Chapter 1

An Introduction to Money and the Financial System

Problems

1.     List some financial transactions you have engaged in over the past week and note how you paid for them. How might each one have been carried out 50 years ago? (LO1)

Answer:  Commercial purchases that you made likely used credit or debit cards. You may have split a restaurant bill with friends by using a payment app such as Venmo.  Fifty years ago they would have all used cash. Payment of utilities (if you do it) might have been done by electronic transfer, rather than a check (which would have been the method 50 years ago). 

2.     How were you, or your family or your friends, affected by the failure of the financial system to function normally during the COVID pandemic? (LO1)

Answer:  While the COVID-pandemic did not lead to the widespread failure of financial institutions like the financial crisis of 2007-2009 did, the forced closure of bank branches may have changed the way you interacted with your bank. For example, you may have carried out transactions online instead of going to the bank in person. You or someone you know may have been refused a business loan or a mortgage, as financial institutions dealt with higher rates of defaults on existing loans in light of business failures and high unemployment due to the pandemic.

3.     List three items you used to buy with cash but you now purchase with a debit card. (LO1)

Answer: Among the possibilities: purchases of cappuccino at the local coffee shop, gasoline for your car, and groceries for the week.

4.     Various financial instruments usually serve one of two distinct purposes: to store value or to transfer risk. Name a financial instrument used for each purpose. (LO1)

Answer: Financial instruments used to store value include bank accounts, stocks and bonds. Instruments used to transfer risk include car insurance and life insurance.

5.     Financial innovation has reduced individuals’ need to carry cash. Explain how. (LO1)

Answer: Everyone has a number of alternative methods of payment.  Electronic forms, like credit and debit cards, are the primary ones that have reduced the need to carry cash. Mobile payment services, such as Venmo and Apply Pay, have also become increasingly popular.

6.     * Many people believe that, despite ongoing financial innovations, cash will always be with us to some degree as a form of money. What core principle could justify this view? (LO2)

Answer: Core Principle 3 – information is the basis for decisions. When cash is used to settle a transaction, it is a final payment, not some form of a promise to pay. No information is needed about the payer once cash has been handed over to settle a transaction. This has obvious advantages for the recipient, as the information costs are negligible. In some circumstances, one or both parties to a transaction may wish to preserve their anonymity, and cash allows this. 

7.     When you apply for a loan, you are required to answer lots of questions. Why? Why is the set of questions you must answer standardized? (LO2)

Answer: The reasons for the questions relate to Core Principle 3 – information is the basis for decisions, and Core Principle 2 – risk requires compensation. The questions are aimed at figuring out how likely you are to repay the loan. Standardizing the questions reduces the cost of gathering information and therefore of making the loan.