Chapter 11

Compounding

when interest is calculated and added on a periodic basis to money borrowed or saved in addition to the interest already charged or earned. ex. $1,000 with 10% interest rate = 100 interest charges

Increasing ROI

1. Choose financial assets with lower liquidity 2.Choose assets that carry a higher level of risk.

Financial intermediaries/institutions

Bridge between savers and borrowers. They include commercial banks, savings and loan associations, credit unions, insurance companies, securities firms and pension funds.

Financial System

Complex set of institutions that allocates scarce resources from savers, those who are spending less than they earn, to borrowers, those who want to use these resources to invest in potentially profitable projects.

Demand curve

Demand comes from people who want to purchase goods and services. Firm are borrowers too. The demand slopes downward because when interest rate is high, fewer projects will have a rate of return high enough to justify investment.

Money Supply

Fed is assigned to measure the money supply

Social Security

Form of retirement savings that nearly every American participates in from the time they start working. Minimum age to begin collecting SS is 62. Unfair to the poor due to short life expectancies.

Liquidity

How quickly, easily and reliably an asset can be converted into cash

Pension plans

Pensions are monthly payments made by your employer from the day you retire until you die, based of the number of years you worked at the company.

Supply and Demand for Loanable Funds

People supply funds to the loanable funds market beacuse they do not spend all of their income; they save. The reward for not spending today is the interest received on savings , enabling people to spend more in the future. Quantity of loanable funds is measured on the horizontal axis, and price of funds (interest rate) is measured on the vertical axis. Supply curve represents savers, demand curve represents borrowers.

Types of Financial Assets

Saves have many options when it comes to where to put their money. The difference among the financial assets is the return on investment.

Return on investment (ROI)

The earnings, such as interest or capital gains, that a saver receives for making funds available to others. Calculated as earnings divided by the amount invested.

Loanable Funds Market

The market for loanable funds is a model that describes the financial market for saving and investment. We assume that savers deal directly with investors.

Supply curve

The supply of funds is positively related to the interest rate because interest rates are the price that savers receive, higher interest rate result in more saving supplied to the market. (people reacting to incentives)

Bond Prices and Interest Rates

When interest rates go up, bond prices go down, vice versa. Yield=Interest Payment/Price of Bond

Shift in the Supply of Loanable Funds

1. Economic outlook : households decide to save a larger proportion of their income because they fear job loss in a recesion. From S0 to S1, equilibirum moves from point a to b. 2.Incentives to save: Governments and companies offer various incentives to individuals to save, will change the level of savings accordingly. 3.Income or Asset Prices: As income rise, people generally save a larger proportion of their income, all else equal. Asset prices increase, poeple spend more and save less. 4. Government Deficit: When a government runs a buget surplus, additional loanable funds are provided to the market, increasing the supply of loanable funds.

Shifts in the Demand for Loanable Funds

1. Investment Tax Incentives: Effectively reduce tax payments for firms building new factoring or buying equipment. An increase would shift demand from D0 to D1, equilibrium from a to c. 2.Technological Advances: Increase demand for Loanable funds 3.Regulations 4.Product Demand 5.Business Expecatations

Functions of Money

1. Medium of Exchange 2. Unit of Account 3. Store of Value

Roles of Financial Institutions

1.Reducing Information Costs: Information costs are the expenses associated with gathering information on individual borrowers and evaluating their creditworthiness. 2.Reducing Transaction Costs: Transaction costs are those associated with finding, selecting, and negotiating contracts between individual savers and borrowers. (savings accounts, stocks, bonds, etc.) 3.Diversifying Assets to Reduce Risk: Firms need funds for long-term investments, but savers want access to their money at a moment's notice and would want their funds invested in a number of diversified projects to reduce risk.

Money

Anything that is accepted in exchange for goods and services or for the payment of debt -its value must be easy to determine -must be divisible -must be durable and portable -a commodity must be accepted by many people

2 Measures of money by the Fed

M1: The narrowest definition of money that measures highly liquid instruments including currency (banknotes and coins), demand deposits (checks), and other accounts that have check-writing or debit capabilities. M2: A broader definition of money that includes "near monies" that are not as liquid as cash, accounts, money market accounts, and money market mutual fund accounts.

Fiat Money

Money without intrinsic value but nonetheless accepted as money because the government has decreed it to be money ex. Cash

Individual Retirement Arragements (IRA)

allow one to save pretax dollars up to a certain limit, which, as discussed earlier, gives an immediate boost to savings compared to posttax dollars. Minimum age to withdraw funds without penalty is 59.5 years.