credit market

1th July, 2016

Credit Market

Instructor: Xi Wang

Credit market

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





• Total amount need to pay back:1000*20%+1000*20%+ 1000*20%+1000

Example 3, Compound interest





• 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


• 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?


• 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


• 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

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

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

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

You are going to use both

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, Book Reading

• Page 220- 238, especially 232-238

• Page 242-264

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

credit market

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