Economics chapter 9

what do interest rates depend on?

- borrower - repayment time - amount of the loan - type of collateral - many features of the loan

how can the bridge between savers and borrowers be broken?

- insecure property rights - inflation - controls on interest rates - politicized lending - massive bank failures -scandals, runs, and panics

interest rate controls will cause...

- misallocation of savings - loss of potential gains from exchange - investment will fall below the market equilibrium

what smooths a consumption path?

1 borrowing 2 saving 3 dissaving

insolvent

a bank or institution whose liabilities are greater in value than their assets - bankrupt - unable to pay owns debts

zero-coupon bond

a bond that makes no coupon payments and is thus initially priced at a deep discount

shadow banking system

a group of institutions that engage in lending activities, much like traditional banks, but do not accept deposits and therefore are not subject to the same regulations as traditional banks

why does financial intermediation fail to build well in poorer countries?

a strong financial system relies on good institutions

when is consumption high?

during working years consumption<income

behavioral economics combines...

economics, psychology, and neurology to study how people make decisions and how to overcome biases

interest rate is a...

market price - has same properties of market prices

commercial bank

money comes from depositors

investment banks

money comes from investors

more impatient

more likely savings rate will be low

higher interest rates

more savings

bank failures lead to

small business failures

individuals want to...

smooth consumption

Determines supply of savings

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

collateral

something of value that helps secure a loan - often houses

higher investment increases...

standard of living and the rate of economic growth

increases savings

supply of savings shift outward - interest rate falls

what counteracts the decreases in investment demand during a recession?

temporary investment tax credit - government offers it

crowded out

the decrease in private consumption and investment that occurs when government borrows more; also, the decrease in private spending that occurs when government increases spending

time preference

the desire to have goods and services sooner rather than later (all else being equal)

lower the interest rate

the greater the quantity of funds demanded for investment

market for loanable funds

the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged

arbitrage

the practice of taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market

default risk

the risk that the borrower will not pay the face value of a bond on the maturity date

more leverage means

the same force (your cash) can be used to move (buy) bigger and bigger assets.

tax credit is temporary...

to encourage firms to invest quickly, when the recession is still in full force

government involvement in banks...

usually leads to political investment (bad)

what do financial intermediaries do?

- reduce costs of moving savings from savers to borrowers - helps mobilize savings toward productive uses - bring about the equilibrium

how do the problems that break the bridge ACTUALLY break the bridge?

- reducing the supply of savings - raising the cost of intermediation - reducing the effectiveness of lending

smoothing consumption

- saving during working years - dissaving during retirement years

what happens to countries without intermediated institutions?

- smaller markets for loans - savings used less effectively - fewer good investments

why do people borrow?

- smooth consumption - finance large investments

iou

A signed document acknowledging a debt

a bond is an...

IOU

financial intermediary examples

bank loans stock IPO Bonds

insolvency is usually followed by what?

bankruptcy

on graph, demand is

borrowing

securitization

bundle together loans or mortgages and sell them on the market as financial assets

how do banks make profit?

charging more for their leans than they pay for the savings

lifecyle theory of savings

consume more at beginning, saving during work, and spend savings while in retirement. Keeps the path straight

increases demand to invest

demand curve shifts up to right - interest rate rises

less optimistic

demand to borrow shifts inward - interest rate falls

shortage of savings

demanders would bid the interest rate up as they compete to borrow

owners equity (buyers equity)

difference between the value of a house and the unpaid amount on the mortgage

financial intermediary

financial institution that bridges the gap between savers and borrowers

investment tax credit

firms that invest in plants and equipment get a tax break

initial public offering (IPO)

first time the stock is sold to the public

why do people save?

fluctuations in income

fire sales

forced, rapid sales of assets to raise needed funds

how do you find zero-coupon bond?

implied rate of return=value at maturity(face value)-price/price*100

consumption=

income

without savings...

income drops consumption drops

price of saving and borrowing

interest rate

no savings

investment dries up, economic growth declines, and the standard of living falls

deposits are government guaranteed but...

investments are not

what does a fire sale do?

its a forced sale of a financial asset that - drives down the price of related assets - forces more sales - further drives down the price

systematic problems in the banking system lead to

large scale economic crises

usury laws

laws that impose an upper limit on the interest rate that lenders can charge

Why dont people save?

level of impatience

interest rates and bond prices move in...

opposite directions

greater government involvement in the allocation of credit raises...

possibility of politicized lending that reduces the efficiency of credit allocation in other countries

FDIC

prevent further bankruptcy, ensures depositors get their money back

when the government borrows a lot of money...

private consumption and investment can be crowded out

the bond market

public lends money to a corporation

behavioral economics

saving is not just a matter of weighing costs and benefits, nudges matter

control on interest rates reduces...

savings

economic growth cannot grow without...

savings

insecure property rights scare...

savings away causing intermediary rights to fail

lifecycle theory

puts demand to borrow and save together

as interest rate falls

quantity of borrowing demanded increases

as interest rate goes up

quantity of savings supplied increases

leverage ratio

ratio of debt to equity

what happens when financial intermediaries decrease efficiency?

recessions

greater risk can...

reduce the supply of funds to the market as a whole

when is consumption low?

retirement years consumption>income

banks spread...

risk

equally risky assets must have...

same rate of return if not, no one would buy the asset with the lower rate of return and price of that asset would fall until the rate of return was competitive with other investments(arbitrage)

on graph, supply is

saving