Transcript Mankiw8e_Student_PPTs_Chapter 20 - E-SGH

CHAPTER 20
The Financial System: Opportunities
and Dangers
A PowerPointTutorial
To Accompany
MACROECONOMICS, 8th 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
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