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Economics Summary
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EconomicsChapter 24
In order to carry out business in any sort, firms have to have capital. There are various ways
to finance capital investment, such like borrowing money from a bank or from a relative. This
type of borrowing involves a promise not only to return the money at a later date but also to
pay interest for the use of money. The financial systems consists of those institutions in the
economy that help to match one person’s saving with another person’s investment. Saving
and investment are key ingredients to long-run economic growth: when a country saves a
large portion of it’s GDP (Gross Domestic Product total income in an economy and
the total expenditure on the economy’s output of goods and services), more resources
are available for investment in capital, and higher capital raises a country’s productivity and
living standard. There is a proportion of income that is not spent and which is saved, at the
same time there are economic actors who want to borrow in order to finance investments in
new and growing businesses. The financial systems moves the economy’s scare resources
from savers (who spend less than they earn) to borrowers (people who spend more than
they earn). Savers supply their money with the expectation that the reward for saving will be
interest. Borrowers demand money from the financial system with the knowledge that they
will be required to pay it back with interest at a later date. The financial system is made up of
various financial institutions that help coordinate savers and borrowers, which can be
grouped into two categories: financial markets and financial intermediaries.
Financial markets
Financial markets are the institutions through which a person who wants to save money can
directly supply funds to a person who wants to borrow. Two of the most important financial
markets in advanced economies are the bond market and the stock market. A bond is a
certificate of indebtedness that specifies the obligations of the borrower to the holder of the
bond if a big company wants to borrow finance for a big project it can borrow directly from
the public, it does this by selling bonds. A bond is a IOU (accounts receivable), 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 periodically until the loan matures. The buyer of a bond gives their money to
a big company in exchange for this promise of interest and eventual repayments. The buyer
can hold the bond until maturity or sell the bond at an earlier date to someone else.
Bond differ in many ways, two characteristics of bonds are most important. The first
characteristic is a bond’s term – the length of time until the bond matures. Long-term bonds
are riskier due to the fact that it takes longer to get the full amount back, if a buyer of a bond
needs its money earlier than the bond matures than the buyer has to sell the bond to
someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds
usually pay higher interest rates than short-term bonds. The second most important
characteristic of a bond is its credits risk – the probability that the borrower will fail to pay
some of the interest or principal. Such a failure is called a default. Borrowers can default on
their loans. When the probability of default is high, the bond buyers demand a higher interest
rate to compensate them for this risk. When governments issues bonds they often called it
sovereign debt. Governments with good bonds have come to be referred to as gilt-edged
bonds, or more simply as gilts, in term of credit risk they are “as good as gold” (early bond
certificates had a golden edge – hence the term “gilt edged”). In contrast, shaky corporations
raise money by issuing junk bonds, which pay very high interest rates; over the years some
countries’ debt has been graded as “junk”. Buyer can check credit risk by checking earlier
bonds, sometimes these bonds are referred to as bellow investment grade bonds.
The yield of the bond is given by: coupon / price x 100 (price is quoted as a percentage of
the principal) principal = the original amount of money the bond certificate is sold. If the
bond holder needs to get access to cash quickly, they will sell their bond for the price of the
bond market (coupon). Reasons why bond prices rise and fall:
Demand of bonds
Supply of bonds
The issue of new bonds
Interest rates
Likelihood of the bond issuer defaulting
Stock represents the ownership in a firm and is, therefore, a claim to the future profits that
the firm makes. A stock can also be referred as a share or as an equity. The sale of stock to
raise money is called equity finance, whereas the sales of bonds is called debt finance.
Example: the owner of BP shares is a part owner of BP; the owner of a BP bond is a creditor
of the corporation. Compared to bonds, stocks offer the holder both higher risk and
potentially higher return; if BP is making more money the shareholder will get more money,
but the bond owner will still receive the same amount of interest vice versa. Corporations
can sell stocks to the public through organized stock exchanges. These first time sales are
referred to as primary market. Shares that are subsequently trade among stockholders on
stock exchanges are refers to as secondary market. Various stock indices are available to
monitor overall level of stock prices for any particular stock market. A stock index is
computed as an average of a group of share prices.
Financial intermediaries
Financial intermediaries are financial institutions through which saver can indirectly provide
funds to borrowers. The term intermediary reflect the role of these institutions in standing
between savers and borrowers. Here we consider two of the most important financial
intermediaries – banks and investment funds. Banks are financial intermediaries with
which people are most familiar with. Primary function of banks take in deposit from people
who want so save and use these deposits to make loans to people who want to borrow.
Banks pay depositors interest on their deposits and charge borrowers slightly higher interest
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