1.2 Five Core Principles of Money and Banking
If you are in this class, you have probably already taken an introductory or principles of finance class. In such a class, you typically learn these five principles of finance. When we use the parlance of financial markets and instruments, we would refer to these as the principles of money and banking.
Money and banking can be summarized into these five core principles.
Time has value. Time is a very important factor that affects the value of all financial instruments. For loans, interest is paid to compensate lenders for the time the borrowers have their money. Stocks are often priced using some form of discount factor model to price the value of future cash flows of a company. In short, time affects the price of financial instruments, and investors and lenders both require compensation for the passage of that time. In the framework of the time value of money, a dollar today is worth more than a dollar tomorrow.
Risk requires compensation. People will accept risk only if they are compensated appropriately for that risk. Compensation comes in the form of explicit payments, like dividends and interest payments, as well as not-yet payments, such as stock appreciation. The higher the risk of a financial instrument, the higher the payment required to have an individual carry the risk. This is a well-known financial principle: the higher the risk, the higher the reward. Or in the immortal words of the movie Jerry Maguire, “SHOW ME THE MONEY!”
Information is the basis for decisions. Information is paramount in the decision process of any investment. The more important the decision, the more information we should gather. If the decision is not as important (meaning not as expensive), we can gather less information. For example, if your investment is a stick of chewing gum, you probably won’t do a deep dive in gathering information while you’re at the gas station counter buying it. However, if you are thinking about buying a $500,000 house, you have strong incentives to gather a lot of data pertaining to the purchase.
Markets determine prices and allocate resources. Markets are the core of the economic system. Markets act as resource channels to minimize the cost of gathering information and making transactions.
Stability improves welfare. A stable economy reduces risk and improves everyone’s welfare. In addition, stable economies grow faster than unstable economies. One way to think about this is through volatility. The more volatile an environment, the less healthy it is, and it makes it difficult to find solid growth. As an example, the financial crisis of 2008 was triggered by financial instability. Central banks attempt to stabilize the economy.