2 WHAT YOU WILL LEARN IN THIS CHAPTER The relationship between savings and investment spendingAspects of the loanable funds market, which shows how savers are matched with borrowersThe purpose of the five principal types of assets: stocks, bonds, loans, real estate, and bank depositsHow financial intermediaries help investors achieve diversificationSome competing views of what determines asset prices and why asset market fluctuations can be a source of macroeconomic instabilityWHAT YOUWILL LEARNIN THIS CHAPTER
3 Circular Flow: Savings, Investment and Financial Markets Government purchases of goods and servicesGovernment borrowingGovernmentConsumer spendingGovernment transfersTaxesPrivate savingsHouseholdsWages, profit, interest, rentMarkets for goods and servicesFinancial MarketsFactor MarketsWages, profit, interest, rentGDPBorrowing and stock issues by firmsInvestmentFirmsForeign borrowing and sales of stockExportsRest of the worldForeign lending and purchases of stockImports
4 Matching savers and borrowers Financial markets: match savers and borrowersSavings: could come from households; foreigners; businesses or governments.Borrowers: could also be households, businesses, foreigners or governments.Net positions? (savings less borrowings by type of decision- maker)Households are net saversBusinesses are net borrowersGovernments are usually net borrowersForeigners? In Canada could be net savers or net borrowers depending on the time period.How matched ? Markets for stocks, bonds, financial institutions (banks)
5 Households and Private Savings To start assume there is no foreign sector (closed economy).Then: GDP = C + I + G (X-IM=0 since closed)(C = consumption spending, I=investment spending G= government spending)Disposable income of households (YD)= GDP + TR-Ti.e. GDP (income) plus Transfers from government (TR) minus taxes (T) paid to the government.Two uses for disposable income: savings or consumption- call household savings ‘private savings’ (Sprivate)- then:YD = C + Sprivate- or, using the definition of YD from above:SPrivate = GDP + TR − T − C
6 Governments and Public Savings Spending by governments: two typesGovernment spending on goods and services (G)Transfers to individuals (TR).Governments pay for G and TR via tax and fee revenues (T) and by borrowing (via bonds).Budget deficit: spending (G+TR) exceeds tax and fee revenues (T).Government must borrow to cover the deficit.Budget surplus: spending (G+TR) is less than tax and fee revenues (T).Government is a saver!Public savings: SPublic = T − TR − G (<0 if budget deficit)(>0 if budget surplus)See The Economist indicators page: deficits? surpluses?Usually stated as % of GDP i.e. scale by size of the economy.
7 Savings-Investment Spending Identity National savings = Private plus public savings.SNational = SPrivate + SPublic= (GDP + TR − T − C) + (T − TR − G)= GDP − C − G = I (since GDP=C+I+G here)So: I = SnationalInvestment spending = National savings in a closed economy.This is an accounting identity: implied by the definitions of concepts it is based on.
8 Savings-Investment Identity in an Open Economy Open economy in the goods market: non-Canadians buy our goods and sell goods to us.Difference is net exports: Exports (X) minus Imports (IM)Open economy in the financial markets: non-Canadians lend their savings to us and also borrow from ustheir lending to us is an inflow of funds (foreign savings).Our lending to them is an outflow of our savings.Difference between is Net foreign investment (NFI).Net foreign investment is the total outflows of funds out of a country minus the total inflows of funds into that country.
9 A Key point: Net Exports (X-IM) = NFI Net foreign investment (NFI) equals net exports in an open economyIf: X-IM<0 then NFI<0 (inflow of funds from abroad is larger than outflow of funds)i.e. we must borrow from abroad to pay for the excess imports.If: X-IM>0 then NFI>0 (outflow of funds to foreigners is larger than the inflow of funds from abroad)i.e. they must borrow from us to pay for the excess of our exports over imports.
10 NFI = X-IM : a closer look Say just Canada and US with X-IM>0.This implies that more US dollars are in Canadian hands than Canadians use to buy imports from the US.What to Canadians do with these extra US dollars? Lend then to Americans (buy US assets)!Say just Canada and US with X-IM<0.This implies that more Cdn. dollars are in American hands than Americans use to buy our exports.What to Americans do with the extra Cdn. dollars? Lend them to Canadians (buy Cdn. Assets)!
11 Savings-Investment Identity for an Open Economy Now three sources of savings:Private savingsPublic savingsNet savings from abroad (-NFI notice minus!).Total savings in the open economy is:SNational –NFI = SPrivate + SPublic - NFI= (GDP + TR − T − C) + (T − TR − G) - (X-IM)= GDP − C − G – (X-IM)= I(last step uses: GDP = C + I + G + X-IM)If: I> SPrivate + SPublic then extra I is financed by borrowing from abroad (NFI<0 net inflow of funds).I< SPrivate + SPublic then some Canadian savings is borrowed by foreigners.NFI = X - IMSNationaI = I + (X – IM) = I + NFI
12 The Savings–Investment Spending Identity Canada 2007: Private + Public savings > Investment. Extra invested abroad (NFI>0)Canada 2010: Investment < Private + Public savings. Extra finance came from abroad (NFI<0)Note: government ran surpluses 2007 and deficits 2010.Figure Caption: Figure 10(25)-1: The Savings–Investment Spending Identity in Canada, 2007 and 2010In 2007, national savings was 25.1% of GDP and exceeded domestic investment (equal to 23.2% of GDP). Canada used the excess amount of funds to invest abroad (positive NFI equal to 1.9% of GDP). The reverse situation occurred in National savings (20.3% of GDP) was less than investment spending (22.2% of GDP); the shortfall was covered by borrowing from abroad (a negative NFI).Source: OECD.12
13 Pitfalls: Financial Investment vs. Physical Investment When macroeconomists use the term investment spending, they mean spending on new physical capital (machines, tools, factories etc.).In ordinary life we often say that someone who buys stocks or purchases an existing building is “investing.”Important to note that only spending that adds to the economy’s stock of physical capital is investment spending.In contrast, purchasing an asset such as a share, a bond, or existing real estate is called making a financial investment.
14 Pitfalls The Different Kinds of Capital It’s important to understand clearly the three different kinds of capital: physical capital, human capital, and financial capital.Physical capital consists of manufactured resources such as buildings and machines.Human capital is the improvement in the labour force generated by education and knowledge.Financial capital is funds from savings that are available for investment spending.So, a country that has a positive net foreign investment is experiencing a net outflow of funds out of the country to finance investment spending abroad.
15 FOR INQUIRING MINDS Who Enforces the Accounting? The savings–investment spending identity is a fact of accounting.By definition, savings equals investment spending for the economy as a whole.
16 Why does the savings-investment identity hold? Short answer? is that actual and desired investment spending aren’t always equal.Suppose that households suddenly decide to save more by spending less.The immediate effect will be that unsold goods pile up.And this increase in inventory counts as investment spending, albeit unintended.So the savings–investment spending identity still holds.Similarly, if households suddenly decide to save less and spend more, inventories will drop—and this will be counted as negative investment spending.Inventory changes: important in business cycle models.
18 The Domestic Market for Loanable Funds The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders.The interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender to a borrower for the use of their savings for one year.The loanable funds model is a supply-demand model of the entire financial system.i.e. has combined markets for all lending and borrowing into one.The Interest rate? Many in fact, this is the average level.
19 Demand for Loanable Funds Curve Demand: funds borrowed to finance domestic investment spending.Interest rate measures the cost of borrowing.Other things equal: expect a rise in the interest rate to decrease demand for loanable funds (next slide).i.e. demand for loanable funds curve is downward sloping.
20 The Domestic Demand for Loanable Funds Figure Caption: Figure 10(25)-2: The Domestic Demand for Loanable FundsThe demand curve for loanable funds slopes downward: the lower the interest rate, the greater the quantity of loanable funds demanded. Here, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $15 billion to $45 billion.20
21 Supply of Loanable Funds Curve Supply: funds savers are willing to make available for lending.Interest rate measures the return to the lender (saver).Other things equal expect that the supply of loanable funds will increase when the interest rate rises.i.e. Supply of loanable funds curve is upward sloping
22 The Domestic Supply of Loanable Funds Figure Caption: Figure 10(25)-3: The Domestic Supply of Loanable FundsThe supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. Here, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $15 billion to $45 billion.22
23 Domestic Loanable Funds Market Equilibrium Figure Caption: Figure 10(25)-4: Equilibrium in the Domestic Loanable Funds MarketAt the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here, the equilibrium interest rate is 8%, with $30 billion of funds lent and borrowed. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not. Projects that are profitable at an interest rate of 8% or higher are funded; those that are profitable only when the interest rate falls below 8% are not.
24 Shifts of the Domestic Demand for Loanable Funds Factors that can cause the demand curve for loanable funds to shift include:Changes in perceived business opportunities: (i.e. in expected payoffs from investment spending).e.g. During the 1990s there was great excitement over the business possibilities created by Internet and businesses rushed to invest.This shifted the demand for loanable funds to the right.Changes in the government policies that affect investment: can affect returns to investment spending.e.g. A tax credit would promote investment as investment becomes more attractive.
25 An Increase in the Domestic Demand for Loanable Funds Figure Caption: Figure 10(25)-5: An Increase in the Domestic Demand for Loanable FundsIf the quantity of funds demanded by borrowers rises at any given interest rate, the demand for loanable funds shifts rightward from D1 to D2. As a result, the equilibrium interest rate rises from i1 to i2.
26 Shifts of the Domestic Supply for Loanable Funds Factors that can cause the supply of loanable funds to shift include:Changes in private savings behavior:e.g. Rising home prices in the past decade made homeowners feel richer, making them willing to spend more and save less.This shifted the supply of loanable funds to the left.Changes in government budget balance (via public savings):e.g. The federal budget balance went from a surplus of $15.4 billion in 2007 to a deficit of $33 billion in 2009.Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending.So a problem with deficits in less private investment and less physical capital.
27 A Decrease in the Domestic Supply of Loanable Funds Figure Caption: Figure 10(25)-6: A Decrease in the Domestic Supply of Loanable FundsIf the quantity of funds supplied by lenders falls at any given interest rate, the supply of loanable funds shifts leftward from S1 to S2. As a result, the equilibrium interest rate rises from i1 to i2.
29 Present Value and Worthwhile Investment Investment decisions involve costs now for future payoffs. In making investments, we need to know how the value of a future dollar compares with the value of a dollar today.What is the “present value” of an expected future return?i.e. what is its value now.The present value of $1 in one year equals $1/(1 + i)the amount of money you must lend out today at interest rate ‘i’ in order to have $1 in one year. i.e. it is the value to you today of $1 realized one year from now.similarly present value of $1 in 2-years is 1/(1+i)2and present value of $1 in N years is 1/(1+i)N
30 Net Present Value and Investment If an investment costs ‘C’ right now and has payoffs of ‘P1’ in one-year and ‘P2’ in two years then it is worthwhile if:P1/(1+i) + P2/(1+i)2 - C >0i.e. if the present value of the benefits minus the costs is positive (Net Present Value >0)Investment is more likely to be worthwhile if:P1 and P2 are large;C is small;i is low.
31 Net Present Value and Investment: Example Investment: Cost: C = $1000 Payoff in 1st year: P1=$500 Payoff in 2nd year: P2=$600 Investment is worthwhile if Net Present Value >0, i.e. P1/(1+i) + P2/(1+i)2 - C >0 Say interest rate is 5% (i=.05): $500/(1+.05) + $600/(1+.05)2 - $1000 = $20.41 >0 (it is worthwhile!)
32 Inflation and Interest Rates Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate.Historically, major changes in interest rates have been driven by many factors, including:changes in government policy.technological innovations that created new investment opportunities.
33 Inflation and Interest Rates However, arguably the most important factor affecting interest rates over time is changing expectations about future inflation.This shifts both the supply and the demand for loanable funds.This is the reason, for example, that interest rates today are much lower than they were in the late 1970s and early 1980s.
34 Inflation and Interest Rates Real interest rate = nominal interest rate − inflation rateIn the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal. Actual loan contracts, therefore, specify a nominal interest rate rather than a real interest rate.
35 The Fisher EffectAccording to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.Say expected inflation rises: at old nominal interest rate suppliers will supply less and demand will be higher (why? real interest rate is lower!)i.e. supply shifts left (up); demand shifts right (up).How big a shift?Supply and Demand would be same as before if nominal interest rose by the amount of the rise in expected inflation.(why? Real interest rate would be unchanged)
36 The Fisher Effect Figure Caption: Figure 10(25)-7: The Fisher Effect D0 and S0 are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase in expected future inflation raises the equilibrium nominal interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged.36
37 ECONOMICS IN ACTION Fifty Years of Canadian Interest Rates Figure Caption: Figure 10(25)-8: Changes in Canada’s Interest Rates,As panel (a) shows, high current inflation leads to expectations of high future inflation, which results in a rise in the interest rate. Panel (b) shows the effect of changes in the expected return on investment spending on interest rates, with a “close-up” of interest rates from In 2007, it was becoming increasingly evident that the housing bubble in the U.S. was about to burst. Canadian businesses became more cautious about investing due to pessimistic future business outlook, which resulted in a leftward shift in the demand for loanable funds and a fall in the interest rate.Source: Statistics Canada.
38 50 year of Interest Rates: Comments Peak interest rates (Government 5-10 year bonds) in the early 1980s. Over 15% !expected inflation and the Fisher effect help explain rising interest rates through the 1970s and early 1980s.Later in the term: will see monetary policy also played a role.Lowest rates: near the end of the sample period.Notice low and quite stable inflation in this period.Panel (b) of the diagram is in this period of stable inflation: likely that interest rate movements then reflect changes in interest rates due to non-inflation factors.e.g. maybe low returns on investment expected? Maybe monetary policy after 2008?
39 The Financial SystemA household’s wealth is the value of its accumulated savings.A financial asset is a claim that entitles the buyer to future income from the seller.A physical asset is a tangible object can be used to generate future income. e.g. a building that you can rent or use; a machine that you can lease or use to produce something.
40 The Financial SystemA liability is a requirement to pay income in the future.Financial asset: is an asset to the owner (buyer) and a liability to the seller (issuer).Transaction costs are the expenses of negotiating and executing a deal.Financial risk is uncertainty about future outcomes that involve financial losses and gains.
41 Three Tasks of a Financial System Reducing transaction costs ─ the cost of making a deal.Reducing financial risk ─ uncertainty about future outcomes that involves financial gains and losses.Providing liquid assets ─ assets that can be quickly converted into cash (in contrast to illiquid assets, which can’t).
42 Three Tasks of a Financial System Individuals can engage in diversification by investing in several assets with unrelated risks so that the possible losses are independent events.An asset is liquid if it can be quickly converted into cash with relatively little loss of value.An asset is illiquid if it cannot be quickly converted into cash with relatively little loss of value.
43 Types of Financial Assets There are four main types of financial assets:loansbondsstocksbank depositsIn addition, financial innovation has allowed the creation of a wide range of loan-backed securities.
44 Types of Financial Assets A loan is a lending agreement between a particular lender and a particular borrower.A default occurs when a borrower fails to make payments as specified by the loan or bond contract.A loan-backed security is an asset created by pooling individual loans and selling shares in that pool.Financial assets are issued through eitherfinancial intermediaries (next page)markets (especially for stocks and bonds)
45 Financial Intermediaries A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets.Most important financial intermediaries (by $ of assets):Banks, Mutual funds, Pension funds and Insurance cos.A mutual fund is a financial intermediary that creates a portfolio of financial assets or other physical assets and then resells shares of this portfolio to individual investors.A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members.
46 An Example of a Diversified Mutual Fund Source: Fidelity Investments
47 Financial Intermediaries A life insurance company sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies.A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded.A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments spending needs of borrowers primarily via bank loans.
48 Finance and Growth: an example In the early 1960s, South Korea’s interest rates on deposits were very low at a time when the country was experiencing high inflation.So, savers didn’t want to save by putting money in a bank, fearing that much of their purchasing power would be eroded by rising prices.Instead, they engaged in current consumption by spending their money on goods and services or on physical assets such as real estate and gold.
49 Banks and the South Korean Miracle In 1965, the South Korean government reformed the country’s banks and increased interest rates.Over the next five years the value of bank deposits increased 600% and the national savings rate more than doubled.The rejuvenated banking system made it possible for South Korean businesses to launch a great investment boom, a key element in the country’s growth surge.Financial system is a key contributor to long-run growth.Savings and investment creates the physical capital that helps determine future output.
50 Financial Fluctuations Financial market fluctuations can be a source of macroeconomic instability.Severe recessions are often associated with financial crisese.g. Great Depression; recent US recession.A financial asset gives you a claim on a stream of future payments, e.g. interest, dividends, resale price of asset.(value of asset rooted in the present value of these expected payments)Stock prices are determined by supply and demand.Demand and prices are high when expected payments from the share are high (firm’s future profitability or “fundamentals”).Share prices will also be high when returns on other assets are low. e.g. when interest rates on bonds or GICs are low.i.e. with low interest rates people buy stocks instead of assets that pay interest.
51 Financial Fluctuations The value of a financial asset today also depends on investors’ beliefs about the future value or price of the asset.If investors believe that it will be worth more in the future, they will demand more of the asset today at any given price.This extra demand will cause today’s equilibrium price of the asset to rise.
52 Financial Fluctuations If investors believe the asset will be worth less in the future, they will demand less today at any given price.Consequently, today’s equilibrium price of the asset will fall.Today’s stock prices will change according to changes in investors’ expectations about future stock prices.
53 Financial Fluctuations There are two principal competing views about how asset price expectations are determined.One view, which comes from traditional economic analysis, emphasizes the rational reasons why expectations should change.The other, widely held by market participants and also supported by some economists, emphasizes the irrationality of market participants.
54 Financial Fluctuations One view of how expectations are formed is the efficient markets hypothesis, which holds that the prices of financial assets embody all publicly available information.e.g. if people received information that suggests a stock will rise in value people buy it now causing it’s price to rise.- The new information is now built into the stock price!It implies that price fluctuations are inherently unpredictable—they follow a random walk.Why? Prices only change when unanticipated, newinformation becomes available: when the unpredictable happens!
55 Irrational Markets?Many market participants and economists believe that, based on actual evidence, financial markets are not as rational as the efficient markets hypothesis claims.Such evidence includes the fact that stock price fluctuations are too great to be driven by fundamentals alone.
56 FOR INQUIRING MINDS BEHAVIORAL FINANCE Behavioral finance is the study of how investors in financial markets often make predictably irrational choices.
57 FOR INQUIRING MINDS BEHAVIORAL FINANCE Like most people, investors depart from rationality in systematic ways.In particular, they are prone to overconfidence, as in having a misguided faith that they are able to spot a winning stock;to loss aversion, being unwilling to sell an unprofitable asset and accept the loss; andto a herd mentality, buying an asset when its price has already been driven high and selling it when its price has already been driven low.
58 FOR INQUIRING MINDS BEHAVIORAL FINANCE This irrational behavior raises an important question: can investors who are rational make a lot of money at the expense of those investors who aren’t— for example, by buying a company’s stock if irrational fears make it cheap?The answer to this question is sometimes yes and sometimes no.Some professional investors have made huge profits by betting against irrational moves in the market (buying when there is irrational selling and selling when there is irrational buying).
59 FOR INQUIRING MINDS BEHAVIORAL FINANCE But sometimes even a rational investor cannot profit from market irrationality.For example, a money manager has to obey customers’ orders to buy or sell even when those actions are irrational.Timing: “The market can stay irrational longer than you can stay solvent.” John Maynard Keynes 1936.(Michael Lewis The Big Short on people betting against mortgage-backed assets prior to the 2008 financial crisis)
60 Asset Prices and Macroeconomics How do macroeconomists and policy-makers deal with the fact that asset prices fluctuate a lot and that these fluctuations can have important economic effects?Should policy-makers try to pop asset bubbles before they get too big?But can policy makers identify when asset prices are too high?A rapid rise in asset prices may be irrational; orA rapid rise in asset price could reflect a change in the true value of the asset.e.g. House prices in US in 2005? Vancouver now?
61 FOR INQUIRING MINDS What FX the TSX? Financial news reports often lead with the day’s stock market action, as measured by changes in the S&P/TSX Composite Index, the Dow Jones Industrial Average, the S&P 500, and the NASDAQ.All four are stock market indices.Like the consumer price index, they are numbers constructed as a summary of average prices.
62 FOR INQUIRING MINDS How Now, Dow Jones? The S&P/TSX is the headline index and principal broad market measure for Canadian equity (stock) markets. It contains about 90% of the Canadian-based firms listed on the Toronto Stock Exchange (TSX).The Dow, created by the financial analysis company Dow Jones, is an index of the prices of stock in 30 leading companies; The S&P 500 is an index of 500 companies, created by Standard and Poor’s; The NASDAQ is compiled by the National Association of Securities Dealers.The movement in an index gives investors a quick, snapshot view of how stocks from certain sectors of the economy are doing.
63 SummaryInvestment in physical capital is necessary for long-run economic growth. So, in order for an economy to grow, it must channel savings into investment spending.
64 SummaryAccording to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole. The government is a source of savings when it runs a positive budget balance or budget surplus; it is a source of dissavings when it runs a negative budget balance or budget deficit. In a closed economy, national savings, the sum of private savings plus the budget balance, is equal to investment spending. In an open economy, national savings is equal to investment spending plus net foreign investment. A positive net foreign investment occurs when some portion of national savings is funding investment spending in other countries.
65 SummaryThe hypothetical loanable funds market shows how loans from savers are allocated among borrowers with investment spending projects. In equilibrium, only those projects with a rate of return greater than or equal to the equilibrium interest rate will be funded. By showing how gains from trade between lenders and borrowers are maximized, the loanable funds market shows why a well-functioning financial system leads to greater long-run economic growth.
66 Summary(Cont.) Government budget deficits can raise the interest rate and can lead to crowding out of investment spending. Changes in perceived business opportunities and government policies shift the demand curve for loanable funds; changes in private savings and government budgetary balance shift the supply curve.
67 SummaryBecause neither borrowers nor lenders can know the future inflation rate, loans specify a nominal interest rate rather than a real interest rate. For a given expected future inflation rate, shifts of the demand and supply curves of loanable funds result in changes in the underlying real interest rate, leading to changes in the nominal interest rate. According to the Fisher effect, an increase in expected future inflation raises the nominal interest rate one-to-one so that the expected real interest rate remains unchanged.
68 SummaryHouseholds invest their current savings or wealth by purchasing assets. Assets come in the form of either a financial asset or a physical asset. A financial asset is also a liability from the point of view of its seller. There are four main types of financial assets: loans, bonds, stocks, and bank deposits. Each of them serves a different purpose in addressing the three fundamental tasks of a financial system: reducing transaction costs—the cost of making a deal; reducing financial risk—uncertainty about future outcomes that involves financial gains and losses; and providing liquid assets— assets that can be quickly converted into cash without much loss of value (in contrast to illiquid assets, which are not easily converted).
69 SummaryAlthough many small and moderately sized borrowers use bank loans to fund investment spending, larger companies typically issue bonds. Bonds with a higher risk of default must typically pay a higher interest rate. Business owners reduce their risk by selling stock. Although stocks usually generate a higher return than bonds, investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events.
70 Summary(Cont.) Loan-backed securities, a recent innovation, are assets created by pooling individual loans and selling shares of that pool to investors. Because they are more diversified and more liquid than individual loans, trading on financial markets like bonds, they are preferred by investors. It can be difficult, however, to assess their quality.
71 SummaryFinancial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify, and life insurance companies reduce risk.A bank allows individuals to hold liquid bank deposits that are then used to finance illiquid loans. Banks can perform this mismatch because, on average, only a small fraction of depositors withdraw their savings at any one time. Banks are a key ingredient in long-run economic growth.
72 SummaryAsset market fluctuations can be a source of short-run macroeconomic instability. Asset prices are determined by supply and demand, as well as by the desirability of competing assets such as bonds: when the interest rate rises, prices of stocks and physical assets such as real estate generally fall, and vice versa.
73 Summary(Cont.) Expectations drive the supply of and demand for assets: expectations of higher future prices push today’s asset prices higher, and expectations of lower future prices drive them lower. One view of how expectations are formed is the efficient markets hypothesis, which holds that the prices of assets embody all publicly available information. It implies that fluctuations are inherently unpredictable—they follow a random walk.
74 SummaryMany market participants and economists believe that, based on actual evidence, financial markets are not as rational as the efficient markets hypothesis claims. Such evidence includes the fact that stock price fluctuations are too great to be driven by fundamentals alone. Policy-makers assume neither that markets always behave rationally nor that they can outsmart them.
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