The Financial System and the Economy

Principles of Money and Banking

Maureen Burton, Bruce Brown

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317456858
• Edition: 5
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

Attempts to assess whether the United States is in economic decline. Appropriate to general readers as well as economics students and scholars, this book examines the fears of Americans about their economic future.

PART 1

Introduction

¹ Introduction and Overview

² Money and Its Role in the Economy

³ The Overseer: The Federal Reserve System

⁴ Financial Markets, Instruments, and Market Makers

CHAPTER ONE

1

Introduction and Overview

Learning Objectives

After reading this chapter, you should know:

The subject matter of economics and finance

The general role of the financial system in a modern economy

The major functions of financial markets and financial intermediaries

What saving is and its uses

How the financial system channels funds from lenders to borrowers

The role of the Federal Reserve and its regulatory and monetary policy responsibilities

WHAT THIS BOOK IS ABOUT

Why have financial institutions and financial regulations changed so dramatically in the last 25 years? Why do banks and others pay so much attention to what the Federal Reserve is doing? What is meant by the globalization of financial markets? How have technological changes affected financial markets? What are the complex financial instruments known as derivatives? Why have there been so many mergers between financial institutions? Why does the international value of the dollar fluctuate so much? Why does the economy experience periodic bouts of high unemployment and/or high inflation? What are the causes of the severe economic downturn in 2008 and 2009? What can policy makers do to mitigate this crisis that started in the financial system and spread to the broader economy?

We could go on, but you get the idea. This list of questions represents only a sample of the issues that motivate the discussions of theory, institutions, and policy found throughout the text. As the questions indicate, these matters affect many aspects of our lives every day.

This chapter begins your study of money and the financial system. It introduces the subject matter and provides an overview of the key concepts and relationships that are vital to understanding the system. Most of the details are ignored, and most terms are not rigorously defined and examined; this is the introduction! However, don’t underestimate the importance of a good beginning.

ECONOMIC AND FINANCIAL ANALYSIS OF AN EVER-CHANGING SYSTEM

Economics is the study of how a society decides what gets produced, how it gets produced, and who gets what. More specifically, given unlimited wants on the part of society, economics is concerned with the following processes:

1. How scarce resources (land, labor, capital, and natural resources) are allocated in the production process among competing uses.¹

2. How income generated in the production and sale of goods and services is distributed among members of society.

3. How people allocate their income through spending, saving, borrowing, and lending decisions.

Economics
The study of how society decides what gets produced and how, and who gets what.

For convenience, economics is traditionally divided into the study of the causes and consequences of individual decision-making units such as households and business firms in a particular market, and the study of the causes and the effects resulting from the sum of decisions made by all firms or households in many markets. The former type of analysis is called microeconomics; the latter, more aggregative, type is called macroeconomics.

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

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

Finance is the study of the financial or monetary aspects of production, spending, borrowing, and lending decisions. Finance deals with the raising and using of money by individuals, firms, governments, and foreign investors. We are familiar with our decisions to spend, borrow, lend, or save. Our everyday language includes such terms as interest rates, checking accounts, debit cards, banks, and credit cards. Finance in this context deals with how individuals manage money.

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 during the borrowing process.

At a macro level, finance is concerned with how the financial system coordinates and channels the flow of funds from lenders to borrowers and vice versa, and how new funds may be created during the borrowing process. The channeling and coordination process and its effects on the cost and availability of funds link developments in the financial system to developments in the rest of the economy. This aspect of financial analysis is emphasized in this text.

As you will soon learn, the production and sale of goods and services within the economic system are intimately related to the deposits, stocks and bonds, and other financial instruments that are bought and sold in the financial system. Thus, what happens on Wall Street can have a profound effect on what happens on Main Street and vice versa.

Because the financial system is vital to a healthy economy, the government regulates and supervises its operation. Such regulatory policy is aimed at promoting an efficient financial system. By establishing and enforcing operating regulations for financial markets and institutions, regulators seek to promote competition and efficiency while preserving the safety and soundness of the system.

Complicating our analysis of the interaction between the financial system and the economy is the fact that the financial system is not stagnant. It continually evolves and changes, sometimes at a faster pace than at other times. For various reasons (discussed in later chapters), the past several decades have seen rapid change, including the ongoing globalization of financial markets. The system is different than it was 20 years ago, and it will be different 20 years from now. The major forces behind these changes are changes in government regulations, advances in computer technologies, and innovations in the ways people spend, save, and borrow funds.

In recent decades, firms and individuals have developed new ways to raise and use money. Today, many manifestations of these financial innovations are all around us. For example, 24-hour automated teller machines (ATMs) are common, debit cards and credit cards are widely accepted at grocery stores, gas stations, and department stores, and home equity lines of credit allow home owners to borrow against the equity in their homes by writing checks as the need arises. Investors have an increasing array of mutual funds and other domestic and global financial instruments to choose from. Stocks and bonds can be purchased over the Internet at a fraction of the brokerage fees charged by full-service brokerage firms. None of these innovations were widely available in the mid-1980s.

New ways for financial and nonfinancial firms to manage risks also have been developed. Banks have merged with brokerage firms, insurance companies, and other firms that offer a whole host of financial and nonfinancial services. All this merger activity in the financial services industry has created new types of financial institutions that transcend national borders. Although still in an early stage in the United States, the use of smart cards and stored-value cards (as well as other ways to make electronic payments) is expected to explode in the very near future. These developments, most of which have been made possible because of changes in technology, have had or will have an impact on spending, saving, borrowing, and lending decisions. Not surprisingly, then, we shall closely examine the causes and consequences of these changes in the financial system.

Because of these financial innovations and other factors, U.S. Congress and the regulatory authorities such as the Federal Reserve have had to reconsider the costs and benefits associated with certain regulations. From the early 1970s until the late 1980s, regulatory changes were mostly in the direction of deregulation, which is the removing or phasing out of some existing regulations. Some regulations were eliminated because it was felt that they had become increasingly ineffective as ...

Table of contents

• Cover
• Title Page
• Copyright Page
• Brief Contents
• Table of Contents
• Preface
• Part One Introduction
• Part Two Financial Prices
• Part Three Financial Institutions
• Part Four Financial Markets
• Part Five Monetary Theory
• Part Six Monetary Policy
• Glossary
• Index
• About the Authors