Chapter 14 Flashcards
What is traded in a financial market
People trade future claims on funds or goods.
Who are the buyers in a financial market
Families buying new houses, students paying tuition, corporations buildings new factories, entrepreneurs starting new ventures, and the government when it needs to finance public spending
Who are the sellers in a financial market
Individuals, corporations, and government entities willing to forgo some spending in return for repayment
What is adverse selection
Adverse selection refers to a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation which results in failure to complete transactions that would have been possible
What are the problems with adverse selection
Without tight regulation on the provision of public information, adverse selection would lead to sharp decreases in the market prices of company stock and higher interest rates on bank loans
What is a moral hazard
The tendency for people to act riskier when they do not face the full consequences of their actions
Ex) when people have car insurance they are mor likely to speed or drive unsafe
What are the consequences of a moral hazard
Sometimes they make financial transactions impossible
What is an information asymmetry
A condition in which one participant in a transaction knows more than another participant
What are the three main functions of financial markets
- Intermediaries: channel funds from people who have them to people who want them
- Provide benefits of liquidity: having cash easily available when you want it
- They help savers diversify risk by providing funds to borrowers
Intermediaries, liquidity, diversify
Describe the market for loanable funds
A hypothetical marketplace that brings together everyone looking to lend money and everyone looking to borrow money
What is the price of loanable funds
The market clears at a price where supply and demand meet. This price is the interest rate
Differentiate between savings and investment
Savings is the portion of income that is not immediately spend on consumption
Investment is spending on productive inputs
List the factors that affect the supply and demand of loanable funds
Factors that determine how much people save:
Wealth, current, economic conditions, expectations about future economic conditions, borrowing constraints, social welfare policies, and culture
Factors that determine investment decisions:
Expectations about future profitability and future economic conditions, borrowing constraints, and crowding out
What is crowding out
Reduction in private borrowing that is caused by an increase in government borrowing
What are two factors that drive differences in interest rates
Length of time and degree of risk
Why do lenders generally want a higher interest rate
To compensate for the added opportunity cost when the loans stretch over a long period and for taking on additional risk
What is the interest rate one would lend if there is no risk involved
A risk-free rate
What does intermediation in financial systems do
Reduces transaction costs by centralizing information about prices and providing a broad and dynamic marketplace for transactions
What are financial intermediaries
Institutions that channel funds from people who have them to people who want them
What does the financial system offer savers and borrowers
A wide set of interconnected markets in which to find financial intermediaries
What is liquidity
A measure of how easily a particular asset can be converted quickly to cash without much loss of value
We say an asset is liquid if it can be sold for cash quickly without much loss of value
What are market makers
They make a market by always being ready to buy or sell
Why is liquidity important
It affects peoples willingness to save: if markets were not liquid, you would be extremely cautious about lending money out for investment which would reduce the supply of loanable funds, drive up interest rates, reducing the amount of investment and leading to slower growth
What is diversification
The process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual
