The financial system

Question 1

What is finance?

Answer 1

This is the field of economics that studies how people make decisions regarding the allocation of resources overtime and handling of risk

Question 2

What is a risk for lenders?

Answer 2

Will they get the money they loan back?

Question 3

What is the financial system made of?

Answer 3

Financial institutions

Question 4

What 4 financial institutions are part of the financial system?

Answer 4

Banks
Investment funds
Stock market
Bond market

Question 5

What do financial institutions act as?

Answer 5

They act to direct the resources of those who want to save some of their income into those who want to borrow

Question 6

What must happen in a closed economy for national saving and investment?

Answer 6

National saving must equal investment

Question 7

What is the market for loanable funds?

Answer 7

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

Question 8

What does the term “loanable funds” refer to?

Answer 8

All income that people have chosen to save and lend out, rather than use for their own consumption

Question 9

Where does the supply of loanable funds come from?

Answer 9

It comes from people who have extra income they want to save and lend out

Question 10

Where does the demand for loanable funds come from?

Answer 10

Households and firms that want to borrow to make investments

Question 11

What is the price of the loan?

Answer 11

The interest rate

Question 12

What does the interest rate represent?

Answer 12

The amount that borrowers pay for loans and the amount that lenders receive on their saving.

Question 13

Which interest rate is used for loans?

Answer 13

The real interest rate

Question 14

What determines the real interest rate?

Answer 14

The equilibrium of supply and demand for loanable funds

Question 15

What happens when the demand for loanable funds increases but the supply doesn’t?

Answer 15

Then the real interest rate rises

Question 16

What happens when the government spends more than it receives in tax revenue?

Answer 16

It causes a shortfall known as a budget deficit

Question 17

What is the accumulation of past budget deficits called?

Answer 17

The government debt

Question 18

What reduces the supply of loanable funds available for households and firms?

Answer 18

Government borrowing

Question 19

Why would the government borrow money?

Answer 19

To finance its budget deficit

Question 20

What is crowding out?

Answer 20

A fall in investment as a result of the government borrowing money and reducing the supply of loanable funds to households and firms

Question 21

What does deficit borrowing do?

Answer 21

It crowds out private borrowers who are trying to finance investments

Question 22

What happens to the supply curve as a result of a decrease in the amount of loanable funds?

Answer 22

The supply curve shifts to the left

Question 23

What happens to the equilibrium interest rate when the supply of loanable funds decreases?

Answer 23

The equilibrium interest rate rises

Question 24

What happens to the equilibrium quantity of loanable funds when the supply decreases?

Answer 24

It reduces the equilibrium quantity of loanable funds

Question 25

What happens when a government reduces national saving by running a deficit?

Answer 25

The interest rate rises and investment falls

Question 26

What does a budget surplus do?

Answer 26

It increases the supply of loanable funds, reduces the interest rate and stimulates investment

Question 27

What does present value refer to?

Answer 27

This refers to the amount of money today needed to produce, using prevailing interest rates, a given amount of money

Question 28

When is the concept of present value useful?

Answer 28

When making investment decisions

Question 29

How can you compare values at different points in time?

Answer 29

Compare their present values

Question 30

When will a firm undertake an investment project?

Answer 30

If the present value of the stream of income of the project is expected to generate exceeds the present value of the cost

Question 31

What is future value?

Answer 31

This is the amount of money in the future that an amount of money today will yield, given prevailing interest rates

Question 32

What makes a person risk averse?

Answer 32

If they exhibit a dislike of uncertainty, that is the possibility of making a loss

Question 33

What are 3 ways in which an individual can reduce risk?

Answer 33

Buy insurance
Diversify
Accept a lower return on investments

Question 34

What is the general feature of insurance contracts?

Answer 34

A person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk

Question 35

What are two problems insurance markets face?

Answer 35

Moral hazard and adverse selection

Question 36

What does diversification refer to?

Answer 36

The reduction of risk achieved by replacing a single risk with a larger number of smaller, unrelated risks

Question 37

Why do risks need to be unrelated when diversifying?

Answer 37

If they were all similar then there is a chance that they could all be affected by the same problem

Question 38

Define idiosyncratic risk

Answer 38

Risk that affects only a single person, firm or project.

The risk associated with a specific company

Question 39

Define aggregate risk

Answer 39

The risk that affects all economic actors at once, the uncertainty associated with the entire economy

Question 40

What can diversification not remove?

Answer 40

Aggregate risk

Question 41

What is assumed when working out diversification risk?

Answer 41

There is equal percentage in their portfolio in each of their shares

Question 42

How can you find the idiosyncratic risk and aggregate risk on a graph?

Answer 42

The top part of the curve until where it flattens out is the idiosyncratic risk
The flat part of the curve to the bottom of the graph is aggregate risk

Question 43

What is a trade off that can help reduce risk?

Answer 43

It is between risk and return. People can reduce risk by accepting a lower rate of expected return

Question 44

What is risk rewarded by?

Answer 44

A higher than expected rate of return

Question 45

What is the risk when it comes to a return?

Answer 45

There is a risk that the return will be lower than expected

Question 46

What is the efficient markets hypothesis?

Answer 46

This is the theory that asset prices reflect all publicly available information about the value of an asset

Question 47

When is a market informally efficient?

Answer 47

When it reflects all available information in a rational way

Question 48

What happens if all markets are efficient?

Answer 48

All stocks are fairly valued and no stock is more likely to appreciate than another

Question 49

What do stock prices follow?

Answer 49

A random walk

Question 50

What is the only thing an investor can do if markets are efficient?

Answer 50

Buy a diversified portfolio

Question 51

What assumption underpinned the financial system in most parts of the world?

Answer 51

The assumption of efficient markets and the belief that markets self correct and revert to reflect true market value

Question 52

What caused faith in markets to shake?

Answer 52

The financial crisis of 2008-9

Question 53

What is one explanation of the financial crisis?

Answer 53

Too much debt causes the economy to become financially fragile - a small shock can trigger a crisis

Question 54

What happens if income falls or the interest rate rises?

Answer 54

People struggle to meet their debt repayments which means that banks are in trouble, leading to falls in lending and therefore spending

Question 55

What is Minsky- financial instability?

Answer 55

Banks become over optimistic and lend too much and lend badly

Question 56

What is moral hazard?

Answer 56

The tendency of someone who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour.

Question 57

Why do banks sometimes have moral hazard?

Answer 57

This is due to failure of regulation and the fact that banks know that if they get into trouble then the Central Bank or tax payer will save them, therefore they don’t see the point in avoiding profitable opportunities.