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Lecture 5

EC140 Lecture Notes - Lecture 5: Negative Relationship, Risk Premium, Negativ


Department
Economics
Course Code
EC140
Professor
Ken Jackson
Lecture
5

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

channels through which saving ows to nance investment in new capital that
grows the economy

providing the funds that nance expenditures on capital. The study of
nance looks at how households and rms obtain and use nancial resources,
how they cope with the risks
 used to pay for goods& services and FoP and to make nancial
transactions; how we use it, how much we hold, how banks create and manage
it, and how its quantity inuences the economy.
 
: items produced in the past and are used to produce
goods/services. Inventories of raw materials, semi-nished goods, and
components are part of physical capital
: funds that rms use to buy physical capital
Along the aggregate production function, the quantity of capital is xed. An
increase in the quantity of capital increases production possibilities and shifts
the function upward.

 increases the quantity of capital;  decreases the
quantity of capital
!: total amount spent on new capital and on replacing
depreciated capital
" change in value of capital = 

#
#: value of all things that people own; related to what they earn (income:
amount received during a given time period from supplying the services of the
resources they own)
$Increases when market value of assets rises (%and vice versa
(%
 income not paid in taxes or spent on consumption goods/ services.
Saving increases wealth.
"&: wealth at start year + saving during the year = income –
consumption expenditure
To make real GDP grow, saving and wealth must be transformed into investment
and capital.

Firm that operates on both sides of nancial capital markets borrower in one,
lender in another.
Financial markets are highly competitive because nancial institutions stand
ready to trade so people with funds to lend and people seeking funds can always
nd someone with whom to trade
' (: accept deposits and use the funds to buy government bonds and other
securities to make loans. Distinguished from other nancial institutions because
bank deposits are money.

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) *: similar services to banks. Largest of them are
owned by banks. They accept deposits, make personal and mortgage loans, &
administer estates, trusts, pension plans.
+ ,banks owned/controlled by their
depositors& borrowers. Regulated by provincial rules, operate only in their
provincial boundaries. Large number, small size.
 - receive pension contributions of rms and workers. They buy
bonds and stocks that they expect to generate an income that balances risk and
return. The income pays pension benets. Some pension funds invest in
mortgage-backed securities.
.  provide risk-sharing services. Enter into agreements to
provide compensation in event of accidents. They receive premiums from
customers and make payments against claims.
$Use the funds to buy bonds/stocks on which they earn an interest income
$Insure corporate bonds and other risky nancial assets  if a rm cannot
meet bond obligations.
$ " steady ow of funds from premiums and interest on the
nancial assets they hold and a steady but smaller ow of funds paying
claims. Prot is the gap between the 2 ows.
$ / when large losses are being incurred, they face di7culty
meeting obligations.
012
A nancial institution’s &: total market value of what it has lent minus
what it has borrowed.
$If positive, the institution is and can remain in business
$If negative, it is and goes out of business. The owners of an
insolvent nancial institution (usually its stockholders) bear the loss when the
assets are sold and debts paid.
A nancial institution borrows and lends, so its net worth might become
negative. To limit that risk, institutions are regulated and a minimum amount of
their ending must be backed by their net worth
Firm is 1if it made long-term loans with borrowed funds and is faced with
demand to repay more of what it has borrowed than its available cash. In normal
times, an illiquid nancial institution can borrow. But if all are short of cash,
market for loans among nancial institutions dries up.
- 
Saving is the source of the funds used to nance investment, and these funds
are supplied/demanded in 3 types of nancial markets
' 0bank loans, sometimes in form of outstanding credit card
balances
$Business often want short-term nance to buy inventories or extend credit to
their customers
$Households often want nance to purchase big-ticket items
$Households also buy new homes (investment) funds usually obtained as a
loan secured by a legal contract that gives ownership of a home
to the lender in the event that the borrower fails to meet the agreed loan
payments (repayment + interest)
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) ( bond is a promise to make specied payments on specied
dates
$Government of Canada issues promises called *23raise nance
by issuing bonds
$Buyer of a bond loans to the company and is entitled to payments promised
by the bond. When a person buys a new bond, he may hold bond until
borrower has repaid, or sell the bond.
$The term of a bond might be long or short (decades vs. few months). Firms
often issue short term bonds as a way of getting paid for their sales before
the buyer is able to pay.
$ 2promise a stated payment of  on specic
date, + periodic payments (%until that date
$ $2bond entitles its holder to income from a
package of mortgages. Mortgage lenders create mortgage backed securities.
They make mortgage loans to home buyers, and then create securities that
they sell to obtain more funds to make mortgage loans. The holder of a
mortgage backed security is entitled to receive payments that derive from
the payments received by the mortgage lender from the home
buyer/borrower.
$ *24% carry no stated coupon rate. Return from buying and
holding a Treasury bill derived from di?erence between price paid to acquire
the bond, and the -4to be received at stated future date). The
smaller the price, the larger the return. Strip = principal.
$ 5-64'7%683
-69
+ -inancial market in which shares of stocks of corporations are
traded
$ certicate of ownership and claim to the rm’s prots
$Ownership of the company = entitled to some of its prots

The  of a nancial asset is the interest received expressed as a %
of the asset’s price
Stocks, bonds, short-term securities and loans are collectively called 

Price of an asset and the interest rate of the asset are determined
simultaneously
"between interest rates and asset prices
1. The market interest rate is negatively related to the price of a bond
2. The market interest rate is positively related to the yield on any given bond
If interest rate rises, price falls, debts are harder to pay, net worth of nancial
institution falls   can arise from previously unexpected large rises in
the interest rate
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