Chapter 23

Finance: is the field of economics that studies how people make decisions
regarding the allocation of resources over time and the handling of risk

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

Financial markets
1. Financial markets: are the institutions trough which savers can directly provide
funds to borrowers ⇒ bond and stock market
2. Financial intermediates: are financial institutions through which savers can
directly provide funds to borrowers ⇒ banks and investment or mutual funds

Bond: is a certificate of indebtedness that specifies obligations of the borrower

to the holder of the bond

Characteristics of a bond:
- Term: the length of time until the bond matures
- Credit risk: the probability that the borrower will fail to pay some of the
interest or principal

Government bonds= the safer the credit risk the lower the interest rate

Stock: represents a claim to partial ownership in a firm and is therefore, a claim

to the profits that the firm makes (They are traded on exchanges)

Equity financing: the sale of stock to raise money

Compared to bonds stocks offer both higher ricks and potentially higher returns

Banks:
- They take deposits from people who want to save and use the deposits to
make loans to people who want to borrow
- They pay depositors interest on their deposits and charge borrowers slightly
higher interest on their loans
 Investment or mutual funds: is a vehicle that allows the public to invest in a
selection, or portfolio of various types of shares, bonds, or both shares and bonds
➥ They allow people with small amounts of money to easily diversify

Present value: measuring the time value of money

Present value: refers to the amount of money today that would be needed to
produce, using prevailing interest rates a given future amount of money
➥ It´s concept is useful when we make investment decisions

- In order to compare values at different point in time, compare their present value
- A firm will undertake an investment project if the present value of the stream of
income the project is expected to generate exceeds the present value of the costs

If r is the interest rate, then an amount X to be received in N years has a present

value of: X / (1 + r)n

Future value: the amount of money in the future that an amount of money today
will yield, given prevailing interest rates

Compounding: the accumulation of a sum of money in say a bank account, where the
interest earned remains in the account to earn additional interest in the future

Applying the concept of net present value

- Helps to explain why investment is inversely related to the interest rate
- The quantity of loanable funds demanded declines when the interest rate
rises
- The decision will also have to take account of many other factors such as
risk, changing interest rates and inflation and is thus more complex but the
use of present value aids decision making

if a person exhibits a dislike of uncertainty

Individuals can reduce risk by:

1. Buy insurance 2. Diversify 3. Accept a lower
return on their
investment
The trade-off between risk and return

People face trade-offs:

- People can reduce risk by accepting a lower rate of return
- The choice of particular combination of risk and return depend on a person's
risk aversion, which reflects a person own preferences

Asset valuation

The price of a share of stock is determined by supply and demand

Fundamental analysis: the study of a company´s accounting statements and future

prospects to determine its value
➥ they can employ this to determine if a stock is undervalued (Goal), overvalued,
or fairly valued

Closed economy: one that does not engage in international trade

➥ Their GDP = Y= C + I + G ⇒ Substituting S for Y - C - G ⇒ equation= S = I

Surplus and deficit
● If T>G, the government runs a budget surplus because it receives more
money than it spends (T - G = plus)
● If G>T, the government runs a budget deficit because it spends more money
than it receives in tax revenue (T - G = minus)

Savings must be equal to investment

Investment: In macroeconomics, refers to the purchase of new capital, such as
equipment or buildings.

Saving: If a person spends less than they earn and uses the rest either put in a
bank, or to buy stocks or investment funds.

Investment: is the purchase of new capital (Investment is not a purchase of

stock or bonds !)

Market for loanable funds: is 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 consumption.
A supply–demand model of the financial system helps us understand:
● How the financial system coordinates saving & investment.
● How government policies and other factors affect saving, investment, the
interest rate.
Supply of loanable funds: comes from people who have extra income they want to
save and lend out.
● Households with extra income can lend it out and earn interest.
● Public saving, if positive, adds to national saving and the supply of loanable
funds. If negative, it reduces national saving and the supply of loanable funds.

Demand for loanable funds: comes from households and firms that wish to borrow
to make investments.
● Firms borrow the funds they need to pay for new equipment, factories, etc.
● Households borrow the funds they need to purchase new houses.

Interest rate: is the price of the loan.

● It represents the amount that borrowers pay for loans and the amount that
lenders receive on their saving.
● The interest rate in the market for loanable funds is the real interest rate.
● A high interest rate makes borrowing more expensive, the quantity of loanable
funds demanded falls as the interest rate rises.
● A high interest rate makes saving more attractive, the quantity of loanable
funds supplied rises as the interest rate rises.
Government Policies That Affect Saving and Investment
We can look at three key policy areas:
1. Taxes and saving 2. Taxes and 3. Government
investment budget deficit

Policy 3: Government Budget Deficits and Surpluses

Budget deficit:When the government spends more than it receives in tax
revenues.

National debt: The accumulation of past budget deficits.

Government borrowing to finance its budget deficit reduces the supply of loanable
funds available to finance investment by households and firms.

Crowding out: This fall in investment

The deficit borrowing crowds out private borrowers who are trying to finance
investments.
 Chapter 24: Part 1

Bartering: the exchange of one good for another (requires double coincidence of
wants)

Money: the set of assets in an economy that people use to buy goods and services
from other people
⬇
3 functions:
1. Medium of exchange: an item that the buyer gives to seller when they want
buy goods and services
2. Unit of account: the yardstick people use to post prices and record debts
3. Store value: an item that people can use to transfer purchasing power from
the present to the future

Liquidity: the ease with which an asset can be converted into the economy’s
medium of exchange

- Money is the most liquid asset available

- Other assets (like stocks, bonds, and real estate) vary in their liquidity

➦ Grondstof
Commodity money: has the form of a commodity with intrinsic value (Ex. gold,
cigarettes)

Gold standard: system in which the currency is based on the value of gold and
where the currency can be converted to gold on demand

Fiat money: is used as money because of government degree

➥ It does not have intrinsic value (Ex. coins, currency, current acc. deposit)

Money in the economy

Money stock: refers to the Q of money circulating in the economy

Currency: the paper bills and coins in the hands of the public
 Demands deposits: are balances in bank
accounts that depositors can access on
demand by writing a check or using a debit
card. (Current account)

The role of central banks and money supply

Central bank: an institution designed to oversee the banking system and regulate
the quantity of money in the economy
- Whenever an economy relies on fiat money, there must be some agency that
regulates the system

Money supply: the quantity of money available in the economy

2 function of central bank:

1. Macroeconomic stability in maintaining stable growth and prices and through
the avoidance of excessive and damaging swings in economic activity
2. The maintenance of stability in the financial system

Monetary stability: the set of actions taken by the central bank in order to
affect the money supply

The federal service system

(Fed) Federal Reserve System serves as the nation's central bank:

- It is designed to oversee the banking system
- It regulates the quantity of money in the economy

Open market operations

Open market operations: refers to the purchase and sale of non-monetary assets
from and to the banking sector by the central bank
 - To increase the money supply, the central bank buys bonds from the public
● The amount of currency in the hands of the public increases
- To reduce the money supply, the central bank sells bonds to the public
● The amount of currency in the hands of the public is reduced

Lenders of the last resort

Liquidity: the cash needed to ensure transactions in the financial system are
honoured

Central bank:
- To maintain financial stability, they supply liquidity to the rest of the banking system
- They can step in as a lender for the last resort
- They also assess bank's ability to meet different levels of financial stress and have
the power to impose regulations

European central bank (ECB): the overall central bank of the 19 countries
comprising the European Monetary Union

➥ It was officially created on 1 June 1998 and is located in Frankfurt

➥ It came into being because 11 countries of the European Union had decided that
they wished to enter European Monetary Union and use the same currency

Primary objective of the ECB:

- To promote price stability throughout the euro area

An important feature of the ECB and Euro system is the independence

Euro system: the system made up of the ECB plus the national central banks of
the 19 countries comprising the European Monetary Union

Bank of England: the central bank of the UK

➥ Founded in 1694, but was given independence in the setting of interest
rates only in 1997
Duty: To deliver price stability

Unlike the ECB the Bank of England does not define for itself what is meant by
price stability
How banks make a profit ?
➥ Most banks make profits by accepting deposits and making loans

Spread:the difference between the average interest rate a bank earns on its
assets and the average interest rate paid on its liabilities

Banks hold a friction of the money deposited as reserves and lend out the rest to
make their profit

NOTE: That banks operating under Islamic Sharia principles make profits from
the sharing of risk and reward between lenders and borrowers

A banks balance sheet

Assets (activa): include reserves of cash, securities it hold, and loans ->(to others)

Liabilities (schulden): include demand deposits, saving deposits, borrowing from

other banks in the interbank market. Its assets must equal its liabilities plus equity
capital.

➦ The bank must keep !

Reserves (bezittingen): are deposits that banks received but have not loaned out
in order to cover possible withdrawals

Frictional-reserve banking system => banks hold a fraction of the money deposited
as reserves and lend out the rest

Reserve ratio: the fraction of deposit that banks hold as reserves

Money creation with frictional-reserve banking

When a bank creates a loan to others from its reserves, the money supply
increases

The money supply is affected by the amount deposited in banks and the amount
that banks loan
A central bank has three main tools in it´s monetary toolbox:
1. Open-market operations: it is conducted when government CB buys
government bonds from, or sell government bonds to the public
- CB buys government bonds ⇒ money supply increase
- CB sells government bonds ⇒ money supply decreases

2. US: changing the reserve requirement: are regulations on the minimum

amount (%) of reserves that banks must hold against deposits (Fed use it to
influence money supply)
- Increasing reserve requirement ⇒ decrease the money supply
- Decreasing reserve requirement ⇒ increase the money supply

3. Changing the refinancing rate: the interest rate the ECB lends on a
short-term basis to the euro area banking sector
- Increasing refinancing rate ⇒ decrease the money supply
- Decreasing refinancing rate ⇒ increase the money supply

4. Quantitative easing (QE)

- Purpose: to put banks in a better position to be able to lend and in so to help
boost the demand
- Process: involves the CB buying assets
Chapter 24: Part b