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Chapter 1
Introducing Money and the Financial System
Brief Chapter Summary and Learning Objectives
1.1 Key Components of the Financial System (pages 2–15)
Identify the key components of the financial system.
Financial assets, financial institutions, and government regulators are the key components of
the financial system.
There are many different types of financial assets with distinctive characteristics.
Financial institutions are distinguished by how they transfer funds from savers or lenders to
borrowers.
There are different regulators that provide oversight to different sectors of the financial system.
1.2 The Financial Crisis of 2007–2009 (pages 15–18)
Provide an overview of the financial crisis of 2007–2009.
The financial crisis of 2007-2009 provides a unique opportunity to explore the role and
significance of the financial system in the economy.
1.3 Key Issues and Questions from the Financial Crisis (pages 18–20)
Explain the key issues and questions the financial crisis raises.
Many issues arise as a result of the financial crisis, most of which will be addressed in future
chapters.
Key Terms and Concepts
Asset Anything of value owned by a person
or a firm.
Bond A financial security issued by a corporation
or a government that represents a promise to repay
a fixed amount of money.
Bubble An unsustainable increase in the price of
a class of assets.
Commercial bank A financial firm that serves
as a financial intermediary by taking in deposits
and using them to make loans.
Diversification Splitting wealth among many
different assets to reduce risk.
Dividend A payment that a corporation makes to
Federal funds rate The interest rate that banks
charge each other on short-term loans.
Federal Reserve The central bank of the United
States; usually referred to as “the Fed.”
Financial asset An asset that represents a claim
on someone else for a payment
Financial intermediary A financial firm, such as
a bank, that borrows funds from savers and lends
them to borrowers.
Financial liability A financial claim owed by a
person or a firm.
Financial market A place or channel for buying
or selling stocks, bonds, and other securities.
Foreign exchange Units of foreign currency.
its shareholders.
Information Facts about borrowers and about
expectations of returns on financial assets.
Interest rate The cost of borrowing funds
(or the payment for lending funds), usually
expressed as a percentage of the amount
borrowed.
Liquidity The ease with which an asset can be
exchanged for money.
Monetary policy The actions the Federal
Reserve takes to manage the money supply and
interest rates to pursue macroeconomic policy
objectives.
Money Anything that is generally accepted in
payment for goods and services or to pay off
debts.
Money supply The total quantity of money in
the economy.
Portfolio A collection of assets, such as
stocks and bonds.
Primary market A financial market in which
stocks, bonds, and other securities are sold for
the first time.
Risk sharing A service the financial system
provides that allows savers and borrower to
spread and transfer risk.
Secondary market A financial market in which
investors buy and sell existing securities.
Securitization The process of converting loans
and other financial assets that are not tradable into
securities.
Security A financial asset that can be
bought and sold in a financial market.
Stock Financial securities that represent
partial ownership of a firm; also called
equities.
Chapter Outline
Is Prosperity Just Around the Corner?
When the recession of 2007-2009 began, some economists considered it to be a normal recession that
would be followed by a typical economic recovery. What made this recession different was that it was
accompanied by a financial crisis, unlike any recession the United States had experienced since the Great
Depression of the 1930s. A financial system can be compared to an irrigation system. The financial crisis
of 2007–2009 showed what happens when credit does not flow. As a lack of water keeps crops from
growing, a lack of credit keeps the economy from growing. Just like a severe drought can cause many
crops to die, an extreme scarcity of credit can kill of parts of the economy, resulting in a severe recession.
People have come to realize the importance of the financial system. The financial crisis also revealed the
complexity of the financial system.
Teaching Tips
This chapter contains two innovations worth noting: an overview of the Federal Reserve System and a
brief account of the financial crisis of 2007-2009. Federal Reserve policy plays an important role in most
money and banking courses. Because of the variety of new policies the Fed implemented during the
financial crisis, many instructors have begun discussing the Fed earlier in their courses. In their own
teaching, the authors found that they couldn’t always rely on students recalling the basics of how the Fed
operates from their principles courses. So they included an overview in this first chapter.
Many students have become more interested in the financial system due to the financial crisis of
2007–2009. However, many have also formed opinions based on incomplete or erroneous information.
Discussion of the financial crisis at the beginning of the semester can help to motivate the study of
money, banking, and financial markets while at the same time highlighting the need to grasp fundamental
concepts underlying the system, including financial assets, financial institutions, and the regulatory
players and process.
Instructors who prefer to leave discussion of the Federal Reserve and the financial crisis for later in the
course are free to do so by omitting these sections of the chapter. None of the discussion in later chapters
directly requires knowledge of these topics.
1.1 Key Components of the Financial System (pages 2–15)
Learning Objective: Identify the key components of the financial system.
A. Financial Assets
Financial assets can be divided among five categories: money, stocks, bonds, foreign exchange,
and securitized loans. Money is anything that people are willing to accept in payment for
goods and services or to pay off debts. Stocks, also called equities, are financial securities that
represent partial ownership of a firm. When you buy a bond issued by a corporation or a
government, you are lending the corporation or the government a fixed amount of money.
Foreign exchange refers to units of foreign currency. Loans that banks could sell on financial
markets became securities, so the process of converting loans into securities is known as
securitization.
B. Financial Institutions
The financial system is made up of two types of financial institutions: Banks and other financial
intermediaries and financial markets. Funds flow from lenders to borrowers indirectly through
financial intermediaries, such as banks, or directly through financial markets. Commercial
banks are the most important financial intermediaries. Some financial intermediaries, such as
savings-and-loans, savings banks, and credit unions, are legally distinct from banks, although
these “nonbanks” operate in a very similar way by taking in deposits and making loans. Other
financial intermediaries include insurance companies, pension funds, mutual funds, hedge
funds, and investment banks. Financial markets are places or channels for buying and selling
stocks,
bonds, and other securities.
C. The Federal Reserve and Other Financial Regulators
The federal government of the United States has several agencies that are devoted to regulating
the financial system, including: the Securities and Exchange Commission, which regulates
financial markets; the Federal Deposit Insurance Corporation, which insures deposits in banks;
the Office of the Comptroller of the Currency, which regulates federally chartered banks; and
the Federal Reserve System, which is the central bank of the United States. Two of the major
roles of the Fed are serving as the lender of last resort and conducting monetary policy.
Monetary policy is the actions the Federal Reserve takes to manage the money supply and
interest rates to pursue macroeconomic policy objectives such as high levels of employment,
low rates of inflation, high rates of growth, and stability of the financial system. Figure 1.2 on
page 12 shows the location of the 12 districts of the Federal Reserve System.
D. What Does the Financial System Do?
The financial system provides three key financial services: risk sharing, liquidity, and
information. Risk sharing gives savers and borrowers ways to reduce the uncertainty to which
they are exposed. Liquidity is a measure of how easily an asset can be converted to cash. The
financial system gathers and communicates information about borrowers’ circumstances.
Teaching Tips
Pages 14–15 of the main text include a Solved Problem, which shows students how to solve an economic
problem by breaking it down step by step. Encourage students to read the Solved Problems in each
chapter because this feature can help them solve homework problems on their own and develop skills
needed to complete exams.
1.2 The Financial Crisis of 2007–2009 (pages 15–18)
Learning Objective: Provide an overview of the financial crisis of 2007–2009.
A. Origins of the Financial Crisis
The origins of the financial crisis lie in large part in the housing bubble of 2000–2005. While
overly optimistic expectations by homebuyers and builders may have played some role in the
housing bubble, many economists believe that changes in the market for mortgages played a
bigger role. By the 2000s, significant changes had taken place in the mortgage market. First,
investment banks became significant participants in the secondary market for mortgages.
Second, by the height of the housing bubble in 2005 and early 2006, lenders had greatly
loosened the standards for obtaining a mortgage loan. Unfortunately, the decline in housing
prices that began in 2006 led to rising defaults among subprime and Alt-A borrowers,
borrowers with adjustable-rate mortgages, and borrowers who had made only small down
payments. By mid-2007, the decline in the value of mortgage-backed securities and the large
losses suffered by commercial and investment banks began to cause turmoil in the financial
system. Many investors refused to buy mortgage-backed securities, and some investors would
only buy bonds issued by the U.S. Treasury. Banks began to restrict credit to all but the safest
borrowers. The flow of funds from savers to borrowers, on which the economy depends, began
to be greatly reduced.
B. The Deepening Crisis and the Response of the Fed and Treasury
The fallout from the Lehman Brothers bankruptcy had widespread repercussions, including a
sharp decline in most types of lending. In October 2008, Congress passed the Troubled Asset
Relief Program (TARP), under which the Treasury provided funds to commercial banks in
exchange for stock in those banks. These actions by the Fed and the Treasury were meant to
restore the flow of funds from savers to borrowers.
1.3 Key Issues and Questions About Money, Banking, and the Financial System
(pages 18–20)
Learning Objective: Explain the key issues and questions the financial crisis raises.
The brief review of the financial crisis raises a number of questions that the authors address in
future chapters.
Teaching Tip
Pages 18–20 list the “Issues and Questions” that serve as a roadmap for the topics the book will explore in
the remaining chapters.
