 My lecture here, I want to give you a little 45-minute talk on the place and the role of finance and financial markets in a free society And it's in the sequencing of classes It's very apt that it comes right after Professor Herbner's talk on fractional reserve banking Because in the last lecture that you listened to he talked about some of the problems they you know the why we have fractional reserve banking where it came from but really what are the problems that it that it creates and You know the problems They're really not unknown all economists understand these problems. I mean Lucas do you teach intro econ or intermediate macro? I mean it's pretty standard in the textbook that you talk about the problems of fractional reserve banking But then you know you kind of brush them aside and well, that's the that's the banking system we have and it's better than nothing so that's kind of it and That all said we have this fractional reserve banking system and for us when you personally need financing Probably the first place you go to is mum and dad, but then after mum and dad If you're like me and then after you know after your parents cut you off finally Then you go to the bank so you want to finance your education go to the bank take out a loan You want to buy a car go get a consumer loan go you want to buy a house fantastic? That's that's what banks are there for right you go and borrow from the bank And the same time if you have savings if you want to make an investment oftentimes you go to your bank to make investments I mean you have it you have some savings You're in the bank anyway sure I'll buy a savings product and it's very strange because the bank is the first place We go to for most of our savings and investing decisions Are investing and and lending decisions rather? But professor Herbner just said well, you know fractional reserve banks There's a lot of very difficult thorny issues with them and they don't function all that well or as well as you think So I want to give you kind of the alternative of where Financing would take place and how it would take place in a free society one without fractional reserve banks So to just get a little bit of brief terminology out of the way finance if you want to give it a concise to such Definition it's just the study of investments But included in investments are many subtopics that are very important and some of them You haven't gotten to yet in the sequencing of classes The time value of money if you've taken an intro finance or economics class This will oftentimes come up just the idea that what's the expression a bird in the hand is worth two in the Bush is that how it goes you'd prefer to have things now rather than wait into the future for them I'm not going to get into that right now because professor Herbner tomorrow will give a lecture devoted to time preference Interest rates and really the time value of money, but just suffice to accept right now That we would prefer to have money now versus the same amount of money in the future The concepts of risk and uncertainty are inherent in investment decisions because you're buying an asset today in Order to get a sum of money in the future So you don't know how much you're going to get or whether it will pay out or anything like that Legal regimes are oftentimes important like for example You know we'll say well the big distinction between stocks and bonds as investment vehicles has to do with the legal regimes that That bond holders are secured creditors and they're higher in the hierarchy of who's gonna get paid off if the Asset goes bankrupt Again, I'm not gonna get into it But the topic of finance includes many subsidiary topics that will come up throughout the remaining days of Mises University And the five actual markets themselves which are much more important for this lecture Are just the place where lenders and borrowers meet together in order to strike deals that are mutually beneficial To make investments or to borrow from each other and these lenders and borrowers if you're a lender It would be somebody again these terms haven't been introduced They won't until tomorrow, but somebody with low time preference is somebody who's willing to not consume today But wait until the future and somebody with high time preference is somebody who lives in the here and now wants to spend money today And you know is not willing to wait until the future and really the financial market is where these people with different Preferences can meet in the same way that the t-shirt market is where people with a high time high preference for t-shirts Meet with stores who have a low preference for t-shirts. They get together and they strike deals Financial markets are no different. It's just that the the preferences are a little bit distinct and the actual financial markets that we have are You know the normal ones well Actually the normal ones you think of are probably the capital markets the stock and bond markets Then you have money markets, which are like short-term lending some oftentimes through banks actually but that's bad I don't want to get into that futures markets a little bit more complex or commodities markets, you know buying Buying wheat gold whatever have you on an unorganized exchange So that's just as some a brief intro on the type of markets we're looking at But really what's important is the preferences that people who are meeting in these financial markets actually have So here's our preference ranking basically from yesterday Person a would most like to have a car today Then he would like to have ten thousand dollars in his pocket And if not that he'd prefer to have ten thousand five hundred dollars next year and dot dot dot all the way down Then he'd like to talk to Joe Salerno And I shouldn't be so hard on Joe because I just didn't have room to extend the preference ranking down But Dave Howden isn't even you know, he's like way down there The one hundredth preference rank So Joe's actually doing really well and then person B Person B is a little bit different, which is important He would most prefer to have ten thousand five hundred one year from now Then he'd like to have ten thousand today Then he'd like to have nine thousand today dot dot dot all the way down to having a chat with David Gordon It's also not here. So even I'm not even anywhere near this eye on David Gordon's preference ranking and The important thing when you look at person a and person B is that they have reverse preferences Because right here person a would much rather have ten thousand dollars today than ten thousand five hundred next year Which is the exact opposite relationship to person B And so you can imagine that there is scope for a trade to be made where person B who has ten thousand dollars trades it to person a and Person a trades back to person be a promise to pay back ten thousand five hundred next year And then of course, what's person a gonna do with the ten thousand dollars? They just got By the car satisfy the most pressing want that they have so we've got a very we've got a disagreement of values But the value that we disagree with is the value of our time or the value of the money Over time for each person and the values are completely reversed in what they want and from these reverse Valuations we can also create the interest rate or we can also determine the interest rate for lending and borrowing money So person B since they're gonna lend a ten thousand dollars today and then get back one year from now ten thousand five hundred dollars That's the same thing as saying they're gonna earn a five hundred dollar interest rate and five hundred on ten thousand is five percent So they just invested in person a some kind of an investment let's say alone at five percent and person a is in the exact opposite situation they have to pay Back that loan at five percent interest to person B So we have a very simple scenario that defines the lending borrowing relationship between two people and it stems ultimately from disagreements or Conflicts on the preference rank where two people have have reverse preferences Now one of the things that I always start with in class because for some reason There is this I don't even know what you call it this psychological people are psychologically predisposed to think that Lenders are good people. No, maybe that's not the case that people who have have excess money Like they have savings and they can lend it to others They're good people and people that are in the position where they have to borrow their you know deadbeats or their bad people Or there's something bad about and wrong about having to borrow money But economics because it's a value-free science We don't take these positions like being a debtor isn't inherently good or bad Maybe it could have been a bad decision after the fact But you never know that ahead of time being a debtor is just something that might be necessary given the person's situation Like that person who preferred to borrow money now rather than save their money that person's not bad They're not stupid or anything like that. That's just their preferences and at the same time Lenders are savers. They're not inherently virtuous like they're not great people just because they're lenders or savers Although, you know, that's something you should strive for personally. I think but it's not naturally virtuous or in the same way You know another way to look at it is a lot of mainstream economists think savings are terrible because that means you're not spending money And if you're not spending money, you're not creating income for other people So they think that you're a miser and you're somebody that's bad But that's not true either. It's just you have preferences for saving and borrowing and it's neither good nor bad It just it just is so I just wanted to get that out of the way before we start now Professor Urbaner gave this lecture on fractional reserve banking And I wanted to give you kind of an in-depth look of how this financial contract works Like how the lending actually works and what it means for you and before I start just sort of curiosity Put your hand up. No wait, I should ask the question before I say that Who thinks that they are the owner of money that's deposited in their bank the legal owner put your hand up Joe you do But I'm glad you did In fact your bank is actually the legal owner according to the the letter of the law your bank is the owner of money that you deposit in it Which is really strange. I mean, I'm offended by it. I don't have a better word for it. I think it's completely ridiculous I worked hard for that money and I entrusted it with a bank and now they're the loner all of a sudden and it's very strange But it flows naturally from this very strange legal framework that fractional reserve banks function within so the base deposit contract It's it's a bit of a hybrid. Well, it's not a bit of a hybrid It's exactly a hybrid because it combines two fundamental financial contracts You deposit your money in a bank and we'll get into the details of what that means in a moment And then your bank lends that money out That's the process professor Herb and I walked you through in the previous lecture And so to you your money is a deposit and to your bank your money is a loan And so the whole fractional reserve demand deposit even though we call it a deposit It's really this hybrid loan deposit hybrid, you know, very strange Frankenstein-y type of financial contract It only exists in banking by the way It doesn't exist in in any other line of business so it's very unique to the financial system and to understand Why it's so strange. It's important to disentangle the contract into its two component pieces And since your bank thinks they have a loan and you have a deposit It's good to go back and just revisit what's different between a loan and a deposit And I want to walk you through the three fundamental economic differences and then I'll take you through the resultant three legal differences So on the economic side of things the first key difference that you see is that with loans You're always exchanging what we call present for future goods Like in the preference ranking that I showed you originally the person who was the lender They were getting rid of their thousand dollars today But they were obtaining in return the promise that they would make 10,500 in the future so they gave away a present good and in return they're getting a claim to a future good But they don't actually have that future good yet. So there is an inter-temporal exchange taking place But economically speaking in the deposit contract. We have no such exchange You deposit your money in a bank and you can always access that money whenever you want it like you go to the cash Point you go to the teller you ask for your money you get it on-demand or in the present So there's none of this inter-temporal exchange going on there or present for future good exchange going on Second key difference is that in a loan contract you necessarily have to transfer the availability of the good that you're lending This is necessary for two reasons on the one hand the person who's borrowing They're borrowing because they want to use whatever it is that you're lending them money in this example So you can't retain availability of that Otherwise that person would not be able to to use it two people can't make use of the same resource at the same time But on deposit contracts this is different because the money is always available to you like your deposit in a bank is Yours and even if you're not using right now you can use it you can go to the cash point and request it So the availability always remains with the depositor and Then the final economic difference is that because there is a difference between present and future goods on the preference scale There has to be a resultant interest rate that results from this exchange While with the deposit since there is no exchange of a present for a future good there will be no interest rate So we have very significantly Economically speaking a deposit could not have an interest rate on it But alone necessarily must have an interest rate on it and these three economic distinctions naturally give rise to three key legal distinctions between the two contracts and the first is Maybe the most important in my eyes is that the purposes of the two contracts are fundamentally different So with loans the very purpose of you making that loan is to transfer the availability of a good like somebody only borrows because they Want their purpose is to get the availability of that good so they can use it over the time period that you've contracted for While with your deposit you never have a purpose of sacrificing your availability you always want to keep it there available to you I mean you're not being remunerated through an interest payment We already saw that so the only reason you'd make a deposit is to keep the availability and use it when you want to and instant interestingly enough this difference in purpose is important because If you go back if anybody's taken a law class or if anybody's a lawyer in contract law, there's there's several Several steps that are necessary for contract formation and one of them is what's called a meeting of the minds You have to have a shared purpose like you can't go to somebody and say hey I'm gonna sell you my boat and have that person say yeah I'm gonna borrow this boat from you That's not a meeting of the minds because you have two different purposes to the contract and in the same way since we have Conflicting purposes here. You can't just go to somebody and say hey, I want to lend you money and have that person Say yeah, I'd like to deposit my money with you because you have these conflicting purposes So it's very important for contract law For legal formation that you have a shared purpose, which notably doesn't exist in the fractional reserve deposit contract The second key legal difference is that in a loan you have to have a term both a minimum and a maximum The reason for the minimum is that the person who's borrowing needs to be secured Be secure in knowing that they will have that borrowed good available to them for them to use for whatever They want for some minimum amount of time like use something simple like I've got a copy of George Riesman's capitalism anybody read that be honest really Lucas George Riesman's capitalism. It's down the bookstore. It's I don't know that thick. It's I don't know how many thousands of pages It's you know, it's a huge book So if I lent my copy to you, you would need a minimum term on this Otherwise, they would be useless for you to borrow it from me I mean, I don't know what two days maybe as I had a minimum just for you to peruse the preface of this book Something like that or go through with the index or see the topics or something like that So we have a minimum term that needs to be established and then the same time it may be more importantly in your mind You need a maximum term because if I gave you my copy of capitalism and then I said, yeah, but don't worry about giving it back To me. I wouldn't be lending it to you. I'd be Gifting it to you. So a loan needs to have a maximum term with which I know that I'm gonna get it back And in financial contracts, these are typically explicitly stated I mean we have written contracts that spell it all out for us between friends typically You don't have to but they're implicitly there you give somebody something to your friends and you know You're gonna get it back after you you reasonably think you'll get it back after a week a month, you know However long well with deposits, there's no term necessary You put your money on deposit in the bank and you don't have to ask for it back And the bank doesn't have to say no you can't have it back and as long as you keep paying your fees your service fees There is no loan Sorry, there is no term established with the deposit contract and then the final legal differences in the obligations So the obligation for the person who borrowed money from you if it's a loan is to return Whatever that good was that was borrowed money your car my copy of capitalism Whatever have you well with the deposit the obligation for the depository like a bank is just to keep the goods safe And then return it to you whenever it is that you ask for it And since there's no maturity since there's no term on your deposit You can ask for it at a moment's notice right you just go to the cash point put in your card Get your money or go to the teller whatever have you so we have three key legal differences between These two types of contracts now These three key legal differences are really fundamentally what the problem at least the legal problem with fractional reserve banking is Because of course your bank all of these things are Should be true for your bank But of course also none of them are true for your bank because they don't really abide by the the strict details of the legal contracts And at the same time these should be true for you, but they're not necessarily true at the same time So we've got this very strange Legal creation in the fractional reserve banking contract But that notwithstanding that seems to be where an awful lot of the lending activity at least for consumers and small businesses Takes place in the economy. It's loans that are predicated based upon your deposits Going off to some third-party. So instead of that I want to give you a glimpse at what you would be doing Or how you would be securing financing or making investments if you didn't rely on your fractional reserve bank because a common criticism that I hear People ask Austrians well if there's no fractional reserve banking How am I going to get a mortgage because my mortgage right now is with my bank and how am I going to get my car? Alone and you know I'll never go to university because nobody will lend me money except for my bank or the government and You know if we don't have the the banking system Who's going to be making all those loans and it's it's a good criticism because you need an alternative or you should have an alternative for people so the way that I want to start is by Just taking a very bird's-eye view at your income you earned income and what you can do with it and In general we can say there's three different choices that you can do with your income when you earn it The first thing is that you earn income and you put it in your cash balance your bank account Currency in your pocket whatever have you and we'll get into the reasons in a little bit for why it is that you would add To your cash balance why you would hold your income in the form of money But for now just accept that you hold it because you're uncertain about something in the future Maybe an expense is going to pop up and so you want to keep a little bit of cash in your pocket to face that uncertain event Uncertain event or expense. I'll give you a more rigorous proof here in a couple minutes second thing you can do with your money Not pay taxes, but that's probably also also important consumption Well, you know you pay your taxes in here with consumption expenditures So you can consume right you get your income and you go and you pay money for your rent And you buy some clothes and you buy some food and some you know all of those types of things And really what you're buying is what we could call present want satisfaction You are exchanging your money to satisfy yourself with something in the present like oh lunch was great now I'm happy you're fantastic and if you're not satisfying yourself in the present You're satisfying yourself in the future and that's really what your savings are devoted to you save money Because you're willing to forgo satisfactions in the present But instead delay them for hopefully an increased satisfaction at some point in time in the future So you save your money and the vehicle through which you save your money. It's not just you know blind savings It's in some investment product and you're saving up for something like you're willing to not consume all of your income today So that you can have a better retirement 40 years from now Or you're willing to not consume all your income today so that you can save up and go for that Vacation over Christmas break or something like that. So we have these three paths that our income can be devoted to and Money is the big one So we need to establish or money for our purposes is is the big one So we need to establish why it is that you would hold money Where does the demand come from because we already looked at in my previous lecture on? Preference and subjective value and preference and price determination Where your demands for the other goods come from I mean t-shirts are on your value scales and What else is on your value scale food in a car and all those types of things But where would money fit into this? Why would you actually want to hold on to money? And Mises in human action He's got these great couple of pages where he introduces what he calls the evenly rotating economy To show a situation where money would not exist so that you can pull the corollary out of it Understand why money would exist and why people would want to hold on to it? And it's a little bit strange when you're reading through it because the Austrians You know in mainstream economics they focus very much on equilibrium states and Austrians Rightfully so we're very critical about this because Equilibrium is not all that interesting in the grand scheme of it and Mises actually introduce Introduces this evenly rotating economy, which is his equilibrium construct in a way But it's actually useful because it shows us all of these very realistic conclusions that we can drive from it So the evenly rotating economy is like this There is a succession of temporal periods years weeks whatever have you but nothing ever changes with the passage of time Prices always remain the same day in and day out Preferences always remain the same all of your buying behavior is always the same everything is always constant It's just time goes by and that's that it would be like saying I wake up every morning and I get a Egg McMuffin for breakfast and Then I go to bed that night and then I wake up the next morning and I buy an egg McMuffin and so on and so forth until you know infinity and When Mises teases out the consequences of this evenly rotating economy, there's really three big ones So the first one he says is well, there's no entrepreneurship since there's no change like you have no scope for an entrepreneurial function If there is no change taking place in the economy For example, McDonald's wouldn't have to work too hard to notice that I wake up and I eat a McMuffin every single morning That would not be especially entrepreneurial of them to act on that if I'm doing it every day without fail More importantly though Mises says well There's no profits in this evenly rotating economy Because the input factors like the things the higher order goods that create a McMuffin would just be bid up To the final value the final selling price of the McMuffin So we've got a bun let's say a bun costs a euro and an egg Sorry a bun costs a dollar and an egg costs a dollar and a McMuffin goes for two dollars And that's that's basically it and Mises says well Of course smart entrepreneurs would just bid up the price of egg and bun to whatever the final selling price is So there would be no profits Except there would be a value spread between the value of those inputs the egg and the bun and the final selling price Which he attributes to a Reginary interest and Professor Herbner will give you tomorrow a much longer Exposay of this originary interest, but right now I'll just make a few sundry and brief comments on it Because we need to be remunerated for the fact that we're not consuming now versus in the future The value of the goods in the present will be discounted or lower than the good that they produce in the future So let's say in this example if I buy a McMuffin for two dollars at the end of every day and McDonald's creates it at The beginning every day they would pay maybe 90 cents for the egg and 90 cents for the bun They would buy those at a discount of 10 cents each and then 10 cents would be their Immuneration for not consuming those things right away and waiting and selling it to me in the in the afternoon or the evening So the 10 cents would not be profit for them That would just be a remuneration for them to wait and not consume the input factors or put them to use in the present But more importantly when Mises looks at the evenly rotating economy He says there's something very strange going on that there's no money. Nobody wants to hold on to any money There's money prices. We know what everything is worth to two dollars for a McMuffin But nobody's actually holding on to money and he has to explain why this is and he says well Why would anybody hold on to money if they were fully certain about what every all of their expenses were going to cost in the future? Like if you were certain about every single expenditure that was going to arise in your life You would never hold on to money and earn zero interest You would park your money in an investment that matures at the exact moment when the expense arises And then you would use the proceeds of that investment to fund the expense Example let's say that let's say that I get paid on the first of the month and my rent comes due on the last of the month I Would not just hold all of my income in the form of money I could buy a 30-day investment product that would pay some interest rate not much right now I guess but some interest rate and it's going to mature at that exact moment of time when my rent comes Due so of course I wouldn't hold money. I would invest it for the relevant maturity 30 days I would earn some investment income off it and the money would still be available for me to pay my rent Or alternatively you could flip the example around and if my income comes on the first of the month my rent's not due until the end I could go to my landlord and I could say I'll pay you a month early at a discount like surely it would be valuable to you to be paid earlier rather than later So instead of I don't know a thousand dollars at the end of the month I'll give you nine hundred and seventy five dollars right now So I'll be able to settle up my expenses if I know they're going to happen at a discount Or you could go to your landlord if you've ever tried this if you rent a place Instead of paying rent monthly just go to them and say hey, I'll front-end load all of my rental payments So I'll give you a whole year's rent right now What what kind of discount will you give me and surely they'll give you something for the security and also? The benefit of having the rental income come in sooner rather than later So Misa says if you are fully certain about all of your expenditures as you are in the evenly rotating economy You would never hold on to money because you would buy a financial product to invest or settle up early at a discount So then he turns that example on his head and he says well then it must be that the only reason you hold money is if you're Uncertain about these future expenditures and fundamentally that's where your demand to come from money That's where your demand to hold money comes from this felt uncertainty or this perceived uncertainty of what's going to happen in the future but then he goes on to say and make a distinction that it can only be that you are hedging yourself against Uncertain events things that you don't actually know or can't probabilistically determine in advance But you're not holding money against risky events because risky events you could Theoretically invest or settle up at a discount according to some probability And he makes this big follow-on distinction between risk and uncertainty, which is relevant here He says uncertainty is a situation where you either don't know the outcomes of a choice Or you cannot assign probabilities to an outcome happening. He gives a couple examples in human action for example I don't know. I forget if this is the actual belligerence, but Germany and France go off and fight a war who's gonna win We can't really assign a probability statement to that I mean we know the outcome is either Germany wins or France wins or actually in war both lose But in the example Germany wins or France wins But we don't know which side's gonna win and we can't assign probabilities We could guess but we have no idea or sports games. Which team's gonna win Well, I know it's either gonna be one or the other but I really don't know at the end of the day There's betting markets you might say so there are probabilities assigned But they're not probabilities in any meaningful sense. They're just estimates They're just guesses and they're the estimates of thousands of people getting together But they're not what we're talking about by by probability quantitative probabilities and then he says Contrast this with risky outcomes Risky would be where you know the actual outcomes and you can make statements Quantitatively about the probabilities like you roll a die and there's a one-sixth chance that each one of the numbers is gonna come Heads up or you flip a coin and it's either gonna be heads or tails and you know 50-50 shot of either or so We have uncertain events and risky events and Misa says when you hold money It has to be for these uncertain events Those are really what you're protecting yourself against or hedging yourself against through your money holdings Now then if that is so what are the specific uncertainties that you're facing with respect to your money holdings and There's two unknowns with your future expenditures You either don't know when they're gonna happen or you don't know how much they're going to be for Like something could happen. What would be a good example of something happening, but you don't know when it's going to happen Okay. Yeah Be an optimist Yeah, I know how you mean a car crash probably probably You will get hungry, but you don't know when you'll get hungry, but you are gonna get hungry There's no question about it fantastic or alternatively. You don't know when it's gonna happen, but you know the magnitude of it For example, I'm gonna keep rolling this dice Maybe that's a bad example, but I'm gonna keep rolling a dice and when a one comes up I'm gonna give you ten dollars But you don't know when exactly a one is gonna come up, but you know when it finally does come up I'll give you ten bucks So you have uncertainty about timing or how much the magnitude of an expenditure or with money holdings You're concerned about both of those things together You don't know how much or when the actual expenditure will be for and that's why you're holding money today like the cash in your pocket right now or the Money in your deposit account is held to guard against these two uncertainties that you have Now let's bring it back to financial assets for for talk on finance All financial assets to the extent that they involve exchanges of money Concern themselves with two questions What are you gonna get from a financial asset and when are you gonna get it and With each of those questions, there's two responses to each of them that we can get which is where this typology is gonna come from What you get is really asking the question of what type of value does a financial asset? Give to you or allow you to have and the two types of value that can exist or what we call either par or market Market is the easier to understand Market value is a value which changes as per the vicissitudes of the market We have supply changes demand changes and the price changes as a result Like your car was worth something when you bought it and then you rolled it off a lot And you lost a third of its value and then you got in a car crash And that was the other two-thirds of the value and the value changed according to the the actual market conditions at the time and Par value is where the value is fixed or predetermined a good example of this is money Like for example, I don't actually have any good thing lunch was provided because I don't have anything except for 25 35 cents this coin is worth 25 cents, which when I was a kid used to get me lunch This 25 cent coin No matter when I spend it the prices might change, but it's always worth 25 cents I mean the face value is 25 So, okay Maybe today I go and I buy a pack of gum and the pack of gum cost me 10 cents So I paid with this 25 cents and tomorrow maybe the pack of gum is going to cost 15 cents And I I still pay with this 25 cent coin the value is always fixed or it's what we call a par value It doesn't change as per market conditions and the question of when you actually get that payment from the financial asset Obviously enough can either be right now in the present on demand or at some time in the future after you wait for the value to mature or come to you and With those two criteria you end up with four quadrants here and each of the four quadrants outlines a specific financial asset So up in the Northwest I've already got it labeled but money is the unique financial asset to take that quadrant because money is the only good in the financial economy that sells in The present like the value is there at a moment's notice. I use this and the value is released I don't have to wait for it at all and your deposit account is the exact same way by the way You get to use it at a moment's notice you swipe your debit card You go to the ATM whatever have you the value is available in the present on demand And you know how much it's going to be for again prices can change But the actual value stated on the money unit does not change so money is a very unique quadrant here And let's go up to a quadrant two in the Northeast Anybody think of an example of a financial asset where you get the value right now? But you don't know exactly how much value you're going to get it just depends on market conditions supply-demand conditions Stocks right you can sell your stock at a moment's notice always what are you going to get for it? I don't know whatever the value of the shares are if it's a good time to sell them make out Okay, if it's not so great, maybe you don't do so well or Kitty corner to that here in the third quadrant a financial asset where you get a par value is Predetermined how much you're going to get but you have to wait a specific period of time until you get it bonds so bond I buy a 30-year bond and you know I give the US government a thousand dollars today and they'd go bankrupt. I don't know 15 years from now and give me nothing or Ideally the 30 years from now they give me my thousand dollars back And then there's a strange quadrant right here in the the fourth quadrant a market value that you don't get until the future Is it just a future or a forward? I'm not going to get into it If you took a finance class, you'd know what I'm talking about But these are just you know the whole shebang You don't know what you're going to get and you can you have to wait until the future in order to get it So we've got four specific types of financial assets that exist in the economy And you can see that in particular when you save when we went back to You earning income and then having three streams that you can spend them on you add to your cash balance You consume or you invest you save and invest well your savings and investment takes place through either an equity investment Or a bond investment you either lend your money to somebody in the form of a bond In which case you wait, I don't know 10 years and you get it back with interest Or you buy a stock or an equity investment and you can get it back you can cash out whenever you want But only at whatever whatever the prevailing Prices and notably neither of these need to take place through a bank Like if you think about your bank, what is the what is the main reason why you go to your bank like the very fundamental reason? Why you go to your bank? Not to take out a loan not to take out a mortgage you could do that But before you do that you have to put money into your bank You have to make a deposit and the fundamental reason that we go to banks is to convert our currency into a deposit account Like I don't feel safe walking around Auburn with these 35 cents in my pocket So I'm gonna go over to the first national bank of Auburn or whatever it's called and open up a deposit account I'm gonna entrust them with my 35 cents. They'll keep it safe for me fantastic All I did was convert between different forms of money currency for a deposit But it was still money at the end of the day So this specific quadrant is what banks are really in the business of doing and these two quadrants have nothing at all to Do with banks at least in a free society they? Possibly seem like they do today, but only because of this very legal this balderdized legal contract of the fractional reserve deposit contract fractional reserve deposit So equity where do we go to buy equities go to the stock market fantastic or you could do it over the counter with with friends You don't have to go formally to the stock market You could strike up equity contracts on your own or the bond market Where do you go to invest in bonds or to borrow with bonds? Well, you can go on the bond market You can go to financial institutions that do this, but they don't have to be your bank Notably in futures. I'm not going to get into because that's a that's a different kettle of fish Now I want to put this in a little bit of different phrasing Well, we'll see how you follow so I want to classify these risk and uncertainties Into into a classificatory scheme So again the two big uncertainties you have with financial assets or how much are you going to get and when are you going to get it? Of course those questions you can either say I know when I'm going to get it or I don't know when I'm going to get it I know how much I'm going to get I don't know how much I'm going to get and Then we can classify and there are four quadrants here the resultant risks or uncertainties that result So if you don't know when something's going to happen, but you know how much you're going to get That's something that we could call structural risk or something that is called structural risk like for example I'm going to die. I don't know when a Structural risk, I mean could be tomorrow could be ten years from now and probably statistically it's going to happen when I'm 79 years old clock is ticking and and Alternatively you could know exactly when something happens, but not the magnitude Hey, I'm going to give you something great if you meet me behind the Mises Institute at five o'clock this afternoon Yeah You're exposed to a lot of systemic risk on that one over the next the next three hours you got to wait to see what it's actually going to be My van is parked out back, yeah and Alternatively you could not know anything about the timing and not know anything about the magnitude and that would make you fully Uncertain and again, that's why you hold money is to since we've already established that you hold money for these very uncertain situations We know that you're holding money to meet the uncertainty posed by this specific quadrant here this this combination of Uncertainty of timing and uncertainty of magnitude of your future expenditures. That's important. It's not just blind It's pertaining to a future expenditure that you have to make now Let's see how your financial assets work within this quadrant system So if you knew exactly when an expense was going to crop up and you knew exactly what it was going to be for Great no problem settle it early at a discount like I know my rent comes at the end of the month And I know how much it's for I settle it early with my landlord at a discount I you know, I save myself twenty five dollars a month or whatever it is. I don't actually do that, but could or In the first quadrant there if you didn't know when something was going to happen But you knew exactly what it was going to be for you could buy an equity investment and depending on your risk your Your propensity to take on risk you could either take a risky investment a risky equity like a high-tech firm Or you could buy a blue chip stock something that's very stable in value So I could buy what's a very stable stock these days utility stock or which one? Amazon is Amazon stable. I don't know much about it. Okay IBM okay some big big blue chip stock with relative with relatively stable cash flows I could buy a stock with that the value is not going to change much I don't know when something is going to happen But it's okay because when it actually does happen and I know how much that the expense is going to be for I'll just cash out my stocks and I'll use that Or if you knew when something was going to happen But not how much you could buy a bond to just mature at that moment in time when the expense was actually going to Happen right just match the maturity of your investment to the perceived maturity of the event that you think is going to happen in the Future or of course you would hold money if you were fully uncertain about all of these things so in the last five minutes, I just want to give you a quick a Quick little model. Maybe you can use to think about these things. So again just to summarize People save money according to their specific Perception of risk or uncertainty and in particular I don't like calling your cash balance savings But you put money into your cash balance if you're completely uncertain about the future and you hold Money in equities for those expenditures where you don't know when they're actually going to happen Or you put money in bonds when you know when something is going to happen But you don't know the magnitude of it when it's actually going to happen. So on the saver side of the model We have some specific reasons of why they would be saving or putting their income into the three specific avenues Same thing on the borrower side except borrowers don't don't borrow cash They either borrow through the bond or equity market So they borrow according to their preferences and again They borrow via bonds if the maturity of their expense is known in advance or with equities if the maturity is unknown in advance but in either case the borrowers and savers are lending or borrowing in money and We can put this all together into a simple little model that we call the the loanable funds model just to show the relationship between savings preferences Borrowing preferences and the resultant interest rate and amount of money available to be lent or borrowed in the economy So here we've got the interest rate is on the y-axis and the x-axis is just the amount of loanable funds This is the amount of money people want to borrow or the amount of money that people want to lend I'm doing this in money terms. It could be borrowing or lending in anything, but money is the easiest And we have a demand curve here The demand curve is what what type of people are looking to borrow money? Well borrowers obviously people with high time preference people that want to borrow money today in order to buy something in Or to consume in the present and then we have a supply curve Which is composed of those people with low time preference those who are willing to not consume today But to save their money and lend it to somebody else so that that person can use it and then pay them back in the future hopefully at a at a profit or a higher rate and The interplay between the supply and demand gives us the interest rate that prevails on the market and also determines the amount of funds that will available to be lent or Borrowed so here we've got a thousand two hundred dollars being lent and borrowed in the market And it's going to be repaid at an interest rate of five percent per year Let's say although the the term is not so important and then we can see what would happen with changes to Savings or lending preferences. So for example, what would happen if all of a sudden many people Increase their time preference rate There are people in general became had a greater propensity to consume in the present Intuitively you say higher interest rates And then if you go back to it you would say well that would be represented by a shift in the supply curve If people had a higher time preference and they started consuming more today That would mean less money available for them to supply or lend to other people and we could illustrate that by just a left word or Joe you like saying up and down when you shift curves, don't you an upward shift in the supply curve And of course the upward shift or the leftward shift represents the smaller amount of savings and It results or it determines that in that loanable funds market There will be less money available to be borrowed which makes sense given people are consuming more and saving less But also that the price or the interest rate that you'll have to pay in order to borrow money Or that you'll be remunerated if you lend will go up as well We'll go up in as a as a response to that decrease in the supply of savings And so throughout this whole lecture. I just wanted to show you that to follow on and to build off Professor Herbner's lecture in the in the previous the previous time slot Commonly we all go to the banking system as our first origin for loans and for investment products Both savers go there to put their money and invest it and borrowers go to their banks in order to borrow money and fund their Fund their expenditures and this doesn't have to be the case at all In fact, it wasn't the case for most of most of history and it's a relatively recent phenomenon that the banking sector Has taken on such prominence and become so important to the detriment of other more traditional financing avenues like equities and and bond investments Thank you