Week 3

Question 1

transaction costs

Answer 1

expenses of negotiating and executing a deal

Question 2

savings-investment spending identity

Answer 2

savings and investment spending are always equal for economy as a whole

Question 3

budget surplus

Answer 3

excess of tax revenue over government spending

Question 4

budget deficit

Answer 4

excess of government spending over tax revenue

Question 5

budget balance

Answer 5

difference between tax revenue and government spending

Question 6

national savings

Answer 6

sum of private savings and budge balance

Question 7

budget balance

Answer 7

total amount of savings generated within an economy

Question 8

financial capital

Answer 8

funds from savings available for investment spending

Question 9

net capital inflow

Answer 9

total flow of funds into a country minus total flow of funds out of a country

Question 10

What does a country with a positive net capital inflow have?

Answer 10

extra flow of funds from abroad that can be used for investment spending

Question 11

net capital inflow equation

Answer 11

net capital inflow = imports - exports

Question 12

investment spending equation

Answer 12

investment spending = national savings + net capital inflow

Question 13

financial market

Answer 13

• bring savers and borrowers brough together
• channels savings of households to businesses that want to borrow in order to purchase capital equipment

Question 14

loanable funds market

Answer 14

• hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
• assume price of loans = nominal IR

Question 15

interest rate

Answer 15

price of borrowing funds

Question 16

Why is the demand for loanable funds downward sloping?

Answer 16

firms borrow more when interest rate decreases because more projects will earn enough to pay for themselves

Question 17

when is an investment worth making?

Answer 17

if it generates future return that is greater than the monetary cost of making the investment today

Question 18

present value

Answer 18

amount of money needed today to receive a given amount of money at a future date given the interest rate

Question 19

present value equation

Answer 19

Y = X(1+IR)

• X = present value
• Y = money to receive
• IR = interest rate

Question 20

graph for loanable funds

Answer 20

• A: only projects that are profitable at an interest rate of X% or more are funded
• B: offers not accepted from lenders who demand interest rate of more than X%
• C: offers accepted from lenders willing to lend at interest rates of X% or less
• D: offers accepted from lenders willing to lend at interest rate of X% or less

Question 21

why is the supply for loanable funds upward sloping?

Answer 21

more people are willing to forgo current consumption and make a loan to a borrower when IR is higher

Question 23

factors causing a shift in demand for loanable funds curve

Answer 23

• changes in perceived business opportunities
• changes in government borrowing

Question 24

crowding out

Answer 24

• potential side effect of government borrowing
• occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending
• not a concern for depressed economy, increase in government spending increases income and private savings

Question 25

factors causing a shift in supply for loanable funds curve

Answer 25

• changes in private savings behaviour
• changes in net capital inflows

Question 26

any shifts in S and D for loanable funds causes?

Answer 26

change in interest rates

Question 27

factors causing a change in interest rates

Answer 27

• changes in government policy
• technological innovation that lead to new investment opportunities
• expectations of future inflation

Question 28

real interest rate equation

Answer 28

real interest rate = nominal interest rate - inflation rate

Question 29

what do loan contracts specifiy in terms of interest rate?

Answer 29

because no one can predict the inflation rate, loan contracts give nominal interest rate

Question 30

Fisher effect

Answer 30

increase in expected future inflation increases nominal interest rate leaving the expected real interest rate unchanged

Question 31

Fisher effect graph

Answer 31

Question 32

wealth

Answer 32

value of a household’s accumulated savings

Question 33

financial asset

Answer 33

paper claim that entitles buyer to future income from seller

Question 34

physical asset

Answer 34

tangible object that can be used to generate future income

Question 35

liability

Answer 35

requirement to pay income in the future

Question 36

why is a well-functioning financial system important in achieving long run growth?

Answer 36

• encourages greater savings and investment spending
• ensures that savings and investment spending undertaken efficiently

Question 37

what are the 3 tasks of a financial system?

Answer 37

1. reduce transaction costs
2. reduce risk
3. provide liquidity

Question 38

financial risk

Answer 38

uncertainty about future outcomes that involve financial losses or gains

Question 39

diversification

Answer 39

investing in several assets with unrelated risks, reduces risk

Question 40

liquidity

Answer 40

measure of how quickly an asset can be converted into cash with relatively little loss of value

Question 41

bond

Answer 41

• IOU issued by borrower
• usually with a set interest rate and maturity date
• risker bonds have higher interest rate

Question 42

default

Answer 42

• concern for investors
• failure of borrower to make payments

Question 43

loan-backed securities

Answer 43

assets created by pooling individual loans and selling shares in that pool

Question 44

securitisation

Answer 44

process of pooling individual loans and selling shares in that pool

Question 45

stock

Answer 45

share in the ownership of a company

Question 46

financial intermediary

Answer 46

• institution that transforms the funds it gathers from many individuals into financial assets
• e.g. mutual funds, pension funds, life insurance, companies, banks

Question 47

mutual fund

Answer 47

financial intermediary which builds stock portfolio and resells shares of this portfolio to individual investors

Question 48

pension fund

Answer 48

type of mutual fund that holds assets to provide retirement income to members

Question 49

life insurance company

Answer 49

sells policies that guarantee a payment to a policyholder’s beneficiaries when a policyholder dies

Question 51

bank

Answer 51

financial intermediary that provides liquid assets in form of bank deposits to lenders and uses those funds to finance illiquid investment spending needs of borrowers who don’t want to use the stock or bond markets

Question 52

bank deposit

Answer 52

financial asset owned by depositor and a liability of the bank that holds it

Question 53

what causes asset price fluctuations?

Answer 53

• demand for stocks
• demand for other stocks
• asset price expectations

Question 54

efficient markets hypothesis

Answer 54

asset prices embody all publicly available information

Question 55

implications of the efficient markets hypothesis?

Answer 55

• at any time stock prices are fairly valued
• price of stocks, etc. should only change in response to new information about underlying fundamentals
• price should move in ‘random walk’

Question 56

‘random walk’

Answer 56

movement over time of unpredictable variable

Question 57

behavioural economics

Answer 57

study of how people make predictable mistakes in their decisions

Question 58

examples of irrational phenomena

Answer 58

• overconfidence
• loss aversion
• herd mentality

Question 59

overconfidence

Answer 59

misguided faith that they can spot winning stock

Question 60

loss aversion

Answer 60

unwilling to sell unprofitable asset and accept loss

Question 61

herd mentality

Answer 61

buying asset when its price has already been driven high and selling when already driven low