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Key Idea from Examples
• We Borrow from the bank or Credit card company
• We need to pay a cost for borrowing
Market is where the trade happens
• We borrow from the bank ; Bank provide Financing services to us
• Auto Finance, Mortage
• Firms like GE, Apple, also borrow from the bank to rent to purchase
physical or financial capital.
• Credi market is then a place where financing service got traded
Price of Fianance Service
• No religion meaning....
• Interest rate is the price of finance services
• Interest rate is the additional payment, above and beyond the repayment
of principal, that a borrower needs to make on a one-dollar loan (at the
end of one year).
• Principal is the amount of money you borrow at very first.
Example 1
• We borrow $1000 from BOA at the end of 2012, annual interst rate is 20%,
we need to pay them back at the end of 2013
• Principal : $1000
• Interst rate 20%
• Total amount need to pay back: 1000+1000*20%
Example 2
• We borrow $1000 from BOA at the end of 2012, annual interst rate is 20%,
we need to pay them back at the end of 2015
• Principal : $1000
• Interst rate 20%
• Total amount need to pay back:1000*20%+1000*20%+ 1000*20%+1000
Example 3, Compound interest
• We borrow $1000 from BOA at the end of 2012, annual interst rate is 20%,
we need to pay them back at the end of 2015
• Principal : $1000
• Interst rate 20%
• Total amount need to pay back:1000*(1+20%)*(1+20%)*(1+20%)
Real Interest rate, (Nominal) Interest rate
• Recall the table we used to Adjust Price?
• Year Nominal Price CPI(or any price index) real Price
• 1 x a x/a
• 2 y b y/b
• 3 z c z/c
Real Interest rate, (Nominal) Interest rate
• Recall the example1, we borrow 1000 from bank, 1 year loan; year 2012 is
the base year
• Year Nominal Price CPI(or any price index) real Price
• 2012 1000 1 1000
• 2013 1000*(1+20%) 1+pi 1020/pi
• What is Pi?
Real Interest rate, (Nominal) Interest rate
• What is Pi?
• Pi is inflation rate. Recall the definition of inflation rate
• Inflation rate is the growth of price index
• So what is the real quantity we borrow at 2012? 1000
• What the real repay amount? 1020/pi
Real Interest rate, (Nominal) Interest rate
• What is Nominal rate?
• You need to repay 1020 for borrowing 1000
• 1000*(1+x)=1020
• Similarly, what is real interest rate?
• 1000*(1+r)=1020/pi=1000*(1+nominal)/(1+inflation)
• So ?
• 1+r=(1+nominal)/(1+inflation)
Real Interest rate, Demand Curve
• R=nominal-inflation
• It is the Real interst rate that matters for business and individual decisions, the
demand for credit will also be a function of this real interest rate.
• But We use nominal rate in reality, so we need
to caculate this real interest rate by ourselves
Real Interest rate, Demand Curve, Example
Size of Investment aft.tax Profit ($)Interest to pay($)
8%Net Benefit ($)
Marginal Benefit
(rate)
100 10 8 2 10%
250 22.5 10 12.5 8.3%
300 26 24 2 7%
350 29 28 1 6%
400 31.5 32 -0.5 5%
450 33.5 36 -2.5 4%
500 35 40 -53%
550 36 44 -82%
600 36.5 48 -11.5 1%
Why is the marginal profit ratio decreasing when you enlarge your operation size?
• Imagine you have 10 project
• profit rate is 5% 4% 10% 3% 2% 8.3% 7% 6% 1% 10%
• All with the size $50, namely you have to invest $50 for each project
• what if you got $50 ? what if you got $100,..., $600
Credit Demand Curve Shift
• Changes in perceived business opportunities for firms.
• Changes in household preferences or expectations.
• Changes in government policy.(tax deduction)
Who is going to supply credit? And why?
• Where do banks obtain the money that they lend out?
• Our deposit, we buy stock
• Why we deposit money into the banks? Saving! Why shall we save?
• To meet future expenditures (life cycle motive)
• To protect against an economic emergency (precautionary motive)
Why would we like to save?
Suppose you have 10
icecream today, and
you know mom won't
buy anymore
icecream during this week, are u going to
eat all them up in one
day?
saving ------------ store
Who is going to supply credit? And why?
• Saving= Income- Expenditure
• Saving rate = Saving/Income
• (Net) Wealth: The value of assets minus liabilities
• Assets: Anything of value that one owns either financial (cash, stocks, bonds,etc.) or real (real estate, jewelry, consumer durables like cars, etc.)
• Liabilities: The debts one owes (credit card balances, loans, mortgages, etc.)
Saving, wealth, Example
• Saving= Income- Expenditure
• Earnings ($300/wk) - Expenditures ($280/wk) = Saving ($20/wk)
• Saving Rate = $20/$300 = 6.7%
• Wealth ($3,030) = Assets ($6,280) - Liabilities ($3,250)
Assets
Cash $ 80
Checking account 1,200
Shares of stock 1,000
Car (market value) 3,500
Furniture (market value) 500
Total $6,280
Liabilities
Student loan $3,000
Credit card balance 250
______
$3,250
Net worth $3,030
Let's think about deposit only
• People and firms with saved money obtain interest by lending the money to a
bank or some other financial institution. (Deposit)
• Saving: A trade off between current consumption and future consumption
• Similar trick with wages: If real interest rate goes up, if we consume one dollar
goods today. it means we give up (1+r) goods tomorrow, So!!! It seems that
today's consumption price goes up!
• Price up-----Demand down-----Expenditure down------Saves more
Credit supply curve shift
• Changes in the saving motives of households.
• Changes in the saving motives of firms.
Credit Market Equilibrium
• Demand and supply curve
• Do we have any simplified assumption here?
• We are assuming that different borrowers all have identical risks of defaulting
on their loan.
Equilibrium Changes
• Imagine that our profit column moves up
• Demand curve will shift to the right
• What does Credit market do? You save your idle resources, since you do
not know where is the valuable investment opportunity. If someone has a
promising project, credit market will allocate your idle resource to him!
Function of Financial or Credit Market
• What does Credit market do? You save your idle resources, since you do not
know where is the valuable investment opportunity. If someone has a promising
project, credit market will allocate your idle resource to him!
• https://www.youtube.com/watch?v=EQgZZqjfA1I
Thought Experiment
• Suppose you have $1,000 set aside for next year.
• If there are no credit markets, you would keep the money in a safe box in your house and earn a zero
nominal return and, quite possibly, a negative real return.
• If there are no credit markets, firms would be unlikely to borrow the money and invest in new plant and
equipment, or, all investment would have to come from their retentions. Yes, you may ask, why do they
need to borrow!
Thought Experiment
• If there are credit markets, you could “lend” the money and earn a positive nominal return and
even a positive real return.
• If there are credit markets, firms could borrow the money and invest in new plant and
equipment.
Key player in Credit market: Banks and Financial Intermediation
• We as savers never meet the borrower
• We put money in bank
• Bank hang out and meet the borrowers
• Hence Banks are matching lenders and borrowers; So we call them to be
financial intermediaries
• Financial intermediaries channel funds from suppliers of financial capital, like
savers, to users of financial capital, like borrowers.
• P.s: Deposit is not the only way of saving
Balance Sheet
• Imagine that how you can purchase a new iphone 6s? Still remember people's balance sheet?
• You can ask your parents to buy that, or you can use your own saving
• Or you can borrow from your friend
• Ok that is iphone 6s
• What if it is a huge project?
Balance Sheet
You are going to use both
• Where does bank spend money? Loans, right?
• Two types of loan: Short and long
YOU Purchases | Your own money+ Borrowing
Balance Sheet, Asset
• Two types of loan: Short and long
• Long term investment, comprises loans to households and firms but
alsoinclude things like the value of the real estate that the bank uses for its
operations
• Cash equivalents, are riskless, liquid assets
• Bank reserves(policy related), include vault cash (dollars and coins held
by Citibank in its own vault) and its holdings on deposit at the Federal
Reserve Bank,
Balance Sheet, Liabilities and Stockholders’ Equity
• Liabilities is what you borrow. Then you have obligation to repay back.
• Bank borrow?
• Yes! (1)Bank borrow from us. Deposit! You give money to bank, and you can
withdraw money when you want to
• (2) Interbank borrowing, bank can borrow from other bank
(Ignore The Page 264)
Balance Sheet, Liabilities and Stockholders’ Equity
• Equity is the fraction you invest in. Belongs to you!
• By the accounting identity,
• Equity= Asset- liability (calculation method)
Functions of Banks
• 1. Banks identify profitable lending opportunities. They are looking for their
customers.
• 2. Banks transform short-term liabilities, like deposits, into long-term
investments in a process called maturity transformation. How?
• 3. Banks manage risk by using diversification strategies and also by
transferring risk from depositors to the bank’s stockholders and, in some
cases, to the U.S. government
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