
 The relative rate of return and risk attached to different
financial assets.

The cost, volatility, and maturity of incoming funds provided
by surplus-budget units.
- Hedging principle – the approximate matching of the maturity of
financial assets held with liabilities taken on.
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Portfolio (Financial-Asset) Decisions by
Financial Institutions

The size of the individual financial institution.
- Larger financial institutions tend to have greater diversification
in their sources and uses of funds and economies of scale.

Regulations and competition.
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Disintermediation of Funds
• Disintermediation refers to the withdrawal of funds from a
financial intermediary by the ultimate lenders (SBUs) and the
lending of those funds directly to the ultimate borrowers
(DBUs).
• Disintermediation involves the shifting of funds from indirect
finance to direct and semidirect finance.
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Disintermediation of Funds
Financial Disintermediation
Primary Securities
Ultimate
borrowers
(DBUs)
Financial
intermediaries
Ultimate
lenders
(SBUs)
Loanable funds
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Disintermediation of Funds
• Some new forms of disintermediation have appeared in recent
years.
 Initiation by financial intermediaries: Some banks sold off
some of their loans because of difficulties in raising capital.
 Initiation by borrowing customers: Some borrowing customers
learned how to raise funds directly from the open market.
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Bank-Dominated Versus Security-Dominated
Financial Systems
• Lesser-developed financial systems are often bank-dominated
financial systems, in which banks and other similar institutions
dominate in supplying credit and attracting savings.
• The more mature systems today are becoming securitydominated financial systems, in which traditional
intermediaries play lesser roles and growing numbers of
borrowers sell securities to the public to raise the funds they
need.
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Markets on the Net
•
•
•
•
•
Bondsonline at www.bondsonline.com
Encyclopedia.com at encyclopedia.com
Federal Reserve Bank of Atlanta at www.frbatlanta.org
Federal Reserve Bank of New York at www.ny.frb.org
Moody’s Investor Service at www.moodys.com
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Markets on the Net
•
•
•
•
•
Money Magazine at www.money.com
New York Stock Exchange at www.nyse.com
Standard & Poor’s Corporation at www.standardandpoor.com
The Bond Market Association at www.investinginbonds.com
U.S. Bureau of Economic Analysis at www.bea.gov
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Markets on the Net
• U.S. Bureau of Labor Statistics at www.bls.gov
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Chapter Review
•
•
•
•
•
•
Introduction: The Role of Financial Assets
The Creation of Financial Assets
Characteristics of Financial Assets
Different Kinds of Financial Assets
How Financial Assets Are Born
Financial Assets and the Financial System
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Chapter Review
• Lending and Borrowing in the Financial System
• Money as a Financial Asset
- What is Money?
- The Functions of Money
• The Value of Money and Other Financial Assets and Inflation
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Chapter Review
• The Evolution of Financial Transactions
- Direct Finance
- Semidirect Finance
- Indirect Finance and Financial Intermediation
• Relative Size and Importance of Major Financial Institutions
• Classification of Financial Institutions
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Chapter Review
• Portfolio (Financial-Asset) Decisions by Financial
Intermediaries and Other Financial Institutions
• Disintermediation of Funds
- New Types of Disintermediation
• Bank-Dominated Versus Security-Dominated Financial
Systems
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