4. Financial system Flashcards
What is financial system?
Help match savings to anothers investment
- Moves resources from savers to borrowers
Includes financial markets and financial intermediaries
What are financial markets
SAvings directly fund borrowers, expecting a return on investment
Two types coordinating savers and borrowers:
- Bond market
- Stock market
What is the bond market
Bonds certificates of indebtness - differ by time of maturity and rate of interest (regularly paid)
- Principal = amount borrowed
Rate of interest reflects probability of default
- Higher risk means higher interest - sovereign vs corporate bonds
- Duration risk - long term bonds normally high interest
- Issuing bonds can be used to obtain funds to set up firms
What is the stock market
Stocks partial claim to ownership in firm, therefore claim on profits (dividends)
- Firms sell claim on its future profits when issuing stocks. If it earns nothing, the stock holder/buyer gets nothing
Stock exchanges trade stocks:
- Determined by D and S
- Demand depends on expected profits and how much people are willing to invest
- Supply depends on firms financial requirements and alternative means of obtaining credit e.g. bonds
- equity vs debt finance - can raise money either by issuing stocks or by borrowing the money
The stock index is an average group of stock prices closely watched as an indicator of future economic conditions
WHat are financial intermediaries
Indstitutions savers indirectly provide funds to borrowers:
1. Banks
2. Mutual/investment funds
Banks:
- Take deposits, pay interest
- Make loans, charge higher interest
- Facilitate purchasing of goods and services - cheques, debit cards, other mediums of exchange
Mutual/investment funds:
- Sell shares to public
- Use proceeds to uby portfolio of stocks and bonds
- Allows diversification for people with small amounts of money - pays management fee
- Access to professional money managers
What is national saving? How do we split it up
S = Y - C - G = I
If T = taxes minus transfer payments,
S = (Y - T - C) + (T - G)
National saving split into two parts:
Private saving (Y-T-C):
- Income households have left after paying for taxes and consumption
Public savings (T-G):
- Tax revenue government has after government expenditure
If public saving > 0, government saves and is in surplus
If public saving < 0, government borrows and is in deficit
What is the market for loanable funds?
The supply/demand of loanble funds meet at the price
Interest rate on y axis, quantity of loanable funds on the x axis
Supply = savings (private and public)
Demand = investment (public investment is G, so only includes private savings)
- Comes from firms and households that want to borrow to invest
The price is the real interest rate:
- What borrowers/investors pay for loan
- What lenders/savers receive
As the real interest rate rises, demand declines and supply increases, adjusting to ensure equilibrium
What is the policy of saving incentives?
Replace income tax with consmption tax:
- shelters savings from taxation
- Affects supply of loanable funds
- Causes increase in supply
- New equilibrium - low interest with higher QoL
- More invesment leads to higher GDP growth
- Possible distributional effect from rich to poor
A change in tax laws to encourage the UK to save more shifts supply of loanable funds to the right
- Equilibrium interest falls, higher supply, investment stimulated
What is the policy of budget deficits/surpluses
Governments decide to run deficit by issuing bonds or gilts. This decreases the supply of loanable funds as it raises interest rates (demand rises)
Creates new equilibrium - higher interest due to crowding out pirvate investment - less investment and lower GDP growth:
- Budget defciit decreases supply of loanable funds
- Raises interest rate to equilibrium
- Equilibrium has lower quantity of loanalbe funds
Deficits lower the national saving, supply of funds decreases so interest rates rise
- Thus, when governments borrow to finance deficit, crowds out households and firms that otherwise would borrow to finance investment
