Topic 6

Money

medium of exchange consisting of bank notes and deposits, or anything else which can be used to purchase goods and services. It allows for purchasing power to be transferred between people allowing for an exchange between goods and services. 

why does moneys value decrease by day

Decreases value day by day because it has the potential to be invested and gain interest 

Wealth

Stock of things owned or value of that stock. It includes the market value of a home, car, any land, buildings, machinery or other capital goods that a person may own. 

Depreciation

The loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).

Income

the amount of money you receive over some period of time. 

Formula for net income

Gross income minus depreciation

Consumption expenditure

Expenditure on consumer goods including both short-lived goods and services and long-lived goods, which are called consumer durables

Investment (expenditure):

expenditure on capital goods, which are goods such as machinery or buildings.

What is a balance sheet

A record of the assets, liabilities, and net worth of an economic actor such as a household, bank, firm, or government

Assets

what you own (including what you are owed by others)

liabilities

what you owe others

Net worth

the difference between your assets and liabilities or shareholder equity (accumulated profit over time). 

formula for assets

liabilities+net worth

Commercial Bank

a firm which makes profits through lending and borrowing activities. The terms on which banks lend to households and firms differ from their borrowing terms.

features of a commercial bank?

• Profit driven; serves firms and individuals

• Accept deposits, provide loans, payment services

• Create money through lending

• Highly supervised by their respective central bank

• EG. ABNamro, ING 

Central bank

creates the money supply for an economy through injection; controls the interest rate and exchange rate. 

Features of the central bank

• Lend to governments, commercial banks

• Usually government owned (self regulated but under government mandates)

• EG. European central bank, federal reserve (the US)

Base money

Cash held by households, firms, and banks, and the balances held by commercial banks in their accounts at the central bank, known as reserves. Base money is the liability of the central bank→to print the money there is a liability because they owe it to the people. 

It's the money created by the central bank and acts as the foundation for the country's entire money supply

Bank money

money in the form of bank deposits created by commercial banks when they extend credit to firms and households. Bank money is the liability of commercial banks. All possible loans

Broad money

base money+bank money 

Maturity transformation

The practice of borrowing money short-term and lending it long-term. For example, a bank accepts deposits, which it promises to repay at short notice or no notice, and makes long-term loans (which can be repaid over many years)

liquidity risk

The risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss. (the bank cant pay back deposit money fast enough)

Banks should have enough base money for this reason 

Default risk

The risk that credit given as loans will not be repaid. (depositer cant pay back the loan)

Equity

equity refers to the value of an ownership stake in an asset or company after all liabilities (debts) have been paid. EG. a houses current value

Costs and revenues of banks

Operational costs

The banks interest costs

The banks revenue
The banks expected return

The banks revenue

 interest on and the repayment of the loans it has extended to its customers. 

What is secured borrowing

• Collateral is pledged: You offer a valuable asset that you own as security for the loan. This asset is subject to a lien, which is a legal claim the lender has against it.

leverage

the reliance a company has on debt. 

assets/liabilities

Lead up to the 2008 crisis

rising debt

rising house prices

increasing inequality

how does collateral connect to the crisis

• You can use a house you donʼt own as collateral and borrow more

• When people expect prices to rise they expect value of collateral to increase and borrow more

Financial accelerator

The mechanism through which firms’ and households’ ability to borrow increases when the value of the collateral they have pledged to the lender (often a bank) goes up.

Financial deregulation—banks increase their borrowing in order to…

1. to extend more loans for housing

2. to extend more loans for consumer durables like cars and furnishings

3. to buy more financial assets based on bundles of home loans

being leveraged means…

using borrowed money to boost an investment

being highly leveraged means…

if majority of an investment is using borrowed money

why does a long period of economic stability make a crisis more likely to happen

• People become overconfident,

• Firms and banks take on more risk,

• And this builds up the conditions for a crisis.

positive feedback loops in the 2008 crisis

• Initial decline in house prices

• More foreclosure

• Financial loss from mortgages being defaulted

• Credit crunch

• Banks unwilling to lend because of default risk

• Fire sale 

Foreclosure PFL

properties that lenders repossess and sell after the original homeowner defaults on their mortgage payments, aiming to recoup their losses

• many people owe more than the house is worth.

• if people face more financial strain, they are more likely to default.

• foreclosed houses increase

Financial Losses from Mortgage Defaults

PFL

more foreclosures lead to more financial losses, foreclosed houses sell at steep discounts, meaning they only recover a fraction of the original mortgage rate.

Credit Crunch PFL

a sudden, sharp decrease in the availability of loans or a severe tightening of lending standards by banks

banks become unsure about which assets are safe so they pull back on lending to businesses, households and each other

fire sale PFL

is the rapid sale of goods or assets at heavily discounted prices, typically because the seller is in urgent financial distress or facing other pressure to liquidate inventory quickly. 

banks need to meet the financial obligations hey must sell their own assets quickly such as: Corporate bonds and Other financial assets—>this leads to the value of assets being pushed down.

Why do fire sales relate to decreased house prices

Because Lower calue of mortgage-backed securities.

Explain the general PFL

House price decline → more foreclosures → losses on mortgage-backed assets → reduced bank capital → credit crunch → banks stop lending → forced asset sales (fire sales) → asset prices fall → house prices fall further → repeat