Financial markets are defined by Mankiw (2012) as "the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow" (Mankiw, 2012, p. 557). There are two critical financial markets in the U.S. economy, the stock and bond markets. In each case, the markets provide a vehicle for individuals or businesses to invest funds to borrowers. The sale of bonds is known as debt finance and the sale of stock is called equity finance.
Bonds are "an interest-bearing, long-term note payable issued by corporations, universities, and governmental agencies" (Reimers, 2011, p. 325). Bonds are a mechanism for companies to borrow money, typically from individual investors or other companies. This type of liability obligates the company to pay interest over the life of the bond and repay the principal to the bondholders at the end of the term. Thus, this becomes a form of financing that requires payment of only the interest until maturity of the bond.
Bonds are issued based on a percentage of face value (Reimers, 2011, pg. 327). If a bond is issued at a premium, it is more than 100 percent face value. Bonds issued at a discount are issued at less than 100 percent value. When the market rate is higher than the stated rate on the bond, the bondholder can get a better value elsewhere for their investment. In order to compensate for lesser interest, the company will issue it at a discount. Thus, the bondholder is able to purchase the bond for less upfront investment. On the other hand, when the market rate is lower than the stated rate, the bondholder will be receiving higher than market value interest through the term of the bond. This drives a higher or premium upfront cost for the bond. When the market rate is identical to the stated rate, the bond will sell at face value.
There are a number of benefits to investors that purchase bonds. For instance, the companies issuing bonds are restricted by "bond covenants" to protect the interests of the bondholders (Reimers, 2011, pg. 327). These covenants may limit the amount of additional funds that the company is able to borrow or enforce debt-equity ratios. In addition, bondholders have priority over the claims of owners if the company was to be liquidated. From my understanding, another benefit of bonds is that they have cash value on a secondary market. The bondholder could sell the bond at any time over the term of the note.
There are also some risks involved with bond investment as well. For instance, bond prices are "inversely related to interest rates, so if interest rates increase, the price of the bond will decrease" (Investor Guide, 2012). The interest rate on a bond is set at the time it is issued. If interest rates increase, investors will be unwilling to purchase the bonds in the secondary market at the lower rate. There is also a risk that the issuing organization could default on their obligations. Thus, the bonds would become essentially worthless. Investors might have gained interest up to the point of default, but they would most likely lose any principal.
The other key financial market is the stock market. A stock is defined as "a claim to partial ownership in a firm" (Mankiw, 2012, p. 558). The owner of shares of stock is part owner of a company. The owner of a bond in the same company is a creditor. Stocks generally come with higher risk, and potentially higher return. Once shares are sold to investors, these shares are traded on organized stock exchanges such as the New York Stock Exchange, the American Stock Exchange, and the National Association of Securities Dealers Automated Quotation system (NASDAQ). Most countries have their own exchanges where local stocks can be traded. When stocks are traded, the issuing corporation does not receive any money.
Stock prices are determined "by the supply of and demand for the stock in these companies" (Mankiw, 2012, p. 558). A share of stock reflects the investor's perception of the company's potential for profitability. If shareholders have an optimistic outlook on a company's profitability, demand for its stock and thus the price per share increases. On the other hand, when expectations are low, the price per share falls.
There are a number of stock indexes, defined as "computed average of a group of stock prices" (Mankiw, 2012, p. 558), that allow for the monitoring of overall stock prices. These indexes are an important economic indicator because they reflect potential profitability of companies within the economy. An example of a common stock index is the Dow Jones Industrial Average.
A financial intermediary is an institution that allows savers to "indirectly provide funds to borrowers" (Mankiw, 2012, p. 559). Essentially, it is an organization that facilitates lending and borrowing. Two of the most common and important intermediaries are banks and mutual funds.
Banks allow individuals and businesses who wish to save money to deposit money and collect interest on those funds. They utilize the deposited funds to loan money to individuals and businesses that wish to borrow. Banks charge borrowers higher interest than is being paid to depositors. The difference between interest rates "covers the banks' costs and returns some profit to the owners of the banks" (Mankiw, 2012, p. 559). Banks also act as a medium of exchange. They facilitate purchases by allowing depositors to make debits against their deposits in order to purchase goods and services. A medium of exchange is "an item that people can easily use to engage in transactions" (Mankiw, 2012, p. 559).
The other type of intermediary is a 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" (Mankiw, 2012, p. 560). This type of institution allows savers with small amounts of money to invest in a diverse group of investments. The shareholder of a mutual fund is solely the beneficiary of any risk or reward associated with the portfolio. However, since the portfolio is a diverse group of investments including various types of stocks and bonds, the risk is mitigated to a certain extent. So, mutual funds are a much safer investment than a single stock or bond.
Financial markets and intermediaries ultimately serve the same underlying purpose. They direct the financial resources of savers to borrowers. Each of these institutions coordinates both saving and investment within the economy.
National saving is the "total income in the economy that remains after paying for consumption and government purchases" (Mankiw, 2012, p. 563). National saving is calculated by adding private saving and public saving. Public saving is tax revenue minus government spending. A federal government budget deficit is when the government is spending more money than it is generating from tax revenue. When this occurs, public saving is a negative number, thus it reduces the national saving. So when the government has a budget deficit, the amount of income in the economy is directly and negatively impacted.
The national debt is "the accumulated total of all the government budget deficits of past years, less the accumulated total of all the government budget surpluses of past years" (Johnson, 2005). In the case of the United States, the national debt is interest-bearing Treasury Bonds and Treasury Bills that can be sold in organized financial markets. Funding to pay the annual interest owed "is provided through appropriations in every year's Federal budget" (Johnson, 2005). Historically, these payments are among the largest appropriations in the budget.
Risk aversion is the "dislike of uncertainty" (Mankiw, 2012, p. 581). Essentially, it means that people generally dislike negative consequences less more than they like positive returns. For example, the pain of losing a million dollars at the blackjack table would exceed the pleasure of winning the same amount. The more wealth an individual possesses, the less utility they receive from an additional dollar.
One method for mitigating risks is purchasing insurance. Individuals facing a risk can purchase coverage. The insurance company then agrees to accept all or part of the risk. Insurance reduces risk, but in and of itself it is a gamble. For instance, many people purchase term life insurance. Each of these policies requires the buyer to pay over the term of the policy. In most cases, the policy is never collected. So, the buyer has essentially lost the amount paid. However, if the policy holder would have died, the company would have paid a large claim. The policy holder was able to avert the risk, with a price. In relation to the economy, "the role of insurance is not to eliminate the risks inherent in life but to spread them around more efficiently" (Mankiw, 2012, p. 582). In the case of the life insurance policy, thousands of individuals cover the risk of the single policy holder who needs to file a claim.
Diversification is another risk aversion technique. Diversification is defined as "the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks" (Mankiw, 2012, p. 582). Investing all of an individual's savings in a single stock is a substantial risk. However, by diversifying the investment into smaller purchases of different stocks spreads the risk amongst multiple companies. In the event a single stock does poorly, the other investments mitigate risk. However, diversification cannot mitigate market risk, "the uncertainty associated with the entire economy" (Mankiw, 2012, p. 583).
A dollar today is worth more than a dollar tomorrow. This relates to the present compared to the future value of money. Mankiw defines the present value of money as "the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money" (Mankiw, 2012, p. 578). In the case of the dollar tomorrow, the present value would most likely be less than the full dollar, because interest would impact the value even in 24 hours. The future value of money is "the amount of money in the future that an amount of money today will yield, given prevailing interest rates" (Mankiw, 2012, p. 578). This means that the future value of a dollar today is equal to the initial value of the dollar plus accrued interest. As interest is compounded, the future value will increase.
This concept is extremely important from the economics perspective. Individuals and companies need to evaluate whether return on investment is prudent. Is investment in present value dollars' worth the future return? Because the present value funds would compound interest, the return would need to account for the potential growth.
If an individual deposited $1,000 in an account paying 6% interest compounded annually, it would take 11.66 years for the money to double. The rule of 70 states that "if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years" (Mankiw, 2012, p. 580). In the case of $1,000 at 6% interest, the formula would divide 70 by the interest rate of 6. The answer is 11.66. Therefore, the initial investment of $1,000 would compound interest for 11.66 years in order to double to $2,000.
