Topic 5 - Financial System Flashcards
What does the financial system allow us to do
- Pay, borrow and insure against risk
What is the approximate value of financial assets held by financial institutions in the UK
- Around £20 trillion
What is the hierarchy for the holding of financial assets
- Banking Sector
- Pension funds and insurance companies
- Other financial institutions
What are the two main roles of the financial system
- Make financial investments
- Provide financial capital
What is the difference between financial capital and physical capital
- Financial: Funds to invest into physical capital
- Physical: Tools, machinery, buildings used for production
What part of Aggregate Expenditure does Financial capital fund
- I , Investment
What is the equation for Investment and how is it derived
- I = S + (T - G) + (M - X)
- Derived by take Aggregate Expenditure equation and setting it equal to Y = C + S + T
Using the equation, How is investment financed
- Private saving
- Government budget surplus
- Borrowing from the rest of the world
In what markets would firms raise finance
- Stock, bond and loan markets
How do stock markets work
- If a company wants to expand, it can sell shares
- Shares are a claim to dividends
- Shareholders become owners of the company
- Known as Equity Issuance
What is an IPO
- Initial Public Offering
- Issuance price set by investment bank (underwritten)
What is the calculation for expected net payoff of buy today sell tomorrow
- (Future price + expected dividend / 1 + i) * S - p * S
What do we get when we maximise expected net payoff with respect to S, and what does this give us
- (Future price - expected dividend / 1 + r) - p = 0
- Stock price, which is p = (Future price - expected dividend / 1 + r)
What is a bond
- A bond is company debt that is sold to raise capital
- Debt issuance
What is the interest rate on a bond
Interest = 100 * Coupon / Issuance price
After Issuance, what happens to bonds, and how is their price calculated
- They can be sold on a secondary market, like stocks
- Resale = Principal + Coupon / 1 + r
What defines a financial institution
- A firm that lends and borrows
- The main financial institutions in the UK are the big four banks
What does a balance sheet show
- Value of assets, liabilities and net worth
- Assets are the value of what the Fi owns or is owed
- Liabilities are the amount it owes to others
How is net worth calculated and what does it represent
- Net Worth = Assets - Liabilities
- Measures the financial health of a firm
- If net worth is negative, the firm is insolvent and must cease trading
How could a firm become insolvent
- Customers do not always repay loans, therefore asset value takes an unexpected hit
What market allows us to exchange pounds for a foreign currency
- The FX (Foreign Exchange) market
- This market determines exchange rates
What is an exchange rate and how is it denoted
- The number of units of foreign currency per pound
- If E($/£) = 2, this means that £1 gets you $2
- In this case, E falling is deprecitation and E rising is Apprecitation
Where are the three main FX centers and what is the total transaction value for all FX markets daily
- Tokyo, New York, London
- $5 trillion a day
How are exports denoted in
- S(£) those in UK who want American exports / assets
- D(£) those in US who want our exports / assets
- When £ deprectiates, S(£) decreases, D(£) increases
Explain “currency risk”
- When borrowing money we can borrow abroad or at home
- If we borrow abroad, we are taking the risk of having to repay more than we should due to exchange rates
- However we may be better off if the pound appreciates as the payments would be cheaper
How do we avoid currency risk
- By using forward contracts
What are forward contracts, how are they denoted and why are they good
- Future exchange rate “locked in” today
- F($/£)
- Greater risk aversion, good option if you are less optimistic in the market
How is the forward exchange rate determined
- Like normal exchange rates, through supply and demand
- F($/£) = expected future E($/£)
- The forward rate provides information into what people think, and how exchange rates may change
What is consumption
- Purchase of goods and services by households
What is the Kensyian consumption function
- C = a + b * Y^d
- a > 0
- b = MPC
- Y^d = current disposable income
What are the conditions for the two period model
- Households live for two periods
- Households can save or borrow
- Savings earn interest at rate r
- Borrowing must be repaid with interest
What mathmatical symbols are used in the two period model
- Given interest rate, r > 0
- Incomes in period 1 and 2, given Y1 and Y2
- Households decide consumption, C1 and C2
What is the utility function in the two period model
- U = u(C1) + βu(C2)
- Where u’(C) > 0, u’‘(C) < 0 and β is a discount factor and is 0 < β <= 1
What are the two budget contraints in the two period model
- C1 = Y1 - S
- C2 = Y2 + (1 + r)S
- Where S is savings
How is the lifetime budget constraint calculated in the two period model
- By making S the subject in both equations for C1 and C2
- Then set both equations equal to eachother and rearrange so that Y and C are on serperate sides
How can we get a solution for the two period model graphically
- Households maximise Utility (Lifetime BC)
- Plot Lifetime BC, then add indifference curves and find the tangent to Lifetime BC
Draw the graphs for the two period model solutions for both borrowers and savers
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What does the decision to save and borrow depend on
- Interest rates
- Income Path
- Preferences
- The ability to save and borrow is beneficial
- This allows for Consumption Smoothing, in which individuals will optimise their standard of living through and appropriate balance of saving and consumption over time
When finding an analytical solution to the two period model, what do we use
- We consider the case that u(C) = ln(C)
- Therefore U = ln(C1) + βln(C2)
- The langaraian for this would be:
- L = U + λ(Lifetime BC)
- Using the first order conditions for C1 and C2, we can get and equation for C2, which is then substituted into Lifetime BC in order to get an equation for C1, which then C1 is substituted back into C2 to get our solutions
What does the two period model include that the Kensyian model doesnt
- Interest rates
- Lifetime income not current
- Impatiance
What is investment
- Mostly firm expenditure on new physical capital
- Most volatile component of GDP
How is investment calculated
- I = New K + Inventories + New Housing
How is investment calculated if new housing and inventories are excluded
- I = New K
- I = K - Old K
Why do we use the production function
- To know how K choices are made
- We focus on profit-maximizing firms
What do production functions show
- How inputs produce output
What is the general production function
- Y = K^α * L^1-α
- Where 0 < α < 1
What are the main properties of the marginal products of K and L
- Both first order marginal products are positive
- Diminishing returns means that second order marginal products are negative
What is the optimal investment point
- MPK = r bar
- Where MPK = α(Li / Ki)^1-α
- Derived from Cobb Douglas PF FOC
Why is investment so volatile
- Capital and Labour are compliments, therefore a decrease in one will cause a decrease in the other, resulting in a large decrease in Investment
What is the capital labour ratio
- (Ki / Li) = (α/r bar)^1/1-α
- This is derived from MPK = r bar
What does the capital labour ratio show us
- As interest rates increase, industrialisation decreases, causing the K/L ratio to decrease
- This means that it is optimal to give workers less capital each
What happens when the capital labour ratio increases
- Wage rates increase
- Derived from FOC of Cobb Douglas function
- Cobb Douglas has automated checkouts
