ECON1010 Lecture Notes - Lecture 6: Real Interest Rate, Nominal Interest Rate, Demand Curve
Lecture 6
Financial system is the group of financial institutions in the economy that help match oe persons saving with
another persons investment
- The reallocation of scarce resources from savers to borrowers happens primarily through financial
institutions
2 MAIN TYPES OF FINANCIAL MARKETS
Financial markets: direct link between savers and borrowers
- Institutions through which savers can directly provide funds to borrowers
- Bond market
- Stock market (ASX)
Financial intermediaries: indirectly
- Banks – indirect link between savers and borrowers
- Managed funds
Others:
- Credit unions
- Pension (superannuation) funds
- Insurance companies
FINANCIAL MARKETS: THE BOND MARKET
- Bond is a certificate of indebtedness (IOU)
- Specifies obligations of the borrow to the holder of the bond
Bonds are issued by governments and large corporations
CHARACTERISTIC OF A BOND
Term: length of time until maturity: until the loan has to be repaid by periodical interest payments.
- Can be few months, years or infinity
Credit Risk: the probability of default
- The probability that the borrower will fail to pay some of the interest or principal
What is considered to be the safest bond
- In Aus, government bonds are considered to be one of the safest
Is there any relationsip between riskiness and return/interest?
- In general, higher risk has to be compensated by higher return
Tax Treatment: the way In which the tax laws treat the interest on the bond
- In Aus, interest earned on bonds is taxed as any other form of income. In the US, municipal bonds are
federal tax exempt
FINANCIAL MARKETS: THE STOCK MARKET
A share is a claim to partial ownership in a firm. Including some of the profits the firm makes
- The sale of stock to raise money is called equity financing.
Compared to bonds, do shares offer higher/lower risk/returns?
- Shares tend to be riskier, therefore offer higher returns
- Share (a part owner) vs. Bond (a creditor)
- Make a differences when the corporations are doing well/losing money
THE STOCK MARKET
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What is the most important stock exchange in Australia?
- the Australian Stock Exchange (ASX).
What information do most newspaper stock tables provide?
- Price (of a share)
- Volume (number of shares sold)
- Dividend (profits paid to stockholders)
- Price-earnings ratio. → market value per share / earnings per share
o The amount to be invested in a company to receive on dollar of that companys earning
FINANCIAL INTERMEDIARIES: INDIRECT BORROWING
BANKS
- Take deposits from people who want to save & use deposits to make loans to people who want to
borrow
- Pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans
Difference between retail & investment banking –
- Both take deposits and make loans, but
o retail banks primarily focus on individual customers
o investment banks on institutional clients
Banks also help create a medium of exchange by allowing people to write cheques against their deposits or
use credit cards
Medium of exchange – an item that people can easily use to engage in transactions
- Facilitates the purchases of goofs and services
Baks a reate oe out of thi air.
- It is an unsettled issue, but the credit creation theory of baking every banks can create money :out of
othig etedig redit. Ca e a prole eause it akes the ontrol of the money more
difficult
FINANCIAL INTERMEDIARIES: MANAGED FUNDS
Managed fund
- Collect sole amounts of investors
- Invest in different shares
o Good so they can reduce the risk of the investment
- Provide portfolio of shares/bonds to investors
Does it sell or buy share
- They allow people with small amounts of money to easily diversify their portfolio
Portfolio and Diversification
- Portfolio is a pool of different of financial assets
- Diversification means that a wide range of investments Is mixed within a portfolio in order to achieve
higher returns at a lower risk than the individual investments in the portfolio
SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS
- ‘eall that GDP is oth total ioe i a eoo ad total epediture o the eoos output of
goods and services:
Y = C + I + G + NX
- Assume a closed economy – one that does not engage in international trade (imports and exports are
zero):
Y = C + I + G
- subtract C and G from both sides of the equation:
Y – C – G = I
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find more resources at oneclass.com
Document Summary
Financial system is the group of financial institutions in the economy that help match oe persons saving with another persons investment. The reallocation of scarce resources from savers to borrowers happens primarily through financial institutions. Financial markets: direct link between savers and borrowers. Institutions through which savers can directly provide funds to borrowers. Banks indirect link between savers and borrowers. Specifies obligations of the borrow to the holder of the bond. Bonds are issued by governments and large corporations. Term: length of time until maturity: until the loan has to be repaid by periodical interest payments. The probability that the borrower will fail to pay some of the interest or principal. What is considered to be the safest bond. In aus, government bonds are considered to be one of the safest. In general, higher risk has to be compensated by higher return. Tax treatment: the way in which the tax laws treat the interest on the bond.
