ECON201 Midterm 2 Review 2014 I Chapter 13 Saving Investment and the Financial System a Financial Markets the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow i Bond Market 1 Bond a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond 2 Date of Maturity time at which the loan will be repaid 3 Characteristics a Term the length of time until the bond matures i The British government has even issued a bond that never matures called a perpetuity This bond pays interest forever but the principal is never repaid ii Long term bonds are riskier long term bonds usually pay higher interest rates than short term bonds to compensate for risk b Credit Risk the probability that the borrower will fail to pay some of the interest or principal i Default failure to pay ii When bond buyers perceive that the probability of default is high they demand a higher interest rate as compensation for this risk iii U S government is considered a safe credit risk government bonds tend to pay low interest rates ECON201 Midterm 2 Review 2014 iv financially shaky corporations raise money by issuing junk bonds which pay very high interest c Tax Treatment the way the tax laws treat the interest rates earned on the bond i Municipal Bonds state and local govt bonds not required to pay federal income tax on interest income as a result bonds issued by state and local governments typically pay a lower interest rate than bonds issued by corporations or the federal government ii Stock Market 1 Stock represents ownership in a firm and is therefore a claim to the profits that the firm makes 2 Equity Finance sale of stock to raise money 3 Debt Finance sale of bonds to raise money 4 Stock Index computed as an average of a group of stock prices 5 Dividend pay out of profits from corporations to their 6 Dividend Yield the dividend expressed as a percentage of the stockholders stock s price ECON201 Midterm 2 Review 2014 7 Price earnings Ratio P E the price of a corporation s stock divided by the amount the corporation earned per share over the past year a Higher indicates that a corporation s stock is expensive relative to its recent earnings his might indicate either that people expect earnings to rise in the future or that the stock is overvalued b Lower indicates that a corporation s stock is cheap relative to its recent earnings this might indicate either that people expect earnings to fall or that the stock is undervalued b Financial Intermediaries financial institutions through which savers can indirectly provide funds to borrowers i Banks Financial intermediaries and create medium of exchange via checks ii Mutual Fund an institution that sells shares to the public and uses the proceeds to buy a selection or portfolio of various types of stocks bonds and debit cards or both stocks and bonds 1 Advantages allow people with small amounts of money to diversify their holdings and give ordinary people access to the skills of professional money managers 2 Index Funds buy all the stocks in a given stock index perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers ECON201 Midterm 2 Review 2014 c Important Identities net exports NX i GDP Y consumption C investment I government purchases G and ii National Saving the total income in the economy that remains after paying for consumption and government purchases S I iii Private Saving the income that households have left after paying for taxes iv Public Saving the tax revenue that the government has left after paying and consumption for its spending v Budget Surplus an excess of tax revenue over government spending vi Budget Deficit a shortfall of tax revenue from government spending d Market for Loanable Funds assumption that economy has only one financial market i Supply and Demand 1 saving is the source of the supply of loanable funds 2 investment is the source of the demand for loanable funds ii Policies 1 Saving Incentives many economists and lawmakers have proposed reforming the tax code to encourage greater saving 2 Investment Incentives passed a tax reform aimed at making investment more attractive investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment ECON201 Midterm 2 Review 2014 3 Government Budget Deficits and Surpluses When the government reduces national saving by running a budget deficit the interest rate rises and investment falls II Chapter 16 The Monetary System a Meaning of Money i Unit of Account the yardstick people use to post prices and record debts ii Store of Value an item that people can use to transfer purchasing power iii Liquidity describe the ease with which an asset can be converted into the from the present to the future economy s medium of exchange iv Commodity Money When money takes the form of a commodity with intrinsic value ex gold standard v Fiat Money Money without intrinsic value b The Federal Reserve System i Federal Reserve The Fed US agency responsible for for regulating the system of fiat money 1 Roles a lender of last resort a lender to those who cannot borrow anywhere else to maintain stability in the overall banking b control the quantity of money that is made available in the system economy money supply ECON201 Midterm 2 Review 2014 ii Central Bank an institution designed to oversee the banking system and regulate the quantity of money in the economy ex the fed iii Monetary Policy Decisions by policymakers concerning the money iv open market operation the purchase and sale of U S government supply bonds c Banks and the Money Supply i Reserves Deposits that banks have received but have not loaned out ii Fractional Reserve Banking a banking system in which banks hold only a fraction of deposits as reserves iii Reserve Ratio The fraction of total deposits that a bank holds as reserves iv Money Multiplier The amount of money the banking system generates with each dollar of reserves reciprocal of reserve ratio v Bank Capital The resources that a bank obtains from issuing vi Leverage the use of borrowed money to supplement existing funds for equity stock to its owners investment purposes vii Leverage Ratio the ratio of the bank s total assets to bank capital viii Capital Requirement a government regulation specifying a minimum amount of bank capital d The Fed s Tools of Monetary Control i Open Market
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