Chapter-10 MACROECO
Default risk -Interest rate on a bond also varies with default risks.
A risk that the bond issuer will not make the promised payments.
_____________ operated by the government of California is the largest US pension fund.
CalPERS
In the graph you've just explored, what is the value of Tom's capital at the end of 2020, if depreciation is $20,000 and gross investment increases to $45,000?
Capital + Investment = $55,000
When any of the other influences on saving changes, the supply of loanable funds changes.
Changes in the other four factors; disposable income, wealth, expected future income, and default risk are the main things that change the supply of loanable funds. -The real interest rate -Disposable income -Wealth -Expected future income -Default Risk
________ is the risk that a loan will not be repaid, or not repaid in full. As default risk increases, the interest rate needed to induce a person to lend rises and the supply of loanable funds _________. In normal times default risk is low, but in times of financial crisis when asset prices tumble, default can become widespread.
Default Risk Decreases
A household's ________ is the income earned minus net taxes.
Disposable income
What is the link between the price of a financial asset and its interest rate?
Falls as the asset's price rises.
Stocks, Bonds, and loans are collectively called
Financial Assets
Government bonds are the safest, so they have the lower rates.
Government Bonds
-Investment is the purchase of new capital goods (tools, instruments, machines, and buildings) and additions to inventories. -Depreciation is the decrease in the value of a firm's capital that results from wear and tear and obsolescence.
Gross Investment - The total amount spent both buying new capital and replacing depreciation capital. Net Investment - The amount by which the value of capital increases. -Net investment equals = gross investment minus (-) depreciation.
What is Tom's net investment in 2020?
Gross investment - Depreciation = $15,000
A firm is ____________ if it has made long term loans with borrowed funds and is faced with a sudden demand repay more of what it has borrowed than its available cash.
Illiquid
In normal times, a financial institution that is _____________ can borrow from another institution.
Illiquid
Income is what this graduate earns. His wealth is what he owns, and his net wealth is what he owns minus what he owes.
Income = Earnings Health = Owes Net Wealth = Own - Owes
The wealth of a nation at the end of the year, equals its wealth at the start of the year plus its saving during the year, which equals income minus consumption expenditure
Income minus Consumption Expenditure
But if all institutions are short of cash, the market for loans among financial institutions dries up.
Insolvency and illiquidity were at the core of financial meltdown of 2007-2008.
If the net worth is negative, the institution is _____________ and must stop trading.
Insolvent
The owners of an ____________ financial institution usually its stockholders bears the loss when the assets are sold and debts paid.
Insolvent
The ___________ of an institution is the total market value of what it has lent minus the market value of what it has borrowed.
Net Worth
Uncertainty between a long and a short term bond.
Normally, a long term bond carries greater uncertainty than a short term bond and has a higher interest rate, so the yield curve usually slopes upward. Exception (2019-The short term outlook becomes very uncertain and short term bonds have a higher interest rate than long term bonds, and the yield curve becomes inverted.)
In the loanable funds market, there is just ________ that we refer to as the _________.
One average interest rate that we refer to as the interest rate.
Lower and Higher Interest Rate
Other things remaining the same, the higher the real interest rate, the greater is the quantity of loanable funds supplied; and the lower the real interest rate, the smaller is the quantity of loanable funds supplied.
Firms invest only when they expect to earn a rate of profit that exceeds the real interest rate. Fewer projects are profitable at a high real interest rate than at a lower interest rate, so:
Other things remaining the same, the higher the real interest rate, the smaller is the quantity of loanable funds demanded; and the lower the real interest rate, the greater is the quantity of loanable funds demanded.
Wealth also called net worth, is the market value of what a household or firm owns minus what it owes. -What people own is related to what they earn. But it is not the same thing. -People can earn an income, which is the amount they receive during a given time period from supplying the services of the resources they own.
Owns - Owes = Wealth/Net worth
When economists use the term capital, what do they mean?
Physical and Human Capital
Capital
Physical capital - tools, instruments, machines, buildings, and inventories, and human capital.
Which of the following items is a source of a loanable funds?
Private Saving
Loanable funds flow from two/three sources:
Private Saving International Borrowing Government Budget Surplus
The ____________ is the total funds available from private saving, the government budget surplus, and international borrowing during a given period.
Quantity of Loanable Funds Supplied
If the net worth is positive, the institution is _____________ and can remain in business.
Solvent
The three types of financial markets are?
Stock Markets Bond Markets Loan Markets
Why, other things remaining the same, does a rise in the real interest rate increase and the quantity of loanable funds supplied? The quantity supplied increases because of a higher real interest rate ____________.
Strengthens the incentive to cut back on consumption and save more. -The real interest rate is the opportunity cost of consumption, so a higher real interest rate strengthens the incentive to cut back on consumption and save and lend more.
The _____________ is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.
Supply of Loanable Funds
Although it has not happened for many years, the government budget could be in __________, in which case government would be a source of funds; and the US could lend to the rest of the world, in which case, international lending would be a use of funds.
Surplus
What is the relationship between the coupon on an asset, the price of the asset and its interest rate?
The coupon divided by the asset's price determines the interest rate on the asset. (The interest rate on an asset equals the coupon on the asset as a percentage of the asset's price. If the asset's price changes, and other things (the coupon) remain the same, then the interest rate changes.
In the graph above you have just made, how does the demand for loanable funds change when the expected profit rate increases?
The demand for loanable funds increases and the demand curve shifts rightward.
Financial Capital
The funds used to buy capital equipment and inventories
Financial Capital is:
The funds used to buy physical capital (equipment & inventories)
The Term of a Bond, called the term of maturity, might be long, like a Walmart 10 year bond, or short (just a month or two) like a US Treasury Bond.
The interest rate on a bond varies with its term to maturity.
According to the video, what can we say about the prices of stocks and bonds? The interest rate influences?
The prices of both stocks and bonds (The video tells us that the interaction between borrowers and savers determines the interest rate, and interest rate influences the prices of stocks and bonds.
Quantity of loanable funds
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period.
Gross Investment
The total amount spent on new capital.
To make real GDP grow, saving and wealth must be transformed into investment and capital.
This transformation takes place in the markets for financial capital and through the activities of financial markets and institutions that we now describe.
What is the distinction between insolvency and illiquidity? A financial institution is insolvent if it ______________ and is illiquid if it is ___________.
has a negative net worth; solvent but short of cash.
As a household's disposable income increases, other things remaining the same,
household saving increases.
The interest rate of a financial asset
is a percentage of the price of the asset
When the expected profit changes,
the demand for loanable fund changes.
Wealth at end of the summer equals= Wealth at start of summer $500 Income $8,000 Minus Expenditure $1500
500 + 8000 - 1500 = 7000
A ___________ is a firm that operates on both sides of the markets for financial capital: The firm borrows in one market and lends to another.
Financial institution
If a bond price rises, other things remaining the same,
its interest falls. And if the price falls, the interest rate rises. (This relationship means that a bond or stock price and interest rate are determined simultaneously - one implies the other.)
Graph illustration of the supply of loanable funds (Part B)
-An increase in disposable income or a decrease in wealth, expected future income, or default risk increases the supply of loanable funds and shifts the supply of loanable funds curve rightward to SLF1. -A decrease in disposable income or an increase in wealth expected future income, or default risk decreases the supply of loanable funds and shifts the supply of loanable funds curve leftward to SLF2
The key financial institutions are:
-Investment Banks -Commercial Banks -Government-sponsored mortgage lenders -Pension Funds -Insurance Companies
Saving is the source of the funds that are used to finance investment, and these funds are supplied and demanded in three types of financial markets.
-Loan Market - Bond Market - Stock Market
Financial Institutions account for ______ of all borrowing.
54%
According to the video, what type of financial institution issues stocks?
An investment bank
A __________ real interest rate provides a strong incentive to cut back on consumption, save more, and increase the quantity of loanable funds supplied.
High
Savings equal income minus expenditure, or wealth at the end of the summer, minus wealth at the start of the summer.
Income - Expenditure = Savings
Individual Interest rates are distributed around the average interest rate for two reasons: Both the length of the term to maturity of a loan or bond and the risk the borrower will default vary.
Interest Rate Distribution
__________ is the major item and is the focus of our explanation of the forces that influence that influence the demand side of the loanable funds market.
Investment
Investment Banks
Investment banks are firms that help other financial institutions and governments raise funds by issuing and selling bonds and stocks, as well as providing advice on transactions such as mergers and acquisitions. -Goldman Sachs is the largest investment bank today.
A Bond
Is a promise to make specified payments on specified dates. Example: In 2019, Walmart issued $1.25 billion of bonds that pay $3.25 every year until 2029 and then make a final payment of $100. The annual payment is called the bond's coupon and the final payment date is called the redemption date. (Corporate & Government Bonds are traded in bond markets.)
Graph that illustrates the demand for loanable funds Shows shift left or right as increases, and decreases. (Graph Part B) See part A
-The demand for loanable fund curve, DLF, passes through these points. -If the real interest rate rises, the quantity of loanable fund demanded decreases. -If the real interest rate falls, the quantity of loanable funds demanded increases. -A change in expected profit changes the demand for loanable funds and shifts the demand for loanable funds curve.
Your decisions will be influenced by many factors, but chief among them are:
-The real interest rate -Disposable income -Wealth -Expected future income -Default Risk
What determines investment and the demand for loanable funds? Many details influence such as decision, but we can summarize them into two factors:
-The real interest rate -Expected profit
Slider graph for supply of loanable fund In the graph you've just explored, how does the supply of loanable funds change when expected future income increases from $30,000 to $40,000?
-The supply of loanable funds decreases and the supply curve shifts leftward.
Real flows and real interest rate are determined in loanable funds market by studying:
The Demand for Loanadable Funds The Supply of Loanable Funds Equilibrium in the Loanable Funds Market
Commercial Banks
The bank that you use for your own banking services and that issues your credit card is a commercial bank.
In the sliders graph the demand for loanable funds. In the graph you've just explored, how does the demand for loanable funds change when expected profit increases from $6 million to $10 million per year?
The demand for loanable funds increases and the demand curve shifts rightward.
What is the interest rate if the price of a bond with a $5 coupon at $100 was 5% per year. If the price of the bond is $200, the interest rate halves down to 2.5%. What if the bond is at $150 then what is the interest rate?
The rate is 3.33% per year. $5 x 100 / $150 = 3.33%
Yield Curve
The relationship between the term of a bond and its interest rate.
Banks lower their risk by selling mortgages to
Fannie Mae and Freddie Mac which package them into mortgage backed securities that they sell to banks and other financial institutions.
Why, other things remaining the same, does a rise in the real interest rate decrease the quantity of loanable funds demanded? The quantity of loanable funds demanded decreases at a higher interest rate ___________.
Fewer projects have an expected rate of profit that exceeds the real interest rate. -A rise in the real interest rate decreases the quantity of loanable funds demanded because at a higher real interest rate, fewer projects have an expected rate of profit that exceeds the real interest rate.
Loan Market
Financing that takes place in loan markets such as mortgages, credit cards, etc. (When a family wants to buy a new home, they get a bank loan that is secured by a mortgage-a legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed payment schedule (of loan repayments and interest.)
We measure all the flows of loanable funds in real terms - in constant 2012 dollars.
Flows of loanable
Graph illustration of the supply of loanable funds. (Part A)
-A rise in the real interest rate increases the quantity of loanable funds supplied. -A fall in the real interest rate decreases the quantity of loanable funds supplied.
Loanable funds flow to two uses:
Business Investment Government Budget Deficit
Financial Markets & Financial Institutions -Provide the channels through which saving flows to finance investment. -The health of these markets and institutions affects the performance of the entire economy and the pace of the economic growth.
Capital - Consists of physical capital - tools, instruments, machines, buildings, and inventories, and human capital. When economists use the term capital, they mean physical capital. Financial Capital - Consists of the funds that firms use to buy physical capital and that households use to buy a home or invest in human capital.
Households take mortgages from
Commercial banks, and the banks reduce their risk by selling those mortgages to the government sponsored mortgage lenders: Fannie Mae and Freddie Mac
The ____________ is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.
Demand for loanable funds
As a household's ____________ increases, other things remaining the same, the less it will save today: If two households have the same current disposable income, the household with the larger expected future disposable income will spend a larger portion of its current disposable income on consumption goods and services and so save less today.
Expected Future Income
Most young households expect to have a higher future income for some years and then to have a lower income during retirement. Because of this pattern of income over the life cycle, young people save a small amount, middle aged people save a lot, and retired people gradually spend their accumulated savings.
Expected Future Income Pattern in Life
In macroeconomics, we group all the individual financial markets into a single _________.
Loanable Funds Market
The _______________ is the aggregate of the markets for loans, bonds, and stocks.
Loanable Funds Market
A _____ real interest rate provides little incentive to cut back on consumption, so a low interest rate brings greater consumption, less saving, and a smaller quantity of loanable funds supplied.
Low
The _________ is the opportunity cost of the funds used to finance the purchase of capital, and firms compare the __________ with the rate of profit they expect to earn on their new capital.
Real Interest Rate
The ___________ influences the supply of loanable funds because it is the opportunity cost of consumption expenditure. A dollar spent on consumption is a dollar not saved and supplied in the loanable funds market. So, the interest that would have been earned on that saving is forgone.
Real Interest Rate
____________ is the main source of supply of loanable funds.
Saving -A government budget surplus and international borrowing are other sources.
Cindy takes a summer job and earns an after tax income of $3,500. Her living expenses during the summer were $1,000. What was Cindy's saving during the summer and the change, if any, in her wealth? The change in Cindy's wealth is?
Savings were $3,500 - $1,000 = $2,500 Change in wealth was also $2,500
In the supply of loanable funds graph, how does the supply funds change when disposable income increases?
The supply of loanable funds increases and the supply curve shifts rightward. -When disposable income increases, the supply of loanable funds increases and the supply of loanable funds curve shifts rightward.
Graph that illustrates the demand for loanable funds Shows movement going up and down the of the rise and decrease. (Graph Part A) See part B
The table sets out a demand for loanable funds schedule. It shows the quantity of loanable funds demanded at five real interest rates -The demand for loanable fund curve, DLF, passes through these points. -If the real interest rate rises, the quantity of loanable fund demanded decreases. -If the real interest rate falls, the quantity of loanable funds demanded increases. -A change in expected profit changes the demand for loanable funds and shifts the demand for loanable funds curve. -An increase in expected profit increases the demand for loanable funds and shifts the demand curve rightward to DLF1. -A decrease in expected profit decreases the demand for loanable funds and shifts the demand curve leftward to DLF2.
Government - Sponsored Mortgage Lenders Government sponsored enterprises
Two large financial institution: -The Federal National Mortgage Association or Fannie Mae -The Federal Home Loan Mortgage Corporation or Freddie Mac
A household's _____ is what it owns. A household with greater wealth, other things remaining the same, will save less than a household with less wealth.
Wealth
Saving - The amount of income that is not paid in taxes or spent on consumption, adds to wealth.
Wealth increases when the market value of asset rises, called capital gains.
What is the distinction between what people own and what they earn?
Wealth is what people own and income is what they earn.
Stock Market -The owners of financial capital in the form of stock trade their stock certificates in stock markets.
When Tesla wants to raise funds to build a new electric car production plant, it issues stock. A stock is a certificate of ownership and claim to a firm's profits. -Tesla sold 13 million shares of its stock at a price of $17/share in 2010. (If you owned 13 Tesla shares, you would own one millionth of Tesla and be entitled to receive one millionth of its profits.) -A Stock Market is a financial market in which shares in corporations' stocks are traded. The New York Stock Exchange, the London Stock Exchange (in England), the Frankfurt Stock Exchange (in Germany), and the Tokyo Stock Exchange (in Japan) are all examples of stock markets.
The inverse relationship between the price of a bond and its interest rate
When the price of the bond doubles, the interest rate on the bond halves. (reduces by half)
Insurance Companies
__________ enters into agreements with households and firms to provide compensation in the event of accident, theft, fire, ill health, and a host of other misfortunes. -Some companies, for example, provide insurance that pays out if a firm fails and cannot meet its bond obligations while some insure others insurers in a complex network of reinsurance. _____________ receive premiums from their customers, make payments against claims, and use the funds they have received but not paid out as claims to buy bonds and stocks on which they earn interest.
Pension Funds Some pension funds are a very large and play an active role in the firms whose stock they hold.
______________ are financial institutions that use the pension contributions of firms and workers to buy bonds and stocks.
Saving and the supply of loanable funds are determined by
decisions by people like you.
