Solution manual for money banking and financial markets 3rd edition cecchetti

Chapter 1An 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 w

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

Reading this chapter will prepare students to:

 Comprehend that a healthy and constantly evolving financial system is the

foundation for economic efficiency and economic growth;

 Define the six parts of the financial system, which are:

o Money, which is used to pay for purchases and to store wealth

o Financial instruments, which are used to transfer resources and risk

o Financial markets, which allow people to buy and sell financial

instruments

o Financial institutions, which allow people access to the financial markets, collect information, and provide a variety of other sources

o Government regulatory agencies, which are responsible for making sure that the elements of the financial system operate in a safe and reliable manner

o Central banks, which stabilize the economy

 Apply five core principles of money and banking, which are:

o Core Principle 1: Time has value

o Core Principle 2: Risk requires compensation

o Core Principle 3: Information is the basis for decisions

o Core Principle 4: Markets determine prices and allocate resources

o Core Principle 5: Stability improves welfare

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:

Financial System

1) Time has value.

2) Risk requires compensation.

3) Information is the basis for decisions.

4) Markets set 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

 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

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:

Financial System

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

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 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

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

The Five Core Principles of Money and Banking

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

Financial System

H Markets determine prices and allocate resources

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 Every chapter of this book begins with an introduction, which presents

real world examples that lead 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

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 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

4 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

5 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

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

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

Financial System 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

Conceptual Problems

1 Try to list the financial transactions you have engaged in over the past week How might each one have been carried out 50 years ago?

Answer: Commercial purchases that you made likely used credit cards and debit cards 50 years ago they would have all used cash Payment of utilities (if you do it) might have been done by electronic transfer, rather than a check (which would have been the method 50 years ago)

2 Can you think of any examples of how you, or your family or friends, were affected

by the failure of the financial system to function normally during the financial crisis

of 2007-2009?

Answer: It is likely that you or someone you know had an account with one of the many financial institutions that folded during the crisis, or that someone you know was refused a business loan or a mortgage or had a bank foreclose on their house

3 Describe the links among the six components of the financial system and the five core principles of money and banking

Answer:

a Money economizes on the need to obtain information Sellers don’t need to know who buyers are

b Financial instruments promise payment that may or may not be made in the future Pricing them uses the first two core principles: time has value and risk requires compensation

c Financial markets are where financial instruments are bought and sold They provide information, and they determine prices Core principles #3 and #4 come into play

d Financial institutions collect and process information They are based on the fact that information is the basis for decisions

e Government regulatory agencies gather information on financial institutions and promote stability in the financial system

f Central banks are engaged in stabilizing the economy and averting financial crisis; their behavior is based on the core principle that stability improves welfare

4 Socialists argue that, to reduce the power exerted by the owners of capital, the state should control the allocation of resources Thus, in a socialist system, the state

allocates investment resources In a market-based capitalist system, financial markets

do that job Which approach do you think works better, and why? Relate your answer

to the core principle that markets determine prices and allocate resources

Answer: Markets allocate use the price system to allocate resources to their most efficient uses Markets aggregate information from a multitude of sources

Command economies do not aggregate information as well, and do not allocate resources as efficiently As the financial crisis of 2007-09 illustrated, markets do not always work perfectly, and so the state usually plays some oversight role through regulation and supervision

5 Financial innovation has reduced individuals’ need to carry cash Explain how

Answer: Everyone has a number of alternative methods of payment Electronic forms, like credit and debit cards, are the primary ones that have reduced need to carry cash

6 * Many people believe that, despite ongoing financial innovations, cash will always

be with us to some degree as a form of money What core principle could justify this view?

Financial System Answer: Core principle 3 – information is the basis for decisions When cash is used

to settle a transaction, it is a final payment, not some form of promise to pay No information is needed about the payer once cash has been handed over to settle a transaction This has obvious advantages to the recipient, as the information costs are 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 a lot of questions Why? Why

is the set of questions you must answer standardized?

Answer: The questions are aimed at figuring out how likely you are to repay the loan They are standardized to reduce the cost of making the loan

8 Merchants that accept Visa or MasterCard pay the issuer of the card a percentage of the transaction For example, for each $100 charged on Visa cards, a merchant might receive only $98 Explain why Visa charges the fee and why the merchant pays it (You should be able to use at least two core principles in your answer.)

Answer: The merchant pays Visa for two things First they are paid immediately, and time has value Second, Visa takes the risk that the buyer will not pay, and risk requires compensation

9 Suppose central bankers have figured out a way to eliminate recessions What

financial and economic changes would you expect to see? Relate these changes to the core principle that stability improves welfare

Answer: If recessions were completely eliminated, then everyone’s income would be stabilized and the returns to business investment would become more predictable This would reduce risk and allow people to do things that they otherwise would not

do One possibility is the economy would grow more quickly

10 * Why do you think the global financial system has become more integrated over time? Can you think of any downside to this increased integration?

Answer: Technological progress is one obvious reason According to core principle

3, information is the basis for decisions Improvements in technology have allowed for huge volumes of information to be collected and disseminated quickly and

cheaply on a global basis, facilitating long distance financial transactions Increased integration allows for problems that arise in the financial system of one country to spread more quickly and easily to other countries, as we saw during the financial crisis of 2007-09