CHAPTER 1Introduction And OverviewChapter Overview

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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.

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.

3. Net Lenders are spending units that spend less than their current income on consumptions and investment.

4. Net Borrowers are spending units that spend more than their current income.

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.

7. The Federal Reserve is a quasi-independent 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.

8. The degree of laissez faire or government activism in economic policy has been directly affected by our economic history.

1

Highlights in Detail

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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

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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 quasi-independent 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 CycleShort run fluctuations in the level of economic activity as measured by output of goods and services

Checkable DepositsDeposits that are subject to withdrawal by writing a check

DefaultWhen a borrower fails to repay a financial claim

Depository InstitutionsFinancial intermediaries that issue checkable deposits

DeregulationThe removing or phasing out of existing regulations

Direct FinanceWhen net lenders lend their funds directly to net borrowers

EconomicsThe study of how society decides what gets produced, how it gets produced, and who gets what

ExpansionThe phase of the business cycle where economic activity increases and unemployment falls

INTRODUCTION AND OVERVIEW 5

Terms and Concepts You Need to Know, ContinuedTear 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 that regulates the banking system and determines monetary policy

FinanceThe 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 IntermediariesFinancial institutions that borrow from net lenders for the purpose of lending to net borrowers

Financial MarketsMarkets in which financial claims are traded

Fiscal PolicyGovernment spending and taxing decisions to speed up or slow down the level of economic activity

Indirect FinanceWhen net borrowers borrow from financial intermediaries that have acquired the funds to lend from net lenders

Laissez Faire

The view that government should pursue a “hands off” policy with regard to the economy

LiquidityThe ease with which a financial claim can be converted to cash without loss of value

MacroeconomicsThe branch of economics that studies the aggregate (total) behavior of households and firms

MicroeconomicsThe branch of economics that studies the behavior of individual decision-making units such as households and business firms

Monetary PolicyThe Fed's efforts to promote the overall health and stability of the economy

MoneySomething 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

RecessionThe phase of the business cycle where economic activity declines over at least two consecutive quarters and unemployment rises

SavingIncome not spent on consumption

Transactions CostsThe costs associated with borrowing and lending or making other exchanges

6 CHAPTER 1

What’s That Question?

You have 10 seconds to provide the question to each of the following answers.

TERMS SAVING & LENDING BUSINESS CYCLEWhen a borrower fails to repay a financial claim

What is?

Spending units that spend more than their current income

What are ?

Business cycle phase where economic activity increases and unemployment falls

What is ?Something that is generally used and accepted as payment for goods and services

What is ?

When Net Lenders lend their funds to Net Borrowers without using an intermediary

What is ?

Lowest point on the business cycle

What is the ? Insurance companies, pension funds, and finance companies are examples

What are ?

Financial intermediaries that offer checkable deposits

What are ?

Short-run fluctuations in the level of economic activity

What is ?“Hands off” government economic policy

What is ?

Income not spent on consumption

What is ?

Highest point on the business cycle

What is the ?Provide financial services to net lenders and borrowers

What are ?

Spending units where income exceeds spending

What are ?

Business cycle phase where economic activity falls and unemployment rises

What is ?

INTRODUCTION AND OVERVIEW 7

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 FThe removing or phasing out of existing regulations

What is ?

The study of production, distribution and consumption

What is ?

Financial institutions that borrow from Net Lenders for the purpose of lending to Net Borrowers

What are ?The Fed’s efforts to promote the overall health and stability of the economy

What is ?

The study of the financial system

What is ?

Markets where financial claims are traded

What are ? 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 is ?

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 are ?

The study of the aggregate behavior of households and business firms

What is ?

The central bank of the U.S.

What is ?

When Net Borrowers borrow from financial intermediaries which have acquired the funds to lend from Net Lenders

What is ?

The study of how society decides what gets produced, how it gets produced, and who gets what

What is ?

The study of how the financial system coordinates and channels the flow of funds

What is ?

8 CHAPTER 1

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.

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 witha. 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.

INTRODUCTION AND OVERVIEW 9

3. An example of direct finance would bea. 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 bea. 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 assetsb. Machinery and equipmentc. Cashd. A and c only

6. Deregulationa. 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 isa. 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 classb. The purchase of a corporate bondc. Paying your rentd. 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 area. financial markets and stock markets.b. financial markets and direct finance.c. financial markets and bond markets.d. financial markets and financial

intermediaries.

10 CHAPTER 1

12. Speaking of financial markets, one of their primary purposes is toa. 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 2000b. A passbook savings account at

Marquette Bankc. A corporate bond held against

CitiGroupd. A quarter-share interest in a business

partnership

14. Financial intermediaries exist because theya. 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 depositd. 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 IBMc. A checking account depositd. A savings account at First Bank

17. Which of the following is not an example of a depository institution?a. Insurance companyb. Savings and loan associationc. Credit uniond. Commercial bank

18. The Federal Reserve, or simply the Fed, is best characterized asa. 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, peakb. Recession, expansion, peak, troughc. Recession, peak, expansion, troughd. 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, activistb. Laissez faire, activist, laissez fairec. Laissez faire, activist, more activistd. Activist, laissez faire, more laissez

faire

Essays and Problems1. 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

INTRODUCTION AND OVERVIEW 11

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?

TERMSSAVING

&LENDING

BUSINESSCYCLE

adefault

Net Borrower

an expansion

money directfinance

trough

other intermediari

es

depositoryinstitutions

thebusiness

cycle

laissez faire

savings peak

Financial institutions

net lenders arecession

What’s That Question Again?

TERMS FIELDS OFSTUDY

BEGINWITH F

Deregulation

economics financialintermed-

iaries

monetarypolicy

finance financial markets

Liquidity micro-economics

fiscalpolicy

Transactions

costs

macro-economics

theFed

IndirectFinance

economics finance

12 CHAPTER 1

True/False1. False. There is considerable overlap

between the two subject areas.2. False. The two main parts of the

financial system are financial intermediaries and financial markets. Depository institutions are financial intermediaries.

3. False. It’s just the opposite.4. False. Although regulation is a

responsibility of the Fed, monetary policy is the primary responsibility of the Fed.

5. True. 6. False. Just the opposite again.7. True.8. True.9. False. Just the opposite. Direct Finance 10. False. Just the opposite. The authors say

that views have shifted back to a “less government intervention is better” perspective.

11. True.12. False. Money is something which is

acceptable in payment. Individuals must pay credit card balances with money.

13. True.14. 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.

15. True.16. False. The recession officially ended in

November 2001. 17. True.

Multiple Choice1. d 2. d 3. b 4. b5. b 6. b 7. c 8. b9. d 10. b 11. d 12. a

13. b 14. d 15. c 16. a17. a 18. b 19. a 20. b

Essays and ProblemsThe following are brief outlines; they are not intended to be fully developed essays.

1. 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 different kinds of financial and nonfinancial firms.

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.

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

INTRODUCTION AND OVERVIEW 13

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.