The financial system Flashcards
(24 cards)
Define the financial system
A group of institutions in the economy that try to match one person’s savings with another’s investment
What is the purpose of the financial markets
So that ‘savers’ can provide funds to ‘borrowers’ upon some roi
What are the two types of financial markets
- bond market
- stock market
What is the bond market
Bonds are offered by the government and firms to be bought by investors in return for interest payments
What is the stock market
A claim to partial ownership in a firm and thus a claim to partial profits (dividends)
What does demand for stocks depend on?
- expected profitability of a firm
- how much money people are willing to invest
What does supply of stocks depend on
- firms financial requirements
- alternative ways of accumulating credit
Define stock index
The average of a group of stocks
Define financial intermediaries
Institutions through which savers can indirectly provide funds to borrowers
What are the two main types of financial intermediaries
- banks
- mutual or investment funds
What do banks do
- take in deposits from savers and pay interest on this
- make loans to borrowers and charges interest (at a higher rate)
What do mutual or investment funds do
- institutions that sell shares to the public
- allows people to diversify but must pay a management fee
What changes in the income = expenditure identity ( Y = C + I + G + NX) when in a closed economy
NX = 0, so Y = C + I + G
What is national savings (S)
- total income in the economy that remains after paying for consumption and government purchases
- S = Y - C - G (=I)
What are the two parts of national savings (let T = taxes)
S = (Y - T - C) + (T - G)
- private saving (Y-T-C)
- public saving (T-G)
Explain private saving
Since it equals Y-T-C, this is the income that households have left after spending on consumption and paying taxes
Explain public savings
Since it is T-G, this is the tax revenue that the government has collected after paying for its spending
What is the relationship between T and G
- if T>G then the government is in budget surplus and saves money
- if T<G then the government is in deficit and must borrow money
What is the supply of loanable funds
Public + private savings
(Y-T-C) + (T-G)
What is the demand for loanable funds
People needing money for investments (I)
Explain the supply and demand of loanable funds in terms of interest rate
- as the real interest rate rises, supply increases and demand decrease
- the demand curve slopes downwards and the supply curve slopes upwards
How can governments incentivise savings
- change income tax to a consumption tax like VAT
- this only taxes on spending which indirectly incentivises people to save more
- hence shifting the supply curve to the right and increasing supply while decreasing interest rates
How can governments reduce the supply of loanable funds
- government goes into deficit by issuing bonds
- this reduces the supply of loanable funds as people invest in government and not intermediaries
- causes a leftward shift in the supply curve which increases interest rates
Define crowding out
A decrease in private investment as a result of government borrowing
