FIVE CORE PRINCIPLES OF MONEY AND BANKING

1. Time has Value

Time affects the value of financial instruments.

Interest payments exist because of time properties of financial instruments.

Example

At 6% interest rate, 4 year loan of $10,000 for a car Requires 48 monthly installments of $263.02 each Total repayment = $263.02×48 = $12,624.96 $12,624.96 > $10,000 (Total repayment) (Amount of loan).

Reason: you are compensating the lender for the time during which you use the funds.

2. Risk Requires Compensation

In a world of uncertainty, individuals will accept risk only if they are compensated in some form.

The world is filled with uncertainty; some possibilities are welcome and some are not.

To deal effectively with risk we must consider the full range of possibilities:

Eliminate some risks,

Reduce others,

Pay someone else to assume particularly onerous risks, and

Just live with what’s left.

Investors must be paid to assume risk, and the higher the risk the higher the required payment.

Car insurance is an example of paying for someone else to shoulder a risk you don’t want to take.

Both parties to the transaction benefit

Drivers are sure of compensation in the event of an accident.

The insurance companies make profit by pooling the insurance premiums and investing them.

Now we can understand the valuation of a broad set of financial instruments.

E.g., lenders charge higher rates if there is a chance the borrower will not repay.

3. Information is the basis for decisions

We collect information before making decisions.

The more important the decision the more information we collect.

The collection and processing of information is the basis of foundation of the financial system.

Some transactions are arranged so that information is NOT needed.

Stock exchanges are organized to eliminate the need for costly information gathering and thus facilitate the exchange of securities.

One way or another, information is the key to the financial system.

4. Markets set prices and allocate resources

Markets are the core of the economic system; the place, physical or virtual,

Where buyers and sellers meet.

Where firms go to issue stocks and bonds,

Where individuals go to purchase assets.

Financial markets are essential to the economy,

Channeling its resources.

Minimizing the cost of gathering information.

Making transactions.

Well-developed financial markets are a necessary precondition for healthy economic growth.

The role of setting prices and allocation of resources makes the markets vital sources of information.

Markets provide the basis for the allocation of capital by attaching prices to different stocks or bonds.

Financial markets require rules to operate properly and authorities to police them.

The role of the govt. is to ensure investor protection.

Investor will only participate if they perceive the markets are fair.

5. Stability improves welfare

To reduce risk, the volatility must be reduced.

Govt. policymakers play pivotal role in reducing some risks.

A stable economy reduces risk and improves everyone’s welfare.

By stabilizing the economy as whole monetary policymakers eliminate risks that individuals can’t and so improve everyone’s welfare in the process.

Stabilizing the economy is the primary function of central banks.

A stable economy grows faster than an unstable one.