1. What is the role of the financial system? Name and describe two markets that are part of the financial system in the U.S. economy. Name and describe two financial intermediaries.
According to Mankiw, 2008, the financial system consists of institutions that match individual’s savings with other people’s investment.
The Bond Market is one of the most important financial markets in the financial system. A bond is a certificate of indebtedness; simply a bond is a promise or an IOU. In the U.S economy, there are millions of different types of bonds. Bonds hold several important characteristics, a bonds term, its credit risk, and the bond’s tax treatment. Purchasing bonds in a firm makes you a creditor of the corporation.
The Stock Market- In contrast to bonds, stocks are a claim to partial ownership in a company and is a claim to profits that the firm makes. Corporations sell stocks to the public and trade them on the stock exchange. The price of a stock is determined by the supply and demand for the stock/company.
Financial Intermediaries: Defined as- Financial institutions through which savers can indirectly provide funds to borrowers. Two examples of financial intermediaries are banks and mutual funds.
Banks are the most common financial intermediaries. Banks pay depositors interest rates on deposits and charge interest rates to borrowers who acquire loans. Banks help create a medium of exchange by allowing bank customers to write checks against their deposits.
The second financial intermediaries are mutual funds. Mutual funds are an institution that sells shares to the public and uses the profits to buy stocks and bonds. Shareholders of the mutual fund accept all the risks and returns associated. One advantage of mutual funds is that they allow people with a small amount of capital to diversify their portfolio.
2. What is the government budget deficit? How does it affect interest rates, investment, and economic growth?
The budget deficit as defined by Mankiw is: “…an excess of the government spending over tax revenue.” Basically, the government budget deficit can be described as a situation when the government spends more than it makes on taxes and other forms of revenue. A government budget deficit lowers national savings because it decreases loanable funds available to finance investments made by households and firms. When loanable funds decrease interest rates increase. Higher interest rates alter the behavior of households/firms part of the loan market. This shifts the demand of many markets. Households buy fewer homes; firms choose not to build new factories/warehouses/office space because higher interest rates are undesirable.
3. What benefit do people get from the market for insurance? What two problems impede the insurance market from working perfectly?
Insurance restores finances in the event of a hazard, such as a car accident (car insurance), home insurance (fire, flood; etc.) and the most common insurance type: health insurance, which covers medical expenses for illnesses, and/or like threatening terminal diseases. In the case of home insurance, it may be possible that in your lifetime, your home never floods so buying flood insurance, for example, is actually a gamble -- (this is part of the reason why insurance companies can pay out repairs to policy holders and still remain in business) however, in the event that your home were to flood insurance is a safety net which will cover the damages of the flood to your home and pay for any repairs. Insurance markets allow for not just individuals to bear the brunt of the cost of an unlucky event- but for the expense to be shared amount thousands (or millions) of other individuals through policy holders, who are “insurance-company” shareholders.
The two problems that market insurance suffers from are: 1.) Adverse Selection- A high risk person is more likely to apply for insurance than a low risk person because high risk people would benefit
