Chapter 01 An Introduction to Money and the Financial System
Chapter 1
An Introduction to Money and the Financial System
Chapter Overview
Chapter 1 introduces students to the five parts of the financial system and to the five core
principles that will be used throughout the text as each topic is covered. The organization
of the text is also discussed.
Learning Objectives: Establish an understanding of
The parts of the financial system
The core principles of money and banking
Special features and organization of the book
Important Points of the Chapter
This section of the instructor’s manual will highlight key points made in each chapter;
these may be the “big questions” (and their answers) raised in the chapter introduction, or
may be “timeless lessons” that students will use well into the future.
Application of Core Principles
A key feature of the text is the distillation of 5 core principles, which are defined in this
chapter and used as organizing themes throughout the rest of the book. While the 5
principles will be fully treated in the chapter outline below, it is worth listing them here;
they are:
1) Time has value.
2) Risk requires compensation.
3) Information is the basis for decisions.
4) Markets determine prices and allocate resources.
5) Stability improves welfare.
Students and instructors should look for the icons in the text that signal that a core
principle is being applied.
Teaching Tips/Student Stumbling Blocks
Students should note that they will be asked to apply the core principles to
different topics; see the problems at the end of this chapter for examples.
You may wish to present the list of five core principles often in your
presentations.
It also might be helpful for students to create a reference list of the five core
principles and keep it in a handy spot; the inside front cover of their class
notebook, perhaps.
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Chapter 01 An Introduction to Money and the Financial System
It will be helpful to find out if the students in your class have already taken
statistics or not; it will help you plan how you will cover Chapter 5 (which
includes discussion of concepts like the mean, expected value, variance, and
standard deviation).
Have students use a spreadsheet to keep track of the purchases they make in a
week, indicating the types of transactions, amounts, and methods of payment.
Collect and, if possible, combine the spreadsheets to point out trends or patterns.
For example, does method of payment change with size of transaction? Is cash
used more often by some students than others (due to, for example, whether or not
the person lives on campus)?
Features in this Chapter
This instructor’s manual will provide, on a chapter-by-chapter basis, brief summaries
(and page references) for the four types of inserts found in the chapters of the text. The
four types of inserts (and their general descriptions) are:
Your Financial World: These inserts provide basic guidelines for applying
economic theory to the bread-and-butter financial decisions that you make nearly
every day.
The first “Your Financial World” insert appears in this chapter. Titled “Guard
Your Identity,” it explains how little personal information thieves need to steal
someone’s identity. Students are also urged to check their financial statements for
unfamiliar charges or cash withdrawals. Finally, information is provided about
government resources to help prevent identity theft.
Applying the Concept: These inserts show how to put theory into practice and
provide real-world examples of the ideas introduced in the chapter (drawn
primarily from history or from relevant public policy debates).
In the News: Each chapter closes with an article drawn from the financial press in
order to provide practice in reading the financial news and to help develop an
understanding of the daily financial news. Each is followed by a brief summary
that points out the lesson(s) of the article.
Tools of the Trade: Many chapters include these inserts that may concentrate on
practical knowledge relevant to the chapter, or provide brief reviews of basic
economics needed for understanding something in the chapter, or which address
specific questions.
Lessons from the Crisis: These inserts cover episodes from the financial crisis of
2007-2009 to give a frame-work for understanding the crisis and to highlight the
relevance and power of the ideas in the book.
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Chapter 01 An Introduction to Money and the Financial System
Additional Teaching Tools
Each chapter of this instructor’s manual will provide suggestions for other materials that
can be used to illuminate the topics covered in the chapter, usually a current events topic
or issue of interest to students.
Virtual Tools
Each chapter of this instructor’s manual will provide suggestions for websites that
provide more information on the topics covered in the chapter or which are good sources
of data or other relevant materials.
For More Discussion
Each chapter of this instructor’s manual will provide suggestions for questions that can be
raised to provoke class discussion on the topics covered in the chapter.
Chapter Outline
I. The Five Parts of the Financial System
A. The financial system has five parts, each of which plays a fundamental
role in our economy. The parts are:
1. Money: used to pay for purchases and store wealth.
2. Financial instruments: used to transfer resources from savers to
investors and to transfer risk to those best equipped to bear it.
3. Financial markets: allow us to buy and sell financial instruments
quickly and cheaply
4. Financial institutions: provide a myriad of services, including
access to financial markets, and collect information about
prospective borrowers to ensure that they are creditworthy.
5. Government regulatory agencies: responsible for making sure that
the elements of the financial system operate in a safe and reliable
manner.
6. Central banks: monitor and stabilize the economy.
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Chapter 01 An Introduction to Money and the Financial System
B. While the essential functions of these five categories endure, their physical
form is constantly evolving.
1. Money has evolved from coins to paper money to today’s
electronic funds transfers.
2. Financial instruments: where once investing was an activity
reserved for the wealthy, today’s small investors have the
opportunity to purchase shares in “mutual funds.”
3. Financial markets have evolved from trading places to electronic
networks. Transactions are cheaper and markets offer a broader
array of financial instruments than were available even 50 years
ago.
4. Financial institutions: Today’s banks are more like financial
supermarkets offering a huge assortment of financial products and
services for sale.
5. Regulations: Dodd Frank Wall Street Reform and Consumer
Protection Act is largest regulatory change since the 1930s.
6. Central banks: what had been government treasuries have evolved
into the modern central bank that controls the availability of money
and credit in such a way as to ensure low inflation, high growth,
and the stability of the financial system. Policy makers strive for
transparency in their operations, which were once shrouded in
mystery. Recent financial crises have compelled central banks to
experiment with new tools.
C. We must therefore develop a way to understand and adapt to the
evolutionary structure of the financial system.
D. One way to do that is to discuss money and banking within a framework
of core principles that do not change over time; this is the focus of the next
section.
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Chapter 01 An Introduction to Money and the Financial System
The Five Core Principles of Money and Banking
E. Time has value
1. The first core principle is that time has value.
2. As a result of interest, time affects the value of financial
transactions.
F. Risk requires compensation.
1. The world is filled with uncertainty; some possibilities are
welcome and some are not.
2. To deal effectively with risk one must consider the full range of
possibilities: eliminate some risks, reduce others, pay someone else
to assume particularly onerous risks, and just live with what’s left.
3. Investors must be paid to assume risk and the higher the risk the
higher the required payment.
4. Car insurance is an example of paying for someone else to
shoulder a risk you don’t want to take. Both parties to the
transaction benefit.
a) Drivers are able to shelter their wealth in the event that they
cause an accident in which someone is seriously injured.
b) The insurance companies pool the premiums that
policyholders pay and invest them. Even though some of
the premiums will have to be paid out to settle claims there
is still a good chance to make a profit.
5. With even these first two principles we can understand the
valuation of a broad set of financial instruments; for example,
lenders charge higher rates if there is a chance the borrower will
not repay.
G. Information is the basis for decisions.
1. Most of us collect information before making decisions, and the
more important the decision the more information we collect.
2. The collecting and processing of information is the foundation of
the financial system.
3. Some transactions are arranged so that information is NOT needed;
for example, stock exchanges are organized to eliminate the need
for costly information gathering and thus facilitate the exchange of
securities.
4. In one way or another, information is the key to the financial
system.
H. Markets determine prices and allocate resources.
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Chapter 01 An Introduction to Money and the Financial System
1. Markets are the core of the economic system; they are the place,
physical or virtual, where firms go to issue stocks and bonds, and
where individuals go to purchase assets.
2. Financial markets are essential to the economy, channeling its
resources and minimizing the cost of gathering information and
making transactions.
3. Well-developed financial markets are a necessary precondition for
healthy economic growth.
4. Markets determine prices and allocate resources and thus are
sources of information.
5. By attaching prices to different stocks or bonds, markets provide
the basis for the allocation of capital.
6. Financial markets do not arise by themselves; they require rules to
operate properly and authorities to police them.
7. Even well-developed markets can break down.
8. For people to participate in a market it must be perceived as fair,
and this creates an important role for the government: when the
government protects investors, financial markets work well
(otherwise they don’t).
I. Stability improves welfare.
1. Reducing volatility reduces risk.
2. Only government policymakers can reduce some risks.
3. By stabilizing the economy monetary policymakers eliminate risks
that individuals can’t eliminate, and so improve everyone’s welfare
in the process.
4. Stabilizing the economy is the primary function of central banks.
5. A stable economy grows faster than an unstable one.
Special Features of this Book
J. The very first special feature of every chapter in this book is its
introduction – each one presents a real-world example that leads to the big
questions the chapter is designed to answer.
K. The text of each chapter presents the economic and financial theory
needed to understand the topics covered.
L. Each chapter also contains a series of inserts that apply the theory; there
are five types of inserts:
1. Your Financial World: These inserts provide basic guidelines for
applying economic theory to the bread-and-butter financial
decisions that you make nearly every day.
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McGraw-Hill Education.
Chapter 01 An Introduction to Money and the Financial System
2. Applying the Concept: These inserts show how to put theory into
practice and provide real-world examples of the ideas introduced
in the chapter (drawn primarily from history or from relevant
public policy debates).
3. Lessons from the Crisis: These inserts cover episodes from the
financial crisis of 2007-2009 and from the European banking and
government debt crisis that began shortly thereafter to give a
frame-work for understanding the crisis and to highlight the
relevance and power of the ideas in the book.
4. In the News: Each chapter closes with an article drawn from the
financial press in order to provide practice in reading the financial
news and to help develop an understanding of the daily financial
news. Each is followed by a brief summary that points out the
lesson(s) of the article.
5. Tools of the Trade: Many chapters include these inserts that may
concentrate on practical knowledge relevant to the chapter, or
provide brief reviews of basic economics needed for understanding
something in the chapter, or which address specific questions.
The Organization of this Book
M. The book is organized into five sections.
N. Each section uses core principles to illuminate a particular part of the
financial system and apply economic theory to the world around us.
O. Each chapter concludes with a list of terms introduced in that chapter, a
summary of the lessons of the chapter, and a set of problems.
End of Chapter Sections
A. Key Terms — A listing of all the technical terms introduced (in bold red) and
defined in the chapter. The key terms are defined in full in the glossary at the end
of the book.
B. Using FRED: Codes for Data in This Chapter –A table identifying economic and
financial data highlighted in the chapter together with the data code (identifier)
that is used to retrieve the data in FRED.
C. Chapter Lessons — A list of the key lessons in the chapter summarized in the form
of an outline that matches the chapter headings—a format designed to aid
comprehension and retention.
D. Problems — Each chapter contains two types of problems at varying levels of
difficulty: (1) conceptual and analytical problems and (2) data exploration
problems using FRED. The problems are designed to reinforce the lessons in the
chapter. The data exploration questions ask you to manipulate economic and
financial data from FRED (Federal Reserve Economic Database), the extensive
online resource maintained and provided free of charge by the Federal Reserve
Bank of St. Louis. FRED allows you to find, transform, and graph data directly
online or to download the data into a spreadsheet for further analysis. Many of the
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Chapter 01 An Introduction to Money and the Financial System
graphs in this book are based on data in FRED. Simple instructions for using
FRED can be found in Appendix B of this chapter. More detailed information
(including helpful tutorials) is available on the FRED Web site
(research.stlouisfed.org/fred2/).
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Chapter 01 An Introduction to Money and the Financial System
Terms Introduced in Chapter 1
central bank
European Central Bank
Federal Reserve System
financial institution
financial instrument
financial market
financial system
information
markets
money
regulatory agencies
regulation
risk
stability
supervision
time
Lessons of Chapter 1
1. A healthy and constantly evolving financial system is the foundation for economic
efficiency and economic growth. It has six parts:
a. Money is used to pay for purchases and to store wealth.
b. Financial instruments are used to transfer resources and risk.
c. Financial markets allow people to buy and sell financial instruments.
d. Financial institutions provide access to the financial markets, collect information,
and provide a variety of other services.
e. Government regulatory agencies aim to make the financial system operate safely
and reliably.
f. Central banks stabilize the economy.
2. The core principles of money and banking are useful in understanding all six parts of
the financial system.
a. Core Principle 1: Time has value.
b. Core Principle 2: Risk requires compensation.
c. Core Principle 3: Information is the basis for decisions.
d. Core Principle 4: Markets determine prices and allocate resources.
e. Core Principle 5: Stability improves welfare.
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