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CHAPTER 1
Introduction and Overview
Chapter Overview
Tear out this page and the next for quick and easy reference.
In this introductory chapter, the subject matter of economics and finance are described and
the roles played and functions performed by the financial system are explained. The
financial system is composed of financial markets and financial intermediaries. The chapter
closes with brief discussions regarding the regulatory and monetary policy responsibilities
of the Federal Reserve and how government policy activism has changed over time.
Highlights in Brief
1.
Economics is the study of how a
society decides what gets produced,
how it gets produced, and who gets
what. In macroeconomics one studies
the causes and consequences of
aggregate (total) behavior of
households and firms. In
microeconomics, one studies the
behavior of individual economic
agents such as households and
business firms. Finance is the study
of how money is created, how it is
channeled from savers to borrowers,
and how it is raised and used by
individuals, firms, governments, and
foreigners.
3. Surplus Spending Units (SSUs) are
units which spend less than their
current income. Deficit Spending
Units (DSUs) are units which spend
more than their current income.
2. The financial system is composed of
financial markets and financial
intermediaries. It is a dynamic system
which continues to evolve. Exhibit 1-3
in the text illustrates how the financial
system moves funds from savers to
borrowers. Changes in the financial
system can have a substantial
influence on the “real” or nonfinancial sector.
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CHAPTER 14
4. Direct finance occurs in financial
markets where SSUs lend directly to
DSUs. Indirect finance occurs when a
financial institution “intermediates”
an SSU’s desire to lend and a DSU’s
desire to borrow.
5. Depository institutions (e.g.,
commercial banks, saving and loan
associations, credit unions, and
mutual savings banks) are the most
important financial intermediaries
because of the role they play in the
money creation process. Other
intermediaries (e.g., insurance
companies, finance companies,
pension funds, mutual funds and
money market mutual funds) take in
premium payments or contributions
and issue other financial claims.
6. The Federal Reserve is a quasiindependent government agency that
serves as our nation’s central bank.
The Fed’s primary responsibility is
monetary policy. It also regulates the
nation’s banking system.
7. The degree of laissez faire or
government activism in economic
policy has been directly affected by
our economic history.
INTRODUCTION AND OVERVIEW
3
Highlights in Detail
Tear out this page and the next for quick and easy reference. “Chapter Overview” and “Highlights in Brief”
are on the reverse side.
1. Economics is the study of how a
society decides what gets produced,
how it gets produced, and who gets
what.
a. Microeconomics is the study of
the causes and consequences of
individual decision-making units
such as households and business
firms in a particular market.
b. Macroeconomics is the study of
the causes and consequences
resulting from the sum of
decisions made by all firms and
households in all markets.
2. Finance is the study of the financial or
monetary aspects of production,
spending, borrowing and lending
decisions of an economy. Finance
deals with the raising and using of
money by individuals, firms,
governments and foreign entities. At
the macro level, finance is concerned
with how money is created and
channeled from lenders to borrowers
3. The financial system is intimately
related to the production and sale of
goods and services within the
economic system; Wall Street affects
Main Street. Hence, government
regulates and supervises the financial
system’s operation.
4. The financial system continues to
evolve and change. The globalization
of markets, financial innovation,
changes in government regulation,
and recurring financial crises make
the subject matter of this course
inherently interesting.
5. Individuals, households, businesses or
governmental units that spend less
than their current income are savers.
They have a surplus of funds. Hence,
they are called Surplus Spending
Units (SSUs). Units that spend more
than their current income must rely on
borrowing because they have a
shortage or deficit of funds. They are
called Deficit Spending Units
(DSUs). Make sure you understand
Exhibit 1-1 (SSUs and DSUs) and 1-2
(The Uses of Savings) in the text.
6. The Financial System is composed of
financial markets and financial
intermediaries.
a. Direct finance occurs in financial
markets (such as the stock and
bond market) where SSUs lend
directly to DSUs.
b. Indirect finance occurs when a
financial intermediary (such as a
bank or savings and loan
association) plays a middle-man or
“intermediary” role between an
SSU’s desire to lend and a DSU’s
desire to borrow.
c. Exhibit 1-3 (The Financial System)
in the text illustrates how the
financial system coordinates the
flows of purchasing power in one
direction and obligations to pay in
the opposite direction.
7. Financial intermediaries exist
because they benefit SSUs (savers)
and DSUs (borrowers). SSUs benefit
from reduced default risk, improved
diversification, decreased transactions
costs, and increased liquidity. SSUs
engage in indirect finance by
depositing their funds with a financial
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CHAPTER 1
intermediary rather than engaging in
direct finance that requires directly
lending to a DSU.
8. Financial intermediaries are of two
main types.
a. Depository institutions (e.g.,
commercial banks, saving and
loan associations, credit unions
and mutual savings banks) take in
funds from households, firms and
INTRODUCTION AND OVERVIEW
5
Highlights in Detail, Continued
Tear out this page for quick and easy reference. “Terms and Concepts You Need to Know, Continued” are on
the reverse side.
government units by issuing
checkable and savings deposits.
They primarily make loans to
commercial businesses and
households.
b. Other intermediaries (e.g.,
insurance companies, finance
companies, pension funds, mutual
funds and money market mutual
funds) take in premium payments
or contributions and issue other
financial claims.
c. Exhibit 1-4 (Types of Financial
Intermediaries) illustrates these
different types of financial
intermediaries.
9. The Federal Reserve is a quasiindependent government agency that
serves as our nation’s central bank.
The Fed’s primary responsibility is
monetary policy. It is through
monetary policy that the Fed
promotes the overall health and
stability of the economy. Make sure
you understand Exhibit 1-5 (The
Influence of the Fed’s Monetary
Policy).
10. Prior to the 1930s economists viewed
the economy as a self-correcting
system requiring only laissez faire
policy. The experience of the Great
Depression led to more activist
stabilization policy by both Democrats
and Republicans. The economic
experience of the 1970s and 1980s once
again called into question
government’s ability to stabilize the
economy. Make sure you understand
Exhibits 1-6 (Long-Run Economic
Growth and the Business Cycle) and
1-7 (Average Inflation,
Unemployment, and Growth During
Recent Decades) which respectively
describe business cycle phases, and
the U.S. economy’s macroeconomic
performance over the last four
decades.
Terms and Concepts You Need to Know
Business Cycle
Short run fluctuations in the level of
economic activity as measured by output
of goods and services in the economy
Checkable Deposits
Deposits which are subject to withdrawal
by writing a check
Default
When a borrower fails to repay a financial
claim
Deficit Spending Units (DSUs)
Spending units (e.g., households and
firms) where spending exceeds income
Depository Institutions
Financial intermediaries which offer
checkable deposits
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CHAPTER 14
Deregulation
The removing or phasing out of existing
regulations
The study of how society decides what
gets produced, how it gets produced, and
who gets what
Direct Finance
When SSUs lend their funds directly to
DSUs
Expansion
The phase of the business cycle where
economic activity increases and
unemployment falls
Economics
INTRODUCTION AND OVERVIEW
7
Terms and Concepts You Need to Know, Continued
Tear out this page for quick and easy reference. “Highlights in Detail, Continued” and “Terms and Concepts
You Need to Know” are on the other side.
Federal Reserve ("Fed")
The central bank of the United States
which regulates the banking system and
determines monetary policy
Laissez Faire
The view that government should pursue
a “hands off” policy with regard to the
economy
Finance
The study of how the financial system
coordinates and channels the flow of
funds from lenders to borrowers (and vice
versa) and how new funds get created by
financial intermediaries in the borrowing
process
Liquidity
The ease with which a financial claim can
be converted to cash without loss of value
Financial Innovation
New ways to access and use money
developed by firms and individuals
Financial Intermediaries
Financial institutions that borrow from
SSUs for the purpose of lending to DSUs
Financial Markets
Markets in which financial claims are
traded
Financial System
Consists of financial intermediaries and
financial markets which facilitate the flow
of funds from SSUs (savers) to DSUs
(borrowers) and vice versa
Fiscal Policy
Government spending and taxing
decisions to speed up or slow down the
level of economic activity
Indirect Finance
The process whereby DSUs borrow from
financial intermediaries (i.e., banks,
savings and loan associations, etc.) which
have acquired the funds to lend from
SSUs
Macroeconomics
The branch of economics that studies the
aggregate (total) behavior of households
and firms
Microeconomics
The branch of economics that studies the
behavior of individual decision-making
units such as households and business
firms
Monetary Policy
The Fed's efforts to promote the overall
health and stability of the economy
Money
Something that is generally used and
accepted as payment for goods and
services
Recession
The phase of the business cycle where
economic activity falls and
unemployment rises
Saving
Income not spent on consumption
Surplus Spending Units (SSUs)
Spending units (e.g., households and
firms) with income that exceeds spending
on consumption or newly constructed
houses
Transactions Costs
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CHAPTER 14
The costs associated with borrowing and
lending
INTRODUCTION AND OVERVIEW
What’s That Question?
You have 10 seconds to provide the question to each of the following answers.
TERMS
When a borrower fails to repay
a financial claim
SAVING & LENDING
BUSINESS CYCLE
Spending units where spending Business cycle phase where
exceeds income
economic activity increases
and unemployment falls
What is
?
Something that is generally
used and accepted as payment
for goods and services
What are
?
When SSUs lend their funds to
DSUs without using an
intermediary
What is
?
Lowest point on the
business cycle
What is
?
Insurance companies, pension
funds, and finance companies
are examples
What is
?
Financial intermediaries that
offer checkable deposits
What is the
?
Short-run fluctuations in the
level of economic activity
What are
?
“Hands off” government
economic policy
What are
?
Income not spent on
consumption
What is
?
Highest point on the
business cycle
What is
?
What is the
What is
?
?
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CHAPTER 1
New ways to access and use
money
Spending units where income
exceeds spending
Business cycle phase where
economic activity falls and
unemployment rises
What are
What are
What is
?
?
?
INTRODUCTION AND OVERVIEW
What’s That Question Again?
You have 10 seconds to provide the question to each of the following answers.
TERMS
The removing or phasing out
of existing regulations
FIELDS OF STUDY
The study of production,
distribution and consumption
BEGIN WITH F
Financial institutions that
borrow from SSUs for the
purpose of lending to DSUs
What is
?
The Fed’s efforts to promote
the overall health and
stability of the economy
What is
?
The study of the financial
system
What are
?
Markets where financial claims
are traded
What is
?
The ease with which a
financial claim can be
converted to cash without
loss of value
What are
What is
?
The study of individual
decision-making units, such as
households and business firms
What is
What is
?
The costs associated with
borrowing and lending
What are
?
The study of the aggregate
behavior of households and
firms
?
Government spending and
taxing decisions to speed up or
slow down the level of
economic activity
What is
?
?
The central bank of the U.S.
What is
What is
?
?
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CHAPTER 1
When DSUs borrow from
financial intermediaries
which have acquired the
funds to lend from SSUs
What is
The study of how society
decides what gets produced,
how it gets produced, and who
gets what
Interest on checking accounts,
debit cards, and ATMs are
recent examples of this
phenomenon
What is
What is
?
?
?
INTRODUCTION AND OVERVIEW
True/False Questions
1.____ The subject matter of economics
and finance are completely
independent fields of study.
2.____ The two main parts of the financial
system are financial intermediaries
and depository institutions.
3.____ From the early 1970s until the late
1980s, the changes in regulation
were mostly in the direction of
deregulation, which is the
removing or phasing out of some
existing regulations.
4.____ SSUs are units which spend more
than their current income. DSUs
are units which spend less than
their current income.
5.____ The Fed’s primary responsibility is
regulating the banking system.
6.____ Indirect finance always requires a
financial intermediary.
7.____ Microeconomics is primarily
concerned with the sum result or
aggregate of all markets, while
macroeconomics is primarily
concerned with the study of
individual households and firms
in a particular market.
8.____ If you buy a corporate bond or
stock issued by Apple Computer,
Inc., you are engaging in direct
finance.
9.____ Business cycles usually proceed
through periods of economic
activity in the following order:
recession, trough, expansion, peak.
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10.___ Following the relatively poor
performance of the economy in the
1970s, economic policy views have
shifted back toward a more
activist policy stance.
11.___ Recent examples of financial
innovation are checking accounts
with interest, ATMs, debit cards,
and home equity lines of credit.
12.___ Credit cards are money.
13.___ The three most important
considerations for an individual
deciding whether to purchase a
particular financial instrument are
the expected return, risk of loss,
and the degree of liquidity
provided by the instrument.
14.___ The corporate bond you bought
from Apple Computer, Inc., in
question Number 8 is an asset to
Apple and a liability to you.
15.___ Liquidity refers to how easy or
difficult it is to exchange a
financial claim for cash without
loss of value.
Multiple Choice
1. Economics is typically broken down
into microeconomics and
macroeconomics.
a. Microeconomics is the study of
individual households and firms
in a particular market.
b. Macroeconomics is the study of
individual households and firms
in a particular market.
c. Macroeconomics is the study of
the causes and consequences
resulting from the sum of all
decisions made by households and
firms in the economy.
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CHAPTER 1
d. Both a and c are correct.
2. Finance is concerned with
a. how the financial system
coordinates and channels the flow
of funds from lenders to
borrowers (and vice versa).
b. how new funds get created by
financial intermediaries in the
borrowing process.
c. the study of the financial or
monetary aspects of the
production, spending, borrowing,
and lending decisions of an
economy.
d. All of the above.
d. your borrowing money from a
friend to buy my ‘84 Mercury.
5. What do economists mean by capital?
a. Financial assets
b. Machinery and equipment
c. Cash
d. A and c only
6. Deregulation
a. is the implementing or phasing in
of new regulations.
b. is the removing or phasing out of
some existing regulations.
c. is any regulation which pertains to
accounting debits.
d. was a trend in the financial system
prior to the 1970s, but the trend of
the 1970s and 1980s has been
toward greater regulation.
7. Money is
a. only cash and currency.
b. cash, currency, and credit cards.
c. something which is used and
accepted as payment.
d. income not spent on consumption.
3. An example of direct finance would
be
a. your professor’s deposit of his or
her salary in a checking account.
b. your purchase of stock in IBM.
c. your use of an ATM to get cash.
d you and your employer making a
contribution into your pension
fund.
4. An example of indirect finance would
be
a. your purchasing a corporate bond
issued by PepsiCo.
b. your borrowing money from
Norwest Bank to buy a used car.
c. your lending money to me to start
a publishing company.
8. Which of the following would be an
example of saving?
a. The purchase of this study guide
for your class
b. The purchase of a corporate bond
c. Paying your rent
d. Using coupons to buy diapers at a
department store
9. The difference between Surplus
Spending Units (SSUs) and Deficit
Spending Units (DSUs) can best be
described by the following:
INTRODUCTION AND OVERVIEW
a. DSUs spend less on consumption
and investment goods than their
current income.
b. SSUs spend more on consumption
and investment goods than their
current income.
c. SSUs need to borrow (or spend
savings).
d. DSUs need to borrow (or
accumulate savings).
10. Exhibit 1-2 in the text shows the uses
of savings for households and
businesses. Which of the following is
false?
a. Savings may be used for
investment in newly constructed
houses.
b. Income distributed to the owners
of business firms is considered
savings, since the owners are
likely to retain it.
c. Businesses may use savings for
investment in new capital (plant
and equipment).
d. Savings is any income not spent
on consumption by consumers or
any income not distributed to the
owners of business firms.
11. The financial system has two major
components. They are
a. financial markets and stock
markets.
b. financial markets and direct
finance.
c. financial markets and bond
markets.
d. financial markets and financial
intermediaries.
12. Speaking of financial markets, one of
their primary purposes is to
a. facilitate direct finance.
b. facilitate indirect finance.
c. bring SSUs and DSUs together
through a financial intermediary.
15
d. make sure financial flows and
financial claims move in the same
direction.
13. Financial claims are of two types:
indirect financial claims and direct
financial claims. Which of the
following would be evidence of an
indirect claim?
a. A share of stock in Gateway 2000
b. A passbook savings account at
Marquette Bank
c. A corporate bond held against
CitiGroup
d. A quarter-share interest in a
business partnership
14. Financial intermediaries exist because
they
a. reduce default risk.
b. allow for greater diversification.
c. decrease transactions costs.
d. all of the above.
15. Which of the following financial
assets has the most liquidity?
a. ownership interest in Zandbrõz
variety (an independent
bookstore/coffee shop)
b. 100 shares of stock in Gateway
2000.
c. a checking account deposit
d. a savings account at First Bank
16. Which of the following financial
assets has the least liquidity?
a. Ownership interest in Zandbrõz
variety (an independent
bookstore/coffee shop)
b. 100 shares of stock in IBM
c. A checking account deposit
d. A savings account at First Bank
17. Which of the following is not an
example of a depository institution?
a. Insurance company
b. Savings and loan association
c. Credit union
d. Commercial bank
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CHAPTER 1
18. The Federal Reserve, or simply the
Fed, is best characterized as
a. an important policy-making
branch of the Treasury
department.
b. a quasi-independent government
agency in charge of monetary
policy.
c. a quasi-independent government
agency in charge of fiscal policy.
d. another term for our federal
government’s regulatory system.
19. Which of the following best describes
the order of business cycle phases?
a. Recession, trough, expansion, peak
b. Recession, expansion, peak, trough
c. Recession, peak, expansion, trough
d. Recession, trough, contraction,
peak
20. If we divide U.S. government policy
history into the following three phases
(pre-1930s, WWII-1970, 1970-1980)
which of the following sets of labels
would be most applicable?
a. Activist, laissez faire, activist
b. Laissez faire, activist, laissez faire
c. Laissez faire, activist, more activist
d. Activist, laissez faire, more laissez
faire
Essays and Problems
1.
In recent decades, firms and
individuals have developed new ways
to raise and use money through
financial innovation. Give three
concrete examples of how recent
financial innovations have manifested
themselves.
2. Discuss how views concerning U.S.
government policy activism have
changed over time.
3. Define direct and indirect finance.
Give two examples of indirect
finance—one where you are the
lender and one where you are the
borrower. Give two similar examples
for direct finance.
4. Draw a graph of a typical business
cycle and label the various phases.
5. Jim earns $30,000 a year. He spends
$28,000 on living expenses, puts
$1,000 in his checking account and
spends the other $1,000 buying stock
in General Motors. Is he a DSU or
SSU? How much is his deficit or
surplus?
6. What is the difference between
investment and saving?
7. What benefits do financial
intermediaries provide to depositors?
8. Explain how borrowers and lenders
are brought together through financial
markets and through financial
intermediaries.
INTRODUCTION AND OVERVIEW
True/False
ANSWER SECTION
What’s That Question?
1.
False. There is considerable overlap
between the two subject areas.
False. The two main parts of the
financial system are financial
intermediaries and financial markets.
Depository institutions are financial
intermediaries.
True.
False. It’s just the opposite.
False. Although regulation is
important, monetary policy is the
primary responsibility of the Fed.
True.
False. Just the opposite again.
True.
True.
False. Just the opposite. The authors
say that views have shifted back to a
“less government intervention is
better” perspective.
True.
False. Money is something which is
acceptable in payment. Individuals
must pay credit card balances with
money.
True.
False. The bond is your asset. It is a
liability to Apple because they must
pay you interest and return your
principal at some time in the future.
True.
2.
TERMS
SAVING
&
LENDING
BUSINESS
CYCLE
a
default
DSUs
an
expansion
money
direct
finance
trough
other
depository
intermediarie institutions
s
laissez
faire
savings
financial
innovations
SSUs
the
business
cycle
3.
4.
5.
6.
7.
8.
9.
10.
peak
11.
12.
a
recession
What’s That Question Again?
TERMS
FIELDS OF
STUDY
BEGIN
WITH F
deregulation
economics
financial
intermediaries
monetary
policy
finance
financial
markets
liquidity
microeconomics
fiscal
policy
transactions
costs
macroeconomics
the
Fed
13.
14.
15.
Multiple Choice
1.
5.
9.
13.
17.
economics
financial
innovation
d
b
d
b
a
2.
6.
10.
14.
18.
d
b
b
d
b
3.
7.
11.
15.
19.
b
c
d
c
a
4.
8.
12.
16.
20.
b
b
a
a
b
Essays and Problems
The following are brief outlines; they are not
intended to be fully developed essays.
1.
indirect
finance
17
Checking accounts now pay interest, allow
ATM access, and often come with debit
cards which are widely accepted for
purchases. Home equity lines of credit
allow homeowners to borrow against their
18
2.
3.
CHAPTER 1
ownership interest in their property. New
types of financial institutions have been
created by the merger of different kinds of
financial and nonfinancial firms.
Prior to the Great Depression, the
economy was viewed as self-correcting
and requiring little if any government
intervention. Laissez faire policy
prevailed. The Great Depression showed
the world that an economy left to its own
devices can get stuck with high
unemployment for a prolonged period of
time. This experience led to the generally
accepted notion that government
intervention in the economy was
necessary for stabilization. The experience
of the 1970s and 1980s has challenged this
notion because of the correlation of a
larger government and slower growth.
This has been put forward as evidence
that government intervention has failed
and that there is a need to return to the
pre-1930s view of a less interventionist
role for government policy.
Indirect finance occurs when a financial
intermediary facilitates an Surplus
Spending Unit’s (SSU’s) desire to lend and
a Deficit Spending Unit’s (DSU’s) desire to
borrow. An example where you are the
lender would be you depositing funds into
your checking account and the bank using
those funds to make a loan to a local
business. An example with you as a
borrower would be your student loan
from a bank which, at the simplest level, is
financed by other’s deposits.
Direct finance occurs when a SSU lends
directly to a DSU. An example of you as
the lender would be your purchase of a
corporate bond or stock from McDonald’s
Corporation. An example of direct finance
with you as the borrower would be your
grandmother lending you $1,000 to go to
college with the understanding that you
would pay her back $2,000 in 10 years.
4.
See Exhibit 1-6 in your text. The main
phases are recession (contraction), the
trough (low point on the cycle), expansion
(recovery), and peak (highest point in the
cycle). Note that the secular growth trend
is upward over time.
5.
Jim is a Surplus Spending Unit (SSU). His
income is greater than his consumption
expenditures by $2,000. Both his $1,000
worth of deposits and $1,000 worth of
financial investment are considered to be
savings.
6.
For a household, savings is income not
spent on consumption. For a firm, savings
is any income not distributed to the
owners of the firm. (In accounting, these
are often referred to as retained earnings.)
Investment is the purchase of new plant
and equipment by a firm or the purchase
of new housing stock by a household. It
is easy in a class like this one to confuse
financial investment (really a form of
savings) and capital investment (the
purchase of new plant and equipment). It
can be confusing when professors use the
same word to mean different things.
Make sure you are clear which one your
professor is talking about.
7.
Financial intermediaries minimize the
transactions costs associated with savings.
They do this by reducing default risk,
increasing diversification and providing
liquidity to depositors.
8.
In financial markets, borrowers and savers
connect directly. A saver can lend to a
borrower by purchasing a share of stock, a
bond, or other debt instrument. Lending
through a financial intermediary makes
this process indirect. A saver will take his
or her money and deposit it in a bank.
The bank in turn will use this money to
make a loan to a firm or individual who
needs to borrow. The depositor receives
interest on the deposit, the borrower gets
the cash that he or she needs, and the bank
earns a return on the loan processing fee
and the difference in the interest rate it
charges the borrower and it pays to the
depositor.
STRAINS AND STRESSES
19