CHAPTER 1

Chapter 1

Introduction And Overview

Chapter 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. 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 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 money is created, how it is channeled from savers to borrowers, and how it is raised and used by individuals, firms, governments, and foreigners.

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 non-financial sector.

3.Surplus Spending Units (SSUs) are economic decision-making units, such as households and firms, which spend less than their current income.

4.Deficit Spending Units (DSUs) are economic decision-making units, such as households and firms, which spend more than their current income.

5.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.

6.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.

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.

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.

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 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 government units by issuing checkable and savings deposits. They primarily make loans to commercial businesses and households.

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 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

Deregulation

The removing or phasing out of existing regulations

Direct Finance

When SSUs lend their funds directly to DSUs

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

Federal Reserve ("Fed")

The central bank of the United States which regulates the banking system and determines monetary policy

Terms and Concepts You Need to Know, Continued

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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 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

Laissez Faire

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

Liquidity

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

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 declines over at least two consecutive quarters and unemployment rises

Saving

The portion of disposable Income which Is 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

The costs associated with borrowing and lending

What’s That Question?

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

TermsSaving & LendingBusiness Cycle

When a borrower fails to repay a financial claim

What is?

Spending units where spending exceeds 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 SSUs lend their funds to DSUs 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?

New ways to access and use money

What are ?

Spending units where income exceeds spending

What are ?

Business cycle phase where economic activity falls and unemployment rises

What is ?

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

What is?

The study of production, distribution and consumption

What is ?

Financial institutions that borrow from SSUs for the purpose of lending to DSUs

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 firms

What is ?

The central bank of the U.S.

What is ?

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

What is ?

Interest on checking accounts, debit cards, and ATMs are recent examples of this phenomenon

What is ?

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.

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.

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.

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.

dyou 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 Surplus Spending Units (SSUs) and Deficit Spending Units (DSUs) can best be described by the following:

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.

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

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.

Answer section

What’s That Question?

Terms

Saving

&

Lending

Business

Cycle

a

default

DSUs

an

expansion

money

direct

finance

trough

other

intermediaries

depository

institutions

the

business

cycle

laissez

faire

savings

peak

Financial innovations

SSUs

a

recession

What’s That Question Again?

Terms

Fields of

study

Begin

With F

Deregulation

economics

financial

intermed-

iaries

monetary

policy

finance

financial markets

Liquidity

micro-

economics

fiscal

policy

Transactions

costs

macro-

economics

the

Fed

Indirect

Finance

economics

financial

innovation

True/False

1.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.True.

4.False. It’s just the opposite.

5.False. Although regulation is important, monetary policy is the primary responsibility of the Fed.

6.True.

7.False. Just the opposite again.

8.True.

9.True.

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.

Multiple Choice

1.d2.d3.b4.b

5.b6.b7.c8.b

9.d10.b11.d12.a

13.b14.d15.c16.a

17.a18.b19.a20.b

Essays and Problems

The 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 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.