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2 sources of economic growth
increases in human capital and physical capital
human capital
skills + knowledge of the workforce
physical capital
simply called capital, goods used to make other goods
spent by firms (exception: infrastructure funded by govt.)
interest rate
the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for 1 yr.
savings-investment spending identity
a basic fact of accounting that states that savings and investment spending are always equal for the economy as a whole
private sector: S = I
+ public sector: S + BB = I
+ foreign markets: S + BB + CI = I
system for savings-investment
total income = total spending
total income = consumer spending + savings
total spending = consumer spending + investment spending
CS + savings = CS + IS
savings = IS
savings equation
national savings + capital inflow
budget balance
difference between tax revenue and govt. spending
positive: budget surplus
negative: budget deficit
budget surplus
tax revenue > G
budget deficit
tax revenue < G
national savings equation
private savings + budget balance
private savings equation
disposable income - consumption
capital inflow
total inflow of foreign funds - total outflow of domestic funds
positive: in > out
negative: in < out
inflow of funds
foreign savings finance domestic investment spending
outflow of funds
domestic savings finance foreign investment spending
IMPORTANT INFO
one dollar of IS financed by inflow has a higher national cost than a dollar of IS financed by national savings
financial markets
where households invest their current savings and their wealth by purchasing financial assets
wealth
value of accumulated savings
financial asset
paper claim that entitles the buyer to future income from the seller
physical asset
claim on a tangible object that gives the owner the right to dispose of the object as they wish
liability
a requirement to pay money in the future
types of financial assets
loans, stocks, bonds, and bank deposits
why is a well-functioning financial system crucial for long-run growth?
creates flows of money in and out of the economy
encourages more savings and investment spending
increases efficiency
3 tasks of a financial system
reducing transaction costs
reducing risk
providing liquidity
transaction costs
expenses of negotiating and executing a deal
why do bond markets primarily exist?
allow companies to borrow large sums of money without incurring large transaction costs
financial risk
uncertainty about future outcomes that involve financial gains and losses
diversification
by engaging in diverse financial assets, there’s lower financial risk
liquid asset
can be quickly converted into cash without much loss of value
illiquid asset
can’t be quickly converted into cash, loses value
t or f: bonds and stocks are illiquid
f: they are highly liquid; more liquid than physical assets and loans
loan-backed securities
assets created by pooling individual loans and selling shares
loan
lending agreement between an individual lender and individual borrower
tailored to borrower’s needs; however, has many transaction costs due to this
many large borrowers sell/issue bonds instead to reduce such costs
liability for borrower, financial asset for lender
not standardized —> low liquidity
bond
IOU issued by the borrower, seller pays a fixed sum of interest annually and repays the principal to the owner on a certain date
low transaction cost (no negotiation)
liability for issuer, financial asset for owner
easy to resell —> high liquidity
principal
value stated on the face of the bond
default
risk that issuer fails to make bond payments
the higher the default risk, the higher the interest rate needed to attract owners
stock
a share in the ownership of a company
liability for company, financial asset for owner
lower risk for owners
increased welfare for owners —> more returns
what does “a bond is a promise, a stock is a hope” mean?
if a company becomes bankrupt, they are obligated to pay back bondholders (if they can’t give them money, they get assets), while stockholders usually get nothing
financial intermediary
an institution that transforms the funds it gathers from many individuals into financial assets
holds ¾ of American financial assets
helps investors + business owners manage risk and get higher returns
4 most important types of financial intermediaries
mutual funds: share of a company
pension funds + life insurance companies: profit institutions that collect consumers savings
banks: provide liquid assets through deposits
diversified portfolio of stocks
a group of stocks in which risks are unrelated
lower risk for investors
helps investors with less money have a diverse portfolio
mutual funds
financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the portfolio to individual investors
solves the problem of high transaction costs when investors try to individually make a diverse portfolio
pension funds
non-profit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing members with income when they retire
like mutual funds, they create diversification in assets
life-insurance company
guarantees a payment to the policyholder’s beneficiaries (usually family) when the policyholder dies
increased welfare by reducing financial risk for beneficiaries (gives them financial aid)
bank
financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance borrowers’ investment spending on illiquid assets
fixes the conflict between lenders’ needs for liquidity and the needs of borrowers who don’t want to use bond or stock markets (have higher cost and risk)
bank deposit
a claim on the bank that obliges the bank to give the depositor their cash when demanded
liability for bank, financial asset for depositor
given when depositors give their money to the bank
t or f: most deposits are lent to borrowers in the form of loans
t; however, the borrower in the loan has an obligation to repay cash (if bank needs to convert it for the depositor’s needs)
FDIC does guarantee emergency deposits (up to $250k) if something like this happens
t or f: savings are leakages out of the circular flow model.
t
if a government taxes more than it spends, what happens to national savings?
national savings increase
role of the financial system
exchanging the assets from the seller to the buyer
Note 
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