Economics summary
Chapter 24 Saving, investment and the financial system
(how the financial system brings together savers and borrowers)
Financial System = the group of institutions that help to match one person’s
saving with another person’s investment.
Financial institutions in the economy
Savers: people who spend less than they earn
Borrowers: people who spend more than they earn
Financial institutions can be grouped into 2 categories:
- Financial markets: financial institutions through which savers can
directly provide funds to borrowers. 2 most important: bond market and
stock market.
Bond market
The sale of bonds is called debt finance.
Bond = certificate of indebtedness that specifies the obligations of the
borrower to the holder of the bond. Bond = IOU.
Date of maturity = the time at which the loan will be repaid.
Coupon = rate of interest that will be paid periodically until the loan
matures.
Principal = the original sum of money.
Sovereign debt = a bond of the government.
Gilt-edged bonds / gilts = as good as gold, very safe credit risk (e.g. UK).
2 characteristics of bonds are important:
1. A bond’s term: the length of time until the bond matures.
(perpetuity = a bond that never matures. Interest is paid forever but
the principal is never repaid). Long-term bonds most of the times have
a higher risk and thus a higher interest rate than short-term bonds.
2. A bond’s credit risk: the probability that the borrower will fail to pay
some of the interest or principal. This is called a default.
,Yield of bond = coupon / price x100.
Stock market
The sale of stock to raise money is called equity finance.
Stocks offer higher risk and higher return than bonds.
Stock / share / equity = a claim to partial ownership and the future profits of a
company.
Primary market = the first-time sales of stocks on the stock exchanges.
Secondary market = shares that are subsequently traded among stockholders on
stock exchanges.
Prices for which stocks are sold depend on supply and demand.
Stock index = an average of a group of share prices.
- Financial intermediaries: financial institutions through which savers can
indirectly provide funds to borrowers.
1. Banks: are financial intermediaries and they help create a special asset
that people can use as a medium of exchange (an item that people can
easily use to engage in transactions; like debit cards).
2. Investment or mutual fund: an institution that sells shares to the public
and uses the proceeds to buy a portfolio of stocks and bonds. The
advantage: they allow people with small amounts of money to diversify
between companies.
Other financial instruments
- Collateralized Debt Obligations (CDOs).
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. CDS’s are bonds backed by a pool of mortgage
debt, they insure against the risk involved.
Protection buyer = the bank seeking to insure the risk
Protection seller = the insurance company / other financial institution
Saving and investment in the national income accounts
Y = GDP
C = consumption
I = investment
G = government purchases
NX = net exports
, Now, the net export is gone because it is zero. A closed economy does
not participate in international trade, imports and exports.
Open economies = they interact with other economies around the world.
What remains after paying for C and G is called national saving.
National saving = S = the total income in the economy that remains after paying
for consumption and government purchases.
Private saving = the income that households have left after paying for taxes and
consumption.
Public saving = the tax revenue that the government has left after paying for its
spending.
Budget surplus = where government tax revenue is greater than spending
because it receives more money than it spends.
, Budget deficit = where government tax revenue is less than spending and the
government has to borrow to finance spending.
Government deficit = a situation where a government spends more than it
generates in tax revenue over a period.
National debt = the total sum of the total debt owed by a government.
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.
Loanable funds = refers to all income that people have chosen to save and lend
out, rather than use for their own cons umption. There is one interest rate,
which is the same for saving and borrowing.
A high interest rate would encourage saving and discourage borrowing
for investment
A low interest rate would encourage borrowing for investment and
discourage saving.
Chapter 24 Saving, investment and the financial system
(how the financial system brings together savers and borrowers)
Financial System = the group of institutions that help to match one person’s
saving with another person’s investment.
Financial institutions in the economy
Savers: people who spend less than they earn
Borrowers: people who spend more than they earn
Financial institutions can be grouped into 2 categories:
- Financial markets: financial institutions through which savers can
directly provide funds to borrowers. 2 most important: bond market and
stock market.
Bond market
The sale of bonds is called debt finance.
Bond = certificate of indebtedness that specifies the obligations of the
borrower to the holder of the bond. Bond = IOU.
Date of maturity = the time at which the loan will be repaid.
Coupon = rate of interest that will be paid periodically until the loan
matures.
Principal = the original sum of money.
Sovereign debt = a bond of the government.
Gilt-edged bonds / gilts = as good as gold, very safe credit risk (e.g. UK).
2 characteristics of bonds are important:
1. A bond’s term: the length of time until the bond matures.
(perpetuity = a bond that never matures. Interest is paid forever but
the principal is never repaid). Long-term bonds most of the times have
a higher risk and thus a higher interest rate than short-term bonds.
2. A bond’s credit risk: the probability that the borrower will fail to pay
some of the interest or principal. This is called a default.
,Yield of bond = coupon / price x100.
Stock market
The sale of stock to raise money is called equity finance.
Stocks offer higher risk and higher return than bonds.
Stock / share / equity = a claim to partial ownership and the future profits of a
company.
Primary market = the first-time sales of stocks on the stock exchanges.
Secondary market = shares that are subsequently traded among stockholders on
stock exchanges.
Prices for which stocks are sold depend on supply and demand.
Stock index = an average of a group of share prices.
- Financial intermediaries: financial institutions through which savers can
indirectly provide funds to borrowers.
1. Banks: are financial intermediaries and they help create a special asset
that people can use as a medium of exchange (an item that people can
easily use to engage in transactions; like debit cards).
2. Investment or mutual fund: an institution that sells shares to the public
and uses the proceeds to buy a portfolio of stocks and bonds. The
advantage: they allow people with small amounts of money to diversify
between companies.
Other financial instruments
- Collateralized Debt Obligations (CDOs).
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. CDS’s are bonds backed by a pool of mortgage
debt, they insure against the risk involved.
Protection buyer = the bank seeking to insure the risk
Protection seller = the insurance company / other financial institution
Saving and investment in the national income accounts
Y = GDP
C = consumption
I = investment
G = government purchases
NX = net exports
, Now, the net export is gone because it is zero. A closed economy does
not participate in international trade, imports and exports.
Open economies = they interact with other economies around the world.
What remains after paying for C and G is called national saving.
National saving = S = the total income in the economy that remains after paying
for consumption and government purchases.
Private saving = the income that households have left after paying for taxes and
consumption.
Public saving = the tax revenue that the government has left after paying for its
spending.
Budget surplus = where government tax revenue is greater than spending
because it receives more money than it spends.
, Budget deficit = where government tax revenue is less than spending and the
government has to borrow to finance spending.
Government deficit = a situation where a government spends more than it
generates in tax revenue over a period.
National debt = the total sum of the total debt owed by a government.
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.
Loanable funds = refers to all income that people have chosen to save and lend
out, rather than use for their own cons umption. There is one interest rate,
which is the same for saving and borrowing.
A high interest rate would encourage saving and discourage borrowing
for investment
A low interest rate would encourage borrowing for investment and
discourage saving.
