CHAPTER 2
The Financial System and the Economy
TEACHING OBJECTIVES
Goals of Part 1: Money and the Financial System
A. Introduce basic ideas behind bond, stock and other financial markets
(Chapter 2), money and the payments system (Chapter 3), the present-value
formula (Chapter 4), the structure of interest rates (Chapter 5), real interest
rates (Chapter 6), and stocks and other assets (Chapter 7).
Goals of Chapter 2
A. Show how the financial system matches borrowers and lenders.
B. Investigate the role of financial securities.
TEACHING NOTES
A. Introduction
1. Borrowing and lending is valuable to an individual and to the society as a
whole
2. The %nancial system consists of securities, intermediaries, and markets
that exist to match savers and borrowers
3. Figure 2.1 illustrates the components of financial system
4. This chapter introduces the financial system and explains why it is an
essential part of a well-functioning economy
B. Financial Securities
Definition of Financial Securities
1. Debt and Equity
a) Define a debt security and an equity security (stock)
b) How much debt and equity exist in the U.S.? Use Figure 2.2
c) Who issues debt and equity? Use Figure 2.3
d) Who owns debt and equity? Define investor and use Figure 2.4
2. differences Between Debt and Equity
a) Maturity; define principal
b) Type of payment being made (interest versus dividends)
c) Bankruptcy
Chapter 2: The Financial System and the Economy 11
d) Use Table 2.1 for the differences between debt and equity
e) differences exist because borrowers and lenders have different needs
C. Matching Borrowers with Lenders
1. Direct versus Indirect Finance
a) Definitions
b) Example; use Figure 2.5 for the differences between direct and
indirect finance
2. Financial Intermediaries
a) different types
b) How average people use them
3. Functions of Financial Intermediaries
a) Help savers through diversi%cation
b) Pool funds of many people
c) Take short-term deposits and make long-term loans
d) Gather information
e) Reduce the costs of financial transactions
D. Financial Markets
1. The Structure of Financial Markets
a) What is a %nancial market?
b) Do financial markets have a physical location?
c) Markets for new securities (primary market) and existing securities
(secondary market); use Figure 2.6
2. How Financial Markets Determine Prices of Securities
a) Supply and demand determine prices
b) Examples of determining equilibrium; use Figure 2.7
c) Prices of securities affected by changes in supply and demand; use
Figure 2.8
E. The Financial System
1. The Financial System and Economic Growth
a) Firms need to borrow to grow
Chapter 2: The Financial System and the Economy 12
c) Mortgages and Housing
(1) Home ownership is easy to obtain in the United States because the
financial system is well developed
(2) In countries with less developed financial systems, homeownership
is more di<cult, requiring greater savings, so people do not own
homes until later in their lives
(3) Since 2008, it has become di<cult for prospective home buyers to
obtain a mortgage loan.
d) The Financial Crisis of 2008
(1) The expectation of constantly rising housing prices was caused in
part by subprime lending
(2) When home prices dropped in 2007, the market for
mortgage-backed securities crashed
(3) A global financial crisis required governments and central banks to
provide bailouts
(4) Unregulated financial firms need to be prevented from growing so
large that they are too big to fail; government regulators need to
respond more quickly to risky financial practices
(5) Dodd-Frankly Act gave more power to government regulators
F. Application to Everyday Life: What Do Investors Care About?
1. Five Determinants of Investors’ Decisions
a) Expected Return
(1) Definition of expected return
b) Risk
(1) Causes of uncertainty about return
(a) Default by issuer of debt security; use Data Bank: Default Risk on
Debt
(b) Unexpected change in dividend paid on equity
(c) Change in the price of the security
(d) Unexpected change in the inDation rate; use Data Bank: How
Much Risk Do Investors Face from InDation?
(2) Quantify risk by standard deviation
(a) General formula for standard deviation
(b) Numerical examples
c) Liquidity
(1) Definition: ease of buying or selling securities at low transaction cost
(2) Marketable versus nonmarketable securities
d) Taxes
(1) Define after-tax expected return
(2) Investors seek to reduce tax burden
e) Maturity
Chapter 2: The Financial System and the Economy 13
(1) Many investors favor securities with shorter times to maturity
(2) Long-term securities must usually offer a higher expected return
than short-term securities
2. Choosing a Financial Investment Portfolio
a) Definition of portfolio
b) Need to examine risk of entire portfolio, taken together, not just
individual security
c) Idiosyncratic risk (unsystematic risk): risk that can be eliminated
by diversification
d) Market risk (systematic risk): risk that cannot be eliminated by
diversification
e) No portfolio is right for everyone; a person who is less risk-averse
should hold a riskier portfolio than someone who is very risk-averse
G. Data Bank: Default Risk on Debt
1. Debt ratings indicate the riskiness of different debt securities
2. Lower rated debt pays higher interest rates in the market; use Figure 2.A
3. The difference in interest rates between debts with different ratings gets
larger in recessions; use Figure 2.B
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. Add a more detailed discussion of diversification. You could start by asking
this question: Why is it usually better for an investor to own 100 different
stocks rather than one? Then you could cite research that suggests that
having about twenty stocks from different industries reduces most of the
idiosyncratic risk to a portfolio.
2. To expand on the discussion of risk and return, you can draw bell-shaped
curves that describe the distribution of returns to a stock. After drawing the
basic curve, you can illustrate a variety of concepts. Show a
mean-preserving spread by drawing two distributions with the same
expected return but different risks, and ask which one an investor would
prefer. Then show that if the security with more risk has a higher expected
return; some investors will prefer one and other investors will prefer the
other.
3. You can introduce the idea of a portfolio-possibilities line by drawing a
diagram showing risk on the horizontal axis and expected return on the
vertical axis. The upward sloping portfolio-possibilities line shows the
trade-o5 that investors face between risk and expected return. Some
investors will prefer to be on the left side of the line, with low risk and low
Chapter 2: The Financial System and the Economy 14
expected return; other investors will prefer to be further to the right on the
line, accepting greater risk in return for increased expected return. No spot