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FINAL EXAM CHAPTERSGDP, INF, UN-N (CH 10,11,15)LF Model (open + closed) (Chp 13,18,19)Monetary Policy (Chp 16,17)Chapter 13: Saving, Investment, and the Financial SystemThese notes more closely follow the book but also lecture notes· Financial system: consists of the institutions that help match one person's savingwith another person's investment· When a country saves a large portion of GDP, more resources are available forcapital investments → higher capital raises productivity and standard for livingI. Financial institutions in the U.S. economyA. Financial markets: the institutions through which a person who wants to candirectly supply funds to a person who wants1. The bond marketi. Bond: certificate of indebtedness that specifies the obligations of the borrowerto the holder (IOU)ii. Debt financeiii. Three characteristics that differentiate bondsa. Term: length of time until the bond matures1. Long-term bonds are riskier than short-term becausetakes longer to repay principal2. Long-term usually pay higher interest ratesb. Credit risk: probability the borrower will fail to pay someof the interest or principal (default)1. Safe credit risk like government pay low interest rates2. Junk bonds pay high interest rates; used by financiallyunstable companies3. Can judge risk by using various private agencies--ex.Standard & Poor'sc. Tax treatment: the way tax laws treat the interest earned1. On most bonds is taxable income2. Municipal bonds: issued by state and local government; owners not required to paytaxes on interest; lower interest rate than company or federal government bonds2. The stock marketi. Stock: represents ownership in a firm → a claim to profitsii. Equity finance1iii. Stock prices determined by supply and demand of stock → demand reflects people'sperception of the company's future profitabilityiv. Stock index: computed as an average of a group of stock pricesA. Ex. Dow Jones Industrial AverageB. Financial intermediaries: financial institutions through which savers canindirectly provide funds to borrowers1. Banksi. Primary job is to take in deposits from people who want to save anduse deposits to make loans to people who want to borrowa. Pay depositors interest on deposits and charge borrowersslightly higher interest on loansii. Facilitate purchase of goods and services by allowing people to writechecks against their deposits and to access those deposits with debit cards →act as a medium of exchange2. Mutual funds: institution that sells shares to public and uses theproceeds to buy a selection (portfolio) of various types of stocks, bonds, orbothi. Value rises → shareholder benefits; value falls → shareholder suffers lossii. Advantage: allow people with small amounts of money to diversify their holdingsa. People who have diverse portfolio face less risk because theyhave a small stake in each companyiii. Advantage: give ordinary people access to professional money managersII. Saving and investment in the national income accountsGDP equation Y=C+I+G+NXY- GDP (income)C-consumptionI-investmentG-government purchasesNX-net exportsClosed economy--no outside interaction (no NX)Y-C=I+G →Y-C-G=I→S=IS=Y-C-G=national savingA. Saving1 .National saving (saving): total income in the economy that remainsafter paying for consumption and government purposesi S=Y-C-G22. Private saving: amount of income that households have left after payingtaxes and for consumptioni Y-T-C3. Public saving: amount of tax revenue government has left after payingfor spendingi T-Gi If T > G, gov't has budget surplusa. T-G=positive #i IF T < G, gov't has budget deficita. T-G=negative #B. The meaning of saving and investment1 .Investment refers to the purchase of new capital (e.g. buildings orequipment)i (Y-C-T)+(T-G)=IPrivate saving + public saving=investment = national savingsIII. The market for loanable fundsA. Market for loanable funds: market in which those who want to save supply fundsand those who want to invest demand funds1. Loanable funds refers to all income that people have chosen to saveand lend out (rather than use for their own consumption), and to theamount that investors have chosen to borrow to fund new investmentprojectsi. One interest ratea. Return to savingb. Cost of borrowing2. Three steps to work loanable funds modeli. Determine which curve (supply or demand) is affectedii. Determine which direction the curve shiftsiii. Use the model to determine what will happen to the interest rates and quantity ofloanable funds exchanged3When more funds are supplied, interest rates falls and more funds are exchangedWhen more funds are demanded, interest rate rises and more funds are exchangedB. Supply and demand for loanable funds1. Saving is the source of the supply of loanable fundsi Comes from people who have extra income they want to save and lendout4a. Direct--household buys bondb. Indirect--household makes a deposit2. Investment is the source of demand for loanable fundsi Comes from when people take out loans to buy homes, capital3. Interest rate is the price of a loani Amount that borrowers pay for loans and amount lenders receive ontheir savingii Nominal interest rate is usually reportediii Real interest rate=nominal IR -inflation ratea. More accurately reflects return to saving and cost ofborrowingb. Model depends on real interest rateC. Policy 1: Saving IncentivesD. Policy 2: Investment Incentives5E. Policy 3: Gov't budget deficits and surpluses1.Gov't budgeti Budget deficit is an excess of spending over tax revenueii Budget surplus is an excess tax revenue over spendingiii Gov't spending = tax revenue → balanced budget2.Ex. Suppose gov't runs a deficiti - public saving (negative)a. Reduces national saving → reduces supplyi Doesn't alter amount firms want to borrow → demand not affected bydeficitii Interest rate risesa. Alters behavior of households and firms → demanders arediscouraged and quantity demanded decreases → fall ininvestmenti Crowding out: a decrease in investment that results from gov'tborrowingii When the government reduces national saving by running abudget deficit, the interest rate rises and investment falls.


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UMD ECON 201 - FINAL EXAM

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