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The Financial System and the The Financial System and the Economy:Economy:

Principles of Money and Banking, 2ePrinciples of Money and Banking, 2e

byBurton and Lombra

© 2000 South-Western College Publishing

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Chapter 1Introduction and Overview

© 2000 South-Western College Publishing

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Economics

The study of how society decides •what gets produced•how it gets produced•who gets what

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Microeconomics

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

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Macroeconomics

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

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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

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Deregulation

The removing or phasing out of existing regulations

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Money is

Something acceptable and generally used as payment for goods and services

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Saving is

Income not spent on consumption

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Surplus spending units (SSUs)

Spending units such as households and firms with income that exceeds spending

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Deficit spending units (DSUs)

Spending units such as households and firms where spending exceeds income

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Inco

me

Sp

end

ing

Sp

end

ing

Inco

me

Exhibit 1-1

Income greater than spending

SSUs

Spending greater than income

DSUs

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(Income not spent on consumption)

Investment Surplus Funds

Investment Surplus Funds

INVESTMENT PLUS SURPLUS FUNDS

Exhibit 1-2

+ +

==

Business Saving

Household Saving

(Income not distributed to the owners of the business firms)

Total Saving

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Financial MarketsFinancial Markets

Markets in which spending units trade financial claims

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Direct finance is...Direct finance is...

When SSUs lend their funds directly to DSUs

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Financial Intermediaries

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

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Indirect FinanceIndirect Finance

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

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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

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Transaction Costs are...Transaction Costs are...

The costs associated with borrowing and lending or making other exchanges

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Liquidity

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

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Depository Institutions

Financial intermediaries that issue checkable deposits

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Checkable DepositsCheckable Deposits

Deposits that are subject to withdrawal by writing a check

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Issue Other Financial ClaimsExhibit 1-4

FINANCIAL INTERMEDIARIES

Depository Institutions Other Intermediaries

Commercial BanksSavings and Loans

Credit UnionsMutual Savings Banks

Life and CasualtyInsurance Companies

Pension FundsMutual Funds

Market Mutual FundsFinance Companies

Issue Checkable Deposits

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The Federal Reserve (Fed)The Federal Reserve (Fed)

The central bank of the United States that regulates the banking system and determines monetary policy

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Monetary PolicyMonetary Policy

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

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The Federal Reserve

Financial System

Economic behaviorof households,

businesses, governments,and foreigners

Overall performanceof health of the economy:

•Inflation•Unemployment

•GrowthExhibit 1-5

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Business Cycle

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

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Expansion isExpansion is

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

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Recession isRecession is

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

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Fiscal PolicyFiscal Policy

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

31Exhibit 1-6

Tot

al Q

uan

tity

of

Goo

ds

and

Ser

vice

s P

rod

uce

d

Year

Recession(Contraction)

Expansion(Recovery)

Trough

Peak

Long-TermTrend

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Laissez-Faire

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

33Exhibit 1-7

Average Inflation, Unemployment,Average Inflation, Unemployment,and Growth During Recent Decadesand Growth During Recent Decades

1960s

1970s

1980s

1990 - 1998*

Inflation UnemploymentGrowth(Output)

2.4%

7.0

5.5

2.8

4.4%

3.2

2.8

2.5

4.75%

6.25

8.25

5.9

*Through 3rd quarter 1998 only