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Chapter 10 (1) - Banks, money, and the credit market - Coggle Diagram
Chapter 10 (1) - Banks, money, and the credit market
Unit 1
Income is the amount of money you receive over some period of time, whether from market earnings, investments, or from the government.
Since it is measured over a period of time (such weekly or yearly), it is a flow variable.
The term wealth is also sometimes used in a broader sense to include immaterial aspects such as your health, skills, and ability to earn an income (your human capital)
Wealth is a stock variable, meaning that it has no time dimension.
One way to think about wealth is that it is the largest amount that you could consume without borrowing, after having paid off your debts and collected any money owed to you
Money allows purchasing power to be transferred among people so that they can exchange goods and services, even when payment takes place at a later date
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Like income, it is a flow, but a negative one.
Money is a medium of exchange consisting of bank notes and bank deposits, or anything else that can be used to purchase goods and services, and is accepted as payment because others can use it for the same purpose.
A nation’s central bank creates a special kind of money called legal tender and lends to banks at its chosen policy interest rate.
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Banks are profit-maximizing firms that create money in the form of bank deposits in the process of supplying credit.
One form that saving can take is the purchase of a financial asset such as shares (or stocks) in a company or a government bond.
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Borrowing and lending is a principal–agent relationship, in which the lender (the principal) cannot guarantee repayment of the loan by the borrower (the agent) by means of an enforceable contract.
While net income is this flow less depreciation. Net income is the maximum amount that you could consume and leave your wealth unchanged.
Unit 3
There are two reasons for pure impatience:
- Myopia (short-sightedness)
- Prudence
To see what pure impatience means, we compare two points on the same indifference curve in Figure 3
To see whether someone is impatient as a person, we ask whether she values a good now more highly than later, when her initial endowment is having the same amount in both periods.
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See how Julia can choose her consumption now and later, and how her preferences can be represented by indifference curves. Diminishing marginal returns to consumption in each period mean that Julia would like to smooth her consumption, that is, to avoid consuming a lot in one period and little in the other.
At point A she has $50 now and $50 later. We ask how much extra consumption she would need to have later in order to compensate her for losing $1 now.
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Point B shows us, if she had only $49 now, she would need $51.50 later in order to stay on the same indifference curve and be equally happy. So she needed $1.50 later to compensate for losing $1 now.
The value to the individual of an additional unit of consumption in a given period declines the more that is consumed. This is called diminishing marginal returns to consumption.
The slope of the indifference curve of 1.5 (in absolute value) at point A in Figure 3 means that she values an extra unit of consumption now 1.5 times as much as an extra unit of consumption later.
Julia could be impatient for two reasons:
- She prefers to smooth out her consumption instead of consuming everything later and nothing now.
- She may be an impatient type of person.
Unit 4
We know that at this tangency point, the slope of the indifference curve is equal to the slope of the feasible frontier
We define a person’s discount rate, ρ as the slope of the indifference curve minus one, which is a measure of how much Julia values an extra unit of consumption now, relative to an extra unit of consumption later.
The highest feasible indifference curve when the interest rate is 10% will be the one that is tangent to the feasible frontier, shown as point E in Figure 4.
Here, she chooses to borrow and consume $58 and repay $64 later, leaving her $36 to consume later.
Discount rate (p) = a measure of a person's impatience
- Consumption smoothing
- Pure impatience
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Julia wishes to get to the highest possible indifference curve, but is limited by her feasible frontier.
Her discount rate ρ depends on both her desire to smooth consumption and on her degree of pure impatience.
Slope of the indifference curve (MRS) = Slope of the feasible frontier (MRT)
We know that:
MRS = 1 + p
=MRT = 1 + r
So:
MRS = MRT
1 + p = 1 + r
If we subtract 1 from both sides of this equation we have:
p = r
Discount rate = rate of interest
Unit 6
Marco ends up consuming at a new point, L, with more both now and in the future.
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The plan shifts Marco’s feasible frontier out even further, as shown by the dotted red line.
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The slope of the red line is −1.5, where the absolute value (1.5) is the marginal rate of transformation of investment into returns, or 1 plus the rate of return on the investment.
This opportunity to invest will further expand his feasible set. Suppose that if he were to invest all of his grain, he could harvest $150 worth of grain later.
Compare the feasible sets of Julia shown in Figure 4 and of Marco, whose options are shown in Figure 10.
Three differences between Marco and Julia explain the disparity in their outcomes.
- Marco starts with an asset while Julia starts with nothing
- Marco has a productive investment opportunity while Julia does not.
- Marco and Julia may face different interest rates
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To summarize, borrowing, lending, storing, and investing are ways of moving goods consumption forward (to the present) or backwards (to the future) in time.
People engage in these activities because:
- They can increase their utility by smoothing consumption
- They can increase their consumption in both periods: By lending, or investing.
If Marco owns some land, he could do even better. He could invest the grain
People differ in which of these activities they engage (some borrowing, some lending) because:
- They have differences in their situation
- They differ in their level of pure impatience.
Unit 5
The borrower and the saver have different indifference curves because they have different endowments
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Marco's indifference curve is quite flat now, indicating that he is looking for a way to transfer some of his consumption to the future.
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This is called Julia’s reservation indifference curve, because it is made of all of the points at which Julia would be just as well off as at her reservation position, which is her endowment with no borrowing or lending
Marco has $100 worth of grain just harvested, and no debts to pay off. He could consume it all now, but as we have seen, this would probably not be the best he could do given the circumstances:
- We have assumed his income in the future is zero
- Like Julia, he has diminishing marginal returns to consumption of grain
Think about what Julia’s indifference curve, passing through her endowment point, might look like. As shown in Figure 5, it is very steep. Because she currently has nothing, she has a strong preference for increasing consumption now.
He could store the grain, but if he did, mice would eat some of it. Mice are a form of depreciation. So, taking account of the mice, if he consumed nothing at all during this period he would have just $80 worth of grain a year later. This means that the cost of moving grain from the present to the future is 20% per year.
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Marco’s wealth, narrowly defined, is $100. Julia’s wealth is zero.
In Figure 6, we see that Marco’s endowment is on the horizontal axis, as he has $100 of grain available now. The dark line shows Marco’s feasible frontier using storage, and the dark shaded area shows his feasible set.
While Julia is deciding how much to borrow, Marco has some goods or funds worth $100, but does not (yet) anticipate receiving any income later. Julia and Marco will both get $100 eventually, but time creates a difference
Marco will find the amount of storage that gets him to the highest feasible indifference curve by finding the point of tangency between the indifference curve and the feasible frontier. This is point H, so he will eat $68 of the grain now, and consume $26 of it later (mice ate $6 of the grain). At point H, Marco has equated his MRS between consumption now and in the future to the MRT, which is the cost of moving goods from the present to the future.
Now think about Marco, an individual facing a different situation from Julia who was considering a payday loan, or a farmer in Chambar seeking a loan until the harvest.
A better plan, if Marco could find a trustworthy borrower, would be to lend the money. If he did this and could be assured of repayment of $(1 + r) for every $1 lent, then he could have feasible consumption of 100 × (1 + r) later, or any of the combinations along his new feasible consumption line. The light line in Figure 6 shows the feasible frontier when Marco lends at 10%. His feasible set is now expanded by the opportunity to lend money at interest. Marco is able to reach a higher indifference curve.
Unit 7
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Net worth is accumulated savings over time.
net worth≡assets−liabilities
≡what the household owns or is owed−what the household owes to others
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net worth or wealth increases with income, and declines with consumption and depreciation.
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Julia started off with neither assets nor liabilities and a net worth of zero, but on the basis of her expected future income she borrowed $58 when the interest rate was 10%
A balance sheet summarizes what the household or firm owns, and what it owes to others. What you own (including what you are owed by others) is called your assets, and what you owe others is called your liabilities
taking out the loan has no effect on her current net worth—the liability and the asset are equal to one another, so her net worth remains unchanged at zero.
Balance sheets are an essential tool for understanding how wealth changes when an individual or a firm borrows and lends.
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Unit 2
Initially Julia is at the point labelled ‘Julia’s endowment’ in Figure 1. To consume now, Julia is considering taking out a payday loan
Julia could, for example, borrow $91 now and promise to pay the lender the whole $100 that she will have later. Her total repayment of $100 would include the principal (how much she borrowed) plus the interest charge at the rate r, or:
repayment=principal + interest
=91+91𝑟
=91(1+𝑟)
=$100
Each point in the figure shows a combination of Julia’s capacity to consume things, now and later. We assume that she spends everything that she has, so each point in the figure gives her consumption now (measured on the horizontal axis) and later (measured on the vertical axis).
And if ‘later’ means in one year from now, then the annual interest rate, r, is:
interest rate=repayment / principal −1
=10091−1
=0.1
=10%
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All of her possible combinations of consumption now and consumption later generate the feasible frontier shown in Figure 1, which is the boundary of the feasible set when the interest rate is 10%.
Borrowing and lending allow us to rearrange our capacity to buy goods and services across time. Borrowing allows us to buy more now, but constrains us to buy less later.
One plus the interest rate (1 + r) is the marginal rate of transformation of goods from the future to the present, because to have one unit of the good now you have to give up 1 + r goods in the future.
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But suppose that, instead of 10%, the interest rate is now 78%, the average rate paid by the farmers in Chambar. At this interest rate Julia can now only borrow a maximum of $56, because at 78% the interest on a loan of $56 is $44, using up all $100 of her future income.
You make choices from the feasible set, based on preferences described by indifference curves that represented how much they valued one objective relative to the other.
Her feasible frontier therefore pivots inward and the feasible set becomes smaller. Because the price of bringing buying power forward in time has increased, the capacity to consume in the present has fallen, just as your capacity to consume grain would fall if the price of grain went up
At the same interest rate (10%), she could also borrow $70 to spend now, and repay $77 at the end of the year, that is:
repayment=70+70𝑟
=70(1+𝑟)
=$77
In that case she would have $23 to spend next year.