MacroCh13

MacroCh13 - Chapter Review Introduction Some people save...

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Chapter Review Introduction Some people save some of their income and have funds that are available to loan. Some people wish to invest in capital equipment and thus need to borrow. The financial system consists of those institutions that help match, or balance, the lending of savers to the borrowing of investors. This is important because investment in capital contributes to economic growth. Financial Institutions in the U.S. Economy The financial system is made up of financial institutions that match borrowers and lenders. Financial institutions can be grouped into two categories: financial markets and financial intermediaries. Financial markets allow firms to borrow directly from those that wish to lend. The two most important financial markets are the bond market and the stock market. The bond market allows large borrowers to borrow directly from the public. The borrower sells a bond (a certificate of indebtedness or IOU), which specifies the date of maturity (the date the loan will be repaid), the amount of interest that will be paid periodically, and the principal (the amount borrowed and to be repaid at maturity). The buyer of the bond is the lender. Bond issues differ in three main ways: (1) Bonds are of different terms (time to maturity). Longer-term bonds are riskier and, thus, usually pay higher interest because the owner of the bond may need to sell it before maturity at a depressed price. (2) Bonds have different credit risk (probability of default). Higher risk bonds pay higher interest. Junk bonds are exceptionally risky bonds. (3) Bonds have different types of tax treatment. The interest received from owning a municipal bond (bond issued by state or local government) is tax exempt. Thus, municipal bonds pay lower interest. The stock market allows large firms to raise funds for expansion by taking on additional "partners" or owners of the firm. The sale of stock is called
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equity finance while the sale of bonds is called debt finance. Owners of stock share in the profits or losses of the firm while owners of bonds receive fixed interest payments as creditors. The stockholder accepts more risk than the bondholder accepts but has a higher potential return. Stocks don’t mature or expire and are traded on stock exchanges such as the New York Stock Exchange and NASDAQ. Stock prices are determined by supply and demand and reflect expectations of the firm’s future profitability. A stock index, such as the Dow Jones Industrial Average, is an average of an important group of stock prices. Financial intermediaries are financial institutions through which savers (lenders) can indirectly loan funds to borrowers. That is, financial intermediaries are middlepersons between borrowers and lenders. The two most important financial intermediaries are banks and mutual funds. Banks
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MacroCh13 - Chapter Review Introduction Some people save...

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