Chapter 10 -SAVINGS, INVESTMENT SPENDING, AND THE FINANCIAL SYSTEM

loanable funds market

a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders

Liquidity

a measure of how quickly you can get your cash without loss of value

Mutual funds

a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors

liability

(n.) a debt; something disadvantageous

Investors depart from rationality in systematic ways:

- Overconfidence: having misguided faith that they are able to spot a winning stock - Loss aversion: being unwilling to sell an unprofitable asset and accept the loss - Herd mentality: buying an asset when its price has already been driven high and selling it when its price h as already been driven low

Factors that can cause the supply curve for loanable funds to shift:

- changes in private savings behavior - changes in net capital inflows

Factors that can cause the demand curve for loanable funds to shift:

- changes in perceived business opportunities - changes in government borrowing

three tasks of a financial system

1. reducing transaction costs 2. reducing risk 3. providing liquidity

What causes asset price fluctuations?

1. the demand for stocks 2. the demand for other assets 3. asset price expectations

If the yearly nominal interest rate on a savings account is 5% and the rate of inflation over the same period is 2%, what is the real interest rate?

3%

S Government

= TaxRev. − Transfer − G

Well functioning financial system

A critical ingredient in achieving long-run growth because it encourages greater savings and investment spending

bank

A financial institution that provides various products and services to its customers, including checking and savings accounts, loans and currency exchange.

Which of the following would cause the demand for loanable funds to increase? A major sporting event in town that causes people to withdraw money from their bank accounts. A reduction in government spending. A new investment tax credit for businesses to expand. A reduction in consumer confidence that causes people to save more.

A new investment tax credit for businesses to expand.

an increase in the amount of supply of loanable funds leads to...

a fall in the equilibrium interest rate

Which of the following assets will likely show the greatest increase in value over time? Low-risk corporate bonds Blue-chip stocks Treasury bonds Savings accounts

Blue-chip stocks

When the stock market is rising rapidly, what tends to happen to bond prices and interest rates on bonds? Bond prices rise, and interest rates on bonds fall. Bond prices fall, and interest rates on bonds fall as well. Bond prices fall, and interest rates on bonds rise. Bond prices rise, and interest rates on bonds rise as well.

Bond prices fall, and interest rates on bonds rise.

SIDE EFFECTS OF GOVERNMENT BORROWING?

Crowding out occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending.

Why does the supply of loanable funds curve slope upward?

More people are willing to forgo current consumptio n and make a loan to a borrower when the interest rate is higher.

Which of the following policies should a country implement in an economic downturn to avoid a Paradox of Thrift? Raise taxes to ensure the government remains funded. Reduce overall government spending. Implement policies to encourage saving. Implement policies to encourage greater consumption.

Implement policies to encourage greater consumption.

Who pays for private investment spending?

In the modern economy, individuals and firms that create physical capital often do it with other people's money.

If an economy's investment outlook improves, leading to increased borrowing to finance new building projects, what is likely to happen to interest rates? Interest rates will stay the same. Interest rates will fall to 0%. Interest rates will fall. Interest rates will rise.

Interest rates will rise.

If interest rates are rising, what might be the relationship between savings and investment that is causing this to happen? Savings is greater than investment demand. Savings and investment are both falling rapidly. Investment demand is greater than savings. Savings and investment are both rising rapidly.

Investment demand is greater than savings.

Martha needs to acquire funds in order to expand her bakery. She does not want to give up control of her business, but her credit score is weak due to the recent foreclosure on her home. What should Martha do to acquire these funds? She should do all of the above. Borrow money from her local bank. Issue stock to willing investors. Issue bonds to willing investors.

Issue bonds to willing investors.

S National = I

National saving = Invest

How does an increase in the savings rate affect the multiplier in an economy, if at all? The multiplier would stay the same. The multiplier would turn from positive to negative. The multiplier would increase. The multiplier would decrease.

The multiplier would decrease.

If consumer confidence rises because of strong job growth in an economy, what is likely to happen to the rate of savings? The savings rate will likely rise. The savings rate will likely fall. The savings rate will turn negative. The savings rate will likely fall to zero.

The savings rate will likely fall.

Which of the following is not a major function of financial institutions? To minimize information costs. To minimize transaction costs. To diversify assets, thereby reducing risk. To minimize interest rates paid to savers.

To minimize interest rates paid to savers.

physical asset

a tangible object that can be used to generate future income

pension fund

a type of mutual fund that holds assets in order to provide retirement income to its members

Suppose a country exports $50 million worth of goods and services, while it imports $60 million worth of goods and services. This country a) has a positive capital inflow. b) lends funds to foreigners. c) has a negative capital inflow. d) Answers (a) and (b) are both correct. e) Answers (b) and (c) are both correct.

a) has a positive capital inflow.

If the level of saving in an economy exceeds investment, what will likely happen to interest rates as the economy moves toward equilibrium? a) Interest rates will fall to spur greater investment. b) Interest rates will fall to spur greater saving. c) Interest rates will rise to spur greater investment. d) Interest rates will rise to spur greater saving.

a) Interest rates will fall to spur greater investment.

According to the Fisher effect:

an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged

financial intermediary

an institution that transforms the funds it gathers from many individuals into financial assets

Which of the following assets is most liquid? a) a home with a market value of $300,000 b) a checking account balance of $1,000 c) a three-carat diamond engagement ring d) a rare edition of an out-of-print book

b) a checking account balance of $1,000

Which of the following situations would likely lead to a higher savings rate in the short run? a) Sue is just about to graduate from college and has a high-paying job offer at a bank. b) JR believes that he may be laid off from his job within the next 6 months. c) Jane's stock portfolio unexpectedly doubles. d) Sean was selected as a first-round pick in the NFL draft and will earn $5 million a year starting next season.

b) JR believes that he may be laid off from his job within the next 6 months.

Suppose the government introduces a new incentive for individuals to save money for retirement. How would this affect the market for loanable funds and the interest rate? a) supply of loanable funds would decrease and interest rates would fall b) supply of loanable funds would increase and interest rates would fall c) supply of loanable funds would decrease and interest rates would rise d) supply of loanable funds would increase and interest rates would rise

b) supply of loanable funds would increase and interest rates would fall

Which of the following is not true about the stock market? a) A person who owns shares of stock becomes an owner of the company. b) A stockholder likely loses its entire investment if the company goes bankrupt. c) A stockholder receives the amount it invests plus interest at a fixed time in the future. d) When a company earns profits or rises in value, the stockholder will earn more money.

c) A stockholder receives the amount it invests plus interest at a fixed time in the future.

Major changes in interest rates have been driven by many factors, including:

changes in government policy; technological innovations that created new investment opportunities. people's expectations about future inflation.

Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve

changes the interest rate.

Financial markets

channel the savings of households to businesses that want to borrow in order to purchase capital equipment.

financial asset

claim on the property or income of a borrower

Total income

consumption spending + investment spending.

total income

consumption spending + savings

Financial markets provide a means for: a) reducing risk for borrowers and lenders. b) reducing transaction costs for borrowers and lenders. c) enhancing liquidity for borrowers and lenders. d) Answers (a), (b), and (c) are all correct.

d) Answers (a), (b), and (c) are all correct. (correct answer)

Budget deficit:

excess of government spending over tax revenue

Budget surplus:

excess of tax revenue over government spending

Net capital inflow =

imports − exports

Present value

is the amount of money needed today to receive a given amount of money at a future date given the interest rate.

net capital inflow

is the total flow of funds into a country minus the total flow of funds out of a country.

But neither lenders nor borrowers

know what inflation will be, so loan contracts specify a nominal interest rate.

It's hard for people without large amounts of money to build a diversified portfolio. The solution is

mutual funds

Investment spending =

national savings + net capital inflow

Crowding out is not a concern in a depressed economy

rather, increased government spending raises income (and private savings).

Savings-investment spending identity

savings and investment spending are always equal for the economy as a whole

Life insurance company

sells policies that guarantee a payment to a policyholder's beneficiaries when the policyholder dies

budget balance

the difference between tax revenue and government spending

Firms borrow more when

the interest rate falls because more projects will earn enough to pay for themselves.

behavioral economics

the study of situations in which people make choices that do not appear to be economically rational

National savings:

the sum of private savings and the budget balance, is the total amount of savings generated within the economy

global loanable funds market arises

when international capital flows are so large that they equalize interest rates across countries.