ap economics: module 22 terms

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

1. reducing transaction costs

2. reducing risk

3. 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