29. Saving, Investment, and the Financial System Flashcards
What are savings?
Income not spend on consumption goods.
Define investments.
Purchase of NEW capital goods (e.g. tools, machinery, factories).
List factors affecting the supply of savings (four).
1) Smoothing consumption
2) Marketing and psychological factors
3) Impatience
4) Interest rates
What happens when someone “dissaves”?
Consumption is greater than income (retirement).
How are fluctuations in income solved via savings?
Saving in good years for a cushion of wealth in the bad years.
What does it mean to be impatient with savings? Give an example of having to be patient.
People have a time preference where today feels more real than tomorrow.
Investing (cost) of a college degree comes well before the benefits.
How does marketing affect savings?
More people save if its marketed as natural and the default option.
What does the quantity of savings depend on?
Interest rate (it is a market price - price of savings).
What is borrowing for?
To smooth consumption and finance large investments.
What is the lifecycle theory?
1) Borrowing (college, buying first home)
2) Saving (prime working years)
3) Dissaving (retirement)
Why is borrowing important for the economy?
Gives entrepreneurs money which helps growth rate of GDP and improves living standards.
Borrowing only occurs if return of investments is ______ than loan costs.
greater
If interest rates are low, are their more or less demands of funds for investment?
More.
What is the equilibrium of the market for loanable funds?
Quantity of funds supplied = quantity of funds borrowed.
What is the equilibrium rate for loanable funds?
8%, $250 billion
What happens during a recession? What is a solution for it?
During a recession there are less investments which prolong the recession.
Solution: tax credit; tax breaks give incentive for quick temporary investments.
Give three types of intermediaries.
1) Banks
2) Bonds
3) Stock markets
How do intermediaries institute equilibrium?
They reduce costs of moving savings from savers to borrowers and give savings productive uses.
What do banks do?
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)
What happens in a bond market?
Corporations borrow from public.
What is a bond?
A corporate IOU. It includes the amount owed and when the payment has to be made.
What are the two types of payment dates?
Single payment: day of maturity
Periodic payment: coupon payments (made in addition to final payment)
What are the benefits of bonds?
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.
What do risky firms (borrowers) do?
Risky firms have higher interest rates and collateral to compensate lenders for default risk.
What is collateral?
Valuable asset that becomes lenders property if borrower defaults.
E.g. a house
What are risks of bonds?
- default
- crowding out
List the three types of US government borrowing (bonds) and what they entail.
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
What is another term for bonds paying at maturity, and why?
Zero-coupon bond or discount bond because they sell at face value.
Face value: value at maturity
How are bond prices expressed in terms of an interest rate?
A zero-coupon bond has an implied rate of return.
[( Face value - price ) / price] x 100
Interest rates and bond prices movie in _________ directions.
opposite
What is the definition for buying/selling equally risky assets for equally risky returns?
Arbitrage principle
What are stocks?
Shares of ownership in a corporation.
Profits is revenue minus costs so shareholders profit is after everyone else (e.g. employees) is paid.
What are the direct and indirect benefits profits of stock?
Direct: firm pays dividends to shareholders.
Indirect: firm reinvests profit to increase stock value.
Where are stocks traded in organised markets? Give an example.
Stock Exchanges
Example: New York Stock Exchange (NYSE) is the world’s largest.
What does IPO stand for and what is it?
Initial Public Offering is when new stock are issued and sold to public for the first time.
What are bridges between savers and borrowers broken by?
1) Insecure property rights
2) Inflation and controls of interest rate
3) Politicised lending
4) Bank failures and panics
What is the process of a bridge breakage?
Reduced savings supply –> raised intermediation costs –> reduced effectiveness of lending
Define usury laws and its loopholes.
Maximum ceiling on interest rate of loans.
Loopholes:
- credit cards can keep borrowing
- set at levels too high to influence loan markets
What happens to the GDP growth rate if more governments run banks?
Lower growth rate.
What happened during the financial crisis of 2007 to 2008?
- 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
What is the leverage ratio? What happens if you have more leverage?
Debt / Equity
More leverage = same force (your cash) can move (buy) bigger assets.
Housing buyers were using more leverage.
What does “securitised” mean? How does it relate to mortgage loans?
Assets get up-front cash with future payments.
Mortgage loans were securitised and sold as financial assets on the market.
Securitised = selling cashflows
Why do banks securitise loans?
- more liquid cash
- securitised assets invested using long-term perspective
What did the increased ability to sell mortgages lead to in the financial crisis?
Low interest rates for home buyers and investors thought securitised mortgages were safe and secure.
Define delinquency.
Failure to pay.
What defines a commercial bank?
- legally guaranteed funding (insurance)
- money from depositors
What defines an investment bank?
- no government insurance
- money from investors (short-term and long-term funds)
- investors prone to panic –> withdrawal of short-term funding
What happens if an investment bank no longer has short-term loans?
Fire sale where selling assets decrease value of other assets, hence a fire storm.
