chap011 - Chapter 11 The Economics of Financial...

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Chapter 11 The Economics of Financial Intermediation Chapter Overview In theory, the market system may seem neat and simple, but in reality economic growth is a messy, chaotic thing. Problems with the flow of information between parties in a market system can derail economic growth unless they are addressed properly. This chapter discusses some of those information problems and the ways that financial intermediaries attempt to solve them. Reading this chapter will prepare students to: Explain how financial intermediaries reduce costs. Define information problems that occur in financial transactions. Assess the degree to which financial intermediaries are effective in solving information problems. Important Points of the Chapter Economic well-being is inextricably tied to the health of the financial intermediaries that make up the financial system. These institutions pool funds from people and firms who save and lend them to people and firms that need to borrow, and when they do their job correctly, investment and economic growth increase at the same time that investment risk and economic volatility decrease. There is a strong link between financial development and economic development; without a stable, well-functioning financial system, no country can prosper. Application of Core Principles Principle #4: Markets (page 252) Financial intermediaries provide access to the payments system and so facilitate the exchange of goods and services, promoting specialization. Moreover, reducing the cost of financial transactions also promotes more trade and specialization. Principle #2: Risk (page 254) Banks mitigate risk by taking deposits from a large number of individuals and make thousands of loans with them, thus giving each depositor a small stake in each of the loans. Principle #2: Risk (page 258) Risk requires compensation, and in the bond market this means that the higher the risk, the greater the risk premium. If a lender can’t tell whether a borrower is a good or bad credit risk, the lender will demand a risk premium based on Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 150
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Chapter 11 The Economics of Financial Intermediation the average risk. The good borrowers are likely to withdraw from the market rather than pay the high rate, and only the bad borrowers will be left. Teaching Tips/Student Stumbling Blocks To emphasize the five functions performed by financial intermediaries (i.e., they pool the resources of small savers; they provide safekeeping and accounting services as well as access to the payments system; they supply liquidity; they provide ways to diversify small investments (reducing their risk); and they collect and process information in ways that reduce information costs) have students list the various financial intermediaries with which they do business. Which function(s) are performed by each? Have students consider the factors that might affect their credit scores (page 270).
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chap011 - Chapter 11 The Economics of Financial...

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