(Solution Manual) Introduction to Finance Markets, Investments, and Financial Management

Melicher, Norton, 17

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Solutions Manual for Introduction to Finance Markets, Investments, and Financial Management, 17e Ronald Melicher, Edgar Norton (All Chapters ) Chapter One: The Financial Environment 1-1 Chapter 1 The Financial Environment CHAPTER PREVIEW This first chapter provides an overview of the three areas of finance —institutions and markets, investments, and financial management. We begin by providing clear answers to the following two questions: What is finance? Why study finance? To underscore the importance of studying finance, we briefly discuss how the financial environment changed during the early -part of the twenty -first century. Six principles of finance are identified and discussed: time value of money, risk versus return, diversification of risk, financial markets are efficient, management versus owner objectives, and reputation matters. The basic requirements of an effective financial system need to be understood in order to tie finance into the economy in general. We also discuss the financial functions in the U.S. system: creating and transferring money, accumulating and lending/investing savings, and marketing and transferring financial assets . We then identify financial markets char acteristics and describe major types of financial market s. We next follow with a brief discussion of some of the careers available in finance and use this introduction about finance careers to provide the basis for more detailed discussions in later chapte rs. The chapter concludes with a description of the plan of study for the book. LEARNING OBJECTIVES LO 1.1 Define finance and describe the three areas of finance. LO 1.2 Explain why finance should be studied. LO 1.3 D escribe and discuss the six p rinciples of finance. LO 1.4 Identify the four components of the financial system and describe their roles. LO 1.5 Describe financial markets characteristics and the four types of financial markets. LO 1.6 Identify several major career opportunities in finance. LO 1.7 Describe this textbook’s plan of study. CHAPTER OUTLINE I. (1.1) WHAT IS FINANCE? A. Two Themes II. (1.2) WHY STUDY FINANCE? III. (1.3) SIX PRINCIPLES OF FINANCE A. Time Value of Money B. Risk Versus Return C. Diversification of Risk D. Financial Markets are Efficient E. Management Versus Owner Objectives Chapter One: The Financial Environment 1-2 F. Reputation Matters IV. (1.4) OVERVIEW OF THE FINANCIAL SYSTEM A. Characteristics and Requirements B. Financial System Components and Financial Functions 1. Creating Money 2. Transferring Money 3. Accumulating S avings 4. Lending and Investing Savings 5. Marketing Financial Assets 6. Transferring Financial Assets V. (1.5) FINANCIAL MARKETS: CHARACTERISTICS AND TYPES A. Money and Capital Markets B. Primary and Secondary Markets C. Major Types of Financial Markets VI. (1.6) CAREERS IN FINANCE VII. (1.7) THE PLAN OF STUDY VIII. SUMMARY LECTURE NOTES I. (1.1) WHAT IS FINANCE? Capitalism is an economic system with private ownership of assets, production of goods and services for profit, a price mechanism for allocating resources, and financial markets. The United States is a mixed market capitalistic system. We describe finance in the context of the U.S. economic system. Finance is the study of how individuals, institutions, governments, and businesses acqui re, spend, and manage money and other financial resources. The financial environment encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently. The three areas of finance within the financial envi ronment and financial system are: institutions and markets, investments, and financial management. Financial institutions are intermediaries that help the financial system operate efficiently and help transfer funds from savers to investors. Financial ma rkets are physical locations or electronic forums that facilitate the flow of funds. Investments involve the marketing of securities, securities analysis, and the management of investment risk. Financial management involves financial planning, asset mana gement, and fund raising decisions to enhance the value of firms. Chapter One: The Financial Environment 1-3 Within the context of the three areas of finance we cover the themes of small business management and personal financial planning. Entrepreneurial finance studies how growth -driven, perfo rmance -focused, early -stage firms raise financial capital and manage their operations and assets. Personal finance studies how individuals prepare for financial emergencies, protect against premature death and the loss of property, and accumulate wealth o ver time. (Use Figure 1.1 and Review Questions 1 through 4 here.) II. (1.2) WHY STUDY FINANCE? The first eighteen years of the twenty -first century has been characterized by a volatile economic environment in the U.S. A price bubble for technol ogy stocks (including dot.com start -ups) burst in 2000. A subsequent economic downturn was made worse by the September 11, 2001 terrorist attack. Although there followed a period of economic recovery, a housing price bubble burst in 2006. Debt securitie s tied to housing prices subsequently fell causing many financial institutions to be pushed to the brink of failure which led to the 2007 -08 financial crisis. The economy entered the 2008 -09 Great Recession. Although e conomic recovery was slow , unemployme nt rates, which exceeded 10 percent in 2009, dropp ed to the 5 percent level by the end of 2015 and below 4 percent by the end of 2018. We encourage instructors to spend time at the beginning of the course explaining to, and di scussing with, their students about the importance of studying finance. We suggest several reasons why students should study finance. a. First, as a citizen (of the U.S.A. or another country), you should want to make informed economic decisions. Whatever your financial and economic goals may be, you need to be an informed participant if you wish to “make a difference.” The operation of the financial system and the performance of the economy are influenced by policy makers. The citizens elect important p olicy makers such as the President and Congress who can pass or change laws, and through their decisions impact on the level of economic activity. Thus, it is important that citizens be informed when making political/economic choices. b. Second, having some knowledge about finance, particularly the financial markets or investments component, should be important to you. An understanding of various aspects of personal finance should help you better manage your existing financial resources, as well as provide the basis for making sound decisions for accumulating wealth over time. c. Third, to be successful in the business world, it is important to have a basic understanding of business finance in addition to an understanding of macro finance and investments (financial markets). Even if your “business interest” is in a non - Chapter One: The Financial Environment 1-4 finance career, you likely will need to interact with finance professionals both within and outside your firm. To do so will require a basic knowledge of the concepts, too ls, and applications of business finance. (Use Review Question s 5 and 6 here.) III. (1.3) SIX PRINCIPLES OF FINANCE Finance is founded on six principles. They are: 1. Money has a time value. 2. Higher returns are expec ted for taking on more risk. 3. Diversificatio n of investments can reduce risk. 4. Financial markets are efficient in pricing securities. 5. Manager and stockholder objectives may differ. 6. Reputation matters. An individual’s reputation reflects his/her et hical behavior which is how an individual treats other legally, fairly, and honestly. (Use Review Questions 7 and 8 here.) IV. (1.4) OVERVIEW OF THE FINANCIAL SYSTEM A democracy is a system of government where limited authority and power are granted by law to its people to vote on government policies and issues. The United States of America is a representative democracy where U.S. citizens elect representatives from amon gst their peers to participate in formulating government policies and plans and addressing government issues . This system of representative democracy provides the framework for viewing and describing the U.S. financial system in this textb ook. An effective financial system is a complex mix of government and policy makers, a monetary system, financial institutions, and financial markets that interact to expedite the flow of financial capital from savings into investment. Basic requirements for an effective financial system include: a monetary system, a savings -investment process, and financial markets. The monetary system must provide an efficient medium for exchanging goods and services. This is accomplished by an efficient system for creating and transferring money. The financial system must also be able to allow capital formation by channeling savings into investment. In addition, markets must exist in which to buy and sell measures of (or claims to) wealth, such as financial assets or real estate. In a simple economy, such as a self -sufficient farm, a farmer can create capital by building a new barn. Capital formation takes place indirectly in a highly developed economy. For example, individ uals may save a portion of their current income which is, in turn, loaned to others who want to purchase equipment. Chapter One: The Financial Environment 1-5 The basic financial functions in an effective financial system include: creation of money, transferring money, accumulating savings in fina ncial institutions, lending and investing savings, marketing financial assets, and transferring financial assets. The functions of finance can be developed in class by asking students to list on the board all financial institutions with which they are fa miliar. They can then be asked which services they and their families receive from these institutions. It will take some probing and grouping of items to develop the list of functions, but time spent on this significant topic is worth the effort. (Use Figu res 1.2 and 1.3 and Review Question s 9 and 10 here.) V. (1.5) FINANCIAL MARKETS : CHARACTERISTICS AND TYPES Financial markets can be classified into: (a) money and capital markets; and (b) primary and secondary markets. Money markets are where debt securities with maturities of one year or less are issued and traded. Capital markets are where debt instruments or securities with maturities longer than one year and corporate stocks (equity securities) are issued and traded. Primary m arkets are where the initial offering or origination of debt and equity securities takes place. Secondary markets are physical locations (or electronic forums) where debt (bonds and mortgages) and equity securities are traded. Debt securities are obl igations to repay borrowed funds. Common stocks are ownership shares in corporations. There are four main types of financial markets —debt securities markets, equity securities markets, derivative securities markets, and foreign exchange markets . Debt securities markets are markets where money market securities, bonds, and mortgages are originated and traded. Equity securities markets are markets where stocks are initially traded and sold. Derivative securities markets are markets for financia l instruments or contracts that derive their values from underlying debt or equity securities. Foreign exchange markets (or FOREX markets) are electronic markets in which banks and institutional traders buy and sell various currencies on behalf of business es and other clients. (Use Review Question s 11 through and 1 4 here.) VI. (1.6) CAREERS IN FINANCE Career opportunities in finance are generally found in the areas of financial management, depository financial institutions, contractual savings and real property organizations, and securities markets and investment firms. Chapter One: The Financial Environment 1-6 Entry -level finance job opportunities also exist in government or not -for-profit organizations, as well as with international or global businesses. (Use Review Question 15 here.) VII. (1.7) THE PLAN OF STUDY Part 1 describes the overall financial environment and introduces the three areas of finance —institutions and markets, investments, and financial management. We also discuss how t he necessary components (a monetary system, financial institutions, and financial markets) of the financial system interact to make the financial system operate efficiently. Part 2 is concerned with the investments area of finance including the characteri stics and valuation of stocks and bonds, as well as the roles and operations of securities markets. Part 3 focuses on the financial management of businesses and includes how the business sector interacts with the financial system. REVIEW QUESTIONS AND ANSWERS 1. (LO 1.1) What is finance? Capitalism is an economic system with private ownership of assets, production of goods and services for profit, a price mechanism for allocating resources, and financial markets. Finance is describe d in the context of the U.S. mixed market capitalistic system. Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial resources. 2. (LO 1.1) What is meant by the t erm financial environment? The financial environment encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently. 3. (LO 1.1) What are the three areas of finance? The three areas of finance within the financial environment and financial system are institutions and markets, investments, and financial management. Financial institutions are intermediaries that help the financial system operate efficiently and assist the sa vings -investment process. Financial markets are physical locations or electronic forums that facilitate the flow of funds. Chapter One: The Financial Environment 1-7 Investments involve the marketing of securities, securities analysis, and the management of investment risk. Financial manage ment involves financial planning, asset management, and fund raising decisions to enhance the value of firms . 4. (LO 1.1) Briefly describe the terms entrepreneurial finance and personal finance . Entrepreneurial finance studies how growth -driven, performance -focused, early -stage firms raise financial capital and manage their operations and assets. Personal finance studies how individuals prepare for financial emergencies, protect against premature death and the loss of property, and accumulate wealth over time. 5. (LO 1.2) Briefly describe how the financial environment has changed during the past few years. The technology/dot.com stock price bubble burst in 2000. The housing price bubble burst in 2006. Falling housing prices accompanied by falling values o f mortgage -backed securities led to the 2007 -08 financial crisis and the resulting 2008 -09 Great Recession. Economic activity has been slow to recover and unemployment rates remained at high levels at the end of the first decade of the twenty -first centur y. 6. (LO 1.2) Identify and briefly describe several reasons for studying finance. There are several reasons to study finance. a. As a citizen (of the U.S.A. or another country), you should want to make informed economic decisions. Whatever your financial and economic goals may be, you need to be an informed participant if you wish to “make a difference.” b. Having some knowledge about finance, particularly the financial markets or investments component, should be important to you. An unde rstanding of various aspects of personal finance should help you better manage your existing financial resources, as well as provide the basis for making sound decisions for accumulating wealth over time. c. To be successful in the business world, it is impo rtant to have a basic understanding of business finance in addition to an understanding of institutions, markets, and investments. 7. (LO 1.3) What are the six principles of finance? The six principles are: 1. Money has a time value. Chapter One: The Financial Environment 1-8 2. Higher ret urns are expected for taking on more risk. 3. Diversification of investments can reduce risk. 4. Financial markets are efficient in pricing securities. 5. Manager and stockholder objectives may differ. 6. Reputation matters. 8. (LO 1.3) Describe wh at is meant by ethical behavior . Ethical behavior is how an individual or organization treats others legally, fairly, and honestly. Laws and regulations ensure minimum levels of protection and compliance and the difference between unethical and ethical be havior. High ethical behavior occurs when behavior exceeds basic legal or regulatory standards. 9. (LO 1.4) What are the four major components of an effective financial system? A democracy is a system of government where limited authority and power are granted by law to its people to vote on government policies and issues. The U . S. is a representative democracy where U.S. citizens elect representatives from amongst their peers to participate in formulating gov ernment policies and plans and addressing government issues . The basic requirements or components of an effective financial system , within the framework of the U.S. being a representative democracy, are: a. Policy m akers. Comprised of the President, Congress, the U.S. Treasury, and the Federal Reserve Board. b. An efficient monetary system: This requires a unit of account such as the dollar and a convenient means of paying for everything from a pack of chewing gum to a business worth millions. c. A system for channeling savings into investment: This requires proper legal instruments and financial institutions so that savers are willing and able to transfer savings to those having a demand for them. d. Financial markets an d procedures for transferring claims to wealth: This facilitates the investment process since the owner of funds will invest more readily if claims can be converted into cash when there is a need or desire to do so. 10. (LO 1.4) Identify and briefly descr ibe the financial functions in the financial system. The three components of the financial system are: a monetary system, financial institutions, and financial markets. a. Monetary system financial functions are: creating money and transf erring money. b. Financial institutions carry out the savings -investment process via the financial functions of accumulating savings and lending/investing savings. c. Financial markets perform the financial functions of marketing and transferring financial ass ets. Chapter One: The Financial Environment 1-9 11. (LO 1.5) Briefly describe the differences between money and capital markets. Money markets are the markets where debt instruments of one year or less are traded. In contrast, capital markets are markets for debt securities with maturities in e xcess of one year and corporate stocks. 12. (LO 1.5) What are the differences between primary and secondary markets? Primary securities markets are markets in which the initial offering of debt and equity securities to the public occu rs. Secondary securities markets are markets where the transfer of existing debt and equity securities between investors occurs. 13. (LO 1.5) How do debt securities and equity securities differ? Debt securities are obligatio ns to repay borrowed funds. Common stocks are ownership shares in corporations. 14. (LO 1.5) Identify the four types of major financial markets. The four types of financial markets are debt securities markets, equity securities markets, derivative securities markets, and foreign exchange markets. Debt securities markets are markets where money market securities, bonds (corporate, financial institution, and government), and mortgages are originated and traded. Equity securities market s are markets where common stocks are initially sold and traded. Derivative securities markets are markets for financial contracts (or instruments) that derive their values from underlying debt and equity securities. Foreign exchange market s are electronic markets in which banks and institutional traders buy and sell various currencies on behalf of businesses and other clients. 15. (LO 1.6) Indicate some of the career opportunities in finance available to business graduates today. Chapter One: The Financial Environment 1-10 Career opportunities are generally found in the following areas. a. Financial management . Entry -level opportunities (either in the treasurer’s department or the controller’s department) include cash management analyst, capital expenditures analyst, credit anal yst, financial analyst, cost analyst, and tax analyst b. Depository financial institutions . Entry -level job opportunities include loan analyst, bank teller, and investments research analyst. c. Contractual savings and real property organizations . Entry -level opportunities include insurance agent or broker, research analyst, real estate agent or broker, and mortgage analyst. d. Securities markets and investment firms . Entry -level opportunities include stockbroker or account executive, security analyst, investme nt banking analyst, and financial planner assistant. Entry -level finance job opportunities are also available in government or not -for- profit organizations. Such jobs may involve management of cash funds, asset acquisition decisions, and borrowing funds. Various entry -level finance job opportunities also are available internationally. EXERCISES AND ANSWERS 1. Match the following dates with the associated events: a. 2000 [#4 technology stock bu bble] b. 2001 [# 2 U.S. terrorist attack] c. 2006 [# 5 housing price bubble] d. 2007 -08 [#3 financial crisis] e. 2008 -09 [#1 great recession] 2. The U.S. financial system is comprised of: (1) policy makers, (2) a monetary system, (3) financial institutions, and (4) f inancial markets. Indicate which of these components is associated with each of the following “roles”: a. accumulate and lend/invest savings [# 3 financial institutions] b. create and transfer money [# 2 a monetary system] c. pass laws and set fiscal and monetary policies [# 1 policy makers] d. market and facilitate transfer of financial assets [# 4 financial markets] 3. Financial markets may be categorized as: (1) debt securities markets, (2) equity securities markets, (3) derivative securities mark ets, and (4) foreign exchange m arkets. Indicate in which of these markets the following securities trade: a. mortgages [# 1 debt securities markets ] Chapter One: The Financial Environment 1-11 b. bonds [# 1 debt securities markets ] c. common stocks [# 2 equity securities markets ] d. currencies [# 4 foreign exchange markets ] 4. In business, ethical dilemmas or situations occur frequently. Laws and regulations exist to define unethical behavior. However, the practicing of high quality ethical behavior often goes beyond just meeting laws and r egulations. Indicate how you would respond to the following situations. a. Your boss has just told you that there will be an ann ouncement tomorrow morning that the Federal Drug Administration has approved your firm’s marketing of a new breakthrough drug. As a result of this information, you are considering purchasing shares of stock in your firm this afternoon. What would you do? The violation of U.S. laws is both illegal, which could result in prison time, and unethical. U. S. securities laws p rohibit officers, employees, and others from taking advantage of “inside” information which when released will impact security prices. This situation seems to violate securities laws and thus you should not purchase shares of stock in your firm prior to t he public announcement of this inside information. b. In the past, your firm has been in compliance with regulatory standards relating to product safety. However, you have heard through the “company grapevine” that recently some of your firm’s products ha ve failed resulting in injuries to customers. You are considering quitting your job due to personal moral concerns. What would you do? Ethical behavior is how an individual or organization treats others legally, fairly, and honestly. Your firm has been legally in compliance with regulatory standards relating to product safety. At this time injury -related product failures seem to be rumors and product safety regulations do not attempt to ensure there will be no injuries. You probably would want to wait until actual “facts” are known before taking any actions. Ultimately you should decide whether you believe your firm is treating customers fairly and honestly in addition to legally. 5. Obtain several recent issues of The Wall Street Journal or Bloomber g Businessweek . Identify , read, and be prepared to discuss at least one article relating to one o f the six principles of finance . The six principles of finance are: 1. Money has a time value. 2. Higher returns are expected for taking on more risk. 3. Diversification of investments can reduce risk. 4. Financial markets are efficient in pricing securities. 5. Manager and stockholder objectives may differ. 6. Reputation matters. Chapter One: The Financial Environment 1-12 The instructor will need to identify recent articles from The Wall Street Journal and/or Bloomberg Businessweek for possible class discussion. 6. Obtain several recent issues of The Wall Street Journal or Bloomberg Businessweek . Identify, read, and be prepared to discuss at least one article re lating to one of the four types of financial markets identified in this c hapter. The four main types of financial markets are: 1. debt securities markets, 2. equity securities markets, 3. derivative securities markets, and 4. foreign exchange markets. The instructor will need to identify recent articles from The Wall Street Journal and/or Bloomberg Businessweek for possible class discussion. 7. Obtain several recent issues of the Wall Street Journal or Bloomberg Businessweek . Identify, read, and be prepared to discuss at least one article relating specifically to recent changes in the financial environment. The instructor will need to identify recent articles in The Wall Street Journal and/or Bloomberg Businessweek for possible class disc ussion. 8. Go to the Small Business Administration (SBA) Web site , www.sba.gov , and search for information on starting a new business. Identify and prepare a written summary of the startup basics described on the SBA site. First go to the SBA Web site. Then, click on “Starting Your Business.” This will take you to “Startup Basics” involving startup topics, financing, topics, marketing topics, tax topics, and legal topics. SUGGESTED QUIZ 1. Briefly answer the q uestion: “What is finance?” 2. Identify the six principles of finance. 1. List the three financial system components and their financial functions in an effective financial system. 2. Identify the four m ain types of financial markets. 3. Describe: Chapter One: The Financial Environment 1-13 a. money markets b. capital markets c. primary markets d. secondary markets Chapter Two: Money and the Monetary System 2-1 Chapter 2 Money and the Monetary System CHAPTER PREVIEW The monetary system plays an important role in the operation and development of the financial and economic system s including reactions to the 2007 -08 financial crisis and the 2008 -09 Great Recession . This chapter describes the monetary system of the United States in detail. We begin with a discussion of the process of moving savings into investment s and follow with an overview of the monetary system. We then cover the three major functions of money a nd how money developed in the U.S. over time. Next, we cover money market securities and follow with measures of the U.S. money supply. This is followed by a brief presentation of the views of monetarists and Keynesians concerning the relationship betwee n the money supply and economic activity. The chapter concludes with a brief coverage of the international monetary system. LEARNING OBJECTIVES LO 2.1 Discuss the developments that led to the 2007 -2008 financial crisis. LO 2.2 Describe three ways in which money is transferred from savers to businesses. LO 2.3 Identify the major components of the monetary system. LO 2.4 Describe the functions of money. LO 2.5 Discuss how money developed in the United States. LO 2.6 Describe major types of money market securities. LO 2.7 Explain the M1 and M2 definitions of the money supply. LO 2.8 Explain possible relationships between money supply and economic activity. LO 2.9 Describe developments in the international monetary system. CHAPTER OUTLINE I. (2.1) THE 2007 -2008 FINANCIAL CRISIS AND SUBSEQUENT RECOVERY II. (2.2) PROCESS OF MOVING SAVINGS INTO INVESTMENTS III. (2.3) OVERVIEW OF THE MONETARY SYSTEM IV. (2.4) CHARACTERISTICS AND FUNCTIONS OF MONEY V. (2.5) DEVELOPMENT OF MONEY IN THE UNITED STATES A. Physica l Money (Coin and Paper Currency) 1. U.S. Coins 2. Paper Currency B. Deposit Money Chapter Two: Money and the Monetary System 2-2 VI. (2.6) MONEY MARKET SECURITIES VII. (2.7) MEASURES OF THE U.S. MONEY SUPPLY A. M1 Money Supply B. M2 Money Supply C. Exclusions from the Money Supply VIII. (2.8) MONEY SUPPLY AND ECONOMIC ACTIVI TY IX. (2.9) INTERNATIONAL MONETARY SYSTEM X. SUMMARY LECTURE NOTES I. (2.1) THE 2007 -2008 FINANCIAL CRISIS AND SUBSEQUENT RECOVERY The financial crisis of 2007 -08 and the subsequent “great recession” of 2008 -09 were the result of a number of negative economi c and financial trends and events coming together. Housing prices peaked in 2006 and continued at low levels throughout the remainder of the decade. The first part of the twenty -first century was a time when U.S. federal government policies encouraged ho me ownership. Lenders were willing to lend to financially risky borrowers seeking mortgage loans. Once housing prices began declining, many homeowners had their equity wiped out and their mortgages became “underwater” when the amount of their loans exceed ed the home values. Many home mortgage loans were pooled together into mortgage -backed securities which, in turn, declined when housing prices began falling. A credit crunch occurred when banks and other financial institutions had inadequate equity capit al due to the decline in mortgage - backed securities. During 2008, the federal government helped some financial institutions to merge, bailed out a number of institutions and businesses, and allowed other financial institutions to fail in an effort to avoi d a collapse in the financial system. Stock prices peaked in mid -2007 and did not bottom out until March, 2009. The great recession began near the end of 2007 and did not end until June, 2009. Fiscal policy spending programs and easy monetary pol icy and financial debt acquisitions by the Fed helped the subsequent U.S. economic recovery which has lasted more than 10 years. By the end of 2018 the unemployment rate had declined to less than 4% and economic growth as measured by the gross domestic pr oduct was at 3%. (Use Review Question 1 here.) II. (2.2) PROCESS OF MOVING SAVINGS INTO INVESTMENTS We begin with a discussion of t he difference between a surplus economic unit and a deficit economic unit . We focus on the savings -investment p rocess that involves the direct or indirect transfer of individual savings to business firms in exchange for their debt Chapter Two: Money and the Monetary System 2-3 securities. Savers may invest directly in a business firm by exchanging their money for the firm’s securities. Savers also may make in direct transfers by first placing their money either through a n investment banking firm or a financial intermediary . When using an investment banking firm, money flows from savers through to the business firm and the business firm’s securities flow back t hrough to the savers. When using a financial intermediary, savers invest their money in a financial institution and receive the institution’s securities. The financial institutions then invest money in the business firm and receive the firm’s securities in exchange for their investment. (Use Figure 2.1 and Review Question s 2 through 4 here.) III. (2.3) OVERVIEW OF THE MONETARY SYSTEM The monetary system is responsible for carrying out the financial functions of creating and transferring m oney. Money is transferred from savers to investors either directly or indirectly. For example, if the investor is a business firm, a direct transfer takes place when savers purchase the securities (stocks or debt instruments) of the business firm by exchanging money for the firm’s securities. An indirect transfer between savers and a business firm can take place either through an investment banking firm or through a financial intermediary. Investment banking firms often first purchase th e securities from the issuing firm and then sell the securities to the savers. However, no additional securities are created in this type of indirect transfer. When using a financial intermediary, savers deposit or invest money with a financial intermedi ary such as a bank which issues its own securities to the saver. The bank, in turn, makes a loan to the business firm. The major participants in the U.S. monetary system include a central bank and a banking system comprised of a number of i ndividual banks. The Federal Reserve System is the central bank in the U.S. and it is responsible for defining and regulating the money supply, as well as facilitating the transferring of money through check processing and clearing. The banking system cr eates money and transfers money through check processing and clearing within the banking system. (Use Figure 2.2 and Review Question 5 here.) IV. (2.4) CHARACTERISTICS AND FUNCTIONS OF MONEY We begin with a discussion of the d ifference b etween real and financial assets. Money is a physical or electronic asset that is accepted as payment for goods, services, and debts. The basic function of money is that of serving as a medium of exchange . Money also serves as a standard of value . This s econd function refers to the fact that prices as well as contracts for deferred payments are expressed in terms of the monetary unit. A third function of money is that it can be held as a store of value (or purchasing power) and thus Chapter Two: Money and the Monetary System 2-4 can be drawn upon at w ill. Money is perfectly liquid since it is a generally accepted medium of exchange. Digit al currency is electronic money accepted for making payments. Virtual currency is unregulated digital money issued, and often controlled, by its decentralized developers and used to make electronic payments. Cryptocurrency is decentralized and unregulated digital money that uses cryptography to record, maintain, and secure electronic payments. Bitcoin is a specific type of cryptocurrency that uses a ledger syste m technology called blockchain to record, maintain, and secure payment transactions. (Use Review Questions 6 through 8 here.) V. (2.5) DEVELOPMENT OF MONEY IN THE UNITED STATES The U.S. monetary system developed to meet the changing needs of the econom y. As primitive economies began to develop, a barter system (based on tables of relative values) was developed to help facilitate the exchange of goods and services. Records in early economies show many items that were useful for food or clothing (i.e., co mmodities) were used as both a medium of exchange and as a unit for measuring value. There was a gradual transition from the use of commodities for exchange to the use of precious metals. The advantages of precious metals eventually led to their general u se. For example, the supply of gold and silver was limited enough so that these metals had great value, and they were also in great demand for ornamentation purposes. Coins with a certain weight of metal in them were developed to aid the process of exchang ing goods and services. Full-bodied money is used to refer to coins that have metal content worth the same as their face values. Coins with face values higher than the value of their metal content are called token coins . Paper money may be either repres entative full -bodied money or fiat money. Representative full -bodied money is paper money that is backed by an amount of precious metal equal in value to the face amount of the paper money. Fiat money is money that is not backed by precious metals but is decreed by the government to be “legal tender” for purposes of making payments and discharging debts. The use of physical money (coin and currency) to complete transactions can be very costly and inefficient. As a result, along with confidence in the ba nking system, a special type of credit money called deposit money has grown in importance. Credit money is money backed by the “creditworthiness” of the issuer. Deposit money is backed by the creditworthiness of the depository institution that issued the deposit. Automatic transfer service (ATS) accounts provide for direct deposits to, and payments from checkable deposit accounts. Employers can have their employees’ wages deposited directly in their checking accounts. Individuals can have regular payme nts such as mortgage payments automatically deducted from their accounts. Debit cards provide for immediate direct transfer of deposit amounts such as when a debit card is Chapter Two: Money and the Monetary System 2-5 used to purchase merchandise at a retailer’s “point of sale” cash register. When t he sale is recorded, the cardholder’s bank transfers the designated amount from the purchaser’s demand account to the retailer’s account. (Use Figures 2. 3, 2.4, and 2. 5 and Review Questions 9 through 1 4 here.) VI. (2.6) MONEY MARKET SECURITIES Mon ey market securities are debt instruments or securities with maturities of one year or less that are created or trade in money markets. We identify six major money market securities: a) treasury bills, b) commercial paper, c) negotiable certificates of de posit (negotiable CDs), e) repurchase agreements, and f) federal funds. (Use Figure 2.6 and Review Question 1 5 here.) VII. (2.7) U.S. MONEY SUPPLY TODAY The M1 definition of the money supply includes only types of money that are acceptable as a medium of exchange. Included are currency, traveler’s checks, demand deposits, and other checkable deposits. All four components are types of credit money. The coins are token money and the paper currency is fiat money in the form of Federal Reserve No tes. M2 is a broader measure of the money supply than M1 because it emphasizes money as a store of value in addition to its function as a medium of exchange. M2 includes all of M1 plus savings deposits, money market deposit accounts (MMDAs), and small - denomination time deposits (under $100,000) at depository institutions plus balance in retail money market mutual funds (MMMFs). (Use Review Questions 1 6 and 17 here.) VIII. (2.8) MONEY SUPPLY AND ECONOMIC ACTIVITY Economists generally believe that m oney supply “matters” when trying to “manage” economic activity. They have observed that economic activity, money supply, and the price levels of goods and services generally move together over time. However, economists disagree as to how these relations hips are to be explained. Monetarists believe that the amount of money in circulation determines the level of gross domestic product (GDP) or economic activity. If we divide GDP by the money supply (MS), we get the number of times the money supply “tur ns over” to produce GDP. This turnover of money is called the velocity of money and measures the rate of circulation of the money supply. Monetarists also believe that when the money supply exceeds the amount of money demanded, the public will spend more rapidly causing real economic activity or prices to rise. A too rapid rate of growth in the money supply will ultimately result in rising prices or inflation because excess money will be used to bid up the prices of existing goods. Chapter Two: Money and the Monetary System 2-6 Other economists, cal led Keynesians , believe that a change in the money supply has a less direct relationship with GDP. They argue that a change in money supply first causes a change in interest rate levels which, in turn, alters the demand for goods and services. Decreases in the money supply will likely cause interest rates to rise. As a result, GDP will grow more slowly or even decline depending on how the higher interest rates affect consumption and spending decisions. (Use Review Questions 1 8 and 1 9 here.) IX. (2.9) INTERNATIONAL MONETARY SYSTEM The globalization of economic activity has grown rapidly during the past several decades . Today, a country’s economic system is necessarily tied to the international exchange of goods and services. A well dev eloped international monetary system is necessary for a successful global economy. The international monetary system has been historically tied to the gold standard. For example, in 1944 many of the world’s economic powers met and agreed to an internation al monetary system that was tied to the U.S. dollar or gold via fixed, or pegged, exchange rates. By early 1973, major currencies were allowed to “float” against each other, resulting in a flexible or floating exchange rate system. Today the current intern ational monetary system is a “managed” floating exchange rate system (because central monetary authorities sometimes intervene). A currency exchange rate indicates the value of one currency relative to another. If demand for a particularly currency falls relative to its supply, the exchange rate falls and the international purchasing power of that nation’s money supply drops. We discuss currency exchange rates in detail in Chapter 6. Eleven countries of the 15 -member European Union voted to accept a uni fied currency called the euro to replace their individual country currencies as of January 1, 1999. Greece meet economic and financial requirements in 2000 and was admitted in 2001. Official implementation of the euro began for 12 European countries on January 1, 2002 . (Use Review Question 20 here.) REVIEW QUESTIONS AND ANSWERS 1. (LO 2.1) Briefly discuss the developments that led to the 2007 -2008 financial crisis. Housing prices peaked in 2006. The first part of the decade of the 2000s was a time wh en U.S. federal government policies encouraged home ownership. Lenders were willing to lend to financially risky borrowers seeking mortgage loans. Once housing prices began declining, Chapter Two: Money and the Monetary System 2-7 many homeowners had their equity wiped out and their mortgages became “ underwater” when the amount of their loans exceeded the home values. Many home mortgage loans were pooled together into mortgage -backed securities which, in turn, declined when housing prices began falling. A credit crunch occurred when banks and other f inancial institutions had inadequate equity capital due to the decline in mortgage -backed securities. During 2008, the federal government helped some financial institutions to merge, bailed out a number of institutions and businesses, and allowed other fi nancial institutions to fail in an effort to avoid a collapse in the financial system. 2. (LO 2.2) How do surplus economic units and deficit economic units differ? A surplus economic unit generates more money than it spends resulting in excess money to save or spend. A deficit economic unit spends more money than it brings in resulting in a need for additional money. 3. (LO 2.2) Describe the three basic ways whereby money is transferred from savers to investors. There can be a direct transfer of money between savers and investors. For example, savers can directly purchase the stocks or debt instruments of a business firm by exchanging money for the firm’s securities. Money also can be transferred from savers to investors via indirect transfers. For e xample, if the investor is a business firm, savers can transfer money to the business firm either through the use of an investment banking firm or through a financial intermediary. 4. (LO 2.2) Identify economic units in addition to business firms who might need funds from savers. Government entities (U.S. government and state and local governments) spending more than their tax revenues may need funds from savers to balance their budgets. Some individuals and other units might seek funds from savers to fina nce home ownership or other real estate investments. 5. (LO 2.3) Identify the major participants in the U.S. monetary system. A central bank (i.e., the Federal Reserve System in the U.S.) is needed to define and regulate money supply and to facilitate the transferring of money through check processing and clearing. An efficient banking system also is needed to create money, transfer money, provide financial intermediation, and to process and clear checks. 6. (LO 2.4) Indicate how real assets and financia l assets differ. Real assets include the direct ownership of land, buildings, homes, equipment, inventories, durable goods, and precious metals. Chapter Two: Money and the Monetary System 2-8 Financial assets include money, debt instruments, equity securities, and other financial contracts backed by real assets and the earning abilities of issuers . 7. (LO 2.4) Define money and indicate the basic functions of money . Money is a physical or electronic asset that is accepted as payment for goods, services, and debts. Money acts as: (a) a medium of excha nge; (b) a standard of value; and (c) a store of value. Unless the value of money is relatively stable, it will not be held long enough to serve as a medium of exchange or as a store of value or purchasing power. It can serve as a standard of value only if its value is relatively stable, since it is all but impossible to use a varying standard for measuring values. Digital currency is electronic money accepted for making payments. Virtual currency is unregulated digital money issued, and often control led, by its decentralized developers and used to make electronic payments. Cryptocurrency is decentralized and unregulated digital money that uses cryptography to record, maintain, and secure electronic payments. Bitcoin is a specific type of cryptocurren cy that uses a blockchain ledger system technology to record, maintain, and secure payment transactions. 8. (LO 2.4) Describe how an individual’s net worth is determined. Individual net worth is the sum of an individual’s money, real assets, and financial assets or claims against others less the individual’s debt obligations. 9. (LO 2.5) Briefly describe the development of money, from barter to the use of precious metals. Barter, or the exchange of goods for goods, developed as specialization o f production and exchange of goods developed. Some items were generally desired and other goods were traded for them since they could always be used for further trading. The goods that were frequently traded also served as a yardstick for measuring the val ue of goods traded less frequently. However, barter was clumsy because items of food, clothing, and ornamentation were difficult to carry around; items were of different quality, so arguments could arise over their value. Exchange was also clumsy since it had to take place in whole units, such as one or two furs, and the like. The use of gold and silver did not present these difficulties, and so they became more widely used. As time went on, these metals were made into coins with definite weights in metals of a certain purity, and they served even more effectively as a medium of exchange. 10. (LO 2.5) What is the difference between full -bodied money and token coins? Full-bodied money is defined as coins that have metal content equal to their face values. Toke coins are coins with face values higher than the values of their metal content. Chapter Two: Money and the Monetary System 2-9 11. (LO 2.5) Describe how representative full -bodied money and fiat money differ. Representative full -bodied money is paper money that is backed by an amount of precious metal equal in value to the face amount of the paper money. Fiat money is paper money without metal backing but where the government decrees the money to be “legal tender” for purposes of making payments and discharging public and private debts. 12. (LO 2.5) What is deposit money and how is it “backed”? Credit money is money backed by the “creditworthiness” of the issuer. Deposit money is backed by the creditworthiness of the depository institution that issued the deposit. 13. (LO 2.5) What are automat ic transfer service (ATS) accounts? ATS accounts provide for direct deposits to, and payments from, checkable deposit accounts. For example, employers can have their employees’ wages deposited directly in their checking accounts instead of issuing payroll checks. 14. (LO 2.5) What are debit cards and how are they used? Debit cards provide for the immediate direct transfer of deposit amounts. For example, when a debit card is used to purchase merchandise at a retailer’s “point of sale” cash register, th e card holder’s bank transfers the designated amount form the purchaser’s demand account to the retailer’s account. 15. (LO 2.6) Define money market securities and briefly describe the major types of these securities. Money market secur ities are debt instruments or securities with maturities of one year or less. We identify six major money market securities: Treasury bills short -term debt obligations issued by the U.S. federal government. Negotiable ce rtificates of deposit (negotiable CDs) are short -term debt instruments issued by depository institutions that can be traded in secondary money markets. Commercial paper is short -term unsecured promissory notes issued by high credit -quality corporations. Banker’s Acceptances are promises of future payment issue d by importing firms and guaranteed by banks. Repurchase agreements are short -term debt securities where sellers agree to repurchase their securities at a specified price and date. Federal funds are ve ry short -term loans between depository institutions with excess funds and those with a need for funds. 16. (LO 2.7) Describe the M1 definition of the money supply and indicate the relative significance of the M1 components. Chapter Two: Money and the Monetary System 2-10 M1 includes: curr ency (coin and federal reserve notes), demand deposits at commercial banks and other checkable deposits at depository institutions (commercial banks, savings and loan associations, savings banks, and credit unions), and travelers checks. Currency and deman d deposits are the two largest components of M1 and together account for over three - fourths of M1. Traveler’s checks represent less than one percent of M1. M1 measures transaction balances which are sums of money that can be spent without first con verting them to some other asset, and which are held for anticipated or unanticipated purchases or payments in the immediate future. Essentially, only those amounts that represent the purchasing power of units in our economy other than the federal governm ent are counted. 17. (LO 2.7) How does M2 differ from M1? What are money market mutual funds? M2 is a broader measure of the money supply than M1 because it emphasizes money as a store of value in addition to its function as a medium of exchange. M2 includes all of M1 plus savings deposits, money market deposit accounts (MMDAs), and small -denomination time deposits (under $100,000) at depository institutions plus balance s in retail money market mutual funds (MMMFs). Money market mutual funds (MM MFs) issue “shares” to customers and invest the proceeds in highly liquid, very short maturity, interest -bearing debt instruments cal led “money market investments.” Thus, MMMFs get their name from the type of investments they make. 18. (LO 2.8) Briefly d escribe the monetarists’ view of the relationship between money supply and economic activity. Monetarists believe that the amount of money in circulation determines the level of GDP or economic activity. If we divide GDP by the money supply, we get the n umber of times the money supply turns over to produce GDP. This turnover of money is called the velocity of money. Monetarists also believe that when the money supply exceeds the amount of money demanded, the public will spend more rapidly causing real e conomic activity or prices to rise. 19. (LO 2.8) How do Keynesians view the relationship between money supply and economic activity? Keynesians believe that a change in the money supply has a less direct relationship with GDP. They argue t hat a change in money supply first causes as change in interest rate levels which, in turn, alters the demand for goods and services. For example, an increase in the money supply might cause interest rates to fall (at least initially) because more money i s being supplied relative to that being demanded. 20. (LO 2.9) Briefly describe the development of the international monetary system. Chapter Two: Money and the Monetary System 2-11 The international monetary system was historically tied to the gold standard. A breakdown in the gold standard occurre d during World War I, and less formal exchange systems continued during the 1930s and during World War II. In 1944, many of the world’s economic powers met and agreed to an international monetary system which was tied to the U.S. dollar or gold via fixed o r pegged exchange rates. By early 1973, major currencies were allowed to “float” against each other resulting in a flexible or floating exchange rate system. The current international monetary system is a “managed” (because sometimes central monetary autho rities attempt to intervene) floating exchange rate system. The majority of the 15 -member European Union countries agreed to accept the euro as the official currency of the European Monetary Union (commonly now referred to as the eurozone member cou ntries) as of January 1, 1999. Initially 11 members met the economic and financial requirements with Greece being admitted in early 2001 so that 12 countries participated in the implementation of the euro on January 1, 2002. EXERCISES AND ANSWERS 1. Match t he following money market securities with their issuers. Securities Issuers a. Treasury bills [# 2] 1. depository institutions b. negotiable CDs [#1] 2. U.S. government c. commercial paper [#4] 3. banks d. banker’s acceptances [#3] 4. business firms and institutions 2. Match the following money market securities with the level of secondary market activity. a. Treasury bills [#4] 1. no activity b. commercial paper [#3] 2. low activity c. federal funds [#1] 3. moderate activity d. negotiable CDs [#2] 4. high activity 3. Go to the Website of the Federal Reserve Bank of St. Louis at http s://www.stlouisfed.org. Go to “ Research and D ata” and click on “FRED Economic Data” to access the Federal Reserve Economic Database (FRED). Compare the present size of M1 and M2 money stock measures with the data presented in the Measures of the U.S. Money Supply section of this chapter. F ind the current sizes of these M1 components: currency, traveler ’s checks, demand deposits, and other checkable deposits. Ex press each component as a percentage of M1 and compare your percentages with those presented in the Measures of the U.S. Money Supply section of this chapter. The instructor should specify a recent month and ask students to find M1 and M2 for that month and compare their findings with data in the Measures of the U.S. Money Supply section of this chapter . While it takes some effort, each of the four components of M1 also can be found for the specified month for comparison purposes.