Lecture 1 & 2 - Introduction and overview of the financial system Flashcards
What are financial markets?
Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.
What are financial markets crucial for?
Promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. They also help to produce efficient allocation of capital (wealth, either physical or financial) which contributes to higher production in the overall economy. Well functioning financial markets also directly improve the well being and economic welfare of consumers by allowing them to time their purchases better (e.g. young people).
What do the activities in financial markets have direct effects on?
Personal wealth, behaviour of businesses and consumers, and the cyclical performance of the economy.
What is a security (financial instrument) ?
A claim on the issuer’s future income or assets.
What are assets?
Any financial claim or piece of property that is subject to ownership.
What is a bond?
A debt security that promises to make payments periodically for a specified period of time.
Why is the bond market especially important to economic activity?
It enables corporations and governments to borrow finance their activities and because it is where interest rates are determined.
What is an interest rate?
It is the cost of borrowing or the price paid for the rental of funds.
What and who do interest rates affect?
The overall health of the economy - governments, consumer’s willingness to spend or save and a businesses’ investment decisions.
The interest rate on UK government bonds that have a maturity of 10 years follows the same pattern as long term government bonds that have no maturity date. What are these types of bonds referred to as?
Consols.
When a firm issues a bond,
It is borrowing money that it will have to repay.
If you buy a bond,
You are a lender who will be repaid with interest.
A security is a liability (IOU or debt) for…
The agent that sells (issues) it.
A security is an asset for…
The agent that buys it.
What is the difference between bonds and stocks?
A bond entitles the owner to receive future payments that are “independent” of the firm’s performance, whereas, with stocks, the owner becomes part owner of the firm and future payments received depend on the firm’s performance.
What does a stock represent?
A share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation.
How do corporations raise funds to finance their activities?
They issue stock and sell it to the public.
What is the stock market?
The market where shares of stock are traded
Why is the stock market an important factor in business investment decisions?
The price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending.
What is the foreign exchange market?
The market where one currency is bought and sold using another currency.
What is the foreign exchange rate?
The price at which one currency is exchanged for another.
Give some examples of financial intermediaries.
Banks, mutual funds, insurance companies, finance companies, and investment banks.
What are financial intermediaries?
Institutions that borrow funds from people who have saved and in turn loan to others.
Why might the same bond type have different interest rates in different countries?
Differences between the countries relating to inflation risk, default risk and political risk.
What are financial crises?
Major disruptions in financial markets that are characterised by sharp declines in asset prices and the failure of many financial and non financial firms.
What are banks?
Banks are financial institutions that accept deposits and make loans.
What is e-finance?
The delivery of financial services electronically.
Define money (money supply).
Anything that is generally accepted in payment for goods and services or in the repayment of debt.
Why is money so important?
Changes in the money supply can directly affect business cycle fluctuations and are linked to changes in major macroeconomic variables.
What is aggregate output?
The total production of goods and services.
What is the unemployment rate?
The percentage of the available labour force unemployed.
What is a business cycle?
The upward and downward movement of aggregate output produced in the economy.
What are recessions?
Periods of declining aggregate output.
What is monetary policy?
Refers to the management of money and short term interest rates by a Central Bank.
What is the aggregate price level?
The average price of goods and services in an economy.
What is inflation?
A continual increase in the price level.
What explains inflation?
Money supply and price level tend to rise together.
What is inflation rate?
The rate of change in price level, usually measured as a percentage per year.
What is fiscal policy?
Involves decisions about government spending and taxation.
What is a budget deficit?
The excess of government expenditures over tax revenues for a particular time period.
What is a budget surplus?
Arises when tax revenues exceed government expenditures.
A budget deficit leads to a…
Higher government debt burden.
A budget surplus leads to a…
Lower government debt burden.
What is Gross Domestic Product (GDP)?
The market value of all final goods and services produced in a country during the course of the year.
Why does the change in the exchange rate have a direct effect on consumers?
It affects the cost of imports.
A strong pound means…
Consumers can purchase foreign goods cheaply.
A weak pound means…
Foreign goods are more expensive.
What is aggregate income?
The total income of factors of production (land, labour and capital). It is thought of as being equal to aggregate output.
What is nominal GDP?
GDP measured using current prices.
What is real GDP?
GDP measured using constant fixed prices.
Define GDP deflator.
Nominal GDP divided by real GDP.
Define Personal Consumption Expenditures (PCE) deflator?
Nominal PCE divided by real PCE.
How is the Consumer Price Index (CPI) measured?
It is measured by pricing a ‘basket’ of goods and services bought by a typical urban household.
The CPI, PCE deflator and GDP deflator measures of the price level can be used to convert or deflate a nominal magnitude into a real magnitude. How is this accomplished?
By dividing the nominal magnitude by the price index.
How is a growth rate defined?
As a percentage change in a variable.
What happens in direct finance?
Borrowers borrow funds directly from lenders in financial markets by selling them securities., which are claims on the borrower’s future income or assets.
What is a stock?
A security that entitles the owner to a share if the company’s profits and assets.
Give an example of direct finance.
A company might issue bonds to raise funds. As a saver, when you buy one of these bonds your funds get transferred to the company and you receive an IOU (the bond).
Why is the channelling of funds from savers to spenders so important to the economy?
The people who save are frequently not the same people who have profitable investment opportunities available to them. Without financial markets, it is hard to transfer funds from a person who has no investment opportunities to on who has them.
What would happen in the absence of financial markets?
Everyone would be stuck with the status quo. Consumers would be forced to consume less and the timing of their purchases would not be optimal. They would not be able to spread consumption optimally over time. Businesses would produce less because it would be more difficult to finance capital investment. They cannot achieve optimal investment pattern.
How does issuing a debt instrument, such as a bond or a mortgage, work?
There is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts of money at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made.
