Chapter 29 Econ
Stocks
(share) a certificate of ownership in a corporation
The Interest Rate
- Businesses borrow when they expect that the return on their investment will be greater than the cost of the loan - The lower the interest rate, the greater the quantity of funds demanded for investment as well as for other purposes
Impatience
- Prefer to consume now rather than later - Time preference - desire to have goods and services sooner rather than later (all else being equal) - The more impatient, the lower the rate of savings
Bond
A sophisticated IOU that documents who owes how much and when payment must be made
Investment banks...
Act like banks but have traditionally been less heavily regulated and monitored than banks and unlike deposits, their short-term sources of funds (loans from investors) are not government guaranteed
Bonds can be rated...
Anywhere from AAA to D
BOND SELLERS ARE...
BORROWERS!
Savers hope for a ______ interest rate.
Higher
Collateral
Something of value that by agreement becomes the property of the lender if the borrower defaults (a house)
Owner equity
The difference between the value of a house and the unpaid amount on the mortgage The value of the assets minus the debt!!!
Rate of return for a zero-coupon bond
((FV-Price)/(Price))*100
Politicized lending
- Banks owned by the government in Japan were not allocating funds efficiently - Study showed that the larger the fraction of government owned banks a country had in 1970, the slower the growth in per capita GDP and productivity over the next several decades
Smoothing their consumption path
- Borrow to invest in education - Tuition payments can be made over many years and the sacrifices are spread out and become less painful
Marketing and psychological factors
- Individuals save more if saving is presented as the natural or default alternative - Opt out of a retirement plan vs. opt in - businesses that used automatic enrollment had higher rates
Finance large investments
- New businesses cannot get underway without borrowing - Revenues don't start flowing until buildings are complete; the costs of developing the building are all upfront - The ability to borrow greatly increases the ability to invest
Savings are necessary for...
Capital accumulation and the more capital and economy can invest the greater the GDP per capita
Sometimes to counteract the decrease in investment demand during a recession, a government offers a temporary investment tax credit
Demand to borrow funds shifts to the right and up
In a commercial bank, money comes from...
Depositors
______ are government guaranteed, _______ are not
Deposits; investments
In the loanable funds market, who is usually the supplier and who is usually the demander?
Entrepreneurs demand loanable funds and savers supply loanable funds
REMEMBER: The way economists define investment is not the same as the way a stockbroker defines investment
For example: John buying new machines for Starbucks is investment John buying stock in Starbucks is not investment (it is a transfer of ownership rights of already existing capital)
Interest rate
How much savers are paid to save Higher interest rates usually call forth more savings
The Stock Market
If profits are high, shareholders benefit
Borrowers want...
The interest rates to rise and bond prices to fall
Investment
The purchase of new capital, things like tools, machinery, and factories
Leverage ratio
The ratio of debt to equity
The Bond Market
Well-known corporations can borrow directly from the public When a member of the public lends money to a corporation, the corporation acknowledges its debt by issuing a bond
Junk bonds
When a bond rates less than BBB
Default risk
When payment is due, the borrower will not be able to pay
The day of maturity
When the payment is due
Securitization
Loans are bundled together and sold on the market as financial assets
Borrowers hope for a ______ interest rate.
Lower
The typical savings supply curve has a positive slope. If a nation's saving supply curve had a perfectly vertical slope, what would that mean?
People save the same no matter what the interest rate is
Coupon payments
Periodic payments
Sometimes investors become less optimistic, which decrease the demand to invest and borrow:
Reduces investment rate Reduces the quantity of savings
If people want to smooth their consumption over time, what will they tend to do when they win the lottery: spend most of it within a year or save most of it for later?
Save most of their winnings so that they can increase their spending over time
Transforming ______ in to ______ is important.
Savings; investment
An economy in which the citizens become less impatient and more willing to save for the future:
Shift in the supply curve to the right and down More savings at any interest rate A willingness to save any given amount in return for a lower interest rate Interest rate falls; savings increases!!!
Major factors that determine the supply of savings:
Smooth consumption Impatience Marketing and psychological factors Interest Rates
People borrow to:
Smooth their consumption path Finance large investments
What does it mean to spread risk?
Spread the loss across the many lenders who deposit their money
Which investment is typically the riskiest? Bank account, bonds, or stocks?
Stocks
Which one gives you an ownership "share" in a company? Bank account, bonds, or stocks?
Stocks
What happens if savers don't feel safe putting their money in banks or buying bonds?
Supply of savings falls and the interest rate rises.
Arbitrage
The buying and selling of equal risky assets, ensures that equally risky assets earn equal returns
Crowding out
The decrease in private consumption and investment that occurs when government borrows more Government consumption causes more savings (because the demand curve shifts outward) and causes the interest rate to increase; private borrowers invest less
Initial public offering
The first time a corporation sells stock to the public in order to raise capital
Lenders want...
The interest rate to fall and bond prices to rise
Financial intermediaries
Banks, bond markets, and stock markets that reduce the costs of moving savings from savers to borrowers and investors
Which is a corporate IOU? Bank account, bonds, or stocks?
Bonds
Which is usually rated by private companies like Moody's or Standard and Poor's? Bank account, bonds, or stocks?
Bonds
Market for loanable funds
Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers)
Investment banks
Part of what has been called the shadow banking system
Massive bank failures and panics
Problems in the banking system usually lead to large-scale economic crises
High leverage ratios...
Put the banks in a very vulnerable position (debt > equity)
Smoothing Consumption
- Once you retire, your income falls: you must save during your workings years to create a smoother transition after retirement - If there are no savings, investment dries up, economic growth declines, and the standard of living falls - Would you save as much if you are expected to die in a few years? - The decline in life expectancy caused by AIDS reduces savings rates, which in turn reduces economic growth and the standard of living - makes it more difficult to combat the disease - Fluctuations in income are another reason why people save - By saving in the good years, workers can build a cushion of wealth to draw from in the bad years - smooth consumption
Banks
- Receive savings from many individuals, pay them interest, and then loan these funds to borrowers or investors, charging them interest - Banks charge more for their loans than they pay for their savings - how they make a profit - Coordinate lenders and minimize information costs - Important example of the benefits of specialization and the division of labor - Spread risk
Insecure property rights
- Saved funds are not immune from later confiscation, freezes, or other restrictions - If individuals expect that contracts will be broken, they will be reluctant to invest in stock markets as well
Inflation and controls on interest rates
- The control on interest rates reduces savings
Rate of return tells us 2 things:
1. Equally risky assets must have the same rate of return 2. Interest rates and bond prices move in opposite directions!!!!!!
The bridge between savers and borrowers can be broken in many ways:
1. Insecure property rights 2. Inflation and controls on interest rates 3. Politicized lending 4. Massive bank failures and panics
T-bonds
30-year bonds that pay interest every 6 months
Insolvent
A firm that has liabilities that exceed its assets (followed by bankruptcy usually)
Which form of investment usually spreads your money over the largest number of investment people? Bank account, bonds, or stocks?
Bank account
Which one usually lets you "withdraw" part of your investment at any time, for any reason? Bank account, bonds, or stocks?
Bank account
Intermediaries
Banks Bonds Stock Markets
Which one is offered by the U.S. government as well as by private corporations? Bank account, bonds, or stocks?
Bonds
T-bills
Bonds with maturities of a few days to 26 weeks that pay only at maturity (zero coupon bond)
T-notes
Bonds with maturities ranging from 2-10 years that also pay interest every 6 months
Savings
Income that is not spent on consumption goods
In an investment bank, money comes from...
Investors
Why are investments not government guaranteed?
Investors are much more prone to panic and to withdraw their short-term funding in times of crisis
When the government outlaws high interest rates and the ceiling is binding, what probably happens to the total amount of money borrowed?
It falls because savers aren't willing to lend as much money at this low interest rate
If a risky company wishes to borrow money...
It has to promise a higher rate of interest, because lenders will demand to be compensated for greater risk of default
Consider three countries: Jovenia (average age: 25), Mittelaltistan (average age: 45)m abd Decrepetia (average age: 75). Based on the lifecycle theory, which of these countries will probably have: 1. A higher savings rate? 2. High rates of borrowing? 3. High rates of dissaving? (That's spending your past savings)
Jovenia will have a high borrowing rate. Mittelaltistan will have a high savings rate Decrepetia will have a high rate of dissaving.
BOND BUYERS ARE...
LENDERS!