Chapter 10 Study Guide
Chapter 10 Study Guide ECON 2
Popular in Intro to Macroeconomic
Popular in Economcs
verified elite notetaker
This 0 page Study Guide was uploaded by Nolan Shapiro on Tuesday November 3, 2015. The Study Guide belongs to ECON 2 at University of California - Santa Cruz taught by Aaron Meininger in Fall 2015. Since its upload, it has received 83 views. For similar materials see Intro to Macroeconomic in Economcs at University of California - Santa Cruz.
Reviews for Chapter 10 Study Guide
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 11/03/15
Chapter 10 Lecture Notes Key Ideas Chap 10 1 The credit market matches borrowers the source of credit demand and savers the source of credit supply 2 The credit market equilibrium determines the real interest rate 3 Banks and other financial intermediaries have three key functions identifying profitable lending opportunities using short run deposits to make long run investments and managing the amount and distribution of risk 4 Banks become insolvent when the value of their liabilities exceeds the value of their assets Debtors or borrowers Economic agents such as entrepreneurs businesses home buyers college students who borrow funds Credit The amount of funds that the debtor receives Interest Rate The additional payment above and beyond the principal the loan amount on a 1 loan Normal interest rate i The annual cost of a 1 loan Total interest payments i x L where L is the loan amount Suppose you borrow 20000 with a promise to pay it back in one year 1200 51000 Real interest rate r The annual real or inflationadjusted cost of a 1 loan r i pie where r interest rate i normal interest rate pie rate of inflation Quantity of credit demand The amount of loans that borrowers are willing to borrow at a given real interest rate Credit demand schedule A table that reports the quantity of credit demanded at different real interest rates holding all else equal The credit demand curve shifts with changes in any of the following 1 Perceived business opportunities for firms 2 Household preferences or expectations 3 Government policy Interest rate increase leads to higher return on savings so people would want to save more The credit supply curve shifts with changes in either of the following 1 saving motives of households 2 saving motives of firms Banks and financial intermediaries are the organizations that connect savers and borrowers There are many different types of financial institutions that channel funds from suppliers savers to borrowers users of financial capital Asset management companies Hedge funds Private equity funds Venture Capital Funds Shadow banking system A balance sheet records the assets and liabilities of a company like a bank An asset is something owned by a bank If asset is sold the payment goes to the bank A liability is something owed to another institution If a liability is sold the payment comes from the bank Assets of a bank 0 Bank reserves are vault cash and holding on deposit at the Federal Reserve Bank 0 Cash equivalents are riskless liquid assets that a bank can immediately access 0 Longterm investments are loans to households and firms and the value of the bank s properties Liabilities of a bank Demand deposits are funds that depositors can access on demand short term borrowing consists of loans from other financial institutions that are short in duration Longterm debt is debt that is due to be repaid in one year or more Stockholders equity is the difference between a bank s total assets and total liabilities It is equal to the estimated value of a company if priced correctly by the stock market IF there is a concern that a bank may run out of liquid assets a bank run ay occur A substantial number of depositors may try to withdraw their deposits at the same time this initial panic may lead other depositors to withdraw before the liquid assets are gone The bank may forced to sell its illiquid assets in fire sales where it receives lower pnces Banks perform three interrelated functions as financial intermediaries 1Identify profitable lending opportunities 2Transform shortterm liabilities into longterm investments maturity transformation 0 3Manage risk through diversification 2Banks transform shortmaturity liabilities like deposits into longterm investments like business and real estate loans 0 This process is called maturity transformation Maturity The time until a debt must be repaid Demand deposits and shortterm borrowing of banks have a 0year maturity since depositors can take back their money at any time Loans and other longterm assets have a maturity ranging from several years to 30 years 3Banks manage risk by O aHolding a diversified portfolio bTransferring risk to stockholders and ultimately to the US government during a severe financial crisis Banks hold a diverse set of assets including mortgages consumer loans business loans loans to other financial institutions and government debt A diversified portfolio is useful in that assets are unlikely to underperform all at the same time Diversification by itself is insufficient to manage risk because a large fraction of a diverse set of assets can still underperform In 2007 2009 12 of all mortgages entered some form of delinquency nonpayment As a result the return on average assets for all US banks became negative When the bank39s assets lose value this translates into a reduction in stockholders equity When shareholders equity falls to zero the bank s creditors may also face losses On the other hand the bank s depositors Will always be repaid if their deposits are in FDIC insured accounts This means that the FDIC is ultimately on the hook to cover the depositors Book Notes 101 What is the Credit Market Debtors or borrowers are economic agents who borrow funds 0 Credit refers to the loans that the debtor receives 0 The interest rate also referred to as the nominal interest rate i is the annual cost of a onedollar loan so ixL is the annual cost of an L loan 0 The real interest rate is given by the nominal rate minus the inflation rate 0 R i n o The credit demand curve is the schedule that reports the relationship between the quantity of credit demanded and the real interest rate 0 Credit demand is steepinelastic 0 Credit demand is flat elastic 0 Factors that cause credit demand curve to shift 0 Changes in perceived business opportunities for firms ex Unit Airlines notices that more people are buying plane tickets their demand will increase bc they want more airplanes 0 Changes in household preferences or expectations if household preferences change so they would want more large scale purchases their demand will increase 0 Changes in government policy Increase in government borrowing in times of recession shifts the demand curve to the right 0 Savings results from a natural tradeoff people can spend their income on consumption today or can save it for consumption in the future 0 The real interest rate is the opportunity cost of current consumption 0 The credit supply curve is the schedule that reports the relationship between the quantity of credit supplied and the real interest rate 0 Factors that cause credit supply curve to shift 0 Changes in saving motives of households lf households start to predict economic hard times ahead they will save more because they want to build up a store of wealth to be better prepared 0 Changes in the saving motives of firms when firms are nervous about their ability to fund their business activities in the future they tend to hold on to more retained earnings instead of paying them out as dividendgt shifts supply curve to right 0 The credit market is where borrowers obtain funds from savers The valuable social role of credit markets is to match savers like you with borrowers 102 Banks and Financial lntermediation Putting Supply and Demand Together 0 Financial intermediaries channel funds from suppliers of financial capital to users of financial capital 0 When a saver turns her savings into credit she loans her saving to another party in exchange for the promise of repayment of her loan with interest When a saver turns her savings into equity she users her savings to become a shareholder in a company which means that she has obtained an ownership share and a claim on future profits of the company 0 Asset management companies enable investors to use their savings to buy financial securities like stocks and bonds 0 Securities are financial contracts For example securities may allocate ownership rights of a company stocks or promise payments to lenders bonds 0 Hedge funds are investment pools gathered from a small number of very wealthy individuals or institutions like university endowments Private equity funds are investment pools that also typically involve a small number of wealthy investors Venture capital funds are a particular kind of private equity fund that invests in start up companies Shadow banking system is comprised of thousands of institutions that are not officially banks bc they don t take deposits but nevertheless act like banks in the sense that they raise money for funds Assets the investment bank has made government securities and bank holds and the money the bank is owed by borrowers Divided into three categories 0 Bank reserves vault cash and its holdings on deposit at the FED 0 Cash equivalents riskless liquid assets that Citibank can immediately access like deposits with other banks 0 Longterm investments mostly comprise loans to households and firms but also include things like the value of the real estate that the bank uses for its operations Liabilities claims that depositors and other lenders have against the bank Divided into four categories 0 Demand deposits funds loaned by to the bank by deposits most think of it as a deposit into a checking account 0 Short term borrowing comprises shortterm loans bank obtained from other financial institutions 0 Longterm debt defined as debt that is due to be repaid in one year or more 0 Stockholder39s equity is the difference between a bank s total assets and total liabilities 103 What Banks Do Three main functions Identifying profitable lending opportunities 0 find creditworthy borrowers and channel savings of depositors to them Banks transform shortterm liabilities like deposits into longterm investments in a process called maturity transformation 0 Maturity refers to the time until debt must be repaid 0 Maturity transformation is the process by which banks take shortmaturity liabilities and invest in longmaturity assets A bank becomes insolvent when the value of the bank s assets is less than the value of its liabilities A bank is solvent when the value of the bank s assets is greater than value of its liabilities
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'