CH 10+12 Flashcards
financial markets (definition)
markets in which the government, firms and individuals trade promises to pay in future (instead of goods)
savings-investment spending identity (definition)
savings and investment spending are always equal for economy as a whole
investment spending (definition)
spending/investing in new physical capital–> only speending that adds to economy’s stock of physical capital is considered investment spending
investing (definition)
buying stock/purchase an existing building
budget surplus (definition)
the difference between tax revenue and government spending when tax revenue exceeds government spending
budget deficit (definition)
the difference between tax revenue and government spending when government spending exceeds tax revenue
government borrowing (definition)
total amount of funds borrowed by federal state, and local governments in the financial markets
Budget balance (definition)
the difference between tax revenue and government spending–> use it to refer to both budget surplus and budget deficit
Budget balance (equation)
Sgovernment= T–G–TR
T= value of tax revenues
TR= value of government transfers
G= government spending
If budget balance is positive…
government is saving–> thus budget surplus
if budget balance is negative…
government is dissaving–> thus budget deficit
national savings (definition)
the sum of private savings and budget balance–> aka the total amount of savings generated within economy
national savings (equation) in open economy
Snational= Sgovernment+Sprivate
national savings (equation) in closed economy
Snational=Investment spending
inflow of funds (definition)
foreign savings that finance investment spending in that country
outflow of funds (definition)
domestic savings that finance investment spending in another country
3 different kinds of capital: (definition+explanation)
- physical capital–> manufactured resources like buildings+machines
- human capital–> the improvement of labour force generated by education+knowledge
- financial capital–> funds from savings that are available for investment spending–> country that has a positive net capital inflow–> is experiencing flow of funds from country from abroad–> this can be used for investment spending
net capital inflow (NCI) (equation)
NCI= IM–EX
in economy with positive net capital inflow…
more capital flowing in than out–> some investment spending is funded by saving foreigners
in economy with negative net capital inflow…
more capital flowing out than it–> portion of national savings is funding investment spending abroad in other countries
how do funds for investment spending get allocated?
through the market of supply+demand
In closed economy… saving=… ?
savings=national savings
in open economy… savings=…?
savings=national savings+capital inflow
loanable funds market (definition)
hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
what price determines the market for loanable funds?
the interest rate (r)
opportunity cost of investment spending (explanation)
instead of spending money on investment spending project, could also just put money in bank and earn interest
–> thus higher the interest rate bank, more attractive to just put money in bank and not loan out–> so the higher the interest rate the higher the opportunity cost
why is the demand curve for loanable funds downwards sloping?
because the demand for loanable funds to finance investment spending is negatively related to the interest rate–> the higher the interest rate for loan, the less quantity of loans people will demand
present value (definition)
the amount of money needed today in order to receive X amount of money in future given interest rate
why is the supply curve for loanable funds upward sloping?
because oppportunity cost for savers when lend to business–> could spend it on consumption
–> so higher the interest rate, more supply–> therefore upward sloping
equilibrium interest rate (definition)
the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded
2 ways equilibrium in loanable funds market shows match-up is effcicient:
- the right investments get made–> the investment spending projects that are actually financed have higher payoffs (in terms of present value) than those that do not get financed
- the right people do the saving and lending–> the savers who actually lend funds are willing to lend for lowers interest rate than those who do not
why does a well functioning financial system increases an economy’s long-run economic growth?
because loanable funds market leads to efficient use of savings
2 reasons for shift of Demand curve for loanable funds: (definition)
- changes in perceived business opportunities
changes in government borrowing
changes in perceived business opportunities (explanation)
changes in beliefs about payoff of investment spending can increase/decrease amount of desired spending at any given interest rate
–> example: in 90’s excitement about business possibilities created by invention of internet–> businesses rushed to invest in computer equipment etc–> resulted in shift R of demand curve for loanable funds
changes in government borrowing (explanation)
if government run budget deficit–> can be major source of demand for loanable funds–> shifting demand curve for loanable funds to R
crowding out (definition)
occurs when government budget deficit rives up interest rate and leads to reduced investment spending
–> affects supply curve and therefore the demand curve
–> BUT crowding out may not occur when economy is depressed
why may crowding out may not occur when economy is depressed?
when economy depressed–> less employment–> government spending can lead to higher income–> this might lead to increased savings at any given interest rate
2 reasons for shift of Supply curve of loanable funds market: (definitions)
- changes in private savings behaviour
- changes in net capital inflow
changes in private savings behaviour (explanation)
can change at any given interest because number of factors
example: following corona pandemic+concerns of growing recession households cut back on spending→ resulting in an increase of savings→ thus shift of the supply curve of loanable funds to the right
changes in net capital inflows (explanation)
capital flows in+out of country can change as investor’s perception of that country’s economy change
global loanable funds market (definition)
arises when international capital flows are so large that they equalise interest rates across countries
What is the most important factor that can change both the supply+demand curve for loanable funds?
changing expectations about future inflation
fisher effect (definition)
an increase n expected future inflation drives up the nominal interest rate–> leaving the expected real interest rate unchanged
–> each additional percentage point of expected future inflation drives up nominal interest rate by 1 percentage point
–> both lenders + borrowers base their decisions on expected real interest rate–> result: change in expected rate of inflation doesn’t effect the equilibrium quantity/interest price–> all it affects is the equilibrium nominal interest wage
financial markets (definition)
where households invest their current+accumulated savings
wealth (definition)
the value of accumulated savings
financial asset (definition)
a paper claim that entitles buyer to future income from seller
–> like a loan
physical asset (definition)
a tangible object that can be used to generate future income
–> like pre-existing house of piece of equipment
–> purchasing physical asset gives owner right to dispose of object how they wish (rent/sell it)
liability (definition)
a requirement to pay income in the future
4 kinds of important financial assets: (definition)
- loans
- stocks
- bonds
- bank deposits
the 3 tasks of a financial system (definition)
- reducing transction costs
- reducing risk
- providing liquidity
reducing transaction costs (explanation)
arranging loan requires time+money negotiating terms of that deal etc
–> when lagre business wants to borrow money: either go bank or sell bonds in market–> avoids large transaction costs
transactional costs (definition)
the expenses of negotiating+executing a deal
opportunity cost of loanable funds(explanation)
the interest rate
–> the higher the interest rate the higher the opportunity cost for loan borrowers
–> can just keep money in bank and earn interest rate there than investment spending–> more valuable if interest rates for loans very high
for lenders its the other way around!
if interest rate rises:
present value of any given project falls, fewer project pass that test
if interest rate falls:
present value of any given project rises, so more projects pass that test
why does a government budget deficit in general leads to less overall spending in an economy? (explanation)
because when a government has a budget deficit that means that they will demand more loans at any given interest rate–> resulting in shift of demand curve to the right–> resulting in higher interest rate–> other borrowers less likely to borrow now and thus overall investment spending decreases–> less overall spending in economy
why do we use nominal interest rate in our graphs instead of real interest rate?
because in real world don’t know what the future inflation rate will be–> therefore in loan contracts have to make deal based on nominal interest rate
providing liquidity (explained)
→ bonds+stocks partial answer to the problem of liquidity
→ banks provide an additional way for individuals to hold liquid asset+still finance illiquid investment spending projects, like buying capital equipment for a business
diversification (definition)
by investing in several different assets so that the possible losses are independent events→ aka lowers total risk because if one asset performs poorly very unlikely that other assets would be affected→ but if owner would have invested everything he had into business and business does poorly was at risk of losing everything
Countercyclical assets (definition)
assets that go up in value when there’s an economic downturn→ like gold or bonds
liquid asset (definition)
if asset can be quickly converted into cash with relative little loss of value
illiquid asset (definition)
can NOT be quickly converted into cash with relative little loss of value
loan (definition)
a lending agreement between an individual lender and an individual borrower
positive aspect loan (explanation)
loan is usually personally tailored to meet needs of borrower and their ability to pay it back in specific time frame
negative aspect loan (explanation)
making loan to individual usually involves lot of transaction costs
bonds (definition)
issued by governments/corporation when they want to raise money. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and pay you periodic interest rate along the way.
- bond financial asset for owner, and liability for its issuer
- avoids transaction costs for issuer
bond purchasers can gather information for free on quality of bond issuer
- easy to resell–> because not specific –> provide liquidity
default (definition)
risk that borrower (bond issuer) fails to make payments as specified by the loan or bond contract
bonds with a higher default risk…
must pay a higher interest rate
loan-backed securities (definition)
asset created by pooling individual loans and selling shares in that pool (securitisation)
stocks (definition)
share in ownership of company
- financial asset for owners, liability for company
why is owning stock of given company riskier than owning bonds of the same company?
because bond is a promise and stock is hope
–> by law companies must first pay out what it oowes to lenders before distributes any profits to shareholders
–> if business fails, its physical+financial assets first goto bondholders, risk of nothing left for shareholders
financial intermediary (definition)
institutions that transforms the funds it gathers from many individuals into financcial assets
4 most important types financial intermediaries:
- mutual funds
- pension funds
- life insurance companies
- banks
diversified portfolio (of stocks) (definition)
group of stocks in which risks are unrelated to, or offset by, one another–> to reduce risk, investors can spread their investment in different companies
mutual fund (definition)
financial intermediary that creates a (diversified) stock portfolio by buying+holding shares in companies and then resells shares of this portfolio to individual investors–> buying these shares, investors woth relatively small ampunt of money to invest can directly hold a diversified portfolio
–> mutual funds save transaction cost by doing research in which companies are trust+worth investing in
pension funds (definition)
non-profit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire
–> functions like mutual fund, but subject to special rules+receive special treatment for tax purposes
life insurance policies (definition)
sells policies that guarantee a payment to a policyholder’s beneficiaries (usually family) when the policy holder dies
bank (definition)
a financial intermediary that provides liquid assets in form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers
–> bank count on fact only small fraction of its depositors want cash back at same time
2 ways a financial asset allows higher future consumption:
- many financial assets provide regular income to their owners in form of interest payments/dividends
- can also buy nin-dividend paying stocks–> with belief that wil earn income from selling the stock in future at a profit–> another way of generating higher future income
the value of a financial asset today depends on…
investor’s belief about future value or price of asset
stock prices are determined by…
- the suppply+demand for shares, which in turn is dependent on investor’s expectations about the future stock price
- changes in attractiveness of substitute assets
fundamentals (definition)
the underlying determinants of company’s future profits
the efficient markets hypothesis (definition)
according to this prices embody all publicly available information–> meaning: value come up with after careful study of company’s prospects etc are same value is already sharing
- at any point 8in time stock prices are fairly valued–> reflect all current publicly available information about fundamentals
- prices of stocks+other assets should change only in response to new information about underlying fundamentals–> new infomation by definition unpredictable–> stock prices will follow random walk
random walk (definition)
the movement over time of an unpredictable variable
succesful market timing (definition)
buying stocks when they are underpriced and selling them when they are overpriced
aggregate demand curve (definition)
shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, government and the rest of the world
2 main reasons why rise in aggregate price level lead to fall in quantity of aggregate demand (definitions)
- the wealth effect
- the interest rate effect
the wealth effect (explanation)
the effect on consumer spending caused by effect of change in aggregate price level on the purchasing power of consumer asset–> consumer spending falls–> therefore downward aggregate demand curve
the interest rate effect (explanation)
the effect on consumer spending and investment spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers and firms money holdings
–> rise in aggregate price level–> depresses investment spending and consumer spending–> therefore downward sloping AD curve
5 factors that can shift AD curve: (definitions)
- changes in expectations
- changes in wealth
- size of the existing stock of physical capital
- monetary policy
- fiscal policy
changes in expectations (explanation)
- if consumers+firms more optimistic–> AD demand shifts R
- if consumers+firms more pessimistic–> shift L AD curve
changes in wealth (explanation)
- when real value of households assets rises–> R shift AD curve
- when real value of households assets drops–> L shift AD curve
size of the existing stock of physical capital (explanation)
- when existing stock of physical capital is relatively small–> R shift AD curve
- when existing stock of physical capital is relatively big–> L shift AD curve
fiscal policy (explanation)
- when government increases spending/cuts taxes–> R shift AD curve
- when government reduces spending/increases taxes–> L shift Ad curve
aggregate supply curve (definition)
shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy
nominal wage (definition)
the dollar amount of the wage paid (doesn’t take into account inflation rate)
sticky wages (definition)
nominal wages that are slow to fall, even in face of high unemployment and slow to rise even in face of labour shortages
–> but nominal wages can’t be sticky forever–> eventually wages renegotiated and will take into account changed economic circumstances
setting price in perfectly competitive market:
producers have no influence on setting of prices
setting price in imperfectly competitive markets:
producers have some ability to choose the prices they charge
short run aggregate supply curve (SRAS) (definition)
shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed.
3 factors that sift SRAS curve (definitions):
- changes in commodity prices
- changes in nominal wages
- changes in productivity
commodity (definition)
a standardised input bought+sold in bulk qualities
changes in commodity prices (explanation)
- when commodity price fals–> R shift SRAS
- when commodity price rises–> L shift SRAS
changes in nominal wages (explanation)
- when nominal wages fall–> R shift SRAS
- when nominal wages rise–> L shift SRAS
changes in productivity (explanation)
- when workers become more productive–> R shift SRAS
- when workers become less productive –> L shift SRAS
the long run (definition)
the period of time in which all prices, including production costs like nominal wages, are fully flexible
- changes in aggregate price level do NOT change the quantity of aggregate output supplied in LR
long run aggregate supply curve (LRAS) (definition)
shows the relationship between the aggregate price level+quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible
potential output (definition)
the level of real GDP the economy would produce if all prices, including nominal wages, are fully flexible
AD-AS Model (definition)
the aggregate supply curve and the aggregate demand curve are used together to analyse economic fluctuations
short-run macro equilibrium (definition)
point at which the quantity of aggregate output supplied is equal to the quantity demanded by domestic households, business, government and rest world
demand shock (definition)
an event that shifts the aggregate demand curve
negative demand shock (explanation)
- shifts AD curve L
- aggregate price level reduces
- aggregate output reduces
- aka lower SR equilibrium
positive demand shock (explanation)
- shift AD curve R
- increase aggregate price level +aggregate output
- aka increase in short run equilibrium
supply shock (definition)
an event that shifts the SRAS curve
negative supply shock (explanation)
- raises production costs
- therefore reduces quantity producers willing to supply at any given aggregate price level
- L shift of SRAS
positive supply shock (explanation)
- reduces production costs
- therefore increases quantity supplied at any given aggregate price level
- R shift SRAS
long-run macroeconomic equilibrium (definition)
when the short-run macroeconomic equilibrium is on the LRAS curve
- noted down as Elr
recessionary gap (definition)
occurs when aggregate output is below its potential output–> corresponds to high unemployment
inflationary gap (definition)
when aggregate output is above potential output–> low unemployment, but more inflation
output gap (definition)
the percentage difference between actual aggregate output and potential output
output gap (equation)
actual aggregate output–potential output X 100
when recessionary gap, output gap is…
negative
when inflationary gap, output gap is…
positive
economy is self correcting (explanation)
when shocks to aggregate demand affect aggregate output in SR, but NOT in Long-Run
stabilisation policy (definition)
use of government policy to help reduce the severity of recessions and reign in excessively strong expansions
2 reasons why policy that make sures economy mainstains original equilibrium is desirable:
- the temporary fall in aggregate output that would happen without policy intervention is a bad thing–> particularily because such decline is associated with high unemployment
- price stability is generally regarded as desirable goal–> preventing deflation (fall in aggregate price level) is good thing
what are government policies that can compensate for shifts of SRAS curve?
There are NONE!
efficiency market hypothesis (definition)
assets tend to be priced according to their actual value–> determined by looking at the fundamentals–> aka whether company is profitable, and how profitable likely to be in the future
