ANSWERS TO END-OF-CHAPTER QUESTIONS
1. Does it make sense that the typical household is a surplus spending unit (SSU) while the typical
business firm is a deficit spending unit (DSU)? Explain.
Households are ultimately SSUs, but have deficit periods when a home or other “big ticket” item
is purchased. Businesses usually invest more in real assets than they receive in current operating
cash flow.
2. Explain the economic role of brokers, dealers, and investment bankers. How does each make a
profit?
Brokers, dealers, and investment bankers make markets at both primary and secondary stages.
Funds are raised and claims issued in primary markets with the help of investment bankers, who
purchase securities from issuers at one price and sell them to the investing public at a higher
price, earning the underwriter’s spread. In secondary markets brokers help bring buyers and
sellers of financial claims together, charging commissions, and dealers trade claims in volume,
providing liquidity and price discovery and earning the difference between ask and bid price (the
bid-ask spread).
3. Why are direct financing transactions more costly or inconvenient than intermediated
transactions?
The parties to direct finance have to find each other and negotiate a more or less exact match of
preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about
financial activity, and drive costs down through competition, diversification, and economies of
scale.
4. Explain how you believe economic activity would be affected if we did not have financial markets
and institutions.
Financing relationships would arise only when preferences of SSUs and DSUs match. DSUs
would not always obtain timely financing for attractive projects and SSUs would under-utilize
their savings. The “production possibilities frontier” of the society would be smaller.
5. Explain the concept of financial intermediation. How does the possibility of financial
intermediation increase the efficiency of the financial system?
Financial intermediation is the process by which financial institutions mediate unmatched
preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries
buy financial claims with one set of characteristics from DSUs, then issue their own liabilities
with different characteristics to SSUs. Thus, financial intermediaries “transform” claims to make
them more attractive to both DSUs and SSUs. This increases the amount and regularity of
participation in the financial system, thus making financial markets more efficient.
6. How do financial intermediaries generate profits?
Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this
margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries
