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Chapter 25: Finance, saving and Investment, In the long run, demand and…
Chapter 25: Finance, saving and Investment
Financial Markets
Finance & money
- finance is the activity of providing funds that finance expenditures on capital
- money is what we use to pay for goods and services and factors of production and to make financial transactions
Physical & financial capital
- physical capital are the tools, inventory, machines used to produce goods and services
- financial capital is funds used to get these goods and services
- an increase in the quantity of capital increases production possibilities and shifts the aggregate production function upward (∴ makes RGDP grow)
Investment and wealth
- quantity of capital changes because of investment and depreciation (Investment increases it, depreciation decreases it)
- Net investment = gross investment - depreciation
- wealth is the value of all things that people own; saving is the amount of income not paid in taxes or consumed.
- saving increases wealth & wealth increases when market value of assets increases (capital gains) & decreases when market asset value decreases (capital losses)
Insolvency and Illiquidity
- a financial institution's net worth is the market value of what it has lent - the market value of what it has borrowed
- if net worth is +ve: institution is solvent
- if net worth is -ve: institution is insolvent & must go out of business
- a firm is illiquid if it has made long-term loans with borrowed funds and suddenly needs to repay more of what it has borrowed than its available cash
Interest rates and asset prices
- interest on an asset is the interest received expressed as a % of the price of the asset
- ∴ there is an inverse relationship between interest rate and asset price
if asset price rises, interest rate decreases
if asset price decreases, interest rate increases
Real interest rate is nominal rate adjusted to remove effects of inflation.
∴RI = Nominal I - Inflation I
- it is the opportunity cost of loanable funds.
Real interest paid on borrowed funds is the OC of borrowing
Real interest forgone when funds are used is the OC of not saving or investing those funds
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In the long run, demand and supply increase subtly, however the real interest rate is constantly fluctuating