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Principles of Economics > 29. Saving, Investment, and the Financial System > Flashcards

29. Saving, Investment, and the Financial System Flashcards

1
Q

What are savings?

A

Income not spend on consumption goods.

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2
Q

Define investments.

A

Purchase of NEW capital goods (e.g. tools, machinery, factories).

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3
Q

List factors affecting the supply of savings (four).

A

1) Smoothing consumption
2) Marketing and psychological factors
3) Impatience
4) Interest rates

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4
Q

What happens when someone “dissaves”?

A

Consumption is greater than income (retirement).

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5
Q

How are fluctuations in income solved via savings?

A

Saving in good years for a cushion of wealth in the bad years.

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6
Q

What does it mean to be impatient with savings? Give an example of having to be patient.

A

People have a time preference where today feels more real than tomorrow.

Investing (cost) of a college degree comes well before the benefits.

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7
Q

How does marketing affect savings?

A

More people save if its marketed as natural and the default option.

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8
Q

What does the quantity of savings depend on?

A

Interest rate (it is a market price - price of savings).

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9
Q

What is borrowing for?

A

To smooth consumption and finance large investments.

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10
Q

What is the lifecycle theory?

A

1) Borrowing (college, buying first home)
2) Saving (prime working years)
3) Dissaving (retirement)

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11
Q

Why is borrowing important for the economy?

A

Gives entrepreneurs money which helps growth rate of GDP and improves living standards.

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12
Q

Borrowing only occurs if return of investments is ______ than loan costs.

A

greater

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13
Q

If interest rates are low, are their more or less demands of funds for investment?

A

More.

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14
Q

What is the equilibrium of the market for loanable funds?

A

Quantity of funds supplied = quantity of funds borrowed.

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15
Q

What is the equilibrium rate for loanable funds?

A

8%, $250 billion

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16
Q

What happens during a recession? What is a solution for it?

A

During a recession there are less investments which prolong the recession.

Solution: tax credit; tax breaks give incentive for quick temporary investments.

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17
Q

Give three types of intermediaries.

A

1) Banks
2) Bonds
3) Stock markets

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18
Q

How do intermediaries institute equilibrium?

A

They reduce costs of moving savings from savers to borrowers and give savings productive uses.

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19
Q

What do banks do?

A

1) Pay savers interest and loan savings to borrowers with interest.
2) Specialise in loan evaluations (where to invest)
3) Spread risk
4) Payment systems (credit card, ATM)

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20
Q

What happens in a bond market?

A

Corporations borrow from public.

21
Q

What is a bond?

A

A corporate IOU. It includes the amount owed and when the payment has to be made.

22
Q

What are the two types of payment dates?

A

Single payment: day of maturity

Periodic payment: coupon payments (made in addition to final payment)

23
Q

What are the benefits of bonds?

A

1) Large sums of money for immediate investment in long-lived assets (e.g. railroad track).
2) Payed back over a long period of time.

24
Q

What do risky firms (borrowers) do?

A

Risky firms have higher interest rates and collateral to compensate lenders for default risk.

25
Q

What is collateral?

A

Valuable asset that becomes lenders property if borrower defaults.

E.g. a house

26
Q

What are risks of bonds?

A
  • default

- crowding out

27
Q

List the three types of US government borrowing (bonds) and what they entail.

A

Treasury bond (T-bond):

  • 30 years
  • pay interest every 6 months

T-notes:

  • maturity of 2 to 20 years
  • interest every 6 months

T-bills:

  • maturity of a few days to 26 weeks
  • pay at maturity
28
Q

What is another term for bonds paying at maturity, and why?

A

Zero-coupon bond or discount bond because they sell at face value.

Face value: value at maturity

29
Q

How are bond prices expressed in terms of an interest rate?

A

A zero-coupon bond has an implied rate of return.

[( Face value - price ) / price] x 100

30
Q

Interest rates and bond prices movie in _________ directions.

A

opposite

31
Q

What is the definition for buying/selling equally risky assets for equally risky returns?

A

Arbitrage principle

32
Q

What are stocks?

A

Shares of ownership in a corporation.

Profits is revenue minus costs so shareholders profit is after everyone else (e.g. employees) is paid.

33
Q

What are the direct and indirect benefits profits of stock?

A

Direct: firm pays dividends to shareholders.

Indirect: firm reinvests profit to increase stock value.

34
Q

Where are stocks traded in organised markets? Give an example.

A

Stock Exchanges

Example: New York Stock Exchange (NYSE) is the world’s largest.

35
Q

What does IPO stand for and what is it?

A

Initial Public Offering is when new stock are issued and sold to public for the first time.

36
Q

What are bridges between savers and borrowers broken by?

A

1) Insecure property rights
2) Inflation and controls of interest rate
3) Politicised lending
4) Bank failures and panics

37
Q

What is the process of a bridge breakage?

A

Reduced savings supply –> raised intermediation costs –> reduced effectiveness of lending

38
Q

Define usury laws and its loopholes.

A

Maximum ceiling on interest rate of loans.

Loopholes:

  • credit cards can keep borrowing
  • set at levels too high to influence loan markets
39
Q

What happens to the GDP growth rate if more governments run banks?

A

Lower growth rate.

40
Q

What happened during the financial crisis of 2007 to 2008?

A
  • America borrowed too much
  • mortgages with 20% down payment, then lowered to 0% as housing prices were expected to rise forever
  • people defaulted and banks had no down payment cushion
41
Q

What is the leverage ratio? What happens if you have more leverage?

A

Debt / Equity

More leverage = same force (your cash) can move (buy) bigger assets.

Housing buyers were using more leverage.

42
Q

What does “securitised” mean? How does it relate to mortgage loans?

A

Assets get up-front cash with future payments.

Mortgage loans were securitised and sold as financial assets on the market.

Securitised = selling cashflows

43
Q

Why do banks securitise loans?

A
  • more liquid cash

- securitised assets invested using long-term perspective

44
Q

What did the increased ability to sell mortgages lead to in the financial crisis?

A

Low interest rates for home buyers and investors thought securitised mortgages were safe and secure.

45
Q

Define delinquency.

A

Failure to pay.

46
Q

What defines a commercial bank?

A
  • legally guaranteed funding (insurance)

- money from depositors

47
Q

What defines an investment bank?

A
  • no government insurance
  • money from investors (short-term and long-term funds)
  • investors prone to panic –> withdrawal of short-term funding
48
Q

What happens if an investment bank no longer has short-term loans?

A

Fire sale where selling assets decrease value of other assets, hence a fire storm.

Principles of Economics (8 decks)

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