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Chapter 26

Chapter 26 Economics.docx

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Economics 10b
Gregory Mankiw

Chapter 26 Economics: Saving, Investment, and the Financial System • Financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment • Financial markets: financial institutions through which savers can directly provide funds to borrowers o Bond Market: a company/government can borrow directly from the public by selling bonds  Bond: a certificate indebtedness that specifies the obligations of the borrower to the holder of the bond; states the date of maturity and the rate of interest earned on the bond • Date of maturity: the time at which the loan will be repaid • Principal: repayment of the amount borrowed  Abuyer can hold a bond until the date of maturity or sell the bond at an earlier date to someone else  Debt finance: the sale of bonds  Characteristics of bonds: • Term: the length of time until the bond matures o Perpetuity: a bond that never matures, but pays interest forever that was issued by the British government o Long term bonds are risker than short-term bonds because the holders of the long term bonds have to wait longer for repayment of principal  If the owner of the bond needs money before the date of maturity, he must sell the bond to someone else probably at a reduced price  As a result of the higher risk, long term bonds pay higher interest • Credit Risk: the probability that the borrower will fail to pay some of the interest or principal o Default: failure to pay; sometimes borrowers do this by declaring bankruptcy o When bond buyers perceive the chance of default to be high, they will demand a higher interest o Junk bonds: high interest bonds issued by financially shaky corporations • Tax Treatment: the way the tax laws treat the interest earned on the bond; most bonds have taxable interest o Municipal bonds: bonds issued by the state and local governments on which bond owners are not required to pay federal income tax on the interest income  As a result, they typically pay lower interest rates  Because government bonds are believed to be more secure, they pay lower interest rates  Corporations receive credit ratings from private agencies like Standard & Poor o Stock Market:  Stock: a claim to partial ownership in a firm  Equity finance: the sale of stock to raise money o The owner of a stock is a part owner of the corporation, whereas the owner of a bond is a creditor of the corporation  If the company is profitable, the stockholders enjoy the benefits of the profits, whereas bondholders only get the interest on their loans  If the company runs into financial difficulty, the bondholders are paid what they are due before the stockholders are paid anything at all  Stocks offer higher risks than bonds, but also a potentially higher return o Acorporation receives no money when its stock changes hands o American stock exchanges: The New York Stock Exchange, theAmerican Stock Exchange, and the NASDAQ (NationalAssociation of Securities DealersAutomated Quotation system)  Other countries have their own stock exchanges o The demand for stock (its price) reflects people’s perception of the corporation’s future profitability  When people are optimistic about a company’s future, then they will bid up the price of the stock; when people are pessimistic about a company’s future, the stock price falls o Stock index: an average of a group of stock prices  The Dow Jones IndustrialAverage (computed since 1896) is based on 30 major U.S. companies (General Electric, Microsoft, Coca-Cola, Walt Disney Company,AT&T, and IBM)  Standard & Poor’s 500 Index: based on the prices of the stocks of 500 major companies  Because stock prices reflect expected profitability, these stock indexes are watched closely as possible indicators of future economic conditions • Store of value for the wealth that people have accumulated in past saving: stocks, bonds, and bank deposits • Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers from savers o Banks: Because a small business cannot issue stocks or bonds profitably, it will finance its business expansion from a local bank  Banks take in deposits from people who want to save and use these deposits to make loans to people who want to borrow • Banks pay interest to savers and receive slightly higher interest from borrowersthe difference between these interest rates covers the banks’ costs and returns profit to the owners of the bank  Banks create an asset that can be used a medium of exchange (an item that people can easily use to engage in transactions) • They facilitate the purchase for goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards o Mutual fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio (selection) of stocks and bonds  The shareholder accepts the risks associated with the portfolio, making money when the value of the portfolio rises and losing money when the value of the portfolio falls  People who hold a diverse portfolio of stocks and bonds face less risk because they only have a small stake in each company  Mutual funds charge a fee of operating said mutual funds (usually between .5- 2% of assets each year)  Mutual funds give people access to the skills of professional money managers, which should increase the return that mutual fund depositors earn on their savings  Index funds: a type of mutual fund that buys all the stocks in a given stock index • As a result, they perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers because they keep costs low by buying/selling rarely and by not paying the salaries of professional money managers o Other financial institutions: credit unions, pension funds, insurance companies, loan sharks • What to watch when following stocks: o Price of a share:  Last/closing price: price of the last transaction that occurred before the stock exchange closed in its most recent day of trading o Dividend: the profit paid out by corporations to their stockholders  Retained earnings: profits not paid out  Dividend yield: the dividend expressed as a percentage of the stock’s price o Price-earnings ratio:  Acorporation’s earnings (accounting profit): the amount of revenue it receives for the sale of its products minus its costs of production as measured by its accountants  Earnings per share: the company’s total earnings divided by the number of shares of stock outstanding  Price-earnings ratio (P/E): the price of a corporation’s stock divided by the amount the corporation earned per share over the past year • Typically, about 15 o Higher P/E indicates that a corporation’s stock is expensive relative to its recent earnings (stock is either overvalued or people are expecting earnings to rise) o Lower P/E indicates that a corporation’s stock is cheap relative to its recent earnings, indicating that people expect earnings to fall or that the stock is undervalued o Buy and hold strategy: buy the stock of a well-run company and do not respond to its daily fluctuations • Financial Crisis: o Large decline in some asset prices like real estate (as in 2008-2009) o Insolvencies at financial institutions like banks defaulting from unpaid housing loans o Decline in confidence in financial institutions:  Not all banks were insured by the government (FDIC)  Worried about bankruptcy from people withdrawing their money, banks started selling off assets (fire-sale) and cut back on new lending o Credit crunch: the financial system has trouble fulfilling its normal duties like giving credit to entrepreneurs with credible ventures o Economic downturn: With people unable to obtain financing for new investment projects, the overall demand for goods/services declinesnational income falls and unemployment rises o Vicious cycle: the economic downturn reduced the profitability of many companies and the value of many assets, returning to decline in asset prices that sparked the financial crisis • Accounting: how various numbers are defined and added up • GDP: both total income in an economy and the total expenditure on the economy’s output of goods and services • Y = C + I + G + NX o GDP = Consumption + Investment + Government Purchases + Net Exports o Assume the economy is closed, meaning that it does not interact with other economies (meaning no international trade in goods/services or international borrowing/lending) NX = 0  Y = C + I + G o Actual economies are open: they interact with other economies around the world o Y – C – G = I  S = I  Total income that remains in the economy after paying for consumption and
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