Breifly explain the five core principles of money and banking?

Answer 1

TIME has value. A dollar today is worth more than a dollar a year from now. Why is this? (Several reasons: inflation erodes the buying power of money over time; having the money now means you can spend it now; having the money now means you can invest it and turn it into more money.) The reason we focus on is the interest that you can earn on your money when you set it aside. The longer you set it aside, the more interest you earn. Later, we'll relate this principle to the concept of present discounted value of future payments, or what they're worth today taking into account the interest you could be earning in the interim.

--An important aspect of the time value of money is that interest compounds over time. Ex. in book: a $10,000 car loan, at 6%. If you repaid the entire loan in one lump sum a year later, you'd pay $10,600 (original amount plus $600 interest). But in the example, the loan is to be paid off in monthly payments over four years, or 48 monthly payments of $235, and the total repayment is $11,280. Why? Interest compounds, or accumulates, from month to month.

2. RISK requires compensation. For securities like stocks and bonds, the higher the risk, the higher the return has to be. For individuals, minimizing the risk of such things as accidents, illness, and theft is worth the expense of monthly insurance premiums. (A note on usage: "Risk" refers to your potential losses, financial and otherwise, not merely to the probability of unwanted events. For example, fire insurance might not reduce the likelihood of your house burning down, but it will compensate you for the damage from your house burning down.)

3. INFORMATION is the basis for decisions. This rather general sentence relates to money, banking, and finance because we live in a world of imperfect information. It is hard for financial transactions to take place when one or both parties lack adequate information about the other, because one party could easily end up getting burned. As a result, banks and other financial institutions that make loans gather a considerable amount of information about their potential borrowers before advancing them money. The collection and provision of company financial information by government agencies like the Securities and Exchange Commission can aid the growth of financial markets by making them more transparent, thus reducing the information barrier for potential investors. Recent advances in computer and communications technology have greatly helped the spread of financial information, thereby paving the way for the growth of important new financial markets like the junk-bond market.

4. MARKETS set prices and allocate resources. Financial institutions and markets, by connecting savers with borrowers, allow for people's leftover money (savings) to be channeled into productive investment in capital (e.g., new technology, machinery, buildings). Financial markets for assets like stocks and bonds allow some companies, especially well-established companies, to obtain funds for new capital investment more cheaply than they could borrow from a bank. Other, less-established companies that cannot get approved for a bank loan can raise money by selling bonds in the junk-bond market (though at higher rates of interest, because these bonds are riskier, and risk requires compensation).

5. STABILITY improves welfare (i.e., well-being).

--Imagine that your next job pays you $3,500 a month (or $42,000 a year). Now imagine that your boss proposes to change your monthly pay to $1,000 times the roll of a die. That is, you'd have an equal chance of receiving $1,000, $2,000, $3,000, $4,000, $5,000, and $6,000, and the average of those numbers (or the expected value of your monthly pay) would still be $3,500. Would you do it? Most people would say no way.

--Real-life example: Professors at the college are officially paid on a nine-month schedule (i.e., nothing in June, July, and August), but we have the option of being paid the same amount stretched out over 12 months. I don't know of a single person who chose the 9-month option. Even though it's not really risky, because the irregularity is known in advance, it could be hard to manage.

--In the interest of stability in the financial sector, governments have created central banks to try to guard against bank failures and financial panics. (Most people think the bubble-and-bust economic fluctuations of 2003-2008 were not desirable.) The tasks of central banks have grown in recent years, as they are now expected to keep inflation low and stable, and also to avoid or minimize recessions.

--Bank deposit insurance is another example of a government intervention for the sake of financial and social stability.

A handy device for memorizing those five principles is the (inelegant) acronym "TRIMS" - for Time, Risk, Information, Markets, Stability. They're worth memorizing, as we will be returning to them again and again in this course.