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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 4 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. 8 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.