Chapter 2

ECONOMICS, MONEY, AND BANKING

I. What Is This Thing Called the Economy?
A.   The economy is the sum total of all the economic activity within a given region

B.   Economics is the study of how a society uses its scarce resources to produce and
distribute goods and services

1.   Microeconomics is the study of economic behavior among consumers, businesses, and

industries that collectively determine the quantity of goods and services demanded and
supplied at different prices

2.     Macroeconomics is the study of a country's larger economic issues, such as

competition, government policies, and how an economy maintains and allocates its scarce
resources

C.   Each society must decide how to use its economic resources or factors of production

1.   Natural resources—things that are useful in their natural state (land, forests, minerals,
and water)

2.   Human resources—people and their individual talents and capacities

3.     Capital—money, computers, machines, tools, and buildings

4.     Entrepreneurship—the spirit of innovation, the initiative, and the willingness to take

on risks involved in creating/operating a business

5.   Knowledge—the collective intelligence of an organization. Knowledge workers are

employees whose primary contribution is the acquisition and application of business
knowledge

D.   Scarcity—a condition of any productive resource that has finite supply

1.     Scarcity creates competition for resources

2.     Scarcity forces consumers, companies, and governments to make trade-offs

a.     Opportunity cost is the value of the most attractive option not selected when
making a trade-off
 E.   Economic indicators are statistics such as interest rates, unemployment rates, housing
data, and industrial productivity

1.     Leading indicators (such as housing starts and durable-goods orders) suggest changes
that may happen to the economy in the future

2.     Lagging indicators (such as the unemployment rate) provide confirmation that

something has happened in the past

3.     Housing starts are a leading indicator showing where several industries are headed;
when housing starts drop, the construction industry contracts, and the effect ripples
through other sectors of the economy

4.     A rise in durable-goods orders, another key leading indicator, is a positive indicator

that business spending is turning around

F.     Price indexes offer a way to monitor inflation or deflation

1.     The consumer price index (CPI) measures rate of inflation by comparing change in
prices of a representative "basket" of consumer goods and services

2.     The producer price index (PPI) is a statistical measure of price trends at the
producer and wholesaler levels

G.     The gross domestic product (GDP) is the value of all the final goods and services
produced by businesses located within a nation's borders

1.   GDP has largely replaced the measure GNP (gross national product). GNP considers
who is responsible for production; GDP considers where it occurs

II. Economic Systems

A.     An economic system is the basic set of rules for allocating a society's resources to
satisfy its citizens' needs

1.   Planned system—governments largely control allocation of resources; also called a

command system or a command-and-control system

a.     Often equated with socialism, which involves collective ownership of the means of
production

2.   Free-market system—individuals and companies decide what products to produce,

how to produce them, to whom to sell them, and at what price
 a.     Referred to as capitalism or private enterprise—private parties own/operate the
majority of businesses and competition, supply, and demand determine goods/services
produced

b.   No economy is without limited intervention by government, creating a mixed

economy or mixed capitalism

3.     Governments change structure of economy in two ways:

a.     Nationalizing—assuming ownership of selected companies or industries

b.     Privatizing—allowing private businesses to perform services once performed by

the government

B.   There is considerable debate over the key roles that governments play in the economy

1.   Regulation—relying more on laws and policies than on markets forces to govern

economic activity

2.   Deregulation—removing regulations to allow the market to prevent excesses and

correct itself over time

C.     The government plays a role in the economy in four major areas:

1.     Protecting stakeholders through numerous regulatory agencies

2.     Fostering competition through prevention of monopolies

a.     Antitrust legislation

b.     Merger and acquisition approval

3.     Stabilizing and stimulating the economy through use of monetary policy and fiscal
policy

a.     Monetary policy involves adjusting the nation's money supply by increasing or

decreasing interest rates. It is administered by the Federal Reserve Board

b.     Fiscal policy involves changes in the government's revenues (taxation) and

expenditures

4.     Encouraging innovation and economic development

III. The Forces of Demand and Supply

A.   Demand—buyers' willingness and ability to purchase products at various price points
 1.     The demand curve shows the relationship between price and demand—as price
decreases, demand increases (i.e., more people are willing to buy)

B.     Supply—the quantities of a good/service that producers will provide on a particular date

at various prices

1.   The supply curve shows the relationship between supply and demand—as price
increases, the quantity that sellers are willing to supply increases

C.     Demand and supply curves intersect at equilibrium price—the point at which quantity
supplied equals quantity demanded

IV. The Macro View: Understanding How an Economy Operates

A.   Competition is rivalry among businesses for the same customers.

B.     There are different degrees of competition

1.     Pure competition—the market situation in which there are so many buyers and
sellers that no single buyer or seller can individually influence market price

2.   Monopoly—the market situation in which one company dominates the market and can
control prices

3.   Monopolistic competition—the market situation in which there are many sellers who
differentiate their products from those of competitors in at least some small way

4.   Oligopoly—the market situation in which a very small number of suppliers, sometimes

only two, provide a particular good or service

C.   Economic activity changes in response to factors such as investment patterns, shifts in

consumer attitudes, world events, and basic economic forces—called economic fluctuation or
business cycles
 1.     Economic expansion—when the economy is growing and consumers are spending
more money

2.     Economic contraction—when spending declines, employment drops, and the

economy slows down

a.     A recession is two consecutive quarters of decline in gross domestic product

b.     A deep and prolonged recession can be considered a depression, a catastrophic

collapse of financial markets

D.   Unemployment rate—the percentage of labor force currently without employment

1.     Four types of unemployment—frictional, structural, cyclical, and seasonal

E.     Inflation—the steady rise in the average prices of goods and services throughout the
economy

1.   Deflation is the sustained fall in average prices

V.   The Money's Role in Business
A.   Money is anything generally accepted as a means of paying for goods and services. It has
four functions:

1.   Medium of exchange—a tool for simplifying buyer/seller transactions

2.     Unit of accounting—a measure of value

3.     Temporary store of value—a way of accumulating wealth until it is needed

4.     Standard of deferred payment—it can be used to represent debt obligations

B.     The practical value of money stems from two key properties: liquidity and trust

1.   Money is the most liquid asset because it can be exchanged easily and often instantly
for something else of value

2.     Currency is accepted because of the trust that it represents real economic value

C.     The U.S. dollar and other modern currencies are called fiat money, issued and
maintained through government fiat or proclamation

1.     A new wave of alternative money is cryptocurrency, digital tokens that rely on

cryptography for security (e.g., Bitcoin). It has the potential to influence business and
economics in the following ways:

a.     An alternative to fiat currency

b.   A disruptive force in global economics and politics

c.     A speculative investment

d.     A driver of potentially disruptive technologies

D.   The money supply is the amount of money in circulation at any given time within an
economy. It can be measured in several ways:                

1.     M1 consists of cash held by the public and money deposited in a variety of checking
accounts: spendable now

2.     M2 is broader, encompassing M1 plus savings accounts, balances in retail money-

market funds, CDs, and spendable fairly soon
The Money Supply

VI. Banking Institutions and Services

A.   The Federal Reserve System (the Fed) is the central banking system of the U.S. and is
responsible for regulating banks and implementing monetary policy. Tools to manage money
supply are:

1.     Two key interest rates:

a. Federal funds rate—the interest rate that member banks charge each other to
borrow money overnight from the funds they keep in the Federal Reserve accounts. Not
set directly but "nudged" through buying/selling treasury bond, bills, and notes;
adjusting reserve requirements; and lending through the discount window

b.     Discount rate—the rate that member banks pay when they borrow money from
the Fed. A change in it generally changes banks' prime rate, the rate it charges its best
loan customers

B.     Other government banking agencies and institutions include:

1.   Federal Deposit Insurance Corporation (FDIC)—federal agency responsible for

protecting money in customer accounts and managing the transition of assets when a bank
fails

2.     NCUA—The National Credit Union Administration (NCUA) provides regulatory

supervision and account protection for credit unions

3.     Fannie Mae and Freddie Mac—two quasi-public companies operating under the
close supervision of the federal government, with a mandate to make mortgage funding
more available to low- and moderate-income home buyers. They don't extend loans
themselves but rather purchase and guarantee loans made by other lends in the secondary
mortgage market.
C.   Investment banks offer a variety of investing and advisory services to organizational
customers, including corporations, other financial institutions, pension funds, and
governments. They provide some combination of these services:

 Facilitating mergers, acquisitions, sales, and spin-offs of companies

 Underwriting initial public offerings
 Managing and advising on investments
 Raising capital on behalf of corporate or government clients
 Advising on and facilitating complex financial transactions
 Investing in or lending money to companies
 Providing risk management advice
 "Making markets" for clients

D.   Commercial banks are financial institutions that accept deposits, offer various types of
checking and savings accounts, and provide loans. Five major types are as follows:

1.     Retail banks provide financial services to consumers

2.     Merchant banks offer financial services to businesses

3.     Thrift banks offer deposit accounts and focus on offering home mortgage loans

4.     Credit unions are not-for-profit, member-owned cooperatives that offer deposit

accounts and lending services to consumers and small business

5.     Private banking is a range of banking services for wealthy individuals and families    

E.     Other financial services:

1.   Independent mortgage companies originate mortgages using their own funds

2.   Mortgage brokers initiate loans on behalf of a mortgage lender in exchange for a fee

3.   Finance companies are nonbank institutions that lend money to consumers and
businesses

4.   Credit rating agencies are companies that offer opinions about the creditworthiness of
borrowers and of specific investments

F.     For all the benefits banking provides, its role in the economy hasn't been without harm
or controversy. Financial firms of all types and sizes played a central role in triggering the
Great Recession of 2007-2009.

1.     The too-big-to-fail dilemma

 a.     The banking industry has consolidated dramatically in recent years; the largest
banks hold a staggering proportion of the country's cash accounts

b.     Calling a bank "too big to fail" doesn't mean a bank can't fail because it is too big;
it means a bank's role in the economy is so big that regulators will take special action to
make sure it doesn't fail

2.     The boundaries of commercial banking and investment banking

a.     Starting in the 1980s, waves of deregulation reshaped the banking and financial
services industry; in the opinions of some, this helped create the conditions that led to
the Great Recession

b.     Debate continues about whether the Glass-Steagall wall should be reinstated to

prevent the risks posed by colossal, multifaceted financial firms

VII. Thriving in the Digital Enterprise: Fintech

A.     Fintech—technologies with the potential to improve or disrupt financial services.
Involves a variety of technologies, including:

1.   Artificial intelligence (AI)

2.   Cloud computing
 3.     Mobile apps, with both customer-facing and back-office technologies

B.   Five major areas are seeing benefits from new fintech, including making financial
services more inclusive

1.   Crowdfunding and peer-to-peer lending bypass intermediaries in the conventional

banking system

2.   Highly automated fintech brokerages like Robinhood and Stash give more people
access to the stock market and other investment opportunities by making it possible to
invest smaller amounts than with traditional brokerages

C.     Improving efficiency of financial activities

1.     A group of fintech activities lower the costs, delays, and complexity of traditional
banking activities

2.     TransferWise lowers the costs and fees associated with international money transfers

D.   Strengthening security of financial systems, for example, with automated AI-based threat
intelligence

E.     Improving the customer experience in financial services

1.     Popular fintech apps include mobile banking apps, peer-to-peer cash transfer apps
like Venmo and Zelle, and financial planning services like Mint

2.     Neobanks provide banking services entirely through mobile and digital channels

F.     Enhancing financial decision-making with robo advisers that aim to improve investors'
returns by removing emotions-driven decision-making and automating time-consuming
manual tasks.