Week 18 - Chapter 23: Financial Markets

Question 1

Financial intermediaries

Answer 1

Firms that extend credit to borrowers using funds raised from savers.
Banks are the most important example of this.

Question 2

Why are banks so important

Answer 2

• Banks pool savings and direct these savings towards high-return investments which allows the bank to make profit while also paying interest to savers.
• Comparative advantage - by giving savings to banks and trusting them to use their expertise to make good investments, individuals do not need in depth knowledge of investments but can still profit from it.
• Banks are important for saving and investment as they have a lower cost of evaluating investment opportunities and can pool savings from multiple people to make large loans and spread out risk - allows for high risk high reward investments.

Question 3

Bond

Answer 3

• Bond: a legal promise to pay someone a debt, usually including both the principal amount and regular interest payments.
• A bond works by the bondholder purchasing the bond for the principle amount with a decided coupon rate and maturity.
  The bond issuer can then use this money as if it was a loan but must make regular coupon payments decided by the coupon rate back to the bondholder.
  After a set time period, the bond matures and the principle amount is repaid back to the bond issuer.

Question 4

Principle amount

Answer 4

The original value of the bond that is lent to the bond issuer.

Question 5

Coupon rate

Answer 5

The interest rate promised when the bond is issued. This is paid to the bondholder through regular coupon payments.

Question 6

Share of stock

Answer 6

A claim to partial ownership of a firm.
Stockholders receive dividends - periodic payment determined by management.
Stocks can be bought and sold but prices are determined by supply and demand in the stock market.
If a stock is sold for profit, you receive capital gains.

Question 7

Use of bonds and stocks - investment

Answer 7

If a large firm wants to invest, it can borrow money through bonds and stocks by issuing new bonds to be sold to savers on the bond market or issue new shares in itself which will be bought on the stock market.

Question 8

Use of bonds and stocks - information about prospective borrowers

Answer 8

• Price of stocks can be seen as a measure of a firms financial health as they represent ownership in a company. Higher prices indicate the company is doing well whereas falling prices indicate otherwise.
• Bonds are evaluated on the risk of investment and given a credit rating which can also determine the interest rate of a bond. A higher risk bond will have a lower credit rating and higher coupon rate.

Question 9

Diversification

Answer 9

Spreading wealth over a variety of different financial investments to reduce overall risk.
By investing less in a large amount of stocks/bonds you lower the risk of your investment as if one smaller investment fails and the rest succeed, it is less of a negative impact than if you put all your savings in one investment which then fails.

Question 10

Supply of savings (S)

Answer 10

The amount of savings that would occur at each possible real interest rate (r). It is upward sloping.
Quantity supplied increases as r increases.

Question 11

Demand for investment (I)

Answer 11

The amount of savings borrowed at each possible real interest rate. It is downward sloping.
The quantity demanded is inversely related to r.

Question 12

Equilibrium interest rate

Answer 12

Occurs where supply of savings (S) and demand for investment (I) intersect.
It equates the amount of saving with the investment funds demanded.
If r>equilibrium, there is a savings surplus.
If r<equilibrium, there is a savings deficit.

Question 13

How market equilibrium changes

Answer 13

Equilibrium principle holds - financial markets adjust to surplus and deficit like any other market.
Changes in factors other than real interest rates will shift saving/investment curves causing a new equilibrium.

Question 14

How technologies improvement affects financial market

Answer 14

New technology raises marginal productivity of capital meaning:
- Increased demand for investment funds – shifts demand curve right because there is a higher marginal product of capital which makes firms more eager to invest.
- Higher interest rates as investors are more likely to accept paying the higher interest rates
- Higher level of savings because of higher interest rates and investment.
- Higher rate of investment reflecting opportunities created by the new technologies.

Question 15

Government Budget Deficit Increases

Answer 15

Increased government budget deficit causes:
- Reduction in nation saving – supply curve shifts left.
- Government use private savings to finance the deficit meaning investors have to compete for a smaller quantity of available savings.
- Higher interest rates to counteract the increased demand for investment.
- Investments are less attractive because of the higher interest rates, causing a lower level of savings and investment.

Question 16

Effects of budget deficit and national savings

Answer 16

Increased national savings rate or reducing government deficit leads to more investment in new capital goods and therefore a higher standard of limit. The same happens in reverse - increasing budget deficits causes investors to compete for a smaller quantity of available savings. Called the crowding-out effect.
Crowding-out effect: the tendency of government budget deficits to reduce investment spending.

Question 17

Austerity policy

Answer 17

Aims to reduce budget deficits by reducing government spending and/or increases in taxes.
Stop debt growing by reducing costs (spending cuts) and increasing revenue (tax increases).
It focuses on long-term economic stability over short-term economic impacts.

Question 18

Pros and cons of austerity policy

Answer 18

Pros:
- Debt reduction can have positive long-term effects on the economy.
- Shrinking state encourages private sector growth
- Cutting deficits increases investor confidence
Cons:
- If it leads to deflation, austerity works against itself.
- Can slow economic growth, especially if used during a recession.
- Has negative short term economic impacts e.g., higher unemployment from shrinking public sector.

Question 19

Stimulus policy

Answer 19

Aims to boost economic activity, often through government intervention to increase spending and reduce taxes.
Involves increased government spending on infrastructure, social programs and direct aid, tax cuts or rebates to encourage consumer spending and low interest rates and monetary policies.

Question 20

Pros and cons of stimulus policy

Answer 20

Pros:
- Can accelerate economic recovery and reduce unemployment.
- Increases demand which leads to higher business investments.
- Prevents deflationary spirals during economic downturns.
Cons:
- Can lead to higher budget deficits and increased national debt which can have negative long term economic effects.
- If poorly managed, can lead to inflation.
- May not always result in proportional economic growth e.g., if consumers save money instead of spending it.