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EC 111 Chapter 13 Notes

by: Julie Knight

EC 111 Chapter 13 Notes EC 111

Julie Knight
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About this Document

These notes cover chapter 13
Macro Economics
Dr. William Walsh
Class Notes
EC, EC 111, Macroeconomics, Economics




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This 5 page Class Notes was uploaded by Julie Knight on Friday March 18, 2016. The Class Notes belongs to EC 111 at University of Alabama - Tuscaloosa taught by Dr. William Walsh in Spring 2015. Since its upload, it has received 19 views. For similar materials see Macro Economics in General at University of Alabama - Tuscaloosa.


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Date Created: 03/18/16
EC 111 Notes Chapter 13  The financial system- the group of institutions in the economy that help match one person’s saving with another person’s investment  Financial market- institutions through which a person who wants to save can directly supply funds to someone who wants to borrow o Bonds and stocks  The bond market- allows producers to borrow directly from the public o Bond- a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bonds  Sale of bonds= debt financing  Principal- the amount borrowed  Interest- rate of interest that will be paid periodically until the loan matures  Date of maturity- time at which the loan will be repaid  Term- length of time until the bond matures o Long term bonds are riskier than short term bonds as you wait longer to be repaid- they command higher interest rates o Perpetuity- a bond that never matures: interest is paid forever but principal is never repaid…  Credit risk- probability a borrower will fail to pay some of the principal or interest (default) via bankruptcy etc. o High default risk (junk bonds)- high interest rate o Low default risk (govt bonds)- low interest rate  Tax treatment-how do tax laws treat the interest earned on the bond o Most bonds create taxable income o State/local governments can issue municipal bonds which pay interest that is exempt from federal income taxes  Tax advantage allows state and local government to pay lower interest rates  The stock market o Stock- represents ownership in the firm- claim to a share of the profits the firm makes  Sale of stock= equity financing  Riskier because earnings are not set/guaranteed by contract (like interest payments on a bound), but there is also more upside (because you could get a share of the profits)  Bondholders get paid before stockholders when the company runs into trouble  Demand for a stock reflects people’s perceptions about a company’s future profitability o Price- high/low; opening/closing/last price o Dividend- share of profits paid directly to shareholders  Dividend yield- dividend as a % of stock’s price o Price earnings ratio- price of stock divided by the amount the corporation earned per share over the past year  High: stock is expensive relative to recent earnings  Low: stock is cheap relative to recent earnings  In finance, the efficient market hypothesis (EMH) asserts that financial markets are “informationally efficient” o One cannot consistently achieve returns in excess of average market returns on a risk adjusted basis, given the information available at the time the investment is made  Weak, semi-strong, and strong  Once a stock is issued by selling shares to the public, the shares can then trade on organized exchanges o NYSE- New York Stock Exchange o NASDAQ o AMEX o Others…  Stock index- computed as an average of a group of stock prices o Dow Jones Industrial Average (DJIA)- o Standard & Poor’s 500 Index (S&P 500)-  Financial intermediaries- institutions through which savers can indirectly provide funds to borrowers o Banks- take is deposits from people who want to save (and earn interest) and loan those deposits to people who want to earn interest  Facilitate purchases of goods/services by allowing customers to write checks against their deposits or to access those deposits with debit cards  Check/debit card= medium of exchange o Mutual funds- an institution that sells shares to the public and then use the proceeds buy a portfolio of various types of stocks, bonds, or both  Allows people with smaller amounts of money to diversify their holdings  Gives ordinary investor access to the skills of a professional money manager  Savings & investment in the national income accounts  Some important identities o Y=C+I+G+Xn o BUT, a closed economy doesn’t engage in international trade  Y=C+I+G  Y-C-G=I  Y-C-G=total income left after paying for consumption and government services= national savings or savings, S  S=I  Savings equal investment  Let T= amount government collects in taxes minus what it pays out in transfer payments like social security & welfare  S=Y-C-G o S=(Y-T-C)+(T-G)  Y-T-C= private saving  The amount of income that households have left after paying their taxes & consumption expenditures  T-G= public savings  The amount of tax revenues the government has left after paying for its spending o If T>G we have a budget surplus o If T<G we have a budget deficit  *deficits lower public savings and thus reduce the supply of loanable funds in market for loanable funds  The Meaning of Savings & Investments o Savings= putting unspent income in a bank or stock or bond  Adds to the nation’s savings o Investment= purchase of new capital (equipment or buildings) o While S= I for economy as a whole, on the individual level we may see S>I (deposit excess in bank) or S<I (borrow shortfall from a bank Loanable Funds Market interest S (savings) - If real i rate is low- rates investment, money is cheap, high QD, low QD= shortage of loanable funds---must increase interest rate D Loanabl e funds The Market for Loanable Funds  The market in which those who want to save supply funds and those who want to borrow demand funds o Simplifying assumptions: only one financial market in this economy- all savers and all borrowers use this market and there is only one interest rate, which is both the return to savings and the cost of borrowing  Savings is the source of the supply of loanable funds  POLICY IMPLICATIONS o Policy 1: (savings incentives)  Reforming the tax code to incentivize savings: expand eligibility for IRAs  (1) tax change alters household incentive to save at any given interest rate- supply of loanable funds would increase because savings would be taxed less heavily  (2) this reduces the interest rate  (3) raises the equilibrium and quantity of loanable funds Loanable Funds Market D Real S interest S rates 1 Loanabl e funds o Policy 2: (investment incentives)  Investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment  (1) tax change rewards firms that borrow and invest in new capital- alters investment incentive at any given interest rate- demand of loanable funds would increase  (2) this would raise the interest rate  (3) increase the equilibrium quantity of loanable funds Loanable Funds Market S interest rates D1 D Loanabl e funds o Policy 3: (government budget deficits and surpluses)  Governments finance budget deficits by borrowing on the bond market o Accumulation of past government borrowing= government debt o Budget surplus can be used to repay accrued debt  Tax cut or spending increases force government to run a budget deficit: o A change in the government budget balance represents a change in public saving and, thereby, in the supply of loanable funds o This is because national savings, the source of the supply of loanable funds, is composed of private and public sacings (which falls with a deficit)  When  When  Becase o (1) o (2) o (3) o - when Loanable Funds Real Market interest S rates 1 S D


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