What do households supply

Many borrowers figured, however, that as long as housing prices kept rising, it made sense to buy. In this way, the lenders off-loaded the risks of the mortgages to investors.

Investors were interested in mortgage-backed securities as they appeared to offer a steady stream of income, provided the mortgages were repaid. Investors relied on the ratings agencies to assess the credit risk associated with the mortgage backed securities. In hindsight, it appears that the credit agencies were far too lenient in their ratings of many of the securitized loans. Bank and financial regulators watched the steady rise in the market for mortgage-backed securities, but saw no reason at the time to intervene.

When housing prices turned down, many households that had borrowed when prices were high found that what they owed the bank was more than their home was worth. Many banks believed that they had diversified by selling their individual loans and instead buying securities based on mortgage loans from all over the country. After all, banks thought back in , the average price of a house had not declined at any time since the Great Depression of the s.

These securities based on mortgage loans, however, turned out to be far riskier than expected. The bust in housing prices weakened the finances of both banks and households, and thus helped bring on the Great Recession of — The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment.

Table 3 summarizes these characteristics. The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved.

Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk.

If risky assets like stocks did not also offer a higher average return, then few investors would want them. This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences.

However, it is often useful to examine risk and return in the context of different time frames. The high returns of stock market investments refer to a high average return that can be expected over a period of several years or decades.

The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in stocks. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts.

Thus, tradeoffs between risk and return must be considered in the context of where the investor is in life. All investments can be categorized according to three key characteristics: average expected return, degree of risk, and liquidity. To get a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit.

Under the federal deposit insurance program, banks purchase insurance against the risk of a bank failure. A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the bond is issued, and then repayment of what was borrowed.

Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase.

Even when bonds make payments based on a fixed rate of interest, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss. Changes in the price of a stock depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies.

An investor in the mutual fund then receives a return depending on the overall performance of the investments made by the fund as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund. Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains.

Housing can also offer a nonfinancial return—specifically, you can live in it. Howley, Kathleen M. Houses Make Cash. Historical Stock Prices. National Association of Realtors.

PricewaterhouseCoopers LLP. Rooney, Ben. Last modified October 1, Investment Company Institute. Skip to content Chapter Financial Markets.

Learning Objectives By the end of this section, you will be able to:. Show the relationship between savers, banks, and borrowers Calculate bond yield Contrast bonds, stocks, mutual funds, and assets Explain the tradeoffs between return and risk.

What was all the commotion in the recent U. Which has a higher average return over time: stocks, bonds, or a savings account? Explain your answer. Investors sometimes fear that a high-risk investment is especially likely to have low returns. Is this fear true? Does a high risk mean the return must be low? Name several different kinds of bank account. How are they different? Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest?

Why should a financial investor care about diversification? What is a mutual fund? What is an index fund? How is buying a house to live in a type of financial investment? Why is it hard to forecast future movements in stock prices? Critical Thinking Questions What are some reasons why the investment strategy of a year-old might differ from the investment strategy of a year-old? Explain why a financial investor in stocks cannot earn high capital gains simply by buying companies with a demonstrated record of high profits.

Calculate what you would actually be willing to pay for this bond. What is the interest rate Ford is paying on the borrowed funds? Will the value of the bond increase or decrease? Solutions Answers to Self-Check Questions Remember, equity is the market value of the house minus what is still owed to the bank. It does not matter what price she bought it for. Over a sustained period of time, stocks have an average return higher than bonds, and bonds have an average return higher than a savings account.

This is because in any given year the value of a savings account changes very little. The value of a bond, which depends largely on interest rate fluctuations, varies far less than a stock, but more than a savings account. When people believe that a high-risk investment must have a low return, they are getting confused between what risk and return mean.

Yes, a high-risk investment might have a low return, but it might also have a high return. Risk refers to the fact that a wide range of outcomes is possible. Price, Marginal Revenue, and Average Revenue.

Economic Profit in the Short Run. Economic Losses in the Short Run. Producing to Minimize Economic Loss. Shutting Down to Minimize Economic Loss. Economic Profit and Economic Loss. Eliminating Losses: The Role of Exit. Entry, Exit, and Production Costs. Changes in Demand and in Production Cost. Start Up: Surrounded by Monopolies. Sources of Monopoly Power. Economies of Scale. Sunk Costs. Restricted Ownership of Raw Materials and Inputs.

Monopoly and Market Demand. Total Revenue and Price Elasticity. Demand and Marginal Revenue. Efficiency, Equity, and Concentration of Power. Monopoly and Efficiency. Monopoly and Equity. Monopoly and the Concentration of Power. Public Policy Toward Monopoly. TRY IT. The World of Imperfect Competition. Profit Maximization. The Short Run. The Long Run Heads Up! Measuring Concentration in Oligopoly. The Collusion Model. Game Theory and Oligopoly Behavior.

Advertising and Information. Advertising and Competition. Wages and Employment in Perfect Competition. Start Up: College Pays. Shifts in Labor Demand. Changes in the Use of Other Factors of Production. Changes in Technology. Changes in Product Demand. Income and Substitution Effects. Wage Changes and the Slope of the Supply Curve.

Shifts in Labor Supply. Changes in Preferences. Changes in Income. Changes in the Prices of Related Goods and Services. Changes in Population.

Changes in Expectations. Changes in Demand and Supply. Case in Point: Technology and the Wage Gap. The Nature of Interest Rates. The Demand for Capital. Capital and Net Present Value. The Demand Curve for Capital.

Shifts in the Demand for Capital. Technological Change. Changing Demand for Goods and Services. Changes in Relative Factor Prices. Changes in Tax Policy. The Market for Loanable Funds. The Demand for Loanable Funds. The Supply of Loanable Funds.

Capital and the Loanable Funds Market. Exhaustible Natural Resources. Expectations and Resource Extraction. Resource Prices Over Time.

Renewable Natural Resources. Carrying Capacity and Future Generations. Case in Point: World Oil Dilemma. Imperfectly Competitive Markets for Factors of Production. Monopsony Equilibrium and the Marginal Decision Rule. Monopoly and Monopsony: A Comparison. Monopsony in the Real World. Monopsonies in Sports. Monopsony in Other Labor Markets. Monopoly Suppliers. A Brief History of Unions. Higher Wages and Other Union Goals. Increasing Demand. Reducing Labor Supply. Bilateral Monopoly.

Unions and the Economy: An Assessment. Other Suppliers and Monopoly Power. Professional Associations. Case in Point: Unions and the Airline Industry. Public Finance and Public Choice. Responding to Market Failure. Imperfect Competition. Assessing Government Responses to Market Failure.

Merit and Demerit Goods. Principles of Taxation. Ability to Pay. Regressive Tax. Proportional Tax. Progressive Tax. Benefits Received. Types of Taxes.

Personal Income Taxes. Property Taxes. Sales Taxes. Excise Taxes. Public Interest Theory. The Public Choice Perspective. Case in Point: The Presidential Election of Antitrust Policy and Business Regulation.

Start Up: The Plastic War. A Brief History of Antitrust Policy. The Sherman Antitrust Act. Other Antitrust Legislation. Cooperative Ventures Abroad. Antitrust Policy and U. Theories of Regulation. The Public Interest Theory of Regulation. The Public Choice Theory of Regulation. Consumer Protection. The Benefits of Consumer Protection. The Cost of Consumer Protection. International Trade. Start Up: Trade Winds.

Production and Consumption Without International Trade. Comparative Advantage. Specialization and the Gains from Trade.

Case in Point: The U. Antidumping Proceedings. Voluntary Export Restrictions. Other Barriers. Justifications for Trade Restriction: An Evaluation. Infant Industries. Strategic Trade Policy. National Security. That is, they are available for investment. The flows in and out of the household sector are discussed in Chapter 12 "Income Taxes". From a macroeconomic perspective, the key functions of government are as follows:. The amount that the government collects in taxes does not need to equal the amount that it pays out for government purchases and transfers.

If the government spends more than it gathers in taxes, then it must borrow from the financial markets to make up the shortfall. Since the flows in and out of the government sector must balance, we know that. Government borrowing is commonly referred to as the budget deficit.

It is also possible that the government takes in more than it spends, in which case the government is saving rather than borrowing, so there is a budget surplus rather than a deficit.

Government finances are discussed in Chapter 14 "Balancing the Budget". The financial sector of an economy is at the heart of the circular flow. It summarizes the behavior of banks and other financial institutions. Most importantly, this sector of the circular flow shows us that the savings of households provide the source of investment funds for firms. On the left-hand side, the figure shows a flow of dollars from the household sector into financial markets, representing the saving of households.

Though we have not included it in Figure 3. As far as the national accounts are concerned, it is as if firms sent these funds to the financial market and then borrowed them back again. When we borrow from other countries, there is a second flow of dollars into the financial markets.

On the right-hand side, there is a flow of money from the financial sector into the firm sector, representing the funds that are available to firms for investment purposes. The linkage between the saving of households and the investment of firms is one of the most important ideas in macroeconomics. The financial sector is also linked to the government sector and the foreign sector.

These flows can go in either direction. As we have already seen, if the government runs a deficit, it does so by borrowing from the financial markets. There is a flow from the financial sector to the government sector. This is the case we have drawn in Figure 3. If the government were to run a surplus, the flow would go in the other direction: government would provide an additional source of saving. The foreign sector can provide an additional source of funds for investment, if those in other countries decide they want to use some of their savings to purchase assets in our economy.

In this case, there is a flow from the foreign sector into the financial sector. Again, this is the case we have drawn. If we lend to other countries, then the flow goes in the other direction.

The flows in and out of the financial sector must balance, so. The foreign sector is perhaps the hardest part of the circular flow to understand because we have to know how international transactions are carried out. Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are instead exported to other countries. Whenever one country sells something to another country, it acquires an asset from that country in exchange.

The simplest way to imagine this is to suppose that the distributor hands over Australian dollar bills to the movie company. The movie company—and, more generally, the US economy—has now acquired a foreign asset—Australian dollars.

Because these Australian dollars can be used to purchase Australian goods and services at some time in the future, the US economy has acquired a claim on Australia. In effect, the United States has made a loan to Australia. It has sent goods to Australia in exchange for the promise that it can claim Australian products at some future date. Similarly, some of the goods consumed in our economy are not produced locally.

For example, suppose that a US restaurant chain purchases Argentine beef. These are imports. We could imagine that the restaurant chain hands over US dollars to the Argentine farmers. In this case, the United States has borrowed from Argentina. It has received goods from Argentina but has promised that it will give some goods or services to Argentina in the future. Of course, international transactions in practice are more complicated than these simple examples.

Yet the insight we have just uncovered remains true no matter how intricate the underlying financial transactions are. Exports are equivalent to a loan to the rest of the world. Imports are equivalent to borrowing from the rest of the world. If we import more than we export, then we are borrowing from the rest of the world. We can see this by looking at the flows in and out of the foreign sector:. If we export more than we import, then—on net—we are lending to the rest of the world, and there is a flow of dollars from the financial markets to the rest of the world.

We saw that, in Argentina, real GDP decreased between and The circular flow of income tells us that when real GDP decreases, it must also be the case that real production decreases and real spending decreases. We are not going to answer that question in this chapter—after all, we are still at the very beginning of your study of macroeconomics. Still, the circular flow still teaches us something very important. If real GDP decreased, then there are really only two possibilities:.

Of course, it could be the case that both of these are true. This insight from the circular flow is a starting point for explaining what happened in Argentina and what happens in other countries when output decreases.

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