Economics summary Y2Q1
Financial system: the group of institutions in the economy that help to match one person’s
savings with another person’s investment.
The financial system is made up of various financial institutions that help coordinates savers
and borrowers. Financial institutions can be grouped into 2 categories:
1. Financial markets: financial institutions though which savers can directly provide
funds to borrowers.
2 of the most important financial markets in advanced economies are:
- The bond market: a bond is a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond. A bond is an IOU, it
identifies the time at which the loan will be repaid, called the date of
maturity, and the rate of interest that will be paid (called the coupon) until
the loan matures.
Every bond has the same 2 important characteristics:
1. a bond’s term (the length of time until the bond matures, if it never does its
called perpetuity)
2. Credit risk, the probability that the borrower will fail to pay some of the
interest or principle. This is called a default
One important point is the relationship between a bond’s price and its yield.
Coupon : price x 100 = price is quoted as a percentage of the principal.
- The stock market: a stock is a claim to partial ownership and the future
profits in a firm. The sale of stock to raise money is called equity finance
(whereas the sale of bonds is called debt finance). compared to bonds, stocks
offer the holder both higher risk and potentially higher return, because a
shareholder will enjoy the benefits if the company is profitable but with
financial difficulty the shareholders don’t receive anything at all.
- Corporations can issue stock by selling shares to the public though organized
stock exchanges, these first time sales are referred to as the primary market.
- Shares that are subsequently traded among stockholders on stock exchanges
is referred to as the secondary market.
- The prices at which shares trade on stock exchanges are determined by the
supply and demand for the stock in these companies. Demand for a stock
reflects people’s perception of the corporation’s future, they raise their
demand for its stock and thereby bid the price up.
- A stock index is computed as an average of a group of share prices. Because
share price reflect expected profitability, stock indices are watched closely as
possible indicators of future economic conditions.
2. Financial intermediaries: financial institutions though which savers can indirectly
provide funds to borrowers. the 2 most important financial intermediaries:
, 1. Banks: mostly used by small businesses wanting to finance their business,
using a loan from a bank. Banks are financial intermediaries with which
people are most familiar.
- A primary function of banks is to take in deposits from people who want to
save and use these deposits to make loans to people who want to borrow.
The difference between the depositors rates and loaners rate covers the
banks costs and profits.
- Banks also play an important role in the economy: they facilitate purchase of
goods and services by allowing people to draw against their deposits, In other
words banks help create a special asset that people can use as a medium of
exchange. A medium of exchange is an item that people can easily use to
engage in transactions. A bank’s role in providing a medium of exchange
distinguishes it from many other financial institutions.
2. Investment funds/mutual fund: an institution that sells to the public and uses
the proceeds to buy a portfolio of stocks and bonds. The primary advantage
of these funds is that they allow people with small amounts of money to
diversity.
Other financial instruments:
- Collateralized debt obligations (CDO), are pools of asset-backed securities
which are dependent on the value of the asset that backs them up and the
stream of income that flows rom these assets.
Sub-prime market: individuals not traditionally seen as being part of the
financial markets because of their high credit risk.
- Credit default swaps (CDS): a means by which a bondholder can insure
against the risk of default.
The rules of national income accounting include several important identities. Recall that GDP
is both total income in an economy and the total expenditure on the economy’s outputof
goods and services. GDP (Y) is divided into 4 components of expenditure: consumption ( C ),
investment (I), government purchases (G) and net exports (NX)
Y= C + I + G + NX
A closed economy is one that does not interact with other economies. Because they don’t
engage in international trade, imports and exports are zero, therefore:
Y=C+I+G
To see what this identity can tell us bout financial markets, if we take Y, on the left hand side
of the equation, to be GDP, we can subtract from this things that are consumed. To retain
the equation, we must also subtract C and G from the right hand side which gives:
Y – C -G = ( C – C ) + I + ( G – G)
Y–C–G=I
, What remains after paying for consumption and government purchases is called national
savings; ( the total income in the economy remains after paying for consumption and
government purchases) and denoted S.
Given Y – C – G = S
S=I
We can write national saving in either 2 ways:
S=Y–C–G
S = (Y-T-C) + (T-G)
We can separate savings into 2 pieces:
- Private saving: income that households have left after paying for taxes and
consumption
(Y-T-C)
- Public savings: the tax revenue that the government has left after paying for
its spending
(T – G)
Budget surplus: where government tax revenue is greater than spending
because it receives more money than its spends. ( T exceeds G )
Budget deficit: where government tax revenue is less than spending and the
government has to borrow to finance spending ( G exceeds T )
Market for loanable funds: the market in which those who want to save supply funds, and
those who want to borrow to invest demand funds.
The economy’s market for loanable funds consists of the supply of and demand for loanable
funds and the price in this market is the interest rate.
Shifts in the demand and supply of loanable funds bring about changes to the interest rate. If
the interest rate was lower than the equilibrium level because of a shift in demand to the
right or of supply to the left, the quantity of loanable funds supplied would be less than the
quantity of loanable funds demanded.
A higher interest rate would encourage saving and discourage borrowing for investment.
Conversely, if the demand for loanable funds shifts to the left or the supply of loanable funds
shifts to the right, the quality supplied would exceed the quantity demanded. As lenders
competed for the scarce borrowers, interest rates would be driven down. This way, the
interest rate approaches the equilibrium level at which the supply and demand for loanable
funds balance.
Recall that the real interest rate is the difference between the nominal interest rate and the
inflation rate.
This model of the supply and demand for loanable fund shows that financial markets work
much like other markers in the economy. The model predicts that the interest rate adjust to
Financial system: the group of institutions in the economy that help to match one person’s
savings with another person’s investment.
The financial system is made up of various financial institutions that help coordinates savers
and borrowers. Financial institutions can be grouped into 2 categories:
1. Financial markets: financial institutions though which savers can directly provide
funds to borrowers.
2 of the most important financial markets in advanced economies are:
- The bond market: a bond is a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond. A bond is an IOU, it
identifies the time at which the loan will be repaid, called the date of
maturity, and the rate of interest that will be paid (called the coupon) until
the loan matures.
Every bond has the same 2 important characteristics:
1. a bond’s term (the length of time until the bond matures, if it never does its
called perpetuity)
2. Credit risk, the probability that the borrower will fail to pay some of the
interest or principle. This is called a default
One important point is the relationship between a bond’s price and its yield.
Coupon : price x 100 = price is quoted as a percentage of the principal.
- The stock market: a stock is a claim to partial ownership and the future
profits in a firm. The sale of stock to raise money is called equity finance
(whereas the sale of bonds is called debt finance). compared to bonds, stocks
offer the holder both higher risk and potentially higher return, because a
shareholder will enjoy the benefits if the company is profitable but with
financial difficulty the shareholders don’t receive anything at all.
- Corporations can issue stock by selling shares to the public though organized
stock exchanges, these first time sales are referred to as the primary market.
- Shares that are subsequently traded among stockholders on stock exchanges
is referred to as the secondary market.
- The prices at which shares trade on stock exchanges are determined by the
supply and demand for the stock in these companies. Demand for a stock
reflects people’s perception of the corporation’s future, they raise their
demand for its stock and thereby bid the price up.
- A stock index is computed as an average of a group of share prices. Because
share price reflect expected profitability, stock indices are watched closely as
possible indicators of future economic conditions.
2. Financial intermediaries: financial institutions though which savers can indirectly
provide funds to borrowers. the 2 most important financial intermediaries:
, 1. Banks: mostly used by small businesses wanting to finance their business,
using a loan from a bank. Banks are financial intermediaries with which
people are most familiar.
- A primary function of banks is to take in deposits from people who want to
save and use these deposits to make loans to people who want to borrow.
The difference between the depositors rates and loaners rate covers the
banks costs and profits.
- Banks also play an important role in the economy: they facilitate purchase of
goods and services by allowing people to draw against their deposits, In other
words banks help create a special asset that people can use as a medium of
exchange. A medium of exchange is an item that people can easily use to
engage in transactions. A bank’s role in providing a medium of exchange
distinguishes it from many other financial institutions.
2. Investment funds/mutual fund: an institution that sells to the public and uses
the proceeds to buy a portfolio of stocks and bonds. The primary advantage
of these funds is that they allow people with small amounts of money to
diversity.
Other financial instruments:
- Collateralized debt obligations (CDO), are pools of asset-backed securities
which are dependent on the value of the asset that backs them up and the
stream of income that flows rom these assets.
Sub-prime market: individuals not traditionally seen as being part of the
financial markets because of their high credit risk.
- Credit default swaps (CDS): a means by which a bondholder can insure
against the risk of default.
The rules of national income accounting include several important identities. Recall that GDP
is both total income in an economy and the total expenditure on the economy’s outputof
goods and services. GDP (Y) is divided into 4 components of expenditure: consumption ( C ),
investment (I), government purchases (G) and net exports (NX)
Y= C + I + G + NX
A closed economy is one that does not interact with other economies. Because they don’t
engage in international trade, imports and exports are zero, therefore:
Y=C+I+G
To see what this identity can tell us bout financial markets, if we take Y, on the left hand side
of the equation, to be GDP, we can subtract from this things that are consumed. To retain
the equation, we must also subtract C and G from the right hand side which gives:
Y – C -G = ( C – C ) + I + ( G – G)
Y–C–G=I
, What remains after paying for consumption and government purchases is called national
savings; ( the total income in the economy remains after paying for consumption and
government purchases) and denoted S.
Given Y – C – G = S
S=I
We can write national saving in either 2 ways:
S=Y–C–G
S = (Y-T-C) + (T-G)
We can separate savings into 2 pieces:
- Private saving: income that households have left after paying for taxes and
consumption
(Y-T-C)
- Public savings: the tax revenue that the government has left after paying for
its spending
(T – G)
Budget surplus: where government tax revenue is greater than spending
because it receives more money than its spends. ( T exceeds G )
Budget deficit: where government tax revenue is less than spending and the
government has to borrow to finance spending ( G exceeds T )
Market for loanable funds: the market in which those who want to save supply funds, and
those who want to borrow to invest demand funds.
The economy’s market for loanable funds consists of the supply of and demand for loanable
funds and the price in this market is the interest rate.
Shifts in the demand and supply of loanable funds bring about changes to the interest rate. If
the interest rate was lower than the equilibrium level because of a shift in demand to the
right or of supply to the left, the quantity of loanable funds supplied would be less than the
quantity of loanable funds demanded.
A higher interest rate would encourage saving and discourage borrowing for investment.
Conversely, if the demand for loanable funds shifts to the left or the supply of loanable funds
shifts to the right, the quality supplied would exceed the quantity demanded. As lenders
competed for the scarce borrowers, interest rates would be driven down. This way, the
interest rate approaches the equilibrium level at which the supply and demand for loanable
funds balance.
Recall that the real interest rate is the difference between the nominal interest rate and the
inflation rate.
This model of the supply and demand for loanable fund shows that financial markets work
much like other markers in the economy. The model predicts that the interest rate adjust to
