The Five Parts of the Financial System
- Money: Good which is used as a means of payment for exchanging goods. Kenya uses paper money, copper and silver coins as a as a means of payment. Further back people used things likes beads etc as a means of payment.
- Financial Instruments: Written legal obligations of one party to transfer something of value to another party at some future date under certain conditions. These obligations usually transfer resources from savers to investors. Examples: Stocks, bonds, insurance policies.
- Financial Markets: Markets where financial instruments are traded. Examples:
- Financial Institutions: These entities provide services and allow agents access to financial instruments and markets. Examples: Banks, securities firms, insurance companies.
- Central Banks: Government entity which monitors the state of the economy and conducts monetary policy. Example: The central Bank of Kenya.
The Five Core Principals of Money and Banking
- Time has Value:
Everyone prefers to have something sooner rather than later. This basic idea makes time influence the value of financial transactions.
Take an example of a buying a home. Every buyer has a choice either wait save and buy a home, or finance the home with a mortgage. Almost everyone takes the second option. The buyers use a mortgage to buy the home now, even though the total payments for the house will be higher with a mortgage than buying the house with savings. On the flip side, the lender had to give up the money to finance the house since that money cannot be used to immediate consumption there is a cost passed on to the lender. To make up for this cost the lender typical charges an interest rate on borrowed funds. This interest rate compensates the lender for delaying consumption.
- Risk Requires Compensation:
Time is not the only factor that generates interest rates. The risk associated with a financial transaction can also influence an interest rate. Simply, the riskier the transaction, the higher the interest rate. This explains why credit cards have high interest rates and student loans have low interest rates. In most situations, risk must be compensated. If not, certain transactions would never occur. Examples: insurance for the elderly, credit cards, small business loans.
- Information is the Basis for Decisions:
Information is gathered before a decision is made. The larger the decision the more information that is collected. Role of information or even the lack of information is key in financial arrangements. Examples: stock vs bond trades, health insurance.
- Market Set Prices and Allocate Resources:
Just as other parts of the economy, markets are the key to the entire financial system. The laws of supply and demand will dictate the prices of financial instruments and who will get these goods. Examples: insurance markets, Nairobi Securities Exchange.
- Stability Improves Welfare:
Stability is preferred throughout the financial system. Sometimes agents can do things which can help to maintain stability e.g. buying insurance. However, these tools only work on sources of volatility which we can control. Some shocks in the economy cannot be insured (business cycles). The desire of stability is the key reason we have things like unemployment insurance and progress taxes. The goal of stability is also a goal of monetary policy. Many moves by the central bank are driven by stability. Example: Raising the interest rate to curb inflation (make prices more stabile).
Money and How We Use It
Money takes on several meanings in everyday discussions. In this class, the word money takes on a specific definition which is that money is anything that can be readily used to make economic transactions. The following is the technical definition of Money:
An asset that is generally accepted as payment for goods and services or repayment of debt. No matter what we use as money (paper, gold, beads), every type of money has the same three basic characteristics:
- A Means of Payment
- A Unit of Account
- A Store of Value
- Means of Payment
The primary characteristic of money is that it is used as a means of payment. Almost all transactions will take money as a form of payment. This is because other forms of payment typically will not work. Without money, transactions would rely on barter. Barter is a situation where two agents exchange goods directly in a transaction. Suppose a baker and a farmer wish to make a transaction. The baker wants eggs from the farmer, and the farmer wants bread. In a barter situation, both parties have to want what the other party has. Thus we have what is called the “double coincidence of wants” problem. Money solves this problem.
- Unit of Account
Money is also a unit of account. A unit of account is simply how we measure prices and debts. In the Kenya, we measure prices in shillings and cents. This unit of measurement allows for a quick comparison of prices across goods. Remember, what is important is the relative prices of goods. So, the unit of account allows us to measure the price of each good relative to a shilling. Without this, we would have to construct relative prices for each good against each other good.
- Store of Value
Money is also an asset which can serve as a store of account. If money is to be valuable for transactions, it needs to be able to retain value over time. A dollar today needs to have the power to purchase goods in the future. Many other assets also serve as a store of value: stocks, bonds, and savings account. What makes money unique is it’s high liquidity. Liquidity is simply a measure of how easy it is to turn assets into consumption. Since, money serves as a means of payment it has a high liquidity. So, although money is not a perfect store of value, it loses buying power over time, the high liquidity can explain why everyone holds some of their assets as money.
The Payments System
The payments system is the organization of arrangements which allow for the exchange of goods and services. This system is how parties receive and pay funds in exchange for goods. Money is the core to this system, but as we will see, the economy no longer relies on passing along a few shillings. Technology has made many types of payments common throughout the economy.
- Commodity and paper monies
The form of money has evolved over time. In the beginning, money took the form of commodity money. Commodity money is a means of payment that is in terms of an actual good. Different places have used different things as money: Silk in China, butter in Norway, and most commonly precious metals like gold and silver. These monies a have one thing in common: intrinsic value. All of these goods have uses other than money. People could actually consume the money. The easiest way to prevent people from consuming money was to make money worthless (as far as consuming). Thus, governments issued paper money and coins which have little to no intrinsic value and the purchasing power of the money depends on the government backing the currency. In Kenya we use shillings for a couple of reasons. First, everyone else accepts them, and we expect to be able to use our currency in the future. Second, the law states that these bills can be used to pay for all debts, public and private. Thus, by law everyone must accept the Kenya shillings as a means of payment.
Currency is not the only way we pay for things. Another common technique is to write a check. First, it should be noted that a check is not legal tender; this is why some places do not take checks. A check is nothing more than an instruction for a bank to transfer funds from one account to another. The actual transfer is the payment for goods and services.
- Electronic Payments
The third and fasting growing form of payments are electronic payments. The two most common electronic payment instruments are credit and debit cards. A debit card works the same way as a check. The card sends an instruction to a bank to transfer money from one account to another. A credit card is a promise by a bank to lend money to the cardholder to make purchases. In this case, money is transferred from the bank to another account. The cardholder is taking out a loan which must be paid back to the bank with interest. Thus, credit cards are not money. More and more transactions are becoming electronic. The simple fact is that using a paper trail is more costly than electronic payments. To this end more and more forms are using automated clearinghouse transactions. The money is automatically withdrawal from your account.