Chapter 1
An Introduction to Money and the Financial System
Problems
1. List the financial transactions you have engaged in over the past week. How might
Answer: Commercial purchases that you made likely used credit cards and debit
have been the method 50 years ago).
2. How were you, or your family or your friends affected by the recent failure of the
Answer: It is likely that you or someone you know had an account with one of the
3. List three items you used to buy with cash but you now purchase with a debit card.
(LO1)
4. Various financial instruments usually serve one of two distinct purposes: to store
Answer: Financial instruments used to store value include bank accounts, stocks and
5. Financial innovation has reduced individuals’ need to carry cash. Explain how. (LO1)
Answer: Everyone has a number of alternative methods of payment. Electronic
6. * Many people believe that, despite ongoing financial innovations, cash will always
Answer: Core Principle 3 – information is the basis for decisions. When cash is used
negligible. In some circumstances, one or both parties to a transaction may wish to
preserve their anonymity, and cash allows this.
7. When you apply for a loan, you are required to answer lots of questions. Why? Why
Answer: The questions are aimed at figuring out how likely you are to repay the loan.
8. Name two distinct financial markets and describe the kind of asset traded in each.
(LO1)
Answer: Among the best-known financial markets are those for stocks and for bonds.
9. * Why do you think the financial system has become more globally integrated over
Answer: Technological progress is one obvious reason. According to Core Principle
3, information is the basis for decisions. Improvements in technology have allowed
spread more quickly and easily to other countries, as we saw during the financial
crisis of 2007-2009.
10. The government is heavily involved in the financial system. Explain why. (LO1)
Answer: For markets to work there have to be rules. And the rules need to be
system, ensuring that people behave themselves, the system would collapse.
11. If offered the choice of receiving $1,000 today or $1,000 in one year’s time, which
option would you choose, and why? (LO2)
Answer: Core Principle 1 states that time has value, so you should choose option 1.
opportunity cost.
12. If time has value, why are financial institutions often willing to extend you a 30-year
(LO2)
Answer: With a mortgage, the house you purchase acts as collateral for the loan. In
compensation the bank requires.
13. Using Core Principle 2, under what circumstances would you expect a job applicant
one with a higher base salary and no commission potential? (LO2)
Answer: The applicant would have to expect to earn a higher total salary working for
14. Suppose medical research confirms earlier speculation that red wine is good for you.
interest rate than before? (LO2)
Answer: The future prospects for the vineyards have improved, reducing the risk
15. * If the U.S. Securities and Exchange Commission eliminated its requirement for
to happen to the stock prices for these companies? (LO2)
Answer: You should expect the stock prices to fall. Gathering sufficient information
16. If 2 percent growth is your break-even point for an investment project, under which
a forecast of 2 percent growth for sure, assuming the forecasts are equally reliable?
What core principle does this illustrate? (LO2)
Answer: You would be more inclined to invest in the project if you knew for sure that
illustrates core principle 5 – stability improves welfare.
17. * Why are large, publicly listed companies much more likely than small businesses to
get their financing from financial institutions such as banks? (LO2)
Answer: Information costs associated with small businesses are higher than those for
willing to lend to smaller businesses.
18. * During the financial crisis of 2007-2009, some financial instruments that received
adversely affected by that development. (LO2)
Answer: Core Principle 3 states that information is the basis for decisions. Ratings
reluctant to lend.
19. Suppose financial institutions didn’t exist but you urgently needed a loan. Where
institution. (LO2)
Answer: In the absence of financial institutions, you are most likely to borrow from a
family member or a friend. An advantage of this arrangement, under Core Principle
lenders in the financial market together to allocate available resources (Core principle
4).
20. In broad terms, explain how a central bank tries to maintain economic and financial
Answer: Central banks can moderate business cycle fluctuations by adjusting interest
on their own, allowing to invest in the future. That promotes economic growth.
21. The Dodd-Frank Act, enacted in the United States in the aftermath of the 2007-2009
(LO2)
Answer:
Core Principle 3 – Information is the basis for decisions. Coordination should improve
Core Principle 5 – Stability improves welfare. Improved regulation as a result of
22. In December 2015, the Federal Reserve increased its policy interest rate target. This
was the first increase since cutting the target to close to zero in December 2008 to
infer from this decision about the Fed’s view of the economy? (LO2)
Answer: The Federal Reserve’s decision to begin raising the target for the policy
Data Exploration
1. Go to the FRED database at the Federal Reserve Bank of St. Louis website
Answer: Sign up as indicated.
2. To begin using FRED, plot the consumer price index (FRED code:
CPIAUCSL) and find the date and level of the latest monthly observation. Then plot
Recessions are depicted by vertical shaded bars.
3. Plot the level of real GDP (FRED code: GDPC1). Then plot the rate of economic
you can recall and update the graph easily when new observations become available.
Answer: The graph for the level of real GDP is:
Real GDP usually declines in recessions and rebounds afterwards. In the 2007-2009
in nearly five decades.
4. Examine nominal GDP (FRED code: GDP) based on a figure showing percent change
Answer: The plot appears below. Unlike other recessions since 1960, nominal GDP
5. Plot on one figure the percent change from a year ago of both the GDP deflator
less than real GDP?
Answer: The data plots with real GDP and the GDP deflator is given below:
Nominal GDP is the product of real GDP and the GDP deflator. Alternatively, real
mid-1980s. Furthermore, it appears less volatile than real GDP.
* indicates more difficult problems