Solution Manual For
Money, Banking and Financial Markets 2024 Release By Stephen
Cecchetti and Kermit Schoenholtz
Chapter 1-23
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.
8. Name two distinct financial markets and describe the kind of asset traded in each. (LO1)
Answer: Among the best-known financial markets are those for stocks and for bonds. In the
stock markets, equities or ownership shares in companies are bought and sold. In the bond
market, debt issues of government units or companies are traded.
9. * Why do you think the global financial system has become more globally integrated over time?
Can you think of any downside to this increased integration? (LO1)
Answer: Technological progress is one obvious reason. According to Core Principle 3,
information is the basis for decisions. Improvements in technology have allowed for huge
volumes of information to be collected and disseminated quickly and cheaply on a global basis,
facilitating long distance financial transactions. A downside of this increased integration is that
it allows for problems that arise in the financial system of one country to spread more quickly
and easily to other countries, as we saw during the financial crisis of 2007-2009.
10. The government is heavily involved in the financial system. Explain why. (LO1)
Answer: For markets to work there have to be rules. And the rules need to be enforced. The
government both makes the rules and enforces them so that we all trust the markets to work as
they should. Without the government to monitor the financial system, ensuring that people
behave themselves, the system would collapse.
11. If offered the choice of receiving $1,000 today or $1,000 in one year’s time, which option
would you choose, and why? (LO2)
, Answer: Core Principle 1 states that time has value, so you should choose option 1. By
receiving the $1,000 today, you can immediately put the money to use. Perhaps you buy a new
computer or put the money in the bank to earn interest. Regardless of what you do with the
money, waiting a year to receive the money involves an opportunity cost.
12. If time has value, why are financial institutions often willing to extend you a 30-year mortgage
at a lower annual interest rate than they would charge for a one-year loan? (LO2)
Answer: With a mortgage, the house you purchase acts as collateral for the loan. In the event
you default, the bank can sell the house and recoup its funds. The existence of collateral reduces
the risk associated with the loan and so reduces the compensation the bank requires.
13. Using Core Principle 2, under what circumstances would you expect a job applicant to accept
an offer of a low base salary and an opportunity to earn commission over one with a higher base
salary and no commission potential? (LO2)
Answer: The applicant would have to expect to earn a higher total salary working for a low base
and commission, as they require compensation for the risk they assume due to the uncertainty
about the level of commission earnings.
14. Suppose medical research confirms earlier speculation that red wine is good for you. Why
would banks be willing to lend to vineyards that produce red wine at a lower interest rate than
before? (LO2)
Answer: The future prospects for the vineyards have improved, reducing the risk involved in
lending to them. The banks require less compensation than before.
15. * If the U.S. Securities and Exchange Commission eliminated its requirement for public
companies to disclose information about their finances, what would you expect to happen to the
stock prices for these companies? (LO2)
Answer: You should expect the stock prices to fall. Gathering sufficient information upon
which to make an informed investment decision would become much more costly for investors,
reducing the demand for the stock at a given price.
16. If 2 percent growth is your break-even point for an investment project, under which outlook for
the economy would you be more inclined to go ahead with the investment: (1) a forecast for
economic growth that ranges from 0 to 4 percent, or (2) a forecast of 2 percent growth for sure,
assuming the forecasts are equally reliable? What core principle does this illustrate? (LO2)
Answer: You would be more inclined to invest in the project if you knew for sure that growth
would be 2%. Uncertainty about the future makes investment less attractive, as you run the risk
of losing out if the lower end of the forecast is realized. This illustrates Core Principle 5 –
stability improves welfare.
, 17. * Why are large, publicly listed companies much more likely than small businesses to sell
financial instruments such as bonds directly to the market, while small businesses get their
financing from financial institutions such as banks? (LO2)
Answer: Information costs associated with small businesses are higher than those for large,
publicly listed companies—costs that bond market investors are unlikely to be willing to incur.
Banks are skilled at gathering information about borrowers and evaluating the risks associated
with loans. Therefore, they are more likely to be willing to lend to smaller businesses.
18. * During the financial crisis of 2007-2009, some financial instruments that received high ratings
in terms of their safety turned out to be much riskier than those ratings indicated. Explain why
markets for other financial instruments might have been adversely affected by that development.
(LO2)
Answer: Core Principle 3 states that information is the basis for decisions. Ratings are an
important source of information for investors in assessing many financial instruments, and so
when confidence in that information is undermined, they are more reluctant to lend.
19. Suppose financial institutions didn’t exist but you urgently needed a loan. Where would you
most likely get this loan? Using core principles, identify an advantage and a disadvantage this
arrangement might have over borrowing from a financial institution. (LO2)
Answer: In the absence of financial institutions, you are most likely to borrow from a family
member or a friend. An advantage of this arrangement, under Core Principle 3, would be that
your family and friends naturally have more information about you than a bank and know,
without having you fill in copious forms, that you can be relied upon to pay them back. A
disadvantage would be the necessity of finding a family member or friend who happened to
have funds available to lend to you at that particular point in time. Financial institutions help
bring potential borrowers and lenders in the financial market together to allocate available
resources (Core Principle 4).
20. In broad terms, explain how a central bank tries to maintain economic and financial stability and
encourage economic growth. (LO1)
Answer: Central banks can moderate business cycle fluctuations by adjusting interest rates.
They also have powerful tools to steady fragile financial systems and to support dysfunctional
markets. By helping to reduce the volatility associated with business cycles and financial
instability, they reduce the risks that individuals can’t eliminate on their own, allowing them to
invest in the future. That promotes economic growth.
21. The Dodd-Frank Act, enacted in the United States in the aftermath of the 2007-2009 financial
crisis, includes provisions aimed at enhancing the coordination of various regulatory agencies.
Which two core principles might best explain these reforms? (LO2)
Answer:
Core Principle 3 – Information is the basis for decisions. Coordination should improve the flow
of information among regulatory agencies, enabling better decision making.
