Economics Chapter 9

Saving

Income that is not spent on consumption goods

Impatience

Most individuals prefer to consume now rather than later. The more impatient a person, the more likely that person's savings rate will be low. Impatience is reflected in any economic situation where people must compare costs and benefits over time. Criminals, addicts, alcoholics, and smokers all tend to discount the future more heavily.

Buying and selling existing shares of stock does

NOT increase net investment in the economy

T-bills

maturities of a few days to 26 weeks; pay only at maturity.

T-notes

maturities ranging from 2 to 10 years; pay interest every 6 months.

The main function of financial intermediaries is to

reduce the costs of moving savings to investors and mobilize the savings towards productive uses

default risk

the risk that the borrower will not pay back the loan.

Shifts in Supply and Demand

Changes in economic conditions will shift the supply or demand curve. The shift will change the equilibrium interest rate and quantity of savings.

Bond Prices and Interest Rates

Equally risky assets must have the same rate of return. If they didn't, no one would buy the asset with the lower rate of return. The price would fall until the rate of return was competitive with other investments. This is called an arbitrage principle

Investment

The purchase of new capital goods

Leverage ratio

The ratio of debt to equity, or D/E

Default risk

The risk that a borrower will not pay the loan back is called

Face Value

The value of a bond at maturity

Owner equity

The value of the asset minus the debt, or E = V − D.

A Ceiling on Interest Rates Creates

a shortage of savings

When interest rates go up...

bond prices fall

when interest rates go down

bond prices rise

Market for loanable funds

Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). Trading in the market for loanable funds determines the equilibrium interest rate

Zero-coupon bonds

Pay only at maturity

Controls on Interest Rates

Price controls on interest rates also cause the loanable funds market to malfunction. Usury laws impose a maximum ceiling on the interest rate that can be charged on a loan. Most U.S. states have usury laws, although often they have loopholes: they don't stop most credit card borrowing. they are set at levels too high to influence most loan markets.

Four of the major factors that determine the supply of savings

Smoothing consumption. Impatience. Marketing and psychological factors. Interest rates.

Collateral

Something of value that by agreement becomes the property of the lender if the borrower defaults

Financial intermediaries

Such as banks, bond markets, and stock markets reduce the costs of moving savings from savers to borrowers and investors help mobilize savings toward productive uses

Arbitrage

The buying and selling of equally risky assets; arbitrage ensures that equally risky assets earn equal returns

Crowding out

The decrease in private consumption and investment that occurs when government borrows more

Time preference

The desire to have goods and services sooner rather than later

bond

corporate IOU

the source of the ___ for loanable funds is investment

demand

Traditional Banks

funded by themselves through large deposits and by the FDIC

The 2007-2008 crisis was brought about by

high leverage and falling asset prices that created a panic and sharply reduced the amount of lending in the economy

Usury laws

impose a maximum ceiling on the interest rate that can be charged on a loan.

If there is a shortage of loanable funds, the interest rate will

increase.

Connecting savers and borrowers

increases the gains from trade and smooths economic growth.

The __________ represents the price of the loan

interest rate

Interest rates and bond prices

move in different directions

stock

or a share is a certificate of ownership in a corporation

rate of return

or implied interest rate, on a zero-coupon bond can be calculated as FV-Price/Price x 100

is a major factor in determining the supply of savings?

patience, impatience, marketing and psychological factors, smoothing consumption, interest rates

The source of the _____ for loanable funds is saving

supply

The Demand to Borrow

One reason people borrow is to smooth consumption. Many young people borrow to invest in their education. Borrowing moves some sacrifices into future periods when students' income is higher. By borrowing, saving, and dissaving, workers can smooth their consumption over their lifetime.

Shadow Banking

includes investment banks, hedge funds, money market funds, and others. Investment banks are funded by investors and are not insured by the FDIC.

The higher the interest rate...

...the greater the quantity saved

T-bonds

30-year bonds; pay interest every 6 months.

The bond contract

A corporation acknowledges its debt to a member of the public by issuing a bond, or corporate IOU. The bond contract lists how much is owed, the rate of interest, and when payment is due

Leverage

A house worth $400,000 with 20% down and a mortgage of $320,000: Equity = $400,000 - $320,000 = $80,000 Leverage ratio = $320,000 / $80,000 = 4 A house worth $400,000 with 10% down and a mortgage of $360,000: Equity = $400,000 - $360,000 = $40,000 Leverage ratio = $360,000 / $40,000 = 9

Equilibrium in Loanable Funds

In equilibrium, the quantity of funds supplied equals the quantity of funds demanded. The interest rate adjusts to equalize savings and borrowing. If the interest rate is higher than equilibrium, the quantity of savings supplied > the quantity of savings demanded, creating a surplus. With a surplus of savings, suppliers will bid the interest rate down as they compete to lend.

The Bond Market

Bonds are a way to raise a large sum of money for long-lived assets, and pay it back over a long period of time. All bonds involve default risk, or the risk that the borrower will not pay back the loan. A risky company has to pay higher interest to compensate lenders for a greater risk of default. Interest rates differ depending on the borrower, repayment time, amount of the loan, type of collateral, and many other features.

The Demand to Borrow

Businesses borrow to finance large projects. Often the people with the best business ideas are not the people with the most savings. The ability to borrow greatly increases the ability to invest. Higher investment increases the standard of living and the rate of economic growth.

Smoothing Consumption

If you consume what you earn every year, consumption is high during your working years. After retirement consumption drops precipitously. You can smooth your consumption by saving during the working years and dissaving during the retirement years. Saving also builds a cushion for unemployment or unexpected health problems. `

Marketing and Psychological Factors

Individuals save more if saving is presented as the natural or default alternative. The retirement savings plan participation rate was 25% higher in businesses that used automatic enrollment rather than opt in. The default also mattered for how much was saved. Simple psychological changes, combined with marketing, can change how much people save.

Insecure Property Rights

Some governments do not offer secure property rights to savers. Savings may be confiscated, frozen, or subject to other restrictions. When Argentina froze bank accounts in 2001, many banks went under and Argentinians lost their savings. Russia has at times confiscated or restricted the value of shareholders' holdings. This negatively affects savings and investment

Initial public offering

The first time a corporation sells stock to the public in order to raise capital.

Consumption Smoothing Definition

borrowing in periods of low income and saving in periods of high income to make consumption less variable than income