Lecture 1:
Financial markets in which funds are transferred from people who have an excess of available
funds to people who have a shortage. Financial markets, such as bonds and stock markets, are
crucial to promoting greater economic efficiency by channeling funds from people who do not
have productive use for them to those who do. Indeed, well-functioning financial markets are a
key factor in producing high economic growth, and poorly performing financial markets are one
reason that many countries in the world remain desperately poor.
A security (also called a financial instrument) is a claim on the issuer’s future income or assets
(any financial claim or piece of property that is subject to ownership). A bond is a debt security
that promises to make periodic payments for a specified period. The bond market is especially
important to economic activity because it enables corporations and governments to borrow
money to finance their activities, and because it is where interest rates are determined. An
interest rate is the cost of borrowing, or the price paid for the rental of funds (usually expressed
as a percentage of the rental of $100 per year).
A common stock (typically called simply a stock) represents a share of ownership in a
corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing
stock and selling it to the public is a way for corporations to raise funds to finance their
activities. The stock market is also an important factor in business investment decisions, because
the price of shares affects the amount of funds that can be raised by selling newly issued stock to
finance investment spending. A higher price for a firm’s shares means that the firm can raise a
larger amount of funds, which it can then use to buy production facilities and equipment.
The financial system is complex, comprising many different types of private sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and
investment banks, all of which are heavily regulated by the government. If an individual wanted
to make a loan to IBM or General Motors, for example, he or she would not go directly to the
president of the company and offer a loan. Instead, he or she would lend to such a company
indirectly through financial intermediaries, which are institutions that borrow funds from people
who have saved and in turn make loans to people who need funds.
Banks are financial institutions that accept deposits and make loans. The term banks includes
firms such as commercial banks, savings and loan associations, mutual savings banks, and credit
unions. Banks are the financial intermediaries that the average person interacts with most
frequently.
Financial innovation, the development of new financial products and services. We will see why
and how financial innovation takes place, with particular emphasis on how dramatic
improvements in information technology have led to new financial products and the ability to
deliver financial services electronically through what has become known as e-finance.
At times, the financial system seizes up and produces financial crises, which are major
disruptions in financial markets that are characterized by sharp declines in asset prices and the
failures of many financial and nonfinancial firms. Financial crises have been a feature of
capitalist economies for hundreds of years and are typically followed by severe business cycle
downturns. Starting in August 2007, the U.S. economy was hit by the worst financial crisis since
the Great Depression. Defaults in subprime residential mortgages led to major losses in financial
institutions, producing not only numerous bank failures but also the demise of Bear Stearns and
Lehman Brothers, two of the largest investment banks in the United States. The crisis produced
the worst economic downturn since the Great Depression, and as a result, it is now referred to as
the “Great Recession.”
Inflation, the average price of goods and services in an economy is called the aggregate price
level or, more simply, the price level. From 1950 to 2014, the price level increased more than
sevenfold. Inflation, a continual increase in the price level, affects individuals, businesses, and
the government. It is generally regarded as an important problem to solve and is often at the top
of political and policymaking agendas.
