CHAPTER 20 The Financial System Opportunities and Dangers

CHAPTER 20 The Financial System: Opportunities and Dangers A Power. Point Tutorial To Accompany MACROECONOMICS, 8 th Edition N. Gregory Mankiw Tutorial written by: Mannig J. Simidian B. A. in Economics with Distinction, Duke University M. P. A. , Harvard University Kennedy School of Government M. B. A. , Massachusetts Institute of Technology (MIT) Sloan School of Management ®

What does the financial system do? There are some individuals who are looking to invest part of their income that they are not currently using (counted in the nation’s savings). They put this money aside. Then, others are looking to start a new venture which may require the purchase of capital equipment (contributing in the nation’s investment). When the two interests intersect, they do so using the financial system: the broad term for the institutions in the economy that facilitate the flow of funds between savers and investors.

Financing investment Two important financial markets are the market for bonds and the market for stocks. Raising investment funds by issuing bonds is called debt finance. Raising investment funds by issuing bonds is called equity finance. Another piece of the financial system is the set of financial intermediaries: they stand between the two sides of the market and help direct financial resources towards their best use.

Sharing Risk aversion: a person who does not like the randomness of financial circumstances. If a person is the latter, they can diversify their investments by reducing risk by holding many imperfectly correlated assets. Example: Mutual funds- financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets.

Dealing with asymmetric information Economists use the phrase asymmetric information to describe a situation in which one party to an economic transaction has more information about the transaction than the other. Hidden knowledge about attributes verses hidden knowledge about actions.

Fostering Economic Growth Many economists believe that one reason poor nations remain poor is that their financial systems are unable to direct their saving to the best possible investments. These nations can foster economic growth by reforming their legal institutions with an eye toward improving the performance of their financial systems. If they succeed, entrepreneurs with good ideas will find it easier to start their business.

Financial crisis A financial crisis is a major disruption in the financial system that impedes the economy’s ability to intermediate between those who want to save and those who want to borrow and invest. Many of the deepest recessions have followed problems in the financial system. These downturns have included the Great Depression of the 1930’s and the great recession of 20082009.

The Anatomy of a Crisis 1) Asset-Price Booms and Busts. Periods of optimism lead to large increases in asset prices which will land that market into a speculative bubble. 2) Insolvencies at Financial Institutions. A large decline in asset prices may cause problems at banks and other financial institutions. 3) Falling Confidence. A decline in confidence in financial institutions in another ingredient in the making of a financial crisis. 4) Credit Crunch. Would-be borrowers have trouble getting loans, even if they have profitable investment projects. 5) Recession. When people are unable to obtain credit and firms are unable to obtain financing for new investment projects, the overall demand for goods and services declines. 6) A Vicious Circle. The economic downturn reduces the profitability of many companies and the value of many assets. The stock market declines. Some firms go bankrupt and default on their loans. Then we return to step 1 (asset-price busts), and 2 (financial institution insolvencies).

Policy Responses to a Crisis Conventional Monetary and Fiscal Policy Lender of Last Resort

Policies to Prevent Crises Focusing on Shadow Banks Restricting Size Reducing Excessive Risk Taking Making Regulation Work Better

Financial system Financial markets Bond Stock Debt Finance Equity Finance Financial Intermediation Risk averse Diversification Mutual funds Asymmetric selection Moral hazard Financial crisis Speculative bubble Leverage Fire sale Liquidity crisis Lender of last resort Shadow banks 11