CHAPTERS 1-4 REVIEW CHAPTER 3 WHAT IS MONEY? SUMMARY 1. To economists, the word money, has a different meaning from income or wealth. Money is anything that is accepted as payment for goods and services or in paying debts. 2. Money serves 3 functions or purposes: as a medium of exchange, as a unit of account, and as a store of value. 3. The payment system has evolved over time. From gold or silver, to paper currency, to checks, to electronic money.

Study Questions - Chapter 3 Why were people in the USA in the 19th century sometimes willing to be paid by check rather than with gold, even though they knew that thee was a possibility the check might bounce, or be no good? In ancient Greece, why was gold a more likely candidate for use as money than wine was? Rank the following assets from most liquid to least liquid? a. Checking account deposits b. Houses c. Currency d. Washing machines e. savings deposits f. Common stock

CHAPTER 1 WHY STUDY BANKING AND FINANCIAL MARKETS? SUMMARY 1. Activities in financial markets have direct effects on individuals’ wealth, the behavior of businesses, and the efficiency of an economy. Three financial markets deserve attention: the bond market (where interest rates are determined), the stock market, and the foreign exchange market. 2. Banks and other financial institutions direct funds from people who might not put them to productive use to people who can do so thus improving the efficiency of the economy. 3. Money appears to be a major influence on inflation, business cycles and interest rates. Because these economic variables are so important to the health of an economy, we need to understand how monetary policy is and should be conducted.

Study Questions – Chapter 1 1. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to real output? b. the inflation rate c. interest rates? 2. When interest rates fall, how might you change your economic behavior? 3. Can you think of any financial innovation in the past 10 years that has affected you personally? Has it made you better off or worse? Why? 4. Is everybody worse off when interest rates rise?

More Study Questions – Chapter 1 5. What is the basic activity of banks? 6. Why are financial markets important to the health of the economy? 7. What effect might a fall in stock prices have on business investment? 8. What effect might a rise in stock prices have on consumer’s decisions to spend?

Chapter 1 Appendix Summary  

Chapter 2 – An Overview of the Financial System Summary The basic function of financial markets is to direct funds from savers who have an excess of money to spenders who need money. Directing money helps consumers by allowing them to make purchases when they need them most. Direct and Indirect Finance is how this is done. Financial markets can be classified as debt and equity, primary and secondary, exchanges and over-the-counter, and money and capital markets. The main money market instruments include, US Treasury Bills, Commercial Paper & Eurodollars. Capital market instruments include stocks & mortgages, corporate bonds

Chapter 2 Summary Continued An important trend in recent years is the growing internationalization of financial markets, such as Eurobonds and Eurodollars. Financial Intermediaries, such as banks play an important role in the financial system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and moral hazard. The main financial intermediaries fall into 3 categories: 1. Depository Institutions – Banks, Savings and Loans and Credit Unions. 2. Life Insurance Companies 3. Finance and Mutual Fund Companies

Review Questions Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft? If I buy a car today for $5,000 and it is worth $10,000 in extra income next year to me (I get a better job where I have to travel), should I take out a loan from a “loan shark” at a 90% interest rate if no one else will give me a loan? Will I be better or worse off for taking out this loan? Should we legalize loan – sharking?

Review Questions 3. Some economists believe one of the reasons that economies in developing countries grow slowly is that they do not have well developed financial markets. Do you agree or disagree? Why? 4. The US economy borrowed from the British in the 1800’s to build railroads. What debt instrument was used? Why did this help each country? 5. “Because corporations do not raise any funds in secondary markets, they are less important to the economy than primary markets.” What do you think about that statement? 6. If a company goes bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?

Asymmetric Information, Adverse Selection and Moral Hazard In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. Adverse Selection is the problem created by asymmetric information before the transaction occurs. This occurs when potential borrowers who are bad credit risks are the most likely ones to seek out a loan and be selected. Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard is the risk (hazard) that the borrower might engage in activities that are bad (immoral) from the lender’s point of view because the borrower might not pay back the loan. Because of this, lenders might not want to make the loan.