Chapter 1
An Introduction to Money and the Financial
System
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Learning Objectives
1. List and explain the six parts of the financial
system.
2. Identify the five core principles of money and
banking.
3. Describe the special features and organization
of the book.
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Introduction
• Every financial transaction has a story.
• There is a complex web of interdependent
institutions and markets making up the
foundation of daily financial transactions:
1. The Six Parts of the Financial System.
2. The Five Core Principles of Money and Banking.
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Six Parts of the Financial System 1
1. Money
To pay for purchases and store wealth.
2. Financial Instruments
To transfer resources from savers to investors and to transfer risk to
those best equipped to bear it.
3. Financial Markets
To buy and sell financial instruments.
4. Financial Institutions
To provide access to financial markets, collect information &
provide services.
5. Regulatory Agencies
To provide oversight for financial system.
6. Central Banks
To monitor financial Institutions and stabilize the economy.
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Six Parts of the Financial System 2
1. Money
• Money has changed from gold/silver coins to
paper currency to electronic funds.
• Cash can be obtained from an ATM any where in
the world.
• Bills are paid and transactions are checked
online.
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Six Parts of the Financial System 3
2. Financial instruments
• Transfers resources from savers to investors.
• Buying and selling individual stocks used to be
only for the wealthy.
• Today we have mutual funds and other stocks
available through banks or online.
• Putting together a portfolio is open to everyone.
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Six Parts of the Financial System 4
3. Financial Markets
Allow the buying and selling of financial
instruments easily.
Went from being in coffee houses and tavern to
well organized markets like the New York Stock
Exchange.
Now transactions are mostly handled by
electronic markets.
• This has reduced the cost of processing financial
transactions making the way for a much broader
array of financial instruments available.
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Six Parts of the Financial System 5
4. Financial Institutions
• Provide all the services of the financial
system like providing access to financial
markets and gathering information.
• Banks began as vaults, developed into
institutions that accepted deposits and gave
loans, and evolved to today’s financial
supermarket.
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Six Parts of the Financial System 6
5. Government regulatory agencies
• Make sure the elements of the financial system
operate safely and reliably.
• Government regulatory agencies were introduced
by federal government after the Great Depression.
• They provide wide-ranging financial regulation,
rules, and supervision; and examine the systems a
bank uses to manage its risk.
• The 2007–2009 financial crises has led
governments to greater regulation, such as the
Dodd-Frank Wall Street Reform and Consumer
Protection Act.
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Six Parts of the Financial System 7
6. Central banks
• They monitor and stabilize the financial system.
• Central banks began as large private banks to
finance wars.
• Central banks control the availability of money
and credit to promote low inflation, high growth
and stability of financial system.
• Today’s policymakers strive for transparency in
their operations.
• The financial crisis of 2007–2009 have led the
U.S. central bank to try many new policy tools.
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Five Core Principles of Money
and Banking 1
1. Time has value.
2. Risk requires compensation.
3. Information is the basis for decisions.
4. Markets determine prices and allocate
resources.
5. Stability improves welfare.
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Five Core Principles of Money
and Banking 2
Core Principle 1: Time has value
• Time affects the value of financial
instruments.
• Interest is paid to compensate the lenders
for the time the borrowers have their
money.
• Chapter 4 develops an understanding of
interest rates and how to use them.
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Five Core Principles of Money
and Banking 3
Core Principle 2: Risk requires compensation
• In a world of uncertainty, individuals will
accept risk only if they are compensated.
• In the financial world, compensation
comes in the form of explicit payments:
the higher the risk the bigger the
payment.
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Five Core Principles of Money
and Banking 4
Core Principle 3: Information is the basis
for decisions
• The more important the decision, the
more information we gather.
• Collection and processing of
information is the foundation of the
financial system.
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Five Core Principles of Money
and Banking 5
Core Principle 4: Markets determine prices
and allocate resources
• Markets are the core of the economic
system.
• Markets channel resources and minimize
the cost of gathering information and
making transactions.
• In general, the better developed the
financial markets, the faster the country
will grow.
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Five Core Principles of Money
and Banking 6
Core Principle 5: Stability improves welfare
• A stable economy reduces risk and
improves everyone’s welfare.
• Financial instability in the autumn of 2008
triggered the worse global downturn since
the Great Depression.
• A stable economy grows faster than an
unstable one.
• One of the main roles of central banks is
stabilizing the economy.
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© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.