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

Full file at this full document at Chapter 01 An Introduction to Money and the
Financial System

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:

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1)
2)
3)
4)
5)

Time has value.
Risk requires compensation.
Information is the basis for decisions.
Markets set prices and allocate resources.
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.

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

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:

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B.

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.

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.

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The Five Core Principles of Money and Banking
E.

F.

Time
1.

The first core principle is that time has value.

2.

As a result of interest, time affects the value of financial
transactions.

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.

5.

G.

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.

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.

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.

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H.

I.

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).

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:

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Financial System

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
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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.

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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?

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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.

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11. The government is heavily involved in the financial system. Explain why.
Answer: For markets to work there have to be rules. And the rules need to be
enforced. The government both makes the rules and enforces them so that we all trust
the markets to work as they should. Without the government to monitor the financial

system, ensuring that people behave themselves, the system would collapse.

Analytical Problems
12. If offered the choice of receiving $1,000 today or $1,000 in one year’s time, which
option would you choose, and why?
Answer: Core principle 1 states that time has value, so you should choose option 1.
By receiving the $1000 today, you can immediately put the money to use. Perhaps
you buy a new computer or put the money in the bank to earn interest. Regardless of
what you do with the money, waiting a year to receive the money involves an
opportunity cost.
13. If time has value, why are financial institutions often willing to extend you a 30-year
mortgage at a lower annual interest rate than they would charge for a one-year loan?
Answer: With a mortgage, the house you purchase acts as collateral for the loan. In
the event you default, the bank can sell the house and recoup its funds. The existence
of collateral reduces the risk associated with the loan and so reduces the
compensation the bank requires.
14. Using Core Principle 2, under what circumstances would you expect a job applicant
to accept an offer of a low base salary and an opportunity to earn commission over
one with a higher base salary and no commission potential?
Answer: The applicant would have to expect to earn a higher total salary working for
a low base and commission, as they require compensation for the risk they assume
due to the uncertainty about the level of commission earnings.
15. Suppose medical research confirms earlier speculation that red wine is good for you.
Why would banks be willing to lend to vineyards that produce red wine at a lower
interest rate than before?
Answer: The future prospects for the vineyards have improved, reducing the risk
involved in lending to them. The banks require less compensation than before.

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16. * If the U.S. Securities and Exchange Commission eliminated its requirement for
public companies to disclose information about their finances, what would you expect
to happen to the stock prices for these companies?
Answer: You should expect the stock prices to fall. Gathering sufficient information
upon which to make an informed investment decision would become much more
costly for investors, reducing the demand for the stock at a given price.
17. If 2 percent growth is your break-even point for an investment project, under which
outlook for the economy would you be more inclined to go ahead with the
investment: (1) A forecast for economic growth that ranges from 0 to 4 percent, or (2)
a forecast of 2 percent growth for sure, assuming the forecasts are equally reliable?
What core principle does this illustrate?
Answer: You would be more inclined to invest in the project if you knew for sure that
growth would be 2%. Uncertainty about the future makes investment less attractive,
as you run the risk of losing out if the lower end of the forecast is realized. This
illustrates core principle 5 – stability improves welfare.
18. * Why are large, publicly listed companies much more likely than small businesses to
sell financial instruments such as bonds directly to the market, while small businesses
get their financing from financial institutions such as banks?
Answer: The information costs associated with small businesses are higher than those
for large, publicly listed companies, costs that bond market investors are unlikely to
be willing to incur. Banks are skilled at gathering information about borrowers and
evaluating the risks associated with loans. Therefore, they are more likely to be
willing to lend to smaller businesses.
19. * During the financial crisis of 2007-2009, some financial instruments that received
high ratings in terms of their safety turned out to be much riskier than those ratings
indicated. Explain why markets for other financial instruments might be adversely

affected by that development.
Answer: Core principle 3 states that information is the basis for decisions. Ratings
are an important source of information for investors in assessing many financial
instruments, and so when confidence in that information is undermined, they are more
reluctant to lend.
20. Suppose financial institutions didn’t exist but you urgently needed a loan. Where
would you most likely get this loan? Using core principles, identify an advantage and
a disadvantage this arrangement might have over borrowing from a financial
institution.

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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 3,
would be that your family and friends naturally have more information about you
than a bank and know, without having you fill in copious forms, that you can be relied
upon to pay them back. A disadvantage would be the necessity of finding a family
member or friend who happened to have funds available to lend to you at that
particular point in time. Financial institutions help bring potential borrowers and
lenders in the financial market together to allocate available resources (core principle
4).
* indicates more difficult problems

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