The financial system Flashcards
What is finance?
This is the field of economics that studies how people make decisions regarding the allocation of resources overtime and handling of risk
What is a risk for lenders?
Will they get the money they loan back?
What is the financial system made of?
Financial institutions
What 4 financial institutions are part of the financial system?
Banks
Investment funds
Stock market
Bond market
What do financial institutions act as?
They act to direct the resources of those who want to save some of their income into those who want to borrow
What must happen in a closed economy for national saving and investment?
National saving must equal investment
What is the market for loanable funds?
The market in which those who want to save supply funds and those who want to borrow to invest demand funds
What does the term “loanable funds” refer to?
All income that people have chosen to save and lend out, rather than use for their own consumption
Where does the supply of loanable funds come from?
It comes from people who have extra income they want to save and lend out
Where does the demand for loanable funds come from?
Households and firms that want to borrow to make investments
What is the price of the loan?
The interest rate
What does the interest rate represent?
The amount that borrowers pay for loans and the amount that lenders receive on their saving.
Which interest rate is used for loans?
The real interest rate
What determines the real interest rate?
The equilibrium of supply and demand for loanable funds
What happens when the demand for loanable funds increases but the supply doesn’t?
Then the real interest rate rises
What happens when the government spends more than it receives in tax revenue?
It causes a shortfall known as a budget deficit
What is the accumulation of past budget deficits called?
The government debt
What reduces the supply of loanable funds available for households and firms?
Government borrowing
Why would the government borrow money?
To finance its budget deficit
What is crowding out?
A fall in investment as a result of the government borrowing money and reducing the supply of loanable funds to households and firms
What does deficit borrowing do?
It crowds out private borrowers who are trying to finance investments
What happens to the supply curve as a result of a decrease in the amount of loanable funds?
The supply curve shifts to the left
What happens to the equilibrium interest rate when the supply of loanable funds decreases?
The equilibrium interest rate rises
What happens to the equilibrium quantity of loanable funds when the supply decreases?
It reduces the equilibrium quantity of loanable funds
What happens when a government reduces national saving by running a deficit?
The interest rate rises and investment falls
What does a budget surplus do?
It increases the supply of loanable funds, reduces the interest rate and stimulates investment
What does present value refer to?
This refers to the amount of money today needed to produce, using prevailing interest rates, a given amount of money
When is the concept of present value useful?
When making investment decisions
How can you compare values at different points in time?
Compare their present values
When will a firm undertake an investment project?
If the present value of the stream of income of the project is expected to generate exceeds the present value of the cost
What is future value?
This is the amount of money in the future that an amount of money today will yield, given prevailing interest rates
What makes a person risk averse?
If they exhibit a dislike of uncertainty, that is the possibility of making a loss
What are 3 ways in which an individual can reduce risk?
Buy insurance
Diversify
Accept a lower return on investments
What is the general feature of insurance contracts?
A person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk
What are two problems insurance markets face?
Moral hazard and adverse selection
What does diversification refer to?
The reduction of risk achieved by replacing a single risk with a larger number of smaller, unrelated risks
Why do risks need to be unrelated when diversifying?
If they were all similar then there is a chance that they could all be affected by the same problem
Define idiosyncratic risk
Risk that affects only a single person, firm or project.
The risk associated with a specific company
Define aggregate risk
The risk that affects all economic actors at once, the uncertainty associated with the entire economy
What can diversification not remove?
Aggregate risk
What is assumed when working out diversification risk?
There is equal percentage in their portfolio in each of their shares
How can you find the idiosyncratic risk and aggregate risk on a graph?
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
What is a trade off that can help reduce risk?
It is between risk and return. People can reduce risk by accepting a lower rate of expected return
What is risk rewarded by?
A higher than expected rate of return
What is the risk when it comes to a return?
There is a risk that the return will be lower than expected
What is the efficient markets hypothesis?
This is the theory that asset prices reflect all publicly available information about the value of an asset
When is a market informally efficient?
When it reflects all available information in a rational way
What happens if all markets are efficient?
All stocks are fairly valued and no stock is more likely to appreciate than another
What do stock prices follow?
A random walk
What is the only thing an investor can do if markets are efficient?
Buy a diversified portfolio
What assumption underpinned the financial system in most parts of the world?
The assumption of efficient markets and the belief that markets self correct and revert to reflect true market value
What caused faith in markets to shake?
The financial crisis of 2008-9
What is one explanation of the financial crisis?
Too much debt causes the economy to become financially fragile - a small shock can trigger a crisis
What happens if income falls or the interest rate rises?
People struggle to meet their debt repayments which means that banks are in trouble, leading to falls in lending and therefore spending
What is Minsky- financial instability?
Banks become over optimistic and lend too much and lend badly
What is moral hazard?
The tendency of someone who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour.
Why do banks sometimes have moral hazard?
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.
