Page 539 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 513

LEARNING OBJECTIVE 3 the macroeconomy through monetary policy. The
Understand how the health of the financial system monetary policy framework of central banks consists of
affects the productivity of the economy, including tools (open market operations, discount rates, and
the roles of the IMF and the World Bank. reserve requirements), operating targets (federal funds
rates and bank reserves), intermediate targets (long-
The financial system is an essential building block to a
healthy economy. As such, regulation in the areas of term interest rates, money supply, and bank credit), and
deposit insurance, equity capital rules, on-site economic goals (output, employment, inflation, and
examinations, and restrictions on asset powers have international trade). Another way for government to
been implemented. Deposit insurance is crucial to affect the macroeconomy is through fiscal policies of
maintaining public confidence and preventing bank taxation and spending. Unfortunately, many times it is
runs, but comes at the cost of moral hazard risk. In not possible to stimulate or slow down the economy
recent years the asset powers of financial institutions using fiscal policy, due to the political difficulties of
have been deregulated in the United States, Europe, making changes in tax rates and government spending.
Japan, and other countries to allow banks, securities For this reason, monetary policy is a superior approach
firms, and insurance companies to compete with one to affecting economic conditions in most instances. Not
another. This deregulation triggered a consolidation surprisingly, the financial press regularly contains news
movement marked by mergers that is creating mega- about what the central bank is doing in the financial
institutions that are global in scale. markets.
LEARNING OBJECTIVE 6
LEARNING OBJECTIVE 4
Compare the different types of financial institutions
Overview the history of money and why money as well as their roles in the economy.
matters to the economy.
Financial firms differ from nonfinancial firms due to
In the money and banking section, we overviewed the
history of money, including coins, paper money, and heavy regulation, large quantities of financial assets and
liabilities on their balance sheets, low levels of equity
emergence of the U.S. dollar as a numeraire capital, and the knowledge of private information about
(benchmark) currency in world currency markets. firms and individuals. The latter information explains
Instability of currency values later led to the European why many experts consider financial firms to be special.
euro in 1999. Problems with currency risk can affect Financial institutions can be classified as depository
economic conditions in countries as well as business institutions—banks and thrifts, including savings and
firms attempting to make payments in international loan associations, mutual savings banks, and credit
trade.
unions—and nondepository institutions—insurance
companies, pension funds, and investment companies.
LEARNING OBJECTIVE 5
Depository institutions are foundational to the
Explain what central banks do to control money and economy due to their pivotal role in the payments
achieve economic goals.
system. Nondepository institutions are repositories of
The quantity theory and related equation of exchange private savings that are pooled and then invested in
show that money matters in the sense that it can impact long-run capital projects in the business sector. Big
economic output and inflation. Central banks have the institutional investors can have a powerful influence on
ability to control money supplies and, in turn, impact capital flows to business firms and even countries.

Chapter Questions 5. What is the Financial Services Modernization Act
of 1999? Are similar changes to financial systems
1. What are the three major components of a occurring in Europe and Japan?
financial system? 6. How did the large number of bank failures during
2. What is financial intermediation? Discuss the the Great Depression affect the economy of the
efficiency benefits of this process to the economy United States at that time?
as a whole. 7. Distinguish between the different roles of the IMF
3. How does the Japanese financial system differ from and the World Bank.
the U.S. financial system? What are the advantages 8. Describe three important characteristics of money.
and disadvantages of the Japanese financial Why did the world change from commodity money
system? to fiat money?
4. List and briefly discuss four ways that regulation 9. Give three examples of electronic money. Why is
can be used to protect the safety and soundness of this form of money gradually replacing paper
financial systems. money?

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