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Economics IIWeek 1
Chapter 8 + 24: The financial system
Financial system = the group of institutions that help match one person’s saving with another
person’s investment.
Financial institutions in the economy:
1. Financial Markets: savers can directly provide funds to borrowers.
- Bond market: bond is a certificate of indebtedness. Debt finance.
- Stock market: stock is a claim of partial ownership in a firm. Equity finance.
2. Financial intermediaries: savers can indirectly provide funds to borrowers.
- Banks
- Investment funds, pension funds, insurance companies.
3. Borrowers: home owners, small and large business, government.
Financial Markets:
Bonds = a certificate of indebtedness that specifies
obligations of the borrower to the holder of the bond.
More reliable than a stock.
- Maturity = the length of time until a bond
expires. Both short- and long-term.
- Credit risk = the probability that the
borrower will fail to pay some of the
interest or principal.
Flat yield of the bond = coupon rate / invested amount x 100. As bond prices fall, yield rises
and vice versa.
Effective yield = flat yield – redemption profit. Redemption profit = ((paid price – nominal
value) / years left / invested amount)* 100
Stocks = a partial claim to ownership of a company. It is a privately held claim. A paper or
electronic certificate. Traded on stock market.
Market parties that need money offer
promissory notes (bonds) and demand liquid
assets (cash) in return. The interest rate
ensures there is a balance on the capital
market between demand and supply.
Financial intermediaries:
Investment or mutual fund = an institution that sells shares to the public and used the
proceeds to buy a portfolio of stocks and bonds.
Money Market = maturity is less than 2 years.
- Wholesale money market: large corporations. Interest rate: Euribor / Libor.
- Retail money market: SMEs. Interest rate: Credit – debit rate.
Capital market = maturity is more than 2 years.
- Official capital market: conditions are publicly announced. E.g. stock exchange,
bonds, mortgage bonds.
- Private capital market: direct negotiations between parties. E.g. real estate
investments.
, GDP = total income in an economy and total expenditure on the economy’s output of goods
and services. 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
- Consumption (C) = the spending by households on goods and services, with
exception of purchasing of new housing.
- Investment (I) = the spending on capital equipment, inventories, and structures,
including new housing.
- Government purchases (G) = the spending on goods and services by local and
central governments. Does not include transfer payments because they are not
made in exchange for currently produced goods or services.
- Net exports (NX) = exports minus imports.
Assume a closed economy – one that does not engage in international trade: 𝑌 = 𝐶 + 𝐼 + 𝐺.
Following subtract consumption and government purchases to both sides, 𝑌 − 𝐶 − 𝐺 = 𝐶 +
𝐼 + 𝐺 − 𝐶 − 𝐺 makes 𝑌 − 𝐶 − 𝐺 = 𝐼
𝑌 − 𝐶 − 𝐺 is called National Savings (S), and for the whole economy it must be equal
Investment (I). 𝑆 = 𝐼
National saving = the total income in the economy that remains after paying for consumption
and government purchases. 𝑆 = (𝑌 − 𝑇 − 𝐶) + (𝑇 − 𝐺) or 𝑌 − 𝐶 − 𝐺 − 𝑻 + 𝑻
Private saving = the amount of income that households have left after paying their taxes and
paying for their consumption. = 𝑌 − 𝑇 − 𝐶
Public saving = the amount of tax revenue that the government has left after paying for its
spending. Government budget = 𝑇 − 𝐺.
- If T > G, the government runs a budget surplus, this represents public saving. Tax
revenue is greater than spending.
- If T < G, the government runs a budget deficit. Tax revenue is less than spending
and the government needs to borrow to finance spending.
The market of loanable funds = the market in which those
who want to save supply funds, and those who want to
borrow to invest demand funds.
- The supply of loanable funds comes from The
Savers. Comes from national savings, both public
and private.
- The demand for loanable funds comes from The
Borrowers (for purpose of investment).
- The (real) interest rate is the price of the loan.
The equilibrium of the supply and demand for loanable funds determines the real
interest rate (nominal interest rate – inflation).
The model predicts that the interest rate in the economy adjust to balance the supply and
demand for loanable funds.
Government policies that affect saving and investment:
Policy 1: Saving Incentive increase the supply of loanable funds.
- Taxes on interest income reduce the incentive to save.
- A tax decrease on savings increases the incentive for households to save at any
given interest rate.
- If a change in tax law encourages greater saving, the result will be lower interest
rates and greater investment.
Policy 2: Investment Incentives increase the demand for loanable funds.
- Investment Tax Credit gives tax advantage to any firm making an investment.
- It increases the incentive to borrow.
- If a change in tax law encourages greater investment, the result will be higher
interest rates and greater saving.
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