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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. By utilizing these components, the
financial system channels funds from lenders to borrowers. The chapter closes with brief discussions
regarding the role of the Federal Reserve and its regulatory and monetary policy responsibilities and
how government policy activism has changed over time and its recent effects on the economy.
Highlights in Brief
1. Economics is the study of how a society
decides what gets produced, how it gets
produced, and who gets the output. 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 the financial
system coordinates and channels the flow
of funds from lenders to borrowers, (and
vice versa) and how new funds are created
by financial intermediaries during the
borrowing process.
5. Direct finance involves lending directly to
net borrowers. Indirect finance involves
lending to a financial intermediary, a type
of financial institution that borrows in
order to relend. Financial
intermediaries issue claims on
themselves. They exist because they help
to minimize the transaction costs
associated with borrowing and lending.
6. Depository institutions (e.g., commercial
banks, saving and loan associations, credit
unions, and mutual savings banks) are
central to the process of determining the
nation’s money supply. 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.
2. The financial system is composed of
financial markets and financial
intermediaries. It is a dynamic system
that continues to evolve. Exhibit 1-3 in
the text illustrates how the financial
system moves funds from net lenders to
net borrowers. Changes in the financial
system can have a substantial influence on
the “real” or non-financial sector.
7. 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.
3. Net Lenders are spending units that
spend less than their current income on
consumptions and investment.
8. The degree of laissez faire or government
activism in economic policy has been
directly affected by our economic history.
4. Net Borrowers are spending units that
spend more than their current income.
1
2
CHAPTER 1
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. From
the early 1970s and recently, regulatory
changes were mostly in the direction of
deregulation. Deregulation is the
removing or phasing out of some existing
regulations.
5. Individuals, households, businesses or
governmental units that spend less than
their current income are savers. Saving is
income that is not spent on consumption.
They have a surplus of funds. Hence, they
are called Net Lenders. Units that spend
more than their current income must rely
on borrowing because they have a
shortage of funds. They are called Net
Borrowers. Make sure you understand
Exhibit (1-1) and 1-2 (The Uses of
Savings) in the text.
6. The Financial System is composed of
financial markets and financial
institutions.
a. Direct finance involves lending
directly to net borrowers.
b. Indirect finance involves lending
directly to net borrowers. Indirect
finance involves lending to a financial
intermediary, a type of financial
institution that borrows in order to
relend. Financial intermediaries issue
claims on themselves. The lenders
receive financial claims on the
financial intermediaries and the
borrowers receive funds from the
financial intermediaries.
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.
Financial intermediaries exist because they
help to minimize the transactions costs
associated with borrowing and lending.
The financial services provided include
appraising and diversifying risk, offering a
menu of financial claims that are
relatively safe and liquid, and pooling
funds from individual net lenders.
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 government
units by issuing checkable and savings
deposits. They primarily make loans
to commercial businesses and
households.
INTRODUCTION AND OVERVIEW
3
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.
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 monetary policy, which influences
interest rates and the volume of funds
available for borrowing and lending
(credit extension), is directed at enhancing
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. Throughout
the 1980s, the economy experienced
healthy growth that was accompanied by
large trade and government deficits. After
a recession in the early 1990s, economic
growth resumed, and the economy
achieved both low inflations and low
unemployment with a record long
expansion into the new millennium. A
recession had actually begun in March
2001. Although the recession officially
ended in November of 2001, the recovery
remained sluggish throughout 2003,
despite aggressive expansionary monetary
policy by the Fed. The recovery picked
up steam in 2004. 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
Checkable Deposits
Deposits that are subject to withdrawal by
writing a check
Default
When a borrower fails to repay a financial
claim
Depository Institutions
Financial intermediaries that issue checkable
deposits
Deregulation
The removing or phasing out of existing
regulations
Direct Finance
When net lenders lend their funds directly to
net borrowers
Economics
The study of how society decides what gets
produced, how it gets produced, and who gets
what
Expansion
The phase of the business cycle where
economic activity increases and
unemployment falls
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CHAPTER 14
Terms and Concepts You Need
to Know, Continued
Laissez Faire
The view that government should pursue a
“hands off” policy with regard to the economy
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.
Liquidity
The ease with which a financial claim can be
converted to cash without loss of value
Federal Reserve ("Fed")
The central bank of the United States that
regulates the banking system and determines
monetary policy
Macroeconomics
The branch of economics that studies the
aggregate (total) behavior of households and
firms
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
Financial Institutions
Firms that provide financial services to net
lenders and net borrowers; the most important
financial institutions are financial
intermediaries
Financial Intermediaries
Financial institutions that borrow from net
lenders for the purpose of lending to net
borrowers
Financial Markets
Markets in which financial claims are traded
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
Net Borrowers
Spending units such as households and firms
whose spending exceeds their income
Net Lenders
Spending units such as households and firms
whose income exceeds their spending
Fiscal Policy
Government spending and taxing decisions to
speed up or slow down the level of economic
activity
Recession
The phase of the business cycle where
economic activity declines over at least two
consecutive quarters and unemployment rises
Indirect Finance
When net borrowers borrow from financial
intermediaries that have acquired the funds to
lend from net lenders
Saving
Income not spent on consumption
Transactions Costs
The costs associated with borrowing and
lending or making other exchanges
INTRODUCTION AND OVERVIEW
What’s That Question?
You have 10 seconds to provide the question to each of the following answers.
TERMS
SAVING & LENDING
BUSINESS CYCLE
When a borrower fails to repay Spending units that spend more Business cycle phase where
a financial claim
than their current 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 Net Lenders lend their
funds to Net Borrowers
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
?
Provide financial services to
net lenders and borrowers
What is
?
Spending units where income
exceeds spending
What is the
?
Business cycle phase where
economic activity falls and
unemployment rises
What are
What are
What is
?
?
?
5
6
CHAPTER 1
What’s That Question Again?
You have 10 seconds to provide the question to each of the following answers.
TERMS
FIELDS OF STUDY
BEGIN WITH F
The removing or phasing out
of existing regulations
The study of production,
distribution and consumption
Financial institutions that
borrow from Net Lenders for
the purpose of lending to Net
Borrowers
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 is
?
The study of individual
decision-making units, such as
households and business firms
What are
?
Government spending and
taxing decisions to speed up or
slow down the level of
economic activity
What is
?
The costs associated with
borrowing and lending
What is
?
The study of the aggregate
behavior of households and
business firms
What is
?
The central bank of the U.S.
What are
What is
What is
?
?
?
When Net Borrowers borrow
from financial intermediaries
which have acquired the
funds to lend from Net
Lenders
The study of how society
decides what gets produced,
how it gets produced, and who
gets what
The study of how the
financial system coordinates
and channels the flow of
funds
What is
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.____ The past several decades have seen
little change in domestic and global
financial markets.
4.____ The Fed’s sole responsibility is
regulating the banking system.
5.____ Indirect finance always requires a
financial intermediary.
6.____ 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.
7.____ If you buy a corporate bond or stock
issued by Apple Computer, Inc., you
are engaging in direct finance.
8.____ Business cycles usually proceed
through periods of economic activity
in the following order: recession,
trough, expansion, peak.
9.____Purchasing stock is an example of
indirect finance.
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.___ Credit cards are money.
12.___ 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.
7
13.___ The corporate bond you bought from
Apple Computer, Inc., in question
Number 8 is an asset to Apple and a
liability to you.
14.___ Liquidity refers to how easy or
difficult it is to exchange a financial
claim for cash without loss of value.
15.___The U.S. economy remained in a
recession during 2004.
16.___The Fed has more control over domestic
commercial banks than other financial
institutions, therefore there is concern
regarding their ability to maintain a
leading role in influencing the
economy.
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.
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.
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CHAPTER 1
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.
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.
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 Net Lenders and
Net Borrowers can best be described by
the following:
a. Net Borrowers spend less on
consumption and investment goods
than their current income.
b. Net Lenders spend more on
consumption and investment goods
than their current income.
c. Net Lenders need to borrow (or spend
savings).
d. Net Borrowers need to borrow (or
accumulate savings).
10. Exhibit 1-5 in the text shows the influence
of the Fed’s monetary policy. Which of
the following factors does the Fed utilize
to analyze the overall health of the
economy?
a. Inflation .
b. Economic behavior of households.
c. Unemployment.
d. Growth.
e. all of the above
11. 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.
INTRODUCTION AND OVERVIEW
12. Speaking of financial markets, one of their
primary purposes is to
a. facilitate direct finance.
b. facilitate indirect finance.
c. bring Net Lenders and Net Borrowers
together through a financial
intermediary.
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
9
d. Commercial bank
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.
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
2. Discuss how views concerning U.S.
government policy activism have changed
over time.
17. Which of the following is not an example
of a depository institution?
a. Insurance company
b. Savings and loan association
c. Credit union
4. Draw a graph of a typical business cycle
and label the various phases.
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.
5. Jim earns $30,000 a year. He spends
$28,000 on living expenses, puts $1,000
10
CHAPTER 1
in his checking account and spends the
other $1,000 buying stock in General
Motors. Is he a Net Borrower or Net
Lender? 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.
ANSWER SECTION
What’s That Question?
TERMS
SAVING
&
LENDING
BUSINESS
CYCLE
a
default
Net
Borrower
an
expansion
money
direct
finance
trough
other
depository
intermediaries institutions
the
business
cycle
laissez
faire
savings
peak
Financial
institutions
net lenders
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
Indirect
Finance
economics
finance
INTRODUCTION AND OVERVIEW
True/False
1.
different kinds of financial and nonfinancial
firms.
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.
False. It’s just the opposite.
False. Although regulation is a
responsibility of the Fed, monetary policy
is the primary responsibility of the Fed.
True.
False. Just the opposite again.
True.
True.
False. Just the opposite. Direct Finance
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.
False. The recession officially ended in
November 2001.
True.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
2.
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.
3.
Indirect finance occurs when a financial
intermediary facilitates a Net Lenders desire to
lend and a Net Borrower’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 Net Lender lends
directly to a Net Borrower. 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.
Multiple Choice
1.
5.
9.
13.
17.
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
4.
Essays and Problems
The following are brief outlines; they are not
intended to be fully developed essays.
1.
11
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 ownership interest in
their property. New types of financial
institutions have been created by the merger of
5.
6.
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.
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.
For a household, savings is income not spent
on consumption. For a firm, savings is any
income not distributed to the owners of the
12
CHAPTER 1
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.