Chapter 18

Question 1

Financial system

Answer 1

Institutions that help match one person’s saving with another person’s investment. The financial system moves the economy’s scarce resources from savers to borrowers.

Question 2

Financial markets

Answer 2

Institutions through which a person who wants to save can directly supply funds to a person who wants to borrow

Question 3

What are the two most important financial markets?

Answer 3

1. Bond market

2. Stock market

Question 4

A bond

Answer 4

A certificate of indebtedness that specifies the obligations of the borrower to the buyer of the bond. A bond buyer is a lender and a bond is an IOU.

Question 5

Date of Maturity

Answer 5

Time the loan will be repaid

Question 6

Principal

Answer 6

Promise of interest and eventual repayment of the amount borrowed

Question 7

Characteristics of a bond

Answer 7

1. term
2. credit risk
3. tax treatment
4. inflation protection

Question 8

Term

Answer 8

the length of time until the bond matures

Question 9

Credit risk

Answer 9

the probability that the borrower will fail to pay some of the interest or principal

Question 10

Tax treatment

Answer 10

the way tax laws treat the interest earned on the bond. The interest on most bonds is taxable income. By contrast, when state and local governments issue bonds, called municipal bonds, the bond owners are not required to pay federal income tax on the interest income. Because of this, the state and local government pays a lower interest rate on bonds than those issued by corporations or the federal government.

Question 11

Inflation protection

Answer 11

Most bonds are in nominal terms, that is, they promise to pay interest and principal in a specific number of dollars. But, in 1997, TIPS (Treasury Inflated-Protected Services) were created by the government, which indexed the payments of interest and principal to a measure of inflation so that when prices rise, the payments rise proportionately. TIPS pay a lower interest rate.

Question 12

Stock

Answer 12

A claim to partial ownership in a firm

Question 13

Equity finance

Answer 13

The sale of stock to raise money

Question 14

Debt finance

Answer 14

The sale of bonds

Question 15

A stock index

Answer 15

The average of a group of stock prices

Question 16

Most famous stock index

Answer 16

The Dow Jones Industrial Average (It’s been computed since 1896. It’s now based on the prices of the stocks of 30 major U.S. companies.

Question 17

Most famous stock index

Answer 17

The Dow Jones Industrial Average (It’s been computed since 1896. It’s now based on the prices of the stocks of 30 major U.S. companies. Another big one is the S

Question 18

Financial intermediaries

Answer 18

Financial institutions through which savers can indirectly provide funds to borrowers

Question 19

Examples of financial intermediaries

Answer 19

1. Banks

2. Mutual funds

Question 20

Medium of exchange

Answer 20

An item people use to engage in transactions

Question 21

Store of value

Answer 21

Stocks, bonds, bank deposits

Question 22

Mutual Fund

Answer 22

An institution that sells shares to the public and uses proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio.

Question 23

Two advantages of a mutual stock

Answer 23

1. They allow people with small amounts of money to diversify their holdings
2. They give ordinary people access to the skills of professional money managers

Question 24

Indentity

Answer 24

An equation that must be true because of the way the variables in the equation are defined

Question 25

GDP Formula

Answer 25

Y=C+I+G+NX

Question 26

GDP in a closed economy

Answer 26

Y=C+I+G

Because a closed economy does not engage in international trade, there are no imports and exports, making NX=0.

Question 27

National saving

Answer 27

The total in the economy that remains after paying for consumption and government purchases

Question 28

National saving formula

Answer 28

Y-C-G=I or S=I or S= (Y-T-C) +(T-G)

Question 29

Private saving

Answer 29

the amount of income that households have left after paying their taxes and paying for their consumption

Question 30

Private saving formula

Answer 30

Y-T-C

Question 31

Public saving

Answer 31

the amount of tax revenue that the government has left after paying for its spending

Question 32

Public saving formula

Answer 32

(T-G)

Question 33

Budget surplus

Answer 33

An excess of tax revenue over government spending

T exceeds G

Question 34

Budget deficit

Answer 34

A shortfall of tax revenue from government spending

G exceeds T

Question 35

Market for loanable funds

Answer 35

the market in which those who want to save supply funds and those who want to borrow to invest demand funds

Question 36

Investment tax credit

Answer 36

An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment

Question 37

Crowding out

Answer 37

A decrease in investment that results from government borrowing. When the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment.

Question 38

Primary cause of fluctuations in government debt has been war. Two reasons that debt financing of war is appropriate.

Answer 38

1. It allows the government to keep tax rates smooth over time
2. Debt financing of wars shifts part of the cost of wars to future generations, who will have to pay off the government debt