Savings, Investment, and the Market for Loanable Funds
1. Trade-off: Liquidity-Return
- Liquidity: The ease of converting an asset into cash without loss of value.
- High liquidity often leads to lower returns due to safer investments (e.g., savings accounts).
- Higher potential returns (e.g., stocks, real estate) generally come with lower liquidity.
2. Cash as a Financial Asset: Costs and Benefits
- Benefits:
- Highly liquid and universally accepted.
- Stable nominal value with minimal risk.
- Costs:
- Earns little to no interest.
- Subject to depreciation from inflation over time.
- A process by which financial institutions (banks) gather funds from savers to lend to borrowers.
- Enhances economic efficiency, connecting surplus fund holders with borrowers needing funds for investments.
4. Types of Accounts
- Checking Accounts:
- High liquidity but typically offer low or no interest.
- Traditional Savings Accounts:
- Moderate interest rates, higher liquidity than investments.
- High-Yield Savings Accounts:
- Higher interest, possible limited access.
- Certificates of Deposit (CDs):
- Fixed-term investments with higher interest, less liquid due to penalties for early withdrawal.
5. Why Do Banks Exist?
- Banks facilitate financial intermediation and safeguard deposits.
- They offer loans and manage the payments system for economic efficiency.
6. How Do Banks Make Money?
- Banks profit through the interest rate spread (difference between interest paid on deposits and charged on loans).
- Additional revenue from various financial services and fees.
7. Federal Deposit Insurance Corporation (FDIC)
- A U.S. government agency that insures bank deposits, ensuring public confidence and stability in the financial system.
8. Savings
- Public Savings:
- Defined as $T - G_T - G$, where $T$ is tax revenue and $G$ is government spending.
- Private Savings:
- Calculated as $Y - T - C$, where $Y$ is income and $C$ is consumption.
- National Savings:
- The aggregate of public and private savings, often funding future investments.
9. Decomposition of the Interest Rate
- Inflation Risk: Compensation for potential loss of purchasing power.
- Credit Risk: Compensation for risk of borrower default.
- Opportunity Cost of Funds: The anticipated return from the next best investment alternative.
10. Government Budget
- Surplus: Occurs when tax revenue exceeds government spending.
- Deficit: Occurs when government spending exceeds revenue.
- Crowding Out: Reduction in private investment due to increased government borrowing.
- Ricardian Equivalence: Suggests that deficits do not affect demand levels as people save for future tax liabilities.
11. Supply and Demand of Loanable Funds
- Supply: Originates from savings.
- Demand: From borrowers seeking funds for investments.
- Graph Representation: Interest rate on the y-axis and quantity of loanable funds on the x-axis; rising interest rates increase savings but decrease borrowing.
12. Case Studies
- Examples include Enron, Intel, and the Hogwarts market showing the complexities of financial markets and investments.
13. Kaldor-Hicks Efficiency
- A model indicating that resource allocation is efficient if those who benefit could theoretically compensate those who lose, improving overall welfare.
1. Trade-off: Risk-Return
- Higher potential returns generally accompany higher risks.
2. Stocks
- Major Indices: Dow, S&P 500, and Nasdaq represent different market segments.
- Value vs. Growth Stocks: Value stocks have lower price/earnings ratios; growth stocks expect higher earnings growth.
3. Bond Rating Agencies
- Agencies like S&P, Fitch, and Moody’s evaluate bond creditworthiness, assigning ratings based on default likelihood.
4. Present Value, Future Value, and Compound Interest
- Present Value (PV): Current worth of future cash flows, accounting for a discount rate.
- Future Value (FV): Worth of an investment at future dates based on interest rate growth.
- Compound Interest: Interest calculated on principal and prior interest accumulated.
5. Risk Aversion and Utility of Wealth
- Preference for certainty over a gamble with equivalent expected value.
- A utility function expresses satisfaction level derived from wealth.
6. St. Petersburg Paradox
- Illustrates how people subjective value potential gains varying by probabilities and magnitudes.
7. Expected Value and Expected Utility
- Expected Value: The probability-weighted average of outcomes.
- Expected Utility: Similar average but incorporates individual risk preferences.
- Moral Hazard: Increased risk-taking due to insulation from consequences.
- Adverse Selection: Information imbalance leading to poor decision-making.
- Techniques include Screening, Collateral, and Monitoring to mitigate risks and enhance information symmetry.
10. Measurement and Types of Risk
- Standard Deviation: Quantifies investment return volatility.
- Idiosyncratic Risk: Unique to an asset; diversifiable.
- Market Risk: Affects the entire market; non-diversifiable.
- Diversification: Method to reduce risk through a variety of asset holdings.
11. Efficient Markets Hypothesis (EMH)
- Weak Form: Prices reflect all past market information.
- Semi-Strong Form: Prices reflect all publicly available information.
- Strong Form: Prices include all information, public and private.
12. Technical Analysis, Fundamental Analysis, Insider Trading
- Technical Analysis: Predicting prices based on historical data patterns.
- Fundamental Analysis: Evaluating stock value based on financial statements and market conditions.
- Insider Trading: Trading based on unpublished, material information.
13. Case Studies
- Examples such as 2022 Nasdaq Sell-off, Beanie Babies, and Tech bubble of the late 90s illustrate market volatility and speculative behavior.
14. Government Budget Balance (Deficits) and Crowding Out
- Examines the effects of government borrowing on private investment, particularly via interest rates.
15. The Effect of Outliers
- Outliers can significantly distort averages, variances, and overall analysis in financial metrics.