Week 3 Flashcards
transaction costs
expenses of negotiating and executing a deal
savings-investment spending identity
savings and investment spending are always equal for economy as a whole
budget surplus
excess of tax revenue over government spending
budget deficit
excess of government spending over tax revenue
budget balance
difference between tax revenue and government spending
national savings
sum of private savings and budge balance
budget balance
total amount of savings generated within an economy
financial capital
funds from savings available for investment spending
net capital inflow
total flow of funds into a country minus total flow of funds out of a country
What does a country with a positive net capital inflow have?
extra flow of funds from abroad that can be used for investment spending
net capital inflow equation
net capital inflow = imports - exports
investment spending equation
investment spending = national savings + net capital inflow
financial market
- bring savers and borrowers brough together
- channels savings of households to businesses that want to borrow in order to purchase capital equipment
loanable funds market
- 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
interest rate
price of borrowing funds
Why is the demand for loanable funds downward sloping?
firms borrow more when interest rate decreases because more projects will earn enough to pay for themselves
when is an investment worth making?
if it generates future return that is greater than the monetary cost of making the investment today
present value
amount of money needed today to receive a given amount of money at a future date given the interest rate
present value equation
Y = X(1+IR)
- X = present value
- Y = money to receive
- IR = interest rate
graph for loanable funds
- 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
why is the supply for loanable funds upward sloping?
more people are willing to forgo current consumption and make a loan to a borrower when IR is higher
factors causing a shift in demand for loanable funds curve
- changes in perceived business opportunities
- changes in government borrowing
crowding out
- 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
factors causing a shift in supply for loanable funds curve
- changes in private savings behaviour
- changes in net capital inflows
any shifts in S and D for loanable funds causes?
change in interest rates
factors causing a change in interest rates
- changes in government policy
- technological innovation that lead to new investment opportunities
- expectations of future inflation
real interest rate equation
real interest rate = nominal interest rate - inflation rate
what do loan contracts specifiy in terms of interest rate?
because no one can predict the inflation rate, loan contracts give nominal interest rate
Fisher effect
increase in expected future inflation increases nominal interest rate leaving the expected real interest rate unchanged
Fisher effect graph
wealth
value of a household’s accumulated savings
financial asset
paper claim that entitles buyer to future income from seller
physical asset
tangible object that can be used to generate future income
liability
requirement to pay income in the future
why is a well-functioning financial system important in achieving long run growth?
- encourages greater savings and investment spending
- ensures that savings and investment spending undertaken efficiently
what are the 3 tasks of a financial system?
- reduce transaction costs
- reduce risk
- provide liquidity
financial risk
uncertainty about future outcomes that involve financial losses or gains
diversification
investing in several assets with unrelated risks, reduces risk
liquidity
measure of how quickly an asset can be converted into cash with relatively little loss of value
bond
- IOU issued by borrower
- usually with a set interest rate and maturity date
- risker bonds have higher interest rate
default
- concern for investors
- failure of borrower to make payments
loan-backed securities
assets created by pooling individual loans and selling shares in that pool
securitisation
process of pooling individual loans and selling shares in that pool
stock
share in the ownership of a company
financial intermediary
- institution that transforms the funds it gathers from many individuals into financial assets
- e.g. mutual funds, pension funds, life insurance, companies, banks
mutual fund
financial intermediary which builds stock portfolio and resells shares of this portfolio to individual investors
pension fund
type of mutual fund that holds assets to provide retirement income to members
life insurance company
sells policies that guarantee a payment to a policyholder’s beneficiaries when a policyholder dies
bank
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
bank deposit
financial asset owned by depositor and a liability of the bank that holds it
what causes asset price fluctuations?
- demand for stocks
- demand for other stocks
- asset price expectations
efficient markets hypothesis
asset prices embody all publicly available information
implications of the efficient markets hypothesis?
- 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’
‘random walk’
movement over time of unpredictable variable
behavioural economics
study of how people make predictable mistakes in their decisions
examples of irrational phenomena
- overconfidence
- loss aversion
- herd mentality
overconfidence
misguided faith that they can spot winning stock
loss aversion
unwilling to sell unprofitable asset and accept loss
herd mentality
buying asset when its price has already been driven high and selling when already driven low
