Question

Your niece just started her college career with a major in economics. She is curious as to the interrelationship between the success of an economy and the financial markets, concepts, and financial institutions. Accordingly, she has developed a list of questions addressing these issues and has asked that you explain the ideas.

• What are the financial markets and what purposes do they serve?
• What are financial intermediaries? How do these intermediaries function in the economy?
• What is a federal government budget deficit? What is the national debt? How does a budget deficit affect the economy?

She is also curious about the time value of money concepts. Specifically, she has the following questions about these concepts:

• Why are consumers considered to be risk averse? What methods could be used to deal with risk?
• It has been said that a dollar received today is worth more than a dollar received tomorrow. What does this mean and what is the significance to the economy?
• What is the difference between the present value of a future sum of money and the future value of a present sum of money? What is the significance of these concepts to economics?
• If you deposited $1,000 in an account paying 6% interest compounded annually, how long would it take to double?

Answer 1

1. What are the financial markets and what purposes do they serve?

“Financial markets are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most important financial markets in our economy are the bond market and the stock market” (Mankiw, 2015, pg. 548).  

The bond market is a financial market wherein its members are afforded with the trading and issuance of debt securities or bonds. “A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU” (Mankiw, 2015, pg. 548). A bond distinguishes the date of maturity or a specific time the loan must be paid back and the interest rate will be paid at regular intervals until the loan matures. The bond market is mainly comprised of corporate-debt securities and government-securities, helping the allocation or transmission of assets from investors to the issuers or establishments demanding assets for continuing operations, business growths and developments, and government plans and assignments. The bond market is sometimes the credit market or debt market.

The stock market is the financial market wherein shares of publicly organized businesses are traded and issued either by way of over-the-counter markets or exchanges. “Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes” (Mankiw, 2015, pg. 549). The stock market is considered one of the most critically important constituents of a free-market economy, because it affords business with access to assets in exchange for giving shareholders a percentage of proprietorship in the company. The stock market is sometimes called the equity market.

2. What are financial intermediaries? How do these intermediaries function in the economy?

“Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers. Here we consider two of the most important financial intermediaries: banks and mutual funds” (Mankiw, 2015, pg. 550).

The financial intermediaries that nearly everyone is familiar with are banks. The bank’s primary duty is to receive deposits from those persons who wish to save and use these deposits to create loans for people who wish to borrow. Banks pay investors interests on their deposits; however, they charge debtors a somewhat higher interest on their loans. “The difference between these rates of interest covers the banks' costs and returns some profit to the owners of the banks” (Mankiw, 2015, pg. 550). In addition to being financial intermediaries, banks also play another vital role in the economy; they make it possible to buy services and goods by permitting patrons to write checks against their deposits and entrance to those deposits by using debit cards. Thus, providing a medium of exchange that people can use to participate in transactions.

“A financial intermediary of increasing importance in the U.S. economy is the mutual fund. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss” (Mankiw, 2015, pg. 551). The main benefit of mutual funds is that they permit persons with little quantities of money or funds to expand their assets. “Buyers of stocks and bonds are well advised to heed the adage: Don't put all your eggs in one basket. Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. Mutual funds make this diversification easy” (Mankiw, 2015, pg. 551).

3. What is a federal government budget deficit? What is the national debt? How does a budget deficit affect the economy?

A federal government budget deficit is a shortage or lack of tax revenue after government spending. “When referring to accrued federal government deficits, the deficits are referred to as the national debt” (Investopedia,2016). A budget deficit can affect the economy in quite a few different ways, particularly it may drive or push the government to fund the deficit. Thus, reducing or diminishing the worth if the nation’s money or currency. “However, running deficits can be beneficial in the short term, as it allows the government to increase GDP and continue to provide the services that allowed it to secure loans from other governments initially” (Reference, 2016).

She is also curious about the time value of money concepts. Specifically, she has the following questions about these concepts:

4. Why are consumers considered to be risk averse? What methods could be used to deal with risk?

“Most people are risk averse. This means more than that people dislike bad things happening to them. It means that they dislike bad things more than they like comparable good things” (Mankiw, 2015, pg. 572). Therefore, consumers are considered as risk adverse because they are the type of investors who avoid risks. They tend to stay “away from high-risk investments and prefers investments which provide a sure shot return. Such investors like to invest in government bonds, debentures and index fund” (The Economic Times, 2016).

Buying insurance is a one method that can be used to deal with risk. The overall attribute of insurance agreements is that an individual dealing with a risk pays a certain rate to an insurance company, who in return decided to consent to the entire risk or a portion. Another way to deal with risk is diversification. Diversification is “the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks” (Mankiw, 2015, pg. 574).

5. It has been said that a dollar received today is worth more than a dollar received tomorrow. What does this mean and what is the significance to the economy?

“The time value of money, or TVM, assumes a dollar in the present is worth more than a dollar in the future because of variables such as inflation and interest rates. Inflation is the general increase in prices. The value of money depreciates as time goes by as a result of a change in the general level of prices” (Investopedia,2016). This is important to the economy because a dollar on hand today can be utilized to invest and receive capital gains or interest. (Investopedia, 2015).

6. What is the difference between the present value of a future sum of money and the future value of a present sum of money? What is the significance of these concepts to economics?

The present value of a future sum of money is “the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money” (Mankiw, 2015, pg. 570). However, the future value of a present sum of money is “the amount of money in the future that an amount of money today will yield, given prevailing interest rates” (Mankiw, 2015, pg. 570). These concepts are significant to economics because they are important to the field of economics. The financial system is critical to the functioning of the economy; therefore, providing basic comprehension and understanding on how the economy operates.

7. If you deposited $1,000 in an account paying 6% interest compounded annually, how long would it take to double?

Compounding is “the accumulation of a sum of money in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future” (Mankiw, 2015, pg. 570).   If I deposited $1,000 in an account paying 6% interest compounded annually, it will take about 17 years to double. Please see the steps below:

P = the principal, the amount invested

A = the new balance

t = the time

r = the interest rate (in decimal form)

P = $1000, t = 1 year, r = 0.06 A= $1000 (1+0.06*1) = $1000 (1.06) = $1060	P = $1000, t = 10 year, r = 0.06 A= $1000 (1+0.06*10) = $1000 (1.6) = $1600
P = $1000, t = 2 year, r = 0.06 A= $1000 (1+0.06*2) = $1000 (1.12) = $1120	P = $1000, t = 11year, r = 0.06 A= $1000 (1+0.06*11) = $1000 (1.66) = $1660
P = $1000, t = 3 year, r = 0.06 A= $1000 (1+0.06*3) = $1000 (1.18) = $1180	P = $1000, t = 12 year, r = 0.06 A= $1000 (1+0.06*12) = $1000 (1.72) = $1720
P = $1000, t = 4year, r = 0.06 A= $1000 (1+0.06*4) = $1000 (1.24) = $1240	P = $1000, t = 13 year, r = 0.06 A= $1000 (1+0.06*13) = $1000 (1.78) = $1780
P = $1000, t = 5 year, r = 0.06 A= $1000 (1+0.06*5) = $1000 (1.30) = $1300	P = $1000, t = 14 year, r = 0.06 A= $1000 (1+0.06*14) = $1000 (1.84) = $1840
P = $1000, t = 6 year, r = 0.06 A= $1000 (1+0.06*6) = $1000 (1.36) = $1360	P = $1000, t = 15 year, r = 0.06 A= $1000 (1+0.06*15) = $1000 (1.90) = $1900
P = $1000, t = 7 year, r = 0.06 A= $1000 (1+0.06*7) = $1000 (1.42) = $1420	P = $1000, t = 16 year, r = 0.06 A= $1000 (1+0.06*16) = $1000 (1.96) = $1960
P = $1000, t = 8 year, r = 0.06 A= $1000 (1+0.06*8) = $1000 (1.48) = $1480	P = $1000, t = 17year, r = 0.06 A= $1000 (1+0.06*17) = $1000 (2.02) = $2020
P = $1000, t = 9 year, r = 0.06 A= $1000 (1+0.06*9) = $1000 (1.54) = $1540