Introduction to Finance

surplus economic unit 
generates 
more money than it spends 
resulting in excess money to save 
or invest
defi cit economic unit 
generates 
less money that it spends resulting 
in a need for additional money

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C H A PT E R 2 Money and the Monetary System
the 2008–09 Great Recession was the massive amount of debt taken on by individuals, busi-
ness fi rms, fi nancial institutions, and government entities during the decade leading up to the 
crises. In an eff ort to survive the fi nancial crisis and recover from the recession, government 
entities, through increased expenditures in the form of stimulus programs, have increased 
their defi cits and, in the case of the U.S. government, dramatically increased the size of the 
national debt. 
Our primary focus is on the 
savings-investment process
that involves the direct or indir-
ect transfer of individual savings to business fi rms in exchange for their debt and stock securit-
ies. 
Figure 2.1
shows three ways whereby money is transferred from savers to a business fi rm. 
As illustrated in the top portion of the fi gure, savers can directly purchase the debt or equity (in 
the form of common stock issued by a corporation) securities of a business fi rm by exchanging 
money for the fi rm’s securities. No fi nancial institution is used in this type of savings-investment 
transaction since it involves only a saver and the business fi rm.
The use of indirect transfers is the more common way by which money is transferred from 
savers to investors. The middle part of Figure 2.1 shows how the transfer process usually takes 
place when savers purchase new securities issued by a business. From Chapter 1, you should 
recall that this indirect transfer involves use of the primary securities market. In this pro-
cess, fi nancial institutions operate to bring savers and security issuers together. Savers provide 
money to purchase the business fi rm’s securities. However, rather than a direct transfer taking 
place, fi nancial institutions, such as investment banks, may facilitate the savings-investment 
process by fi rst purchasing the securities being issued by a corporation and then reselling the 
securities to savers. No additional securities are created in this type of indirect transfer.
The bottom part of Figure 2.1 illustrates the typical capital formation process involving a 
fi nancial institution. Savers deposit or invest money with a fi nancial institution, such as a bank, 
insurance company, or mutual fund. The fi nancial institution issues its own securities to the 
saver. For example, a saver may give money in the form of currency to a bank in exchange for 
the bank’s savings or time-deposit obligation. The bank, in turn, may lend money to a business 
fi rm in exchange for that fi rm’s “I owe you” (IOU) in the form of a loan. As money passes 
from savers through a fi nancial institution to a business fi rm, a debt instrument or security is 
created by the fi nancial institution and by the business fi rm. This is the process of fi nancial 
intermediation that we will discuss further in Chapter 3. 
Of course, the savings-investment process could, alternatively, focus on the fl ow of money 
from savers to government entities that are operating at defi cits caused by expenditures greater 
than tax revenues. The U.S. government and state and local governments can sell their debt