Macroeconomics Chapter 8

The group of institutions in the economy that help to match one person's saving with another person's investment

The financial system moves the economy's scarce resources from savers (households and governments) to borrowers (firms).

- Financial institutions through which savers can directly provide funds to borrowers - Directly bring savers and borrowers together - Bonds and stocks

A certificate of indebtedness that specifies the obligations of the borrow to the holder of the bond

Firms and governments

Identifies the time at which the loan will be repaid, as specified by the bond agreement

Promise of interest and eventual repayment of the amount burrowed

A bond that never matures

Long-term bonds are riskier than short-term bonds.

The probability that the borrower will fail to pay some of the interest or principal.

- Level of debt carried by issuer of bond - Recent changes in amount of debt carried - Stability of owner's revenues

Failure to pay; borrowers can default on their loans by declaring bankruptcy.

Junk bonds pay considerably higher interest rates than the bonds issued by more secure corporations and by governments.

A claim to partial ownership in a firm

- Dividend: a share of profits earned by partial owners - Capital gain: selling a stock for more than it was purchased for

- Stocks are usually riskier than bonds because of the risk of capital loss - In the case of bankruptcy, stock holders are the last ones that are compensated

The sale of stock to raise money

An average of a group of stock prices

Expected profitability

No

- Financial institutions through which savers can indirectly provide funds to borrowers - Indirectly bring together savers and borrowers - Banks and mutual funds

Provide loans to borrowers and accept deposits from savers

They allow people to write cheques against their deposits

An institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds

1. Allow people with small amounts of money to diversify with little risk because they only have a small stake in each company. 2. Actively managed mutual funds give ordinary people access to the skills of professional money managers, usually for a fee.

Mutual funds that buy all the stocks in a given stock index and perform somewhat better on average than mutual funds that take advantage of active management

Y = C + I + G - Y = GDP in a closed economy - C = consumption - I = investment - G = government purchases

The total income in the economy that remains after paying for consumption and government purchases. In a closed economy, saving equals investment.

S = Sp + Sg = I

The income that households have left after paying for taxes and consumption

Sp = Y - T - C

Sg = T - G

The tax revenue that the government has left after paying for its spending

An excess of tax revenue over government spending (T>G)

A shortfall of tax revenue from government spending (G>T)

The sum of all past budget deficits and surpluses

Debt is a stock variable, while deficit is a flow variable.

The market in which those who want to save supply funds and those who want to borrow to invest demand funds

All income that people have chosen to save and lend out, rather than use for their own consumption

• All borrowing is done by firms who want to invest (purchase new capital equipment) • All saving is done by households and governments whose income is greater than their current spending on goods and services • Treat public (government) borrowing as negative saving

Saving by households and governments

The slope of the supply curve is positive because higher interest rates increase the return of lending by households

Anything that causes the households/government to save more at any interest rate increases the supply of loanable funds.

Changes in "T" do not shift supply curve since T is added to S(g) and subtracted from S(p), and national saving is S(g) + S(p)

Investment by firms

The slope of the demand curve is negative because higher interest rates increase the cost of borrowing

Anything that causes a firm to want to purchase more capital at any interest rate will cause the demand to increase

The interest rate approaches the equilibrium level at which the supply and demand for loanable funds exactly balance.

The supply and demand for loanable funds depend on the real interest rate rather than the nominal interest rate.

The monetary return to saving and cost of borrowing

The nominal interest rate corrected for inflation

Under a consumption tax, income that is saved is not taxed, encouraging greater saving.

A tax change alters the incentive for households to save at any given interest rate, therefore it would affect the quantity of loanable funds supplied at each interest rate.

If a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment.

Gives a tax advantage to any firm building a new factory or buying a new piece of equipment

If a reform of the tax laws encouraged greater investment, the result would be higher interest rates and greater saving.

A change in the government budget balance represents a change in public saving and, thereby, in the supply of loanable funds.

When the government runs a budget deficit, public saving is negative, and national saving is reduced.

When the government reduces national saving by running a budget deficit, the interest rate rises, and investment by firms falls. A government budget deficit reduces the supply of loanable funds.

A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment by firms. Higher investment means great capital accumulation and more rapid economic growth.

- Cut taxes - Increase spending on social programs - Pay off past debt

The difference between the value of government financial liabilities and financial assets • Declining net debt indicates that the economy is living within its means • Economic slowdowns cause the government net debt to rise