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!