1 The Financial System and the Economy: Principles of Money and Banking, 2e by Burton and Lombra © 2000 South-Western College Publishing

2 Chapter 1 Introduction and Overview © 2000 South-Western College Publishing

3 Economics The study of how society decides what gets produced how it gets produced who gets what

4 Microeconomics The branch of economics that studies the behavior of individual decision-making units such as households and business firms

5 Macroeconomics The branch of economics that studies the aggregate or total behavior of all households and firms

6 Finance The study of how the financial system coordinates and channels the flow of funds from lenders to borrowers - and vice versa - and how new funds are created by financial intermediaries in the borrowing process

7 Deregulation The removing or phasing out of existing regulations

8 Money is Something acceptable and generally used as payment for goods and services

9 Saving is Income not spent on consumption

10 Surplus spending units (SSUs) Spending units such as households and firms with income that exceeds spending

11 Deficit spending units (DSUs) Spending units such as households and firms where spending exceeds income

12 Income Spending Income Exhibit 1-1 Income greater than spending SSUs Spending greater than income DSUs

13 (Income not spent on consumption) InvestmentSurplus FundsInvestmentSurplus Funds INVESTMENT PLUS SURPLUS FUNDS Exhibit == Business Saving Household Saving (Income not distributed to the owners of the business firms) Total Saving

14 Financial Markets Markets in which spending units trade financial claims

15 Direct finance is... When SSUs lend their funds directly to DSUs

16 Financial Intermediaries Financial institutions that borrow form SSUs for the purpose of lending to DSUs

17 Indirect Finance When DSUs borrow from financial intermediaries that have acquired the funds to lend from SSUs

18 Surplus Spending Units Financial Markets Financial Intermediaries Deficit Spending Units DIRECT FINANCE INDIRECT FINANCE Exhibit 1-3 Purchasing Power flows one way Legal obligations flow back The Financial System

19 Transaction Costs are... The costs associated with borrowing and lending or making other exchanges

20 Liquidity The ease with which a financial claim can be converted to cash without loss of value

21 Depository Institutions Financial intermediaries that issue checkable deposits

22 Checkable Deposits Deposits that are subject to withdrawal by writing a check

23 Issue Other Financial Claims Exhibit 1-4 FINANCIAL INTERMEDIARIES Depository InstitutionsOther Intermediaries Commercial Banks Savings and Loans Credit Unions Mutual Savings Banks Life and Casualty Insurance Companies Pension Funds Mutual Funds Market Mutual Funds Finance Companies Issue Checkable Deposits

24 The Federal Reserve (Fed) The central bank of the United States that regulates the banking system and determines monetary policy

25 Monetary Policy The Fed’s efforts to promote the overall health and stability of the economy

26 The Federal Reserve Financial System Economic behavior of households, businesses, governments, and foreigners Overall performance of health of the economy: Inflation Unemployment Growth Exhibit 1-5

27 Business Cycle Short-run fluctuations in the level of economic activity as measured by the output of goods and services in the economy

28 Expansion is The phase of the business cycle during which economic activity increases and unemployment falls

29 Recession is The phase of the business cycle during which economic activity falls and unemployment rises

30 Fiscal Policy Government spending and taxing decisions to speed up or slow down the level of economic activity

31 Exhibit 1-6 Total Quantity of Goods and Services Produced Year Recession (Contraction) Expansion (Recovery) Trough Peak Long-Term Trend

32 Laissez-Faire The view that government should pursue a hands-off policy with regard to the economy

33 Exhibit 1-7 Average Inflation, Unemployment, and Growth During Recent Decades 1960s 1970s 1980s * InflationUnemployment Growth (Output) 2.4% % % *Through 3rd quarter 1998 only