END CHAPTER SOLUTIONS

ANSWERS TO QUESTIONS

1. If I can buy a car today for $5,000 and it is worth $10,000 in extra income next year to
me because it enables me to get a job as a traveling salesman, should I take out a loan
from Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will
I be better or worse off as a result of taking out this loan? Can you make a case for
legalizing loan sharking?

Yes, I should take out the loan, because I will be better off as a result of doing so. My
interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional
$10,000, so I will be ahead of the game by $5,500. Since Larry’s loan-sharking business
can make some people better off, as in this example, loan sharking may have social
benefits. (One argument against legalizing loan sharking, however, is that it is frequently
a violent activity.)

2. Some economists suspect that one of the reasons that economies in developing
countries grow so slowly is that they do not have well-developed financial markets.
Does this argument make sense?
Yes, because the absence of financial markets means that funds cannot be channeled
to people who have the most productive use for them. Entrepreneurs then cannot
acquire funds to set up businesses that would help the economy grow rapidly.

3. Why is a share of Microsoft common stock an asset for its owner and a liability for
Microsoft?

The share of Microsoft stock is an asset for its owner, because it entitles the owner to a
share of the earnings and assets of Microsoft. The share is a liability for Microsoft,
because it is a claim on its earnings and assets by the owner of the share.

4. If you suspect that a company will go bankrupt next year, which would you rather
hold, bonds issued by the company or equities issued by the company? Why?

You would rather hold bonds, because bondholders are paid off before equity holders,
who are the residual claimants.

5. “Because corporations do not actually raise any funds in secondary markets, they are
less important to the economy than primary markets are.” Is this statement true, false,
or uncertain?

This statement is false. Prices in secondary markets determine the prices that firms
issuing securities receive in primary markets. In addition, secondary markets make
securities more liquid and thus easier to sell in the primary markets. Therefore,
secondary markets are, if anything, more important than primary markets.
6. For each of the following money market instruments, describe who issues the debt:
a. Treasury bills
b. Certificates of deposit
c. Commercial paper
d. Repurchase agreement
e. Fed funds

Treasury bills are short-term debt instruments issued by the United States government
to cover immediate spending obligations, i.e. finance deficit spending. Certificates of
deposit (CDs) are issued by banks and sold to depositors. Commercial paper is issued
by corporations and large banks as a method of short-term funding in debt markets.
Repos are issued primarily by banks, and funded by corporations and other banks
through loans in which treasury bills serve as collateral, with an explicit agreement to
pay off the debt (repurchase the treasuries) in the near future. Fed funds are overnight
loans from one bank to another.

7. What is the difference between a mortgage and a mortgage-backed security?

Mortgages are loans to households or firms to purchase housing, land, or other real
structures, where the structure or land itself serves as collateral for the loans. Mortgage-
backed securities are bond-like debt instruments which are backed by a bundle of
individual mortgages, whose interest and principal payments are collectively paid to the
holders of the security. In other words, when an individual takes out a mortgage, that
loan is bundled with other individual mortgages to create a composite debt instrument,
which is then sold to investors.

8. The U.S. economy borrowed heavily from the British in the nineteenth century to build
a railroad system. Why did this make both countries better off?

The British gained because they were able to earn higher interest rates as a result of
lending to Americans, while the Americans gained because they now had access to
capital to start up profitable businesses such as railroads.

9. A significant number of European banks held large amounts of assets as mortgage-

backed securities derived from the U.S. housing market, which crashed after 2006. How
does this demonstrate both a benefit and a cost to the internationalization of financial
markets?
The international trade of mortgage-backed securities is generally beneficial in that the
European banks that held the mortgages could earn a return on those holdings, while
providing needed capital to U.S. financial markets to support borrowing for new home
construction and other productive uses. In this sense, both European banks and U.S.
borrowers should have benefitted. However, with the sharp decline in the U.S. housing
market, default rates on mortgages rose sharply, and the value of the mortgage-backed
securities held by European banks fell sharply. Even though the financial crisis began
primarily in the United States as a housing downturn, it significantly affected European
markets; Europe would have been much less affected without such internationalization
of financial markets.

10. How does risk sharing benefit both financial intermediaries and private investors?

Financial intermediaries benefit by carrying risk at relatively low transaction costs. Since
higher risk assets on average earn a higher return, financial intermediaries can earn a
profit on a diversified portfolio of risky assets. Individual investors benefit by earning
returns on a pooled collection of assets issued by financial intermediaries at lower risk.
Risk to individual investors is lowered through the pooling of assets by the financial
intermediary.

11. How can the adverse selection problem explain why you are more likely to make a
loan to a family member than to a stranger?

Because you know your family member better than a stranger, you know more about
the borrower’s honesty, propensity for risk taking, and other traits. There is less
asymmetric information than with a stranger and less likelihood of an adverse selection
problem, with the result that you are more likely to lend to the family member.

12. One of the factors contributing to the financial crisis of 2007–2009 was the
widespread issuance of subprime mortgages. How does this demonstrate adverse
selection?

The issuance of subprime mortgages represents lenders loaning money to the pool of
potential homeowners who are the highest credit risk and have the lowest net wealth
and other financial resources. In other words, this group of borrowers most in need of
mortgage credit was also the highest risk to lenders, a perfect example of adverse
selection.

13. Why do loan sharks worry less about moral hazard in connection with their
borrowers than some other lenders do?

Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that
might jeopardize their paying off the loan. Hence borrowers from a loan shark are less
likely to increase moral hazard.

14. If you are an employer, what kinds of moral hazard problems might you worry about
with your employees?

They might not work hard enough while you are not looking or may steal or commit
fraud.
15. If there were no asymmetry in the information that a borrower and a lender had,
could a moral hazard problem still exist?

Yes, because even if you know that a borrower is taking actions that might jeopardize
paying off the loan, you must still stop the borrower from doing so. Because that may be
costly, you may not spend the time and effort to reduce moral hazard, and so the
problem of moral hazard still exists.

16. “In a world without information costs and transaction costs, financial intermediaries
would not exist.” Is this statement true, false, or uncertain? Explain your answer.

True. If there are no informational or transactions costs, people could make loans to
each other at no cost and would thus have no need for financial intermediaries.

17. Why might you be willing to make a loan to your neighbor by putting funds in a
savings account earning a 5% interest rate at the bank and having the bank lend her the
funds at a 10% interest rate rather than lend her the funds yourself.

Because the costs of making the loan to your neighbor are high (legal fees, fees for a
credit check, and so on), you will probably not be able earn 5% on the loan after your
expenses even though it has a 10% interest rate. You are better off depositing your
savings with a financial intermediary and earning 5% interest. In addition, you are likely
to bear less risk by depositing your savings at the bank rather than lending them to your
neighbor.

18. How do conflicts of interest make the asymmetric information problem worse?

Potentially competing interests may lead an individual or firm to conceal information or

disseminate misleading information. A substantial reduction in the quality of information
in financial markets increases asymmetric information problems and prevents financial
markets from channeling funds into the most productive investment opportunities.
Consequently, the financial markets and the economy become less efficient. That is,
false information as a result of a conflict of interest can lead to a more inefficient
allocation of capital than just asymmetric information alone.

19. How can the provision of several types of financial services by one firm be both
beneficial and problematic?

Financial firms that provide multiple types of financial services can be more efficient
through economies of scope, that is, by lowering the cost of information production.
However, this can be problematic since it can also lead to conflicts of interest, in which
the financial firm provides false or misleading information to protect its own interests.
This can lead to a worsening of the asymmetric information problem, making financial
markets less efficient.
20. If you were going to get a loan to purchase a new car, which financial intermediary
would you use: a credit union, a pension fund, or an investment bank?

You would likely use a credit union if you are a member, since their primary business is
consumer loans. In some cases, it is possible to borrow directly from pension funds, but
it can come with high borrowing costs and tax implications. Investment banks do not
provide loans to the general public.

21. Why would a life insurance company be concerned about the financial stability of
major corporations or the health of the housing market?

Most life insurance companies hold large amounts of corporate bonds and mortgage
assets, thus poor corporate profits or a downturn in the housing market can significantly
adversely impact the value of asset holdings of insurance companies.

22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised
the limit on insured losses to bank depositors from $100,000 per account to $250,000
per account. How would this help stabilize the financial system?

During the financial panic, regulators were concerned that depositors worried their
banks would fail, and that depositors (especially with accounts over $100,000) would
pull money from banks, leaving cash-starved banks with even less cash to satisfy
customer demands and day-to-day operations. This could create a contagious bank
panic in which otherwise healthy banks would fail. Raising the insurance limit would
reassure depositors that their money was safe in banks and prevent a bank panic,
helping to stabilize the financial system.
Chapter 3
ANSWERS TO QUESTIONS

1. Why is simply counting currency an inadequate measure of money?

Since a lot of other assets have liquidity properties that are similar to currency but can
be used as money to purchase goods and services, not counting them would understate
an economy’s access to liquidity for transactions purposes. For this reason, counting
assets such as checking deposits or savings accounts more accurately reflects the
stock of assets that can be considered money.

2. In prison, cigarettes are sometimes used among inmates as a form of payment. How
is it possible for cigarettes to solve the “double coincidence of wants” problem, even if a
prisoner does not smoke?

Even if he or she is a non-smoker, since the prisoner knows that others in the prison will
accept cigarettes as a form of payment, they themselves would be willing to accept
cigarettes as a form of payment. So, rather than prisoners having to barter and trade
favors, cigarettes satisfy the double coincidence of wants in that both parties to a trade
stand ready to use them to “purchase” goods or services.

3. Three goods are produced in an economy by three individuals:

Good Producer
Apples Orchard owner
Bananas Banana grower
Chocolate Chocolatier
If the orchard owner likes only bananas, the banana grower likes only chocolate, and
the chocolatier likes only apples, will any trade between these three persons take place
in a barter economy? How will introducing money into the economy benefit these three
producers?

Because the orchard owner likes only bananas but the banana grower doesn’t like
apples, the banana grower will not want apples in exchange for his bananas, and they
will not trade. Similarly, the chocolatier will not be willing to trade with the banana
grower because she does not like bananas. The orchard owner will not trade with the
chocolatier because he doesn’t like chocolate. Hence, in a barter economy, trade
among these three people may well not take place, because in no case is there a
double coincidence of wants. However, if money is introduced into the economy, the
orchard owner can sell his apples to the chocolatier and then use the money to buy
bananas from the banana grower. Similarly, the banana grower can use the money he
receives from the orchard owner to buy chocolate from the chocolatier, and the
chocolatier can use the money to buy apples from the orchard owner. The result is that
the need for a double coincidence of wants is eliminated, and everyone is better off
because all three producers are now able to eat what they like best.
4. Why did cavemen not need money?

Cavemen did not need money. In their primitive economy, they did not specialize in
producing one type of good and they had little need to trade with other cavemen.

5. Most of the time it is quite difficult to separate the three functions of money. Money
performs its three functions at all times, but sometimes we can stress one in particular.
For each of the following situations, identify which function of money is emphasized.

a. Brooke accepts money in exchange for performing her daily tasks at her office, since
she knows she can use that money to buy goods and services.
b. Tim wants to calculate the relative value of oranges and apples, and therefore
checks the price per pound of each of these goods quoted in currency units.
c. Maria is currently pregnant. She expects her expenditures to increase in the future
and decides to increase the balance in her savings account.

(a) This situation illustrates the medium-of-exchange function of money. We often do

not think why we accept money in exchange for hours spent working, as we are so
accustomed to using money. The medium-of-exchange function of money refers to its
ability to facilitate trades (hours worked for money and then money for groceries) in a
society. (b) In this case we observe money performing its unit-of-account function. If
modern societies did not use money as a unit of account, then the price of apples would
have to be quoted in terms of all the other items in the market. This quickly becomes an
impossible task. Suppose that a pound of apples sells for 0.80 pounds of oranges, half
a gallon of milk, one third of a pound of meat, 2 razor blades, 1.5 pound of potatoes,
etc., etc., etc.! (c) Maria is contemplating the store-of-value function of money. As a
medium of exchange and unit of account, measures of money known as M1 or M2 have
no important rivals. With respect to the store-of-value function, however, there are many
assets that can preserve value better than a checking account. Maria’s choice to
preserve the purchasing power of her income by increasing her savings account
balance is fine for a small period of time. For a period of 20 years, however, you might
choose to buy a U.S. Treasury bond that matures in 20 years (as many grandparents
have done as a way to pay for their grandchildren’s educations).

6. In Brazil, a country that underwent a rapid inflation before 1994, many transactions
were conducted in dollars rather than in reals, the domestic currency. Why?

Because of the rapid inflation in Brazil, the domestic currency, the real, was a poor store
of value. Thus many people preferred to hold dollars, which were a better store of value,
and used them in their daily shopping.
7. Was money a better store of value in the United States in the 1950s than in the
1970s? Why or why not? In which period would you have been more willing to hold
money?

Because money was losing value at a slower rate (the inflation rate was lower) in the
1950s than in the 1970s, it was a better store of value then, and you would have been
willing to hold more of it.

8. Why have some economists described money during a hyperinflation as a “hot

potato” that is quickly passed from one person to another?

Money loses its value at an extremely rapid rate in hyperinflation, so you want to hold it
for as short a time as possible. Thus money is like a hot potato that is quickly passed
from one person to another.

9. Why were people in the United States in the nineteenth century sometimes willing to
be paid by check rather than with gold, even though they knew there was a possibility
that the check might bounce?

Because a check was so much easier to transport than gold, people would frequently
rather be paid by check even if there was a possibility that the check might bounce. In
other words, the lower transactions costs involved in handling checks made people
more willing to accept them.

10. In ancient Greece, why was gold a more likely candidate for use as money than
wine was?

Wine is more difficult to transport than gold and is also more perishable. Gold is thus a
better store of value than wine and also leads to lower transactions cost. It is therefore a
better candidate for use as money.

11. If you use an online payment system such as PayPal to purchase goods or services
on the Internet, does this affect the M1 money supply, M2 money supply, both, or
neither? Explain.

Neither. Although PayPal and many other e-money systems work as other forms of
money do to facilitate purchases of goods and services, it does not count in the M1 or
M2 money supplies. Because PayPal and similar payment systems are generally credit-
based, this requires payment at a future date for funds used today; those future
payments must be made using existing money that is already in the system, such as
currency or funds in a bank deposit account. In other words, the M1 and M2 money
supplies would theoretically remain the same, but money would move from your
checking account to a third party, once the credit transaction is settled.
12. Rank the following assets from most liquid to least liquid:
a. Checking account deposits
b. Houses
c. Currency
d. Automobile
e. Savings deposits
f. Common stock

The ranking from most liquid to least liquid is: (c), (a), (e), (f), (d), and (b).

13. Which of the Federal Reserve’s measures of the monetary aggregates—M1 or M2

—is composed of the most liquid assets? Which is the larger measure?

M1 contains the most liquid assets. M2 is the largest measure.

14. It is not unusual to find a business that displays a sign saying “no personal checks,
please.” On the basis of this observation, comment on the relative degree of liquidity of
a checking account and currency.

The degree of liquidity of an asset is measured by considering how much time and effort
(i.e., transaction costs) are needed to convert that asset into currency. Currency is by
definition the most liquid type of money. Different types of money have different degrees
of liquidity. A check, which represents a balance on a checking account, is a quite liquid
type of money. After all, all that is needed to pay for a good or service using a check is
the two minutes it takes to include the date and amount and sign the check. However,
the above example shows that some merchants refuse to accept checks as a means of
payment. (They cannot refuse to accept dollars, as dollars are legal tender in the United
States.) This can result in significant transaction costs in trying to find a bank or an
ATM. It is even possible that the transaction never takes place. This example illustrates
the point that even inside the same monetary aggregate, different types of money do
not have the same degree of liquidity.

15. For each of the following assets, indicate which of the monetary aggregates (M1
and M2) includes them:
a. Currency
b. Money market mutual funds
c. Small-denomination time deposits
d. Checkable deposits

a. M1 and M2,
b. M2,
c. M2,
d. M1 and M2.
16. Assume that you are interested in earning some return on idle balances you usually
keep in your checking account and decide to buy some money market mutual funds
shares by writing a check. Comment on the effect of your action (with everything else
the same) on M1 and M2.

Your actions will reduce your checking account balance and increase your holdings of
money market mutual fund shares. Considering this transaction only, M1 will decrease
as one of its components decreased. M2 will remain constant, as M2 is composed of all
items that add up to M1 plus some other types of money that are not so liquid to be
considered part of M1. One of these categories is money market mutual fund shares.
The decrease in your checking account balance is offset by the increase in money
market mutual fund shares, and therefore M2 remains constant

17. In September 2008, the growth rate of the M1 money supply was zero, while the
growth rate of the M2 money supply was about 5%. In July 2009, the growth rate of M1
was about 17%, and the growth rate of M2 was about 8%. How should Federal Reserve
policymakers interpret these changes in the growth rates of M1 and M2?

During the period in question, the M1 growth rate increased by 17 percentage points,
while the M2 growth rate increased by only 3 percentage points. Although both
measures are moving in the same direction, the magnitude of the difference in growth
rates between the two makes it difficult to judge the appropriateness of monetary policy
by just looking at the money supply measures alone. For instance, if one focused just
on the M2 money supply, knowing the economy was in severe economic contraction
would suggest that the growth rate of M2 perhaps should be even higher than the 3
percentage point increase over this time. On the other hand, if one just focused on the
M1 growth increase of 17 percentage points, this may seem alarmingly high and
suggest an inflationary problem in the future.

18. Suppose that a researcher discovers that a measure of the total amount of debt in
the U.S. economy over the past twenty years was a better predictor of inflation and the
business cycle than M1 or M2. Does this discovery mean that we should define money
as equal to the total amount of debt in the economy?

Not necessarily. Although the total amount of debt has predicted inflation and the
business cycle better than M1 or M2, it may not be a better predictor in the future.
Without some theoretical reason for believing that the total amount of debt will continue
to predict well in the future, we may not want to define money as the total amount of
debt.

CHAPTER 2

adverse selection
The problem created by asymmetric information before the transaction occurs.

asset transformation
The process of turning risky assets into safer assests for investors by creating and selling assets
for investors by creating and selling assets with risk characteristics that people are comfortable
with and then using the funds acquired by sellings these assets to purchase other assets that may
have far more risk.

asymmetric information
The unequal knowledge that each party to a transaction has about the other party.

brokers
Agents for investors; they match buyers with sellers.

capital
Wealth, either financial or physical, that is employed to produce more wealth.

capital market
A financial market in which longer-term debt (generally with original maturity of greater than
one year) and equity instruments are traded.

conflicts of interest
A manifestation of the moral hazard problem, particularly when a financial institution provides
multiple services and the potentially competing interests of those services may lead to a
concealment of information or dissertation of misleading information.

currency
Paper money (such as dollar bills) and coins.

dealers
People who link buyers with sellers by buying and selling securities at stated prices.

default
A situation in which the party issuing a debt instrument is unable to make interest payments or
pay off the amount owed when the instrument matures.

diversification
Investing in a collection (portfolio) of assests whose returns do not always move together, with
the result that overall risk is lower for individual assets

dividends
Periodic payments made by equities to shareholders.

economies of scale
The reduction in transaction costs per dollar of transaction as the size of transactions increases.
economies of scope
The ability to use one resource to provide many different products and services.

Equities
Claims to share in the net income and assets of a corporation (such as common stock).

Eurobond
Bonds denominated in a currency other than that of the country in which they are sold.

Eurocurrencies
Variant of the Eurobond; foreign currencies deposited in banks outside the home country.

Eurodollars
U.S. dollars that are deposited in foreign banks
outside the United States or in foreign branches of U.S.
banks.

exchanges
Secondary markets in which buyers and sellers of
securities (or their agents or brokers) meet in one central location to conduct trades.

federal funds rate

The interest rate on overnight loans of deposits at the Federal Reserve.

financial intermediation
The process of indirect finance whereby financial intermediaries’ links lender-savers and
borrower-spenders.

financial panic
The widespread collapse of financial markets
and intermediaries in an economy.

foreign bonds
Bonds sold in a foreign country and denominated in that country's currency.

intermediate-term
With reference to a debt instrument, having a maturity of between one and ten years.

investment banks
Firms that assist in the initial sale of securities in the primary market.

liabilities
IOUs or debts.
liquid
Easily converted into cash.

liquidity services
Services financial intermediaries provide to their customers to make it easier for them to conduct
their transactions.

long-term
With reference to a debt instrument, having a maturity of ten years or more.

maturity
Time to the expiration date (maturity date) of a debt instrument.

money market
A financial market in which only short-term debt instruments (generally those with original
maturity of less than one year) are traded.

moral hazard
The risk that one party to a transaction will
engage in behavior that is undesirable from the other party's point of view.

mortgages
Loans to households or firms to purchase housing, land, or other real structures, in which the
structure or land itself serves as collateral for the loans.

mortgage-backed securities
Securities that cheaply bundle and quantify the default risk of the underlying high-risk
mortgages.

over-the-counter (OTC) market

A secondary market in which dealers at different locations who have an inventory of securities
stand ready to buy and sell securities "over the counter" to anyone who comes to them and is
willing to accept their prices.

portfolio
A collection or group of assets.

primary market
financial market in which new issues of a security are sold to initial buyers.

risk
The degree of uncertainty associated with the return on an asset.
risk sharing
The process of creating and selling assets with risk characteristics that people are comfortable
with and then using the funds acquired by selling these assets to purchase other assets that may
have far more risk.

secondary market
A financial market in which securities that have previously been issued (and are thus
secondhand) can be resold.

short-term
With reference to a debt instrument, having a maturity of one year or less.

thrift institutions (thrifts)

Savings and loan associations, mutual savings banks, and credit unions.

transaction costs
The time and money spent trying to exchange financial assets, goods, or services.

underwrite
Purchase securities from a corporation at a predetermined price and then resell them in the
market.

CHAPTER 3

commodity money
Money made up of precious metals or another valuable commodity

currency
Paper money (such as dollar bills) and coins

e-cash
Electronic money that is used on the Internet to purchase goods or services

electronic money (e-money)

Money that exists only in electronic form and substitutes for cash as well

fiat money
Paper currency decreed by a government as legal tender but not convertible into coins or
precious metal

hyperinflation
An extreme inflation in which the inflation rate exceeds 50% per month
income
The flow of earnings
liquidity
The relative ease and speed with which an asset can be converted into cash

M1
A measure of money that includes currency, traveler's checks, and checkable deposits

M2
A measure of money that adds to Ml money market deposit accounts, money market mutual fund
shares, small denomination time deposits, savings deposits, overnight repurchase agreements,
and overnight Eurodollars

medium of exchange
Anything that is used to pay for goods and services

monetary aggregates
The measures of the money supply used by the Federal Reserve System (Ml and M2)

payments system
The method of conducting transactions in the economy

smart card
A stored-value card that contains a computer chip that lets it be loaded with digital cash from the
owner's bank account whenever needed

store of value
A repository of purchasing power over time

unit of account
Anything used to measure value in an economy

wealth
All resources owned by an individual, including all assets

Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income.

In direct finance, borrowers borrow funds directly from lenders in financial markets by selling
them securities (also called financial instruments), which are claims on the borrower’s future
income or assets.

Securities are assets for the person who buys them but liabilities (IOUs or debts) for the
individual or firm that sells (issues) them.

A primary market is a financial market in which new issues of a security, such as a bond or a
stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
 A secondary market is a financial market in which securities that have been previously issued
can be resold.

Negotiable Bank Certificates of Deposit - A certificate of deposit (CD) is a debt instrument sold
by a bank to depositors that pays annual interest of a given amount and at maturity pays back the
original purchase price.

Commercial Paper Commercial paper - is a short-term debt instrument issued by large banks
and well-known corporations, such as Microsoft and General Motors.

Repurchase agreements (repos) - are effectively short-term loans (usually with a maturity of less
than two weeks) for which Treasury bills serve as collateral, an asset that the lender receives if
the borrower does not pay back the loan.

Federal (Fed) Funds - These instruments are typically overnight loans between banks of their
deposits at the Federal Reserve. This market is very sensitive to the credit needs of the banks, so
the interest rate on these loans, called the federal funds rate, is a closely watched barometer of
the tightness of credit market conditions in the banking system and the stance of monetary
policy.

Capital market instruments are debt and equity instruments with maturities of greater than one
year.

Stocks are equity claims on the net income and assets of a corporation

Mortgages are loans to households or firms to purchase land, housing, or other real structures, in
which the structure or land itself serves as collateral for the loans.

mortgage-backed securities, a bond-like debt instrument backed by a bundle of individual

mortgages, whose interest and principal payments are collectively paid to the holders of the
security.

Corporate Bonds These long-term bonds are issued by corporations with very strong credit
ratings.

U.S. Government Securities These long-term debt instruments are issued by the U.S. Treasury to
finance the deficits of the federal government.

U.S. Government Agency Securities These long-term bonds are issued by various government
agencies such as Ginnie Mae, the Federal Farm Credit Bank, and the Tennessee Valley Authority
to finance such items as mortgages, farm loans, or power generating equipment.

State and local bonds, also called municipal bonds, are long-term debt instruments issued by
state and local governments to finance expenditures on schools, roads, and other large programs.
Consumer and Bank Commercial Loans These loans to consumers and businesses are made
principally by banks but, in the case of consumer loans, also by finance companies.

The traditional instruments in the international bond market are known as foreign bonds.

A more recent innovation in the international bond market is the Eurobond, a bond denominated
in a currency other than that of the country in which it is sold—for example, a bond denominated
in U.S. dollars sold in London.

A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks
outside the home country. The most important of the Eurocurrencies are Eurodollars, which are
U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S.
banks.

Financial intermediaries can substantially reduce transaction costs because they have developed
expertise in lowering them and because their large size allows them to take advantage of
economies of scale, the reduction in transaction costs per dollar of transactions as the size (scale)
of transactions increases.

liquidity services, services that make it easier for customers to conduct transactions.

Another benefit made possible by the low transaction costs of financial institutions is that they
can help reduce the exposure of investors to risk—that is, uncertainty about the returns investors
will earn on assets. Financial intermediaries do this through the process known as risk sharing.

This process of risk sharing is also sometimes referred to as asset transformation, because in a
sense, risky assets are turned into safer assets for investors.

Diversification entails investing in a collection (portfolio) of assets whose returns do not always
move together, with the result that overall risk is lower than for individual assets.

The presence of transaction costs in financial markets explains, in part, why financial
intermediaries and indirect finance play such an important role in financial markets. An
additional reason is that in financial markets, one party often does not know enough about the
other party to make accurate decisions. This inequality is called asymmetric information.

Adverse selection is the problem created by asymmetric information before the transaction
occurs.

Moral hazard is the problem created by asymmetric information after the transaction occurs.

Another reason why financial intermediaries play such an important part in the economy is that
by providing multiple financial services to their customers, such as offering them bank loans or
selling their bonds for them, they can also achieve economies of scope.
Although economies of scope may substantially benefit financial institutions, they also create
potential costs in terms of conflicts of interest. Conflicts of interest, a type of moral hazard
problem, arise when a person or institution has multiple objectives (interests) and, as a result, has
conflicts between those objectives.