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Summary economics IB year 2 Q1
A summary written about the course taught at Avans, in year 2, the first quarter, all required learning included.
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Chapter 24 – Saving, investment and the financial systemThe financial system 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 its GDP, more resources are available for investment in capital, and higher
capital raises a country’s productivity and living standard.
The financial system is made up of various financial institutions that help coordinate
savers and borrowers. Financial institutions can be grouped into 2 categories:
financial markets and financial intermediaries.
Financial markets are the institutions through which a person who wants to save
can directly supply funds to a person who wants to borrow. 2 of the most important
are the bond market and the stock market.
The bond market
A bond is a certificate of indebtedness that specifies the obligations of the borrower
to the holder of the bond. 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 (coupon
rate) until the loan matures. 2 important characteristics of a bond:
1. A bond’s term – the length of time until the bond matures. The interest rate
depends on its term. Long-term bonds are riskier than short-term bonds
because they have to wait longer for repayment.
2. Its credit risk – the probability that the borrower will fail to pay some of the
interest or principal. Such a failure to pay is called a default. Borrowers can
default on their loans. When bond buyers perceive that the probability of
default is high, they demand a higher interest rate.
When national governments want to borrow money to finance public spending, they
issue bonds – sovereign debt. Some government bonds are considered a safe credit
risk, some are referred to as gilt-edged bonds, those are ‘as good as gold’. In
financially shaky corporations they are junk bonds, high risk with high interest.
The yield of the bond is given by the coupon/price x 100
There is an inverse relationship between price and yield. As bond prices rise, the
yield falls etc.
Bond prices are affected by existing bonds in the market, the issue of new bonds, the
likelihood of the bond issuer defaulting and interest rates on other securities. The
issue of a new bond is also affected by these factors. If current interest rates are
high, new issues have to have a coupon which will compete etc.
The stock market
Stock (or share or equity) represents ownership in a firm and is, therefore, a claim
to the future profits that the firm makes.
The sale of stock to raise money is called equity finance, whereas the sale of bonds
is called debt finance.
,Corporations can issue stock by selling shares to the public through 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.
A stock index is computed as an average of a group of share prices.
Because share prices reflect expected profitability, stock indices are watched closely
as possible indicators of future economic conditions.
Financial intermediaries
Financial intermediaries are financial institutions through which savers can
indirectly provide funds to borrowers. 2 of the most important: banks and investments
funds.
Banks
Banks are the 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. Banks pay depositors interest
on their deposits and charge borrowers slightly higher interest on their loans. The
difference between these rates of interest covers the banks’ costs and returns some
profit to the owners of the banks.
Banks play a second important role in the economy: the facilitate purchases of goods
and services by allowing people to draw against their deposits, or to use debit cards
to transfer money electronically from their account to the account of the person or
corporation they are buying from.
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. Stocks and bonds, like bank deposits, are a possible store of value for
the wealth that people have accumulated in past saving.
Investment funds
An investment or mutual fund 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.
The shareholder of the fund accepts all the risk and return associated with the
portfolio. If the value of the portfolio rises, the shareholder benefits, and the other
way around.
The primary advantage of these funds is that they allow people with small amounts of
money to diversify. Closely related to investment funds are unit trusts, the difference
being that when people put money into a unit trust, more units or shares are issued,
whereas the only way to buy into an investment fund is to buy existing shares in the
fund. For this reason, unit trusts are sometimes referred to as ‘open-ended’.
, Other financial instruments
Collateralized debt obligations (CDOs) 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 from these assets. In setting up a CDO, a manager encourages
investors to buy bonds, the funds of which are used to buy pools of debt – mortgage
debt. This debt is split and rated according to its risk into tranches; low-risk tranches
attract low interest rates whilst the riskier tranches attract higher interest rates.
Problems for CDOs began when holders of sub-prime mortgages began to default on
payments. The sub-prime market offered mortgage opportunities to those not
traditionally seen as being part of the financial markets because of their high credit
risk and was part of the way in which banks and other landers sought to increase
their lending.
A credit default swap (CDS) is a means by which bondholders can insure
themselves against the risk of default.
Saving and investment in the national income accounts
GDP is both total income in an economy and the total expenditure on the economy’s
output of goods and services. GDP is divided into 4 components of expenditure:
Y = C + I + G +NX
This equation is an identity because every euro of expenditure that shows up on the
left-hand side also shows up in one of the 4 components on the right-hand side.
A closed economy is one that does not interact with other economies, does not
engage in international trade in goods and services, and does not engage in
international borrowing and lending. Open economies interact with other economies
around the world. For now we assume a closed economy: Y = C + I + G
Also: Y – C – G = I
What remains after paying for consumption and government purchases is called
national saving. Given Y – C – G = S S=I
S = (Y – T – C) + (T – G)
This last equation separates national saving into 2 pieces: private saving (Y – T – C)
and public saving (T – G). Private saving is the amount of income that households
have left after paying their taxes and paying for their consumption. Public saving is
the amount of tax revenue that the government has left after paying for its spending.
If T exceeds G, the government runs a budget surplus because it receives more
money than it spends. This surplus represents public saving. If the government
spends more than it receives in tax revenue, the government runs a budget deficit,
and public saving is a negative number. In this case the government has to borrow
money to fund spending by issuing sovereign debt in the form of bonds.
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