Ch. 9 Saving, Investment, and the Financial System Flashcards
Saving definition
Income that is not spend on consumption goods
Investment definition
purchase of new capital: tools, machinery, factories.
what determines the supply of savings?
- smoothing consumption
- impatience
- market and psychological factors
- interest rates
Why do individuals want to smooth consumption?
- To save during working years to provide for retirement.
2. Manage fluctuations in income (save during good times to ride out bad times)
Time preference definition
the desire to have goods and services sooner rather than later
What happens as the interest rate increases?
the greater the quantity saved, but the smaller the quantity demanded of savings will be
What determines the demand for savings?
- smoothing consumption
- Financing large investments
- the interest rate
What is the Lifecycle Theory of Saving?
By borrowing, saving, and dissaving at different times in life, workers can smooth their consumption path, improving their overall satisfaction.
Why is borrowing necessary?
To finance large investments, such as education, new apartment buildings, and highway systems
When is an investment profitable?
if its rate of return is greater than the interest rate
When does a market for loanable funds occur? What does it determine?
when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers); determines the EQ interest rate and the EQ quanitity of savings/borrowing
What are the three financial intermediaries and what to they do?
Banks, bond market, and stock market. They reduce the costs of moving savings from savers to borrowers and investors.
What do banks do?
- gather savings
- reduce cost of mobilizing savings to productive uses
- spread risk
What is a bond?
a sophisticated IOU that documents who owns how much and when payment must be paid
What happens when a risk of a bond increases?
the greater the interest rate required to get lenders to buy the bonds, also higher risk means higher return
what is a collateral?
something of value that by agreement becomes the property of the lender if the borrower defaults
What is crowding out?
Decrease in private spending that occurs when govt. borrows more
What is arbitrage?
The buying and selling of equally risky assets, ensures that equally risky assets earn equal returns
What happens when intermediation fails? what are the factors the break the bridge?
Slower economic growth;
- reducing the supply of savings
- raising the cost of intermediation
- reducing the effectiveness of lending
What are usury laws/
They create legal ceilings on interest rates
Owner equity
The value of the asset minus the debt (E=V-D)
Leverage ratio
the ratio of debt to equity (D/E)
What is insolvency?
When a firm’s liabilities > assets
What is securitization?
bundling loans together and selling the bundles as financial assets
Why do banks securitize?
- get more liquid cash
- make the balance sheet safer
- loan assets can be held by institutions with long-term perspectives
- to put a better face on “bad” loans so they can be sold
Why is high leverage bad/risky?
- high leverage = accelerated defaults
- higher default rate = losses for banks
- high leverage of banks accelerated losses and many banks were pushed to insolvency
