Week 4 Lecture 1 Flashcards
What is a financial system?
- A financial system is a group of institutions in an economy that help match one person’s savings with another person’s investments
- It essentially moves the economy’s scarce resources from savers to borrowers
What are two types of financial institutions?
- Financial markets
- Financial intermediaries
What is the purpose of financial markets?
- Financial markets allow savers to directly provide funds to borrowers
- They do so by expecting some return on their ‘investment’
What are the main two types of financial markets?
1- The bond market
2- The stock market
Explain what the bond market is and how it works
- Bonds are certificates of indebtedness: Bonds differ by their time to maturity (when the loan will be repaid and their interest rate which is paid regularly)
- The principal of a bond is the amount that has been borrowed
- The interest rate of a bond reflects the probability of default
- Higher risk requires higher expected return and so the interest rate will be higher
- Long term bonds also normally pay a higher interest rate
How do most firms obtain the funds needed to start up initially?
Most firms obtain the funds to start up by borrowing money through the bond market (issuing bonds)
Explain what the stock market is and how it works
- A stock is a claim to partial ownership in a firm and therefore a claim on its profits (dividends)
- Essentially a firm sells a claim on its future profits when it issues stocks
- If it earns no money, the stock holder/buyer gets nothing
What are stock prices determined by?
Stock prices are determined by supply and demand
- The demand for stocks depends on the expected profitability of the firm
- The supply of stocks depends mostly on firm’s financial requirements and their alternative means of obtaining credit
What is the relationship between raising funds and the stock and bond market?
Money can be raised either by issuing stocks or by borrowing the money (corporate bonds)
What is a stock index?
A stock index is the average of a group of stock prices
- Stock indexes are closely watched as indicators of future economic conditions
What are financial intermediaries?
Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers
What are the two main types of financial intermediaries?
1- Banks
2- Mutual or investment funds
Describe banks as financial intemediaries
- Banks take in deposits from savers and pay interest
- Banks make loans to borrowers and charge interest
- Banks also facilitate the purchasing of goods and services
Describe mutual or investment funds as a financial intermediary
- Mutual or investment funds are institutions that sell shares to the public
- They use the earnings to buy a portfolio of stocks and bonds
- They then allow people with small amounts of money to diversify, but you pay a management fee as you gain access to professional money managers
What are net exports in both a closed economy and an open economy?
- A closed economy doesn’t interact with other economies so net exports are zero
- An open economy does interact with other economies so generally net exports are not equal to zero
State the formula for calculating GDP
Y = C + I + G + NX
What is GDP also equal to?
GDP = Total income = Total expenditure
What is national saving (S)?
National saving (S) is the total income in the economy that remains after paying for consumption and government purchases
State the formula used to calculate national saving (S)
S = Y - C - G = I
- Therefore S=I
- We don’t include NX as in a closed economy NX=0
What are the two parts of national savings and how are they derived?
Let T = Taxes minus transfer payments so
S = Y - C - G = (Y-T-C) + (T-G)
Hence the two parts of national savings are:
1- Private savings: (Y-T-C)
This is income that households have left after paying for taxes and consumption
2- Public savings: (T-G)
This is tax revenue that the government has left after paying for its spending
How can we identify whether there is a budget surplus or a budget deficit?
- If T-G>0 there is a budget surplus
- If T-G<0 there is a budget deficit
How do we calculate the supply and demand for loanable funds?
- The supply of loanable funds is equal to savings (private savings + public savings)
- The demand for loanable funds is equal to investments but public investment is included in G so it is only private savings
What is the price of loanable funds equal to?
Price of loanable funds = real interest rate
As the real interest rate rises, how does the supply and demand for loanable funds change?
As the real interest rate rises:
- Demand decreases
- Supply increases
State the main two ways the government can intervene in the market for loanable funds
1- Provide saving incentives
2- Project indirect interference through a budget deficit or surplus
Explain how the government intervenes in the market for loanable funds by providing saving incentives
- The government provides incentives to save by replacing income tax with a consumption tax like VAT
- This shelters saving from taxation which will affect the supply of loanable funds
- This causes an increase in the supply of loanable funds and so there will be a new equilibrium and a lower interest rate
- This increase in supply results in more investment and so higher GDP growth
Draw a diagram to show the effect of the government providing saving incentives on the market for loanable funds
See slide 25 of the week 4 lecture
Explain how the government intervenes in the market for loanable funds by creating a budget surplus/deficit
- The government starts with a balanced budget
- It then starts running a budget deficit by issuing bonds or gilts
- This decreases the supply of loanable funds
- There is a new equilibrium and a higher interest rate
- This means there is less investment and lower GDP growth
Draw a diagram to show the effect of the government creating a budget deficit on the market for loanable funds
See slide 27 of the week 4 lecture
