Economics Lecture Notes: Loanable Funds, Financial Markets, Multipliers, Demand, and Supply

These flashcards cover key concepts from the lecture notes including loanable funds, financial markets, multipliers, and aggregate demand and supply.

What is the loanable funds market?

A market where savers supply funds and borrowers demand them; the interest rate is the price.

Why does the demand for loanable funds slope downward?

Lower interest rates make borrowing cheaper.

What shifts the demand curve for loanable funds?

Changes in business opportunities or government borrowing.

Why does the supply of loanable funds slope upward?

Higher interest rates incentivize saving.

What shifts the supply curve for loanable funds?

Changes in private saving behavior or capital inflows.

What is the crowding out effect?

Government borrowing raises interest rates, reducing private investment.

Fisher Effect

An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged - expected future inflation rate drives up the nominal interest rate by 1 percentage point.

What is the formula for present value (PV)?

PV = FV / (1 + r)^n.

How do you calculate net present value (NPV)?

Sum of discounted future benefits minus initial cost.

Why do we use present value?

Money today is worth more than money in the future.

Financial Markets

Where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.

Financial Asset

is a claim that promises the buyer to future income from the seller

Physical asset

is a tangible item, such as real estate or equipment, that can produce future income.

Liability

is a legal obligation to pay a future financial commitment or debt.

What are the 3 tasks of financial markets?

Reduce transaction costs, reduce risk, provide liquidity.

Transaction Costs

are the expenses of negotiating and executing a deal - between lender and borrower

Liquid

is a term describing assets that can be quickly converted to cash without significant loss of value. - illiquid is the opposite

Financial Risk

the uncertainty surrounding the future outcomes involving financial losses and gains

Risk-Averse

a person who has more anxious about the loss of an equal dollar amount than the gain of it - most people are risk-averse.

What is diversification?

Investing in many assets to reduce risk.

What are the 4 financial assets?

Loans, bonds, stocks, bank deposits.

Loan

A lending agreement made between a lender and a borrower.

Difficult to resell - not very liquid

Large amount transaction costs - investigating the borrower’s credit score and borrowing history.

Bonds

An IOU - written promise - issued by a borrower - the seller of the bond promises to pay a fixed sum of interest each year and repay the principal (initial value of the bond) on a a certain date.

Scheduled payments are called coupon payments (paid out every 3 to 6 months)

Buyer can hold the bond until maturity or sell it to someone else prematurely.

Easy to resell - aka provides liquidity

A financial asset from the lender's POV

A liability from the borrower’s POV

Companies and the government usually sell or issue bonds.

Why does the bond market exist?

So firms can borrow large sum of money without having to face a large transaction cost.

Loan-Backed Security

An asset created by pooling individual loans and sell shares in that pool.

Provides a lot of diversification and liquidity

It can be difficult to assess the quality of the asset when these securities are packaged.

EX/

Student Loans

Home Mortgages

Credit Card Loans

Auto Loans

Stock

a share in the ownership of a company is a stock

A share of stock is a financial asset from the lender’s POV

A liability from the company's POV.

Privately held companies tend to not sell shares of their stock

OWNING A STOCK IN A COMPANY IS RISKER THAN OWNING A BONDING IN THE SAME COMPANY

Why? A bond is a promise while a stock is a hope. By law the company has to pay its bondholders - if anything were to happen they would pay their bondholders first an the rest to the shareholders.

Provides higher return compared to a bond

After shares are issued, they are traded among stockholders or an organized stock exchanges - NYSE (New York Stock Exchange), NASDAQ

Why companies issue stock?

Raise capital without borrowing.

Reduce risk for business owners ( vs. bonds)

Equity Finance

When firms sell stocks.

Two types of Financial Markets

The Bond Market

The Stock Market

Default

Occurs when a borrower fails to meet the repayment terms of a loan or bond.

What do financial intermediaries do?

Channel funds from savers to borrowers efficiently.

The Three types of Financial Intermediaries

Mutual Funds

Pension Funds

Bank

Mutual Fund

A financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors.

Allows investors to diversify their portfolio without the high transaction costs.

The mutual fund industry is responsible for majority of the US’s financial system.

Two types of mutual funds

1) Index -

follows a broad market indicator

2) Specialized

• focuses on specific sectors or industries.

Pension Funds

A nonprofit institution that manages retirement savings and invests in financial markets to provide income to retirees.

Are subjected to special rules and receives special treatment for tax purposes - they are very similar to the generic mutual fund.

Defined Benefit - guaranteed fixed payout to employees who have met certain required years of service.

Defined Contribution: Employees pay in a certain amount each year. Employer matches some portion.

Life Insurance Policies: Gurantee a payment to a policyholder’s beneficiaries when the policyholder dies.

Bank

A financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers.

Commercial - what we typically interact with when we think of a bank.

Investment - they provide liquidity to the financial markets by issuing stocks and bonds on behalf of companies. Investment banks engage in underwriting and buy any of the shares that are not purchased by investors.

Prior to 1999 when Glass-Steagall was repealed, banks couldn’t be both commercial and investment banks.

Bank Deposit

A claim on a bank that obliges the bank to return the deposited amount on demand or at maturity.

It is a common way for individuals to save money while earning interest from the bank.

Banks help solve the issue of liquidity by providing access to funds for depositors and borrowers.

What are systematic vs. unsystematic risk?

Systematic = market-wide risk; Unsystematic = asset-specific.

Four Simplifying Assumptions

1) Producers are willing to supply additional output at a fixed price.

2) Interest rate is given.

3) No government spending or taxes.

4) Closed Economy - no imports or exports

What is MPC?

Marginal Propensity to Consume — is the increase in consumer spending when disposable income rises by $1.

It is always between 0 and 1.

MPC Formula

Δ Consumer Spending / Δ Disposable Income

What is MPS?

Marginal Propensity to Save - is the increase in household savings when disposable income rises by $1.

How is MPC related to MPS?

MPC + MPS = 1.

MPS is what is left over from MPC

What is the multiplier formula?

1 / (1 - MPC).

What determines the size of the multiplier?

MPC

What is an autonomous change in aggregate spending?

An initial change in the desired level of spending by firms, individuals, or the government.

What is the consumption function?

c = a + MPC × yd.

c=consumer spending

a=autonomous consumer spending - household spending when disposable income is at 0.

MPC= the marginal propensity to consume

yd= current disposable income

What does the slope of the consumption function represent?

MPC.

slope=rise/run

What shifts the aggregate consumption function?

Changes in future expected disposable income,

Aggregate wealth,

What is the life-cycle hypothesis?

Consumers plan some of their spending over a lifetime, not just in terms of their current disposable income.People slow down their consumption over the course of their lives.

What does planned investment depend on?

1) Interest rates - negative relationship

2) Expected Real GDP - positive relationship

3) Production capacity - negative relationship

What is aggregate demand (AD)?

Total demand for goods/services at all price levels.

Why is the AD curve downward sloping?

Wealth effect - a high agregrate price level reduces the purchasing power of household’s wealth resulting in them saving more - reduce consumer spending.

interest rate effect - same case but also reduces investment spending as well - because interest rates raised.

Negatively related to wealth and interest rates.

What shifts the AD curve?

Changes in Expectations, Wealth, Size of existing physical capital, Monetary and Fiscal policy

What causes movement along the AD curve?

A change in the price level.

What is the GDP equation?

Y = C + I + G + (X - IM).

What is the aggregate supply curve (AS)?

Shows the relationship between the aggregate price level and the amount of aggregate output is produced (GDP) in the economy.

Why is the SRAS curve upward sloping?

Sticky wages mean higher prices = higher profits.

Has positive relationship between price level and output

What are sticky wages?

Wages that adjust slowly to economic changes.

What shifts the SRAS curve?

Commodity prices, nominal wages, productivity.

What causes movement along the SRAS?

Changes in the aggregate price level.

What’s the profit per unit of output formula?

Price per unit − Cost per unit.

What is LRAS?

Shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages were fully flexible.

LRAS is vertical - because the aggregate price level does not affect the long-run determinants of real GDP.

Potential Output

The level of real GDP the economy can produce if the all the prices, including nominal wages were flexible and if both capital and emplyoment are fully used.