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Econ 105 > Final Exam > Flashcards

Final Exam Flashcards

1
Q

Why is a financial system needed?

A
  • Most economies have some sort of financial system to handle household wealth and make loans
  • A well-functioning financial system is a critical ingredient in achieving long run growth because it encourages greater savings and investment spending
  • It also ensures that savings and investment spending are undertaken efficiently
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2
Q

What are the tasks of financial systems

A

Reducing transaction costs

o Transaction costs: The expense of negotiating and executing a deal

Reducing risk

o Financial risk: Uncertainty about future outcomes that involve financial losses or gains
o Diversification: investing in several assets

Task 3: Providing liquidity

o Liquidity: A measure of how quickly an asset can be converted into cash with relatively little loss of value
o If it can be converted quickly, its liquid, if not, illiquid

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3
Q

Reducing transaction costs

A
  • Suppose a business needed to raise 1 billion dollars for a new investment project
  • Not one individual would be willing to lend that much
  • Negotiating individual loans with thousands of individuals would be very costly
  • Business’ can get the loans the bank instead (or issue corporate bonds or stocks)
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4
Q

What is reducing risk?

A
  • A person who is more sensitive to a loss than to a gain of an equal dollar amount is called risk-averse
  • The owner of a business expects to make a greater profit if she buys additional capital equipment, but she isn’t completely sure that this will happen
  • Being risk-averse, this business owner wants to share the risk of purchasing new capital equipment with someone, even if that requires some of the profit if all goes well
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5
Q

What is Diversification?

A
  • By selling a share of her business, the owner can achieve diversification
  • Invest in several things in a way that lowers her total risk
  • Investments in these different assets because their different risks are unrelated, or independent, events
  • If one asset performs poorly, it is very likely that her other assets will be unaffected and, as a result, her total risk of loss has been reduced
  • Don’t put all of your eggs in one basket

Examples:
o Ford develops the electric f-150
o Oil companies invest in green technologies
o Elon Musk sells shares of Tesla and buys twitter

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6
Q

What is providing liquidity?

A
  • Having made a loan, a lender suddenly finds himself in need of cash
  • If that loan was made to a business that used it to buy new equipment, the business cannot repay the loan on short notice to satisfy the lender’s need to recover his money
  • Knowing in advance that there is a danger of needing to get this money back before the term of the loan is up, our lender might be reluctant to lock up his money by lending it to a business.
  • An asset is liquid if it can be quickly converted into cash with relatively little loss of value, illiquid if it cannot
  • Banks provide an additional way for individuals to hold liquid assets and still finance illiquid investment spending projects, such as buying capital equipment for a business
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7
Q

What are the types of financial assets and their definitions:

A
  • To help lenders and borrowers make mutually beneficial deals, then, the economy needs ways to reduce transaction costs, to reduce and manage risk through diversification, and to provide liquidity
  • It does so by creating financial assets, like loans, bonds, stocks

Loans
o A lending agreement between a lender and a borrower. Ex: student loans, mortgage, car loan
o Advantage is that it is usually tailored to the needs of the borrower
o High transaction cost: Negotiating terms, investing borrower’s credit history, etc….

Bonds
o Lend some amount of money in exchange for repayment plus fixed interest payments. It’s a liability from point of view of the issuer of the bond.
o Seller of the bond promises to pay a fixed sum of interest each year and to repay the principal – the value stated on the face of the bond – to the owner of the bond on a particular date
o A bond seller sells bonds to whoever wants to buy them
o Buyer of the bond can freely collect info about issuer of bond from bond rating agencies
o Bonds with higher default risk must pay higher interest
o Can be easily resold

Loan backed securities
o Assets created by pooling individual loans and selling shares in that pool. Ex: Mortgage Backed securities
o Traded in financial markets like bonds
o They provide more diversification and liquidity than individual loans
o Many loans combined together may make it difficult to know how good the asset is

Stocks
o A share in the ownership of a company is a stock
o Allows owners to diversify risk
o Investors who take up the risk, benefit by obtaining higher returns

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8
Q

Savings and Wealth

A

Wealth
o Is the value of a household’s accumulated savings

Financial asset
o Is a paper claim that entitles the buyer to future income from the seller

Physical asset
o Is a tangible object that can be used to generate future income

Liability
o Is a requirement to pay income in the future

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9
Q

Wealth and balance sheet

A

Wealth
- A balance sheet is a list of an economic unit’s assets and liabilities on a specific date

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10
Q

Formula to calculate Net Worth:

A

Net Worth = Total assets – total liabilities

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11
Q

Savings and Wealth Cont’

A

A flow is a measure that is defined per unit of time (saving)
o The faucet uses 2 gallons per minute of water
o I save 100$ each month

A stock is a measure that is defined at a point in time (wealth)
o My net worth or wealth is 102,000$ today

  • Saving is not the only factor that determines wealth
  • Wealth changes from changes in the values of the real or financial assets on owns:
    o Suppose you own a house worth 230,000$ in 2006
    o Today, the house is only worth 160,000$
    o That’s a 30% reduction in the house’s value and a 30% reduction in your wealth
    o The saving behavior doesn’t change, yet your wealth decreased!

Capital gains
o Increases in the value of existing assets

Capital losses
o Decreases in the value of existing assets

Change in wealth formula:
o Change in wealth = saving + capital gain – capital losses

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12
Q

How is the price of an asset determined?

A
  • The price of an asset is determined by 2 factors:

Fundamentals:
 The intrinsic value of the asset. For example: value of a stock is influenced by how good the business model of the company is.

Future expectations
 The expectation about the increase in price of the asset

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13
Q

Asset and Price Bubbles

A
  • If we expect the price of an asset to go up in the future, we demand more of the asset today
  • Increase in demand rises the price of the asset today
  • This reinforces our expectations of future price in increases
  • This could lead to irrational exuberance
  • Future expectations about prices become detached from fundamentals and become increasingly optimistic
  • Eventually price expectations come back to normal and the bubble “bursts” leading to a decline in the price
  • Bubble is a controversial concept among economists
  • Charles Kindleberger defines a Bubble as “upward price movement over an extended range that then implodes”
  • Drawback: only know it’s a bubble after the fact
  • Bubbles go against the efficient market hypothesis according to which asset prices embody all publicly available information. And depend only on fundamentals.
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14
Q

Economic effects of a burst

A
  • Policy makers are reluctant to say that “the market is wrong”, (this usually means asset prices are too high)
  • When dot come bubble burst, a lot of tech stocks lost 2/3 of their value in a short time
  • Most severe economic effects usually occur when the bursting of a bubble reduces the value of collateral backing bank loans
  • This combined with bubble investors inability to repay loans may lead to a banking crisis
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15
Q

Are investors irrational?

A

Behavioral economics
o The study of how people make (predictable) mistakes in their decisions

Investors depart from rationality in systematic ways:
o Overconfidence: Having misguided faith that they are able to sport a winning stock
o Loss aversion: Being unwilling to sell an unprofitable asset and accept the loss
o Herd Mentality: Buying an asset when its price has already been driven high and selling it when its price has already driven low

Making theories based on irrationality has the disadvantage that anything can be explained

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16
Q

What is money?

A
  • Any asset that can easily be used to purchase goods and services
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17
Q

What is Currency circulation?

A
  • Actual cash in the hands of the public (cash held by the public)
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18
Q

What are Chequable deposits?

A
  • Bank accounts that can be accessed using debit cards, digital payments, and cheques
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19
Q

What is Money supply?

A
  • The total value of financial assets in the economy that are considered money
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20
Q

What are the roles of money?

A

Medium of exchange
o An asset that individuals use to trade for goods and services rather than consumption

Store value
o A means of holding purchasing power over time
o Transfer wealth into the future

Unit of account
o A measure used to set prices and make economic calculations
o Natural unit for transactions

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21
Q

What are types of money?

A

Commodity money
o A good (normally gold or silver) used as a medium of exchange that has intrinsic value in other uses.

  • To make things easier and safer societies began using commodity-backed money

Commodity-backed money
o A medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods

  • Most modern economies use fiat money
  • Fiat money
    o A medium of exchange whose value derives entirely from its official status as a means of payment
    o Advantage:
     Supply can be adjusted more easily based on needs of the economy
    o Disadvantage
     Governments that can create money whenever they feel like it will be tempted to abuse the privilege
     Easier to counterfeit
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22
Q

Measuring Money Supply and Monetary Aggregates

A

Measuring the money supply
- The bank of Canada calculates the size of several monetary aggregates
- Monetary aggregates
o The total value in the economy of certain assets considered money
o M1 is currency + checkable deposits
o M2 = M1 + savings and term deposits that can easily be converted into M1

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23
Q

What are the monetary roles of banks?

A

Only 8% of M1 is currency; where does the rest come from?
o Bank deposits make up half of M1 and most of M2
- Financial institutions operate as part of a fractional reserve banking system
- In such a system Financial institution like commercial banks create money
- Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets.

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24
Q

Money Creation

A
  • When you deposit money in a bank account, the bank is required to hold part of it in its vault as cash (or else in an account with the regional federal reserve bank)
    o Currency in bank vaults and bank deposits at the BOC are called bank reserves
  • The rest the bank is allowed to use to give loans
  • These loans are deposited back into the financial system and so increase the total amount of money
  • This process is repeated and therefore increases the overall amount of money
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25
Q

What is a T-account?

A
  • A tool for analyzing a business’s financial position by showing the business’s assets and liabilities
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26
Q

What is the reserve ratio?

A
  • The fraction of bank deposits that a bank holds as reserves (100,000/1,000,000) = 10%
27
Q

What is the problem of bank runs

A

Banks hold only a fraction of deposits on reserve. The rest they use to make loans
o From time to time people get worried about the bank losing their money

Bank run:
o A phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure
o Historically, the have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs

28
Q

Bank Regulation

A

Deposit insurance:
o Guarantees that a banks depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account
o Creates a well-known incentive problem: Banks can take more risks, since they are insured

Capital requirements:
o Requirement that the owners of banks hold substantially more assets than the value of its bank deposits

Reserve requirements:
o Federal government required Canada’s chartered banks to hold a minimum part of their assets as non-interest-bearing reserves
o Canadian banks are no longer required to hold minimum reserves, they do so voluntarily

The discount window:
o An arrangement in which the Bank of Canada stands ready to lend money to banks in trouble

29
Q

What is the money multiplier in reality?

A

The monetary base
o The sum of currency in circulation and bank reserves
The money multiplier
o The ratio of the money supply to the monetary base

30
Q

What are Central banks and what do they do?

A

Who decides how large the monetary base will be?
- For all developed economies it is the central bank, an institution that oversees and regulates the banking system and controls the monetary base
- Canada’s central bank is the Bank of Canada

31
Q

What are the functions of the Central Bank?

A
  • The central bank acts as Banker for Commercial Banks
  • The central bank acts as Banker for Federal Government
  • The central bank issues currency
  • The central bank conducts monetary policy
32
Q

What is the structure of the bank of Canada?

A
  • Bank of Canada legally is a crown corporation owned by the government
  • Bank of Canada is a partially independent institution with considerable autonomy to carry out its responsibilities
  • The governor and five deputy governors form the Governing Council, and it is this body that implements Canada’s monetary policy
33
Q

What is the federal reserve system?

A
  • The Federal Reserve System (FED) is the central bank of the United States
  • A central bank is the public authority that regulates a nation’s depository institutions and controls the quantity of money. It also acts as a lender of last resort.
34
Q

How does the FED fit into the government?

A
  • The FED is an independent agency within the government
  • President appoints leadership
  • Congress authorizes the RED to regulate the money supply
35
Q

What is the history and structure?

A

Created by the Federal Reserve Act of 1913, came into being in 1914.
There are 12 regional Federal Reserve Banks
- they study regional economies and provide check- clearing services to banks & other depository institutions,
- hold the reserve accounts of banks,
- lend reserves to banks,
- issue currency

36
Q

What are the main roles of the FED?

A
  1. The Federal Reserve Act of 1913 did not incorporate any macroeconomic goals for monetary policy, but instead required the Fed to “provide an elastic currency.” The idea was that the Fed would help prevent financial crises and banking panics.
  2. In 1977, Congress amended The Federal Reserve Act to state:
    “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.“
    Attention to both price stability and employment is known as “the dual mandate.”
37
Q

What are the Central Bank’s tools for Monetary Policy?

A

central banks have four main tools to control the money supply:
– Reserve requirements,
– The bank interest rate (or the discount interest rate),
– Open-market operations
– Government deposit switching.

38
Q

What are Reserve Requirements?

A
  • Reserve requirements influence how much money the banking system can create with each dollar of reserves.
  • Currently, the voluntary reserve ratio of Canadian banks is around 4%, and on occasions even lower.
39
Q

The Bank Rate Part 1:

A
  • Cheques are cleared at the end of the day, some banks may gain deposits and some may lose.
  • If a commercial bank doesn’t have enough in its deposit account with the Bank of Canada to settle its debts?
  • Normally, a bank will borrow additional reserves from other banks.
40
Q

The bank rate part 2

A
  • Banks lend money to each other in the overnight funds market.
  • The overnight funds market is a financial market that allows banks to borrow reserves from each other, usually just overnight.
  • The interest rate in this market is called the overnight rate and is determined by supply and demand, both of which are strongly affected by Bank of Canada, FED, European Central Bank, etc… actions.
  • When the Federal Open Market committee(FMOC) meets it sets a target rate.
  • To control the rate it uses Open Market Operations
41
Q

What is the federal funds market and rate?

A
  • What does a bank do if it can’t meet the Fed’s reserve requirement?
  • The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves.
    – The federal funds rate is the interest rate determined in the federal funds market.
42
Q

What are open market operations?

A

When the Fed buys an asset it increases the money in circulation.
* Because government bonds can be stored indefinitely and are easy to buy and sell on the open market, the Fed chooses this commodity to buy and sell daily.
– The Fed can buy and sell billions of dollars’ worth of government bonds in minutes.
* The Fed usually buys and sells short-term bonds called Treasury bills, or T-bills.

the Fed can increase or reduce the Reserves that Banks hold by buying or selling assets to them
The Federal Reserve’s Balance sheet (Assets and Liabilities):

43
Q

What is an open market purchase?

A
  • If the Fed wants to decrease interest rate, it will buy T-bills:
  • in exchange for the T-bills, Fed increases the reserves of the commercial Bank
  • It deposits credit in the Bank balance sheet giving them more reserves than they need.
  • banks reduce federal funds rate so they can lend the extra funds to each other.
  • money supply increases as the loans/money creation process ripples through the economy in reverse
44
Q

What is the Glass-Steagall Act

A

Another new regulation, the Glass-Steagall Act (1933) separated banks into two categories:
* – Commercial banks: depository banks that accepted deposits and were covered by deposit insurance
* – Investment banks: banks that engaged in creating and trading financial assets (stocks and corporate bonds), but were not covered by deposit insurance because their activities were considered riskier

45
Q

What is the multiplier effect?

A
  • Reduction in exports leads to reduction in income.
  • Less income makes families spend less on goods and services.
  • This reduced income for those who produce these goods and services.
  • Leading to another “round” of decrease in expenditure and income.
  • incomes fell, consumer spending fell even further, leading to further declines in incomes, leading to further cuts, and so on.
46
Q

Multiplier Effect helps understand the business cycle

A
  • Finland’s troubles illustrate the way booms and busts happen for the economy as a whole.
  • The business cycle is often driven by ups or downs in one particular kind of spending—either exports, as is the case in Finland, or investment spending.
  • These first-round changes in spending then lead to changes in consumer spending, which magnify—or, as economists usually
    say, multiply—the effect of the initial changes on the economy as a whole.
47
Q

Multiplier assumptions

A

1.We assume that producers are willing to supply additional output at a fixed price.
Changes in aggregate spending translate into changes in aggregate output (NOT PRICES)
2.We take the interest rate as given.
3. We assume that there is no government spending and no taxes.
4.We assume that exports and imports are zero.

48
Q

Marginal Propensity to Consume

A
  • The increase in households’ disposable income leads to a rise in consumer spending.
  • How much of the increase in disposable income is consumed?
  • This is called marginal propensity to consume (mpc).
  • For every extra dollar of disposable income how much is consumed?
  • For example: If mpc=0.8, then a $1000 increase in disposable income would lead to an increase of consumption of $800.
  • Marginal propensity to consumer, or MPC

MPC = Δ consumer spending/ Δ disposable income
– For example, if consumer spending goes up by $6 and disposable income goes up by $10, MPC = $6/10 = 0.6
* Whatever is not spent is saved, so:
* Marginal propensity to save, or MPS = the fraction of an additional dollar of
disposable income that is saved.
MPS = 1 − MPC

49
Q

Total Increase in Real GDP from increase in Investment:

A

Example: $10 billion rise in investment
1/1-MPC x $10 billion

50
Q

Autonomous change in aggregate expenditure

A
  • We’ve described the effects of a change in investment spending, but the same analysis can be applied to any other change in aggregate expenditure
  • Distinguish between the initial change in aggregate expenditure, before real GDP rises,
  • Additional change in aggregate expenditure caused by the change in real GDP as the chain reaction unfolds.
  • An initial rise or fall in aggregate expenditure at a given level of real GDP is called an autonomous change in aggregate expenditure.
51
Q

Multiplier: Formal definition

A
  • the multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate expenditure to the size of that autonomous change.
  • If ΔAAS = autonomous change in aggregate spending and ΔY = change in real GDP
52
Q

How does it relate to the Business Cycle?

A
  • The idea of multiplier suggest that the business cycle is driven by fluctuations in aggregate spending.
  • As we discussed we can break up Aggregate spending into C + I + G + X-M
  • So we can look at how each one of these behaves to understand the causes of the business cycle.
53
Q

What does consumer spending depend on?

A

Income

54
Q

What is the CONSUMPTION FUNCTION

A
  • Consumption function: an equation showing how an individual household’s consumer spending varies with the household’s disposable income
  • c = a + MPC × yd
  • Where
    c = a household’s consumer spending yd = household disposable income MPC = marginal propensity to consume
  • a = a constant, autonomous consumer spending—what a family would spend even with zero income
55
Q

What is the AGGREGATE CONSUMPTION FUNCTION?

A
  • Aggregate consumption function: the relationship for the economy as a whole between aggregate disposable income and aggregate consumer spending
    c = a + MPC × yd
  • Same form as consumption function, just aggregate.
56
Q

What SHIFTS IN THE AGGREGATE CONSUMPTION FUNCTION

A
  • If consumers expect higher aggregate income or wealth? Consumption increases at all income levels now and vice versa.
  • What causes shifts?
    – Changes in expected future disposable income
    – Changes in aggregate wealth
57
Q

Investment spending

A

Although much smaller than consumer spending, investment spending tends to drive the booms and busts in the business cycle.

58
Q

What drives (PLANNED) INVESTMENT SPENDING?

A
  • Planned investment spending: the investment spending that businesses intend to undertake during a given period
  • It depends on:
  1. Interest rate: Higher interest rate lower planned investment
  2. Expected future real GDP: Higher expected future real GDP increases planned investment
  3. Current level of production capacity: Higher production capacity today lower planned investment.

Accelerator principle: planned investment spending is greatly influenced by expected growth rate of real GDP

59
Q

the interest rate and investment spending

A

Interest rates are often the cost of investment projects.
- When interest rates are low, more loans are undertaken, and investment rises (other things equal).

60
Q

INVENTORIES AND UNPLANNED INVESTMENT SPENDING

A
  • Inventories: stocks of goods held to satisfy future sales
  • Inventory investment: the value of the change in total inventories held in the economy during a given period
  • Unplanned inventory investment: unplanned changes in inventories that occur when actual sales are more or less than businesses expected
  • Actual investment spending: the sum of planned investment spending and unplanned inventory investment
  • So, in any period: I = IUnplanned + IPlanned
61
Q

INCOME–EXPENDITURE EQUILIBRIUM LOGIC

A
  • Planned aggregate spending can be different from real GDP only if there is unplanned inventory investment, IUnplanned, in the economy.
  • If firms have overestimated sales and produced too much, there will be unintended additions to inventories (and IUnplanned will be positive).
  • If firms have underestimated sales and produced too little, there will be unintended drops in inventories (and IUnplanned will be negative).
  • The economy is in income–expenditure equilibrium when aggregate output (real GDP) is equal to planned aggregate spending.
62
Q

PLANNED AGGREGATE SPENDING AND REAL GDP

A
  • In our simplified economy, GDP = C + I and
    YD = GDP
    and our aggregate consumption function is
    C = A + MPC × YD
    and we assume Iplanned is fixed so
    AEPlanned = C + IPlanned
  • where planned aggregate spending = the total amount of planned spending in the economy.
63
Q

What is the multiplier process? What happens where there a shift of the planned aggregate spending line?

A
  • What happens when there’s a shift of the planned aggregate spending line?
  • Two possible sources of a shift:
  • – change in interest rate
  • – change in wealth
  • When planned spending doesn’t equal output, it shows up in changes to inventories.
  • This is why changes in inventories are considered a leading indicator of future economic activity.
64
Q

WHAT ABOUT EXPORTS AND IMPORTS?

A
  • In the real world, countries have international trade. How do we deal with exports and imports in our model?
  • Exports: Income earned from exports is a source of spending on domestically produced goods and services and are therefore like an increase in autonomous spending.
  • The multiplier process is made somewhat weaker with foreign trade: when consumer spending rises or falls, part of that change is spending on imports, which don’t affect a nation’s own income.
  • Economic interdependence: Trade links between economies are one reason business cycles are often international in scope. Many countries tend to have recessions and recoveries at the same time.

Econ 105 (3 decks)

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