Introduction to Finance

41
Summary
LO 2.1 
Several developments led to the 2007–2008 fi nancial crisis. A 
rapid decline in housing prices led to increased unemployment, fi rst 
in housing-related activities and then more broadly. As a result, many 
homeowners were forced to default on their home mortgage loans. 
The fi nancial crisis was made worse because the downturn occurred 
at a time when individuals, fi nancial institutions, and businesses were 
heavily in debt.
LO 2.2 
Money is transferred from savers to businesses in three ways. 
Direct transfers occur when savers purchase a business fi rm’s securities 
from the business fi rm that issued the securities. Indirect transfers can 
involve an investment banking fi rm that uses money from savers to 
purchase a business fi rm’s securities and then distribute the securities 
to savers. Indirect transfers also may be carried out through a fi nan-
cial intermediary. For example, a fi nancial institution may issue its 
own securities to obtain money from savers, and then use the money 
to purchase a business fi rm’s securities.
LO 2.3 
The major components of the monetary system include a 
central bank (the Fed) and a banking system. The Fed defi nes and 
regulates the money supply, as well as facilitates the transferring of 
money through check processing and clearing. An effi
cient banking 
system, creates money, transfers money, provides fi nancial interme-
diation, and processes/clears checks. 
LO 2.4 
Money is anything generally accepted as a means of pay-
ment for goods, services, and debts. The functions of money include 
serving as a medium of exchange, a store of value, and a standard 
of value.
LO 2.5 
Physical money (coin and currency) in the United States 
developed from full backing in gold or silver to token coins or fi at 
money. Coins were initially full-bodied money because they con-
tained the same value in metal as their face value. Today, we have 
token coins because there face values are higher than the value of 
their metal content. Paper money was originally representative 
full-bodied money because the money was backed by an amount of 
precious metal equal in value to the face amount of the currency. 
Today, paper money is not backed by precious metals and is referred 
to as fi at money because currency is declared legal tender for pur-
poses of making payments and discharging debts.
LO 2.6 
The major types of money market securities are Treasury bills 
(short-term debt obligation issued by the government), commercial 
paper (short-term unsecured promissory note issued by high-quality 
corporations), negotiable certifi cate of deposit (short-term debt 
instrument issued by depository institutions), banker’s acceptance 
(promise of future payment issued by a fi rm and guaranteed by a 
commercial bank), repurchase agreement (short-term debt security 
where the seller agrees to repurchase the security at a specifi ed price 
and date), and federal funds (short-term loans typically for one day to 
one week made between depository institutions.
LO 2.7 
The M1 money supply consists of currency, traveler’s checks, 
demand deposits, and other checkable deposits at depository institu-
tions. The M2 money supply defi nition consists of M1 plus highly 
liquid fi nancial assets, including savings accounts, small time depos-
its, and retail money market mutual funds.
LO 2.8 
The output of goods and services in the economy is known 
as the gross domestic product (GDP). The money supply times the 
velocity of money equals GDP. A net increase in the changes in 
the money supply and the velocity of money will lead to a higher GDP. 
Economists also express GDP as being equal to real output times 
the price level. Thus, a larger GDP due to an increase in the money 
supply with no change in the velocity of money also means that a 
net increase in changes in real output and price level must occur. 
Monetarists contend that there is a direct link between the money 
supply and gross domestic product (GDP) via the velocity of money. 
Keynesians believe the link is less direct because changes in money 
supply fi rst aff ect interest rates, which, in turn, infl uence GDP through 
changes in consumption and investment. Evidence does not indicate 
that one group is right and the other is wrong.
LO 2.9 
The international monetary system was historically tied to the 
gold standard. In 1944, the exchange rates between the currencies of 
most industrialized countries were fi xed relative to the U.S. dollar or 
gold. By early 1973, major currencies were allowed to fl oat against 
each other, resulting in a fl exible, or fl oating, exchange rate system. 
Another major international monetary system development occurred 
when an initial 11 European Union countries agreed to give up their 
individual currencies for a unifi ed currency called the euro, begin-
ning January 1, 1999, with monetary policy being administered by 
the European Central Bank.
Occasionally the savings of some individuals are directed to 
other individuals who want to purchase homes using mortgage loans. 
Individual, institutional, and business savings also may be directed 
to help government entities to fi nance defi cits causes by tax revenues 
being exceeded by expenditures.