Studied by 9 people
Wealth
A stock variable (measured one time). It is everything you own (real estate, machinery, capital goods) - the debt you owe + debt owed to you
Bond
A security that promises to pay fixed amount of money at specific intervals
e.g you loan money to the government in return for a agreed rate of interest decided by the bond-coupon
Usually over a long period of time (10-30 years)
if you loan 1000€ for 10 years with a 5% interest, you get paid 50€ every year.
Considered as a low risk investment
Income
The amount of money one receives over some period of time
Depreciation
Reduction in the values of a stock or wealth over time
Net income
Gross income- depreciation
Earnings
Income from labor
Savings
Income that is not consumed
Investment
Expenditure on newly produced capital goods that is going to be used to make new goods and services.
Interest rate
The price of bringing some buying power forward in time
What decides the amount of consumption an individual will bring forward?
Consumption smoothing
Impatience
Consumption smoothing
Consumption smoothing is the strategy of maintaining a stable level of spending over time by saving during periods of high income to cover expenses during periods of low income.
Diminishing marginal returns to consumption
The value of an additional unit declines, the more consumption the individual has
Pure impatience
myopia; (short-sightedness): People experience the present satisfaction more strongly than the same satisfaction later
Prudence; People know that they may not be around in the future, and so they want to consume now
What is the consumer’s optimal point of consumption?
Where their discount rate (MRS) is tangent with the rate of interest (MRT)
Reservation indifference curve
All of the points at which the individual would be just as well off as at the reservation position (endowment)
Endowment
The facts about an individual may affect their income, such as the physical wealth a person has, either land, housing, or a portfolio of shares (stocks). It also includes other relevant qualities such as schooling, gender, etc.
For a borrower, their endowment refers to the resources they already have available to them before engaging in borrowing. This could include cash reserves, assets, or any other form of wealth that they can utilize to fulfill their borrowing needs.
For a saver, their endowment represents the resources they allocate towards saving or investing. This could include income, assets, or any other form of wealth that they set aside for future use.
Balance sheet
Summarises what the household or firm owns, and what it owes to others
Asset
Anything of value that is owed; liabilities + net worth
Liabilities
Anything of value that is owed
Net worth
Assets- liabilites
Stock
A part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm’s profit and to benefit when the firm’s assets become more valuable
Central bank
A central bank is a financial institution that manages a country's currency, money supply, and interest rates to stabilize the economy and control inflation.
The CB acts as the banker for the commercial banks, who have accounts at the central bank that hold legal tender
Legal tender
Currency that must be accepted for payment of debts and obligations within a specific jurisdiction.
Base money
Base money refers to the total amount of physical currency in circulation and the reserves held by the central bank. It is also known as high-powered money.
Bank Money
The money that commercial banks create by making loans
a liability to the bank
banks earn profit by charging interest on bank money
≠ legal tender
Broad money
base money + bank money
Default risk
Default risk is the likelihood that a borrower will not be able to repay a loan or meet their debt obligations, leading to financial loss for the lender.
e.g. mortgage loan, your house is at risk if you don’t pay the loan bank
Liquidity risk
Liquidity risk refers to the possibility of not being able to buy or sell an asset quickly without affecting its price.
Systematic risk
A risk that affects all assets in the market, so that it is not possible for investors to reduce their exposure to the risk by holding a combination of different asset
aka. undiversifiable risk
Idiosyncratic risk
A risk that only affects a small number of assets at one time. Traders can almost eliminate their exposure to such risks by holding a diverse portfolio of assets affected by different risks
aka diversifiable risk
Maturity transformation
Maturity transformation is a banking strategy where short-term deposits are used to fund long-term loans, profiting from the interest rate spread.
Since short-term deposits can be taken out at any time, this creates liquidity risk
Liquidity transformation
Liquidity transformation is the process where financial institutions convert short-term liabilities into long-term assets, balancing liquidity needs.
Market capitalization rate
The rate of return that is just high enough to induce investors to hold shares in a particular company. This will be high if the company is subject to a high level of systematic risk.
Fundamental value of share
The share price based on anticipated future earnings and the level of risk.
Bank-run
A situation where all depositors demand their money at once; may result in bank failure
Policy interest rate
The interest rate on base money, set by the central bank to influence monetary conditions, inflation, and economic growth in a country.
Affects the level of spending in the economy, because households and firms borrow to spend
Bank lending rate
The average interest rate charges by commercial banks to firms and households
Official rate
Official rate is the exchange rate set by the government or central bank, used for official transactions and to control the value of the national currency.
Leverage
Refers to the ability to use borrowed funds or financial instruments to amplify the potential returns of an investment or business activity
In order to increase profit, one would like to decrease net worth and increase total assets
From a risk POV, higher leverage makes it more likely that you will be insolvent (unable to pay debts owed)
Principal-agent problem
A conflict of interest between principal and agent, about some hidden action or attribute of the agent that cannot be enforced or guaranteed in a binding contract.
What can be done in order to resolve the conflict of interest between the principal (lender) and the agent (borrower)?
Equity: the lender may require the borrower to put some of her wealth into the project
Collateral: the borrower has to set aside property that will be transferred to the lender if the loan is not repaid
Credit rationing
When those with less wealth are credit-constrained or credit excluded
credit constrained, borrow on unfavorable terms compared with those with more wealth
Credit excluded, poor people are refused a loan
Explain the mechanism behind how lowering the official rate by the Central Bank stimulates consumption and investment
Change in base money: The central bank typically implements monetary policy by adjusting the base money supply, which includes physical currency and commercial bank reserves
Change in Credit Provision by Commercial Banks: owering the central bank's interest rate makes it cheaper for commercial banks to borrow money from the central bank. As a result, commercial banks are encouraged to lend more money to businesses and consumers at lower interest rates.
Change in Bank Money: When commercial banks lend money to businesses and consumers, they create bank money. This is money in the form of deposits that can be used for transactions.
Change in Broad Money: Broad money refers to the total money supply within an economy, including both base money and bank money. As commercial banks increase their lending in response to lower interest rates, the broad money supply expands. This increase in the availability of money encourages spending and investment throughout the economy.
Changes in Feasible Frontiers of Saving, Borrowing, and Investing: Lowering interest rates alters the feasible frontiers of saving, borrowing, and investing for individuals and businesses. When interest rates are lower, the cost of borrowing decreases, making it more attractive for businesses to invest in new projects and for consumers to purchase big-ticket items through loans.
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