03 14 2013 The group of institutions in the economy that help to match one person s Financial institutions through which savers can directly provide funds to Vocab Financial System saving with another person s investment Financial Markets borrowers Bond A certificate of indebtedness Stock A claim to partial ownership in a firm A claim to the profits that the firm makes Financial Intermediaries Financial institutions through which savers can indirectly provide funds to An institution that sells shares to the public and uses the proceeds to buy a the total income in the economy that remains after paying for consumption The income that households have left after paying for taxes and borrowers Mutual Fund portfolio of stocks and bonds National Saving Saving and government purchases Private Saving consumption Public Saving The tax revenue that the government has left after paying for its spending Budget Surplus Budget Deficit An excess of tax revenue over government spending A shortfall of tax revenue from government spending Market for Loanable Funds The market in which those who want to save supply funds and those who want to borrow to invest demand funds Crowding Out A decrease in investment that results from government borrowing Notes When a country saves a large portion of its GDP more resources are available for investment in capital and higher capital raises a country s productivity and living standard The financial system moves the economy s scarce resources from savers people who spend less than they earn to borrowers people who spend more than they earn Financial Markets The Bond Market The buyer of a bond gives his or her money to a company in exchange for this promise of interest and eventual repayment of the amount borrowed Known as Principal Perpetuity A bond that never matures and pays interest forever Long term bonds are riskier than short term bonds because holders of long term bonds have to wait longer for repayment of principal If a holder of a long term bond needs his money earlier than the distant date of maturity he has no choice but to sell the bond to someone else perhaps at a reduced price To compensate for the risk of long term bonds long term bonds usually pay higher interest rates than short term bonds Credit Risk The probability that the borrower will fail to pay some of the interest or principal Default The borrowers failure to pay back Borrowers can and sometimes do default on their loans by declaring bankruptcy When bond buyers perceive that the probability of default is high they demand a higher interest rate to compensate them for this risk Junk Bonds Which pay very high interest rates Tax Treatment The way the tax laws treat the interest earned on the bond The interest on most bonds is taxable income that is the bond owner has to pay a portion of the interest in income taxes Municipal Bonds The bond owners are not required to pay federal income tax on the interest income The Stock Market Equity Finance The sale of stock to raise money Debt Finance The sale of bonds The owner of shares in a company s stock is a part owner of that company The owner of a company s bond is a creditor of the corporation If a company is very profitable the stockholders enjoy the benefits of these profits The owner of a company s bondholders get only the interest on their bonds If a company runs into financial difficulty the bondholders are paid what they are due before stockholders receive anything at all Compared to bonds stocks offer the holder both higher risk and potentially higher return A corporation receives no money when stocks are traded The most important stock exchanges in the U S economy are the New York Stock Exchange NYSE the American Stock Exchange and the NASDAQ National Association of Securities Dealers Automated Quotation system The prices at which shares trade on stock exchanges are determined by the supply of and demand for the stock in these companies The demand for a stock and thus its price reflects people s perception of the corporation s future profitability When people become optimistic about a company s future they raise their demand for its stock and thereby bid up the price of a share of stock When people come to expect a company to have little profit or even losses the price of a share falls Stock Index Computed as an average of a group of stock prices The most famous stock index is the Dow Jones Industrial Average which has been computed regularly since 1896 Big stock indexes are watched closely as possible indicators of future economic conditions Financial Intermediaries Banks familiar companies Most buyers of stocks and bonds prefer to buy those issued by larger more Banks are the financial intermediaries with which people are most familiar A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans The difference between these rates of interest covers the banks costs and returns some profit to the owners of the banks Medium of Exchange An item that people can easily use to engage in transactions Mutual Funds The shareholder of the mutual fund accepts all the risk The primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings Holding a single kind of stock or bond is very risky People who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company Index Funds Buy all the stocks in a given stock index Financial institutions all serve the same goal directing the resources of savers into the hands of borrowers Saving and Investment in the Nation Income Accounts Accounting refers to how various numbers are defined and added up Identity An equation that must be true because of the way the variables in Important Identities the equation are defined Y C I G NX exports NX around the world Y C I G Y C G I GDP denoted as Y is divided into four components of expenditure consumption C investment I government purchases G and net A closed economy is one that does not interact with other economies Actual economies are open economies they interact with other economies Because a closed economy does not engage in international trade imports and exports are exactly zero Therefore net exports NX are also zero The left side of this equation Y C G is the total income
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