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TheFinancialSystemandthe
LevelofInterestRates

LearningObjectives
1 Describetheroleofthefinancial
systemintheeconomyandthe
twobasicwaysinwhichmoney
flowsthroughthesystem.
2 Discussdirectfinancingandthe
importantrolethatinvestment
banksplayinthisprocess.
3 Describetheprimary,secondary,
andmoneymarkets,explaining
thespecialimportanceof
secondaryandmoneymarketsto
businessorganizations.
4 Explainwhatanefficientmarket
isandwhymarketefficiencyis
importanttofinancialmanagers.
5 Explainhowfinancialinstitutions
servetheneedsofconsumers,
smallbusinesses,and
corporations.
6 Computethenominalandthe
realratesofinterest,
differentiatingbetweenthem.

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neofthemostimportantinstitutionalplayersinthefinancialsystemistheFederalReserveSystem

(calledtheFed).Infact,itissometimessaidthatthechairmanoftheFederalReserveBoardisthesecondmost
powerfulpersonintheUnitedStatessecondonlytothepresident.Wheredoesallofthispowercomefrom?
ItcomesfromtheFed'sroleasthenation'scentralbanktheinstitutionthatcontrolsthemoneysupply.The
Fedmanagesthenation'seconomybyconductingmonetarypolicy,whichaffectshowmuchmoneyis
availableintheeconomy.Onewayitdoesthisisbysettingatargetshortterminterestrateatwhichlarge
moneycenterbankslendtoeachother(calledthefederalfundsrate)andbybuyingandsellingTreasuryand
federalagencysecuritiestoachievethisrate.Increasesinthemoneysupplyputdownwardpressureonshort
terminterestrates.Overtime,thiscanleadtoincreasesinthelevelofeconomicactivity,alongwithhigher
inflation.Conversely,decreasesinthemoneysupplyputupwardpressureonshortterminterestrates.Thiscan
leadtoalowerlevelofeconomicactivityandlowerinflation.
SmallwonderthatwhentheFedspeaks,everyonestopsandlistens.BenBernanke,thecurrentFedchairman,
describedtheeffectsofFedannouncementsonthestockmarketasfollows:
Normally,the[FederalOpenMarketCommittee,or]FOMC,themonetarypolicymakingarmoftheFederal
Reserve,announcesitsinterestratedecisionsataround2:15 P.M.followingeachofitseightregularlyscheduled
meetingseachyear.Anairofexpectationreignsinfinancialmarketsinthefewminutesbeforetothe
announcement.Ifyouhappentohaveaccesstoamonitorthattrackskeymarketindexes,at2:15 P.M.onan
announcementdayyoucanwatchthoseindexesquiverasiftryingtodigesttheinformationintheratedecision
andtheFOMC'saccompanyingstatementofexplanation.Thentheblacklinerepresentingeachmarketindex
movesquicklyupordown,andthemarketshavepricedtheFOMCactionintotheaggregatevaluesofU.S.
equities,bonds,andotherassets. 1
Asyoucansee,theFed'spolicyactionsaretransmittedquicklythroughthefinancialsystemandultimately
affecttheeconomicwellbeingofnearlyallconsumersandbusinesses.Thischapterprovidesabasic
explanationofhowthefinancialsystemworksanddiscussesinterestratesandtheirmovements.

CHAPTERPREVIEW
Chapter1identifiedthreekindsofdecisionsthatfinancialmanagersmake:capitalbudgetingdecisions,
whichconcernthepurchaseofproductiveassetsfinancingdecisions,whichconcernhowassetswillbe
paidforandworkingcapitalmanagementdecisions,whichconcerndaytodayfinancialmatters.In
makingcapitalbudgetingdecisions,financialmanagersshouldselectprojectswhosecashflows
increasethevalueofthefirm.Thefinancialmodelsusedtoevaluatetheseprojectsrequirean
understandingoftheconceptscoveredinthischapter.Inmakingfinancingdecisions,financial
managerswanttoobtaincapitalatthelowestpossiblecost,whichmeansthattheyneedto
understandhowfinancialmarketsworkandwhatfinancingalternativesareavailable.Finally,working
capitalmanagementisconcernedwithwhetherafirmhasenoughmoneytopayitsbillsandhowit
investsitssparecashtoearninterest.Makingdecisionsintheseareasrequiresknowledgeofthe
financialsystemandwhatdeterminesthelevelofinterestrates.
Thischapterprovidesanoverviewofkeyconcepts,manyofwhichwewillrevisitinlaterchapters.We
beginthechapterbylookingathowthefinancialsystemfacilitatesthetransferofmoneyfromthose
whohaveittothosewhoneedit.Thenwedescribedirectfinancing,throughwhichbusinessesfinance
themselvesbyissuingdebtandequity,andtheimportantrolethatinvestmentbanksplayinthe
process.Nextwedescribedifferenttypesoffinancialmarketsthatareinthefinancialsystemand
discusstheconceptofmarketefficiency.Wethenexamineindirectfinancingandtheservicesthat
financialinstitutionsprovidelargeandsmallbusinesses.Finally,wediscussthefactorsthatdetermine
thegenerallevelofinterestratesintheeconomyandexplainhowinterestratesvaryoverthe
businesscycle.

Copyright2012JohnWiley&Sons,Inc.Allrightsreserved.
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