Page 330 - Krugmans Economics for AP Text Book_Neat

Section 5 Review

Summary
1. Investment in physical capital is necessary for long -run they are preferred by investors. It can be difficult, how-
economic growth. So in order for an economy to grow, ever, to assess their quality.
it must channel savings into investment spending. 5. Financial intermediaries—institutions such as mutual
2. According to the savings–investment spending iden- funds, pension funds, life insurance companies, and
tity, savings and investment spending are always equal banks—are critical components of the financial system.
for the economy as a whole. The government is a source Mutual funds and pension funds allow small investors
of savings when it runs a positive budget balance, also to diversify and life insurance companies allow families
known as a budget surplus; it is a source of dissavings to reduce risk.
when it runs a negative budget balance, also known as a 6. A bank allows individuals to hold liquid bank deposits
budget deficit. In a closed economy, savings is equal to that are then used to finance illiquid loans. Banks can per-
national savings, the sum of private savings plus the form this mismatch because on average only a small frac-
budget balance. In an open economy, savings is equal to tion of depositors withdraw their savings at any one time.
national savings plus capital inflow of foreign savings. Banks are a key ingredient in long -run economic growth.
When a capital outflow, or negative capital inflow, oc- 7. Money is any asset that can easily be used to purchase
curs, some portion of national savings is funding invest- goods and services. Currency in circulation and
ment spending in other countries. checkable bank deposits are both considered part of
3. Households invest their current savings or wealth— the money supply. Money plays three roles: it is a
their accumulated savings—by purchasing assets. Assets medium of exchange used for transactions, a store of
come in the form of either a financial asset, a paper value that holds purchasing power over time, and a
claim that entitles the buyer to future income from the unit of account in which prices are stated.
seller, or a physical asset, a claim on a tangible object 8. Over time, commodity money, which consists of goods
that gives the owner the right to dispose of it as desired. possessing value aside from their role as money, such as
A financial asset is also a liability from the point of gold and silver coins, was replaced by commodity -
view of its seller. There are four main types of financial backed money, such as paper currency backed by gold.
assets: loans, bonds, stocks, and bank deposits. Each of Today the dollar is pure fiat money, whose value de-
them serves a different purpose in addressing the three rives solely from its official role.
fundamental tasks of a financial system: reducing 9. The Federal Reserve calculates two measures of the
transaction costs—the cost of making a deal; reducing money supply. M1 is the narrowest monetary aggre-
financial risk—uncertainty about future outcomes that gate; it contains only currency in circulation, traveler’s
involves financial gains and losses; and providing liq- checks, and checkable bank deposits. M2 includes a
uid assets—assets that can be quickly converted into wider range of assets called near -moneys, mainly other
cash without much loss of value (in contrast to illiquid forms of bank deposits, that can easily be converted
assets, which are not easily converted). into checkable bank deposits.
4. Although many small and moderate -size borrowers use 10. In order to evaluate a project in which costs or benefits
bank loans to fund investment spending, larger compa- are realized in the future, you must first transform
nies typically issue bonds. Bonds with a higher risk of them into their present values using the interest rate,
default must typically pay a higher interest rate. Busi- r. The present value of $1 realized one year from now is
ness owners reduce their risk by selling stock. Although $1/(1 + r), the amount of money you must lend out
stocks usually generate a higher return than bonds, in- today to have $1 one year from now. Once this transfor-
vestors typically wish to reduce their risk by engaging in mation is done, you should choose the project with the
diversification, owning a wide range of assets whose highest net present value.
returns are based on unrelated, or independent, events. 11. Banks allow depositors immediate access to their funds,
Most people are risk -averse, viewing the loss of a given but they also lend out most of the funds deposited in
amount of money as a significant hardship but viewing their care. To meet demands for cash, they maintain
the gain of an equal amount of money as a much less bank reserves composed of both currency held in
significant benefit. Loan-backed securities, a recent vaults and deposits at the Federal Reserve. The reserve
innovation, are assets created by pooling individual ratio is the ratio of bank reserves to bank deposits. A
loans and selling shares of that pool to investors. Be- T-account summarizes a bank’s financial position, with
cause they are more diversified and more liquid than in- loans and reserves counted as assets, and deposits
dividual loans, trading on financial markets like bonds, counted as liabilities.

288 section 5 The Financial Sector