Macroeconomics, Ch. 10

Goals of Financial System

1. Reduce transaction costs 2. Reducing financial risk 3. Providing liquid assets

Physical asset

A claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes

Financial Intermediaries

A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets. 1. Mutual Fund 2. Pension Fund 3. Life Insurance company 4. Bank Deposit 5. Bank

Savings-Investment Spending Identity (closed)

According to the savings-investment spending identity, savings and investment spending are always equal for the economy as a whole.

Shifters of Demand for Loanable Funds Market

Factors that can cause the demand curve for loanable funds to shift include: Changes in perceived business opportunities Changes in the government's borrowing Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending.

Efficient Market Hypothesis

Holds that the prices of financial assets embody all publicly available information. Implies that fluctuations are inherently unpredictable- they follow a random walk. Regarded by many as oversimplified.

Irrational Markets

Many Investors believe markets behave irrationally and a good investor can engage in "market timing". Buying stocks when they are too low and selling when they are too high.

Fisher effect

Increase in expected future inflation drives up the nominal interest rate, leaving expected real interest rate unchanged Expected Real interest rate = Nominal Interest Rate - Expected Inflation

Diversification

Invest in several things so that the possible losses are independent events to avoid risk

Financial Fluctuations

Source of Macroeconomic instability. Stock prices are determined by supply and demand as well as the desirability of competing assets, like bonds. Value of a financial asset today depends on investors beliefs about future value or price of the asset.

Loanable Funds Market

The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders

Capital Inflow

Capital inflow is the net inflow of funds into a country. NCI = IM-X I=NCI+S(national)

Shifters of Supply for Loanable Funds Market

Changes in private savings behavior Changes in capital inflows

Most important factor affecting interest rates over time

Changing expectations about future inflation. Shifts both supply and demand.

Demand for Loanable Funds

Demand is downward sloping for the following reason. There are more projects which would become profitable borrowing money at a lower interest rate. Only a few projects have really high rates of return (and can borrow at high interest rates). As the interest rate goes down the number of projects which demand funds goes up

National Savings

National savings, the sum of private savings plus the budget balance, is the total amount of savings generated within the economy. S(national) = S(govt.) + S(private) S(national) = I

Financial Asset

Paper claim that entitles the buyer to future income from seller

Liability

Requirement to pay income in the future

Transaction costs

The expenses of negotiating and executing a deal.

Budget: Balance, surplus, balance

The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending. The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue. The budget balance is the difference between tax revenue and government spending. S(govt.)=T-G-TR(govt. transfers)

Efficiency of Loanable Funds Market

The equilibrium outcome is efficient The projects with the highest rate of return get funded. Those projects are funded by individuals who have the lowest opportunity cost of holding money. Those are individuals who are willing to accept the lowest interest rate on their savings.

Supply for Loanable Funds

The supply of loanable funds is upward sloping for the following reason. More people are willing to delay current consumption and invest their money in a bank at a higher interest rate in hopes of higher levels of consumption in the future (opportunity cost of holding onto money is given by the interest rate).

Wealth

The value of a households accumulated savings

Types of Financial assets

There are 4 main types 1. Loans 2. Bonds 3. Stocks 4. Bank Deposits In addition, financial innovation has allowed the creation of a wide range of loan-backed securities.

Savings Investment Spending Identity Proof

Total Income = Total Spending Total Income = Consumption spending + Savings Total Spending = Consumption spending + Investment Spending so Consumption Spending + Savings = Consumption Spending + Investment Spending subtract Consumption spending Savings = Investment Spending

Financial Risk

Uncertainty about future outcomes that involve financial losses and gains