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.

3. Financial Intermediation

• 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.

Chapter 27: Risk, Uncertainty, and Information

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.

8. Asymmetric Information

• Moral Hazard: Increased risk-taking due to insulation from consequences.
• Adverse Selection: Information imbalance leading to poor decision-making.

9. Overcoming Asymmetric Information

• 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.