<< Chapter < Page Chapter >> Page >

Getting additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means putting off earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice.

How capital markets transform financial flows

Financial capital markets have the power to repackage money as it moves from those who supply financial capital to those who demand it. Banks accept checking account deposits and turn them into long-term loans to companies. Individual firms sell shares of stock and issue bonds to raise capital. Firms make and sell an astonishing array of goods and services, but an investor can receive a return on the company’s decisions by buying stock in that company. Stocks and bonds are sold and resold by financial investors to one another. Venture capitalists and angel investors search for promising small companies. Mutual funds combine the stocks and bonds—and thus, indirectly, the products and investments—of many different companies.

Visit this website to read an article about how austerity can work.

In this chapter, we discussed the basic mechanisms of financial markets. (A more advanced course in economics or finance will consider more sophisticated tools.) The fundamentals of those financial capital markets remain the same: Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return, risk, and liquidity. Financial markets are society’s mechanisms for bringing together these forces of demand and supply.

The housing bubble and the financial crisis of 2007

The housing boom and bust in the United States, and the resulting multi-trillion-dollar decline in home equity, started with the fall of home prices starting in 2007. As home values fell, many home prices fell below the amount owed on the mortgage and owners stopped paying and defaulted on their loan. Banks found that their assets (loans) became worthless. Many financial institutions around the world had invested in mortgage-backed securities, or had purchased insurance on mortgage-backed securities. When housing prices collapsed, the value of those financial assets collapsed as well. The asset side of the banks’ balance sheets dropped, causing bank failures and bank runs. Around the globe, financial institutions were bankrupted or nearly so. The result was a large decrease in lending and borrowing, referred to as a freezing up of available credit. When credit dries up, the economy is on its knees. The crisis was not limited to the United States. Iceland, Ireland, the United Kingdom, Spain, Portugal, and Greece all had similar housing boom and bust cycles, and similar credit freezes.

If businesses cannot access financial capital, they cannot make physical capital investments. Those investments ultimately lead to job creation. So when credit dried up, businesses invested less, and they ultimately laid off millions of workers. This caused incomes to drop, which caused demand to drop. In turn businesses sold less, so they laid off more workers. Compounding these events, as economic conditions worsened, financial institutions were even less likely to make loans.

To make matters even worse, as businesses sold less, their expected future profit decreased, and this led to a drop in stock prices. Combining all these effects led to major decreases in incomes, demand, consumption, and employment, and to the Great Recession, which in the United States officially lasted from December 2007 to June 2009. During this time, the unemployment rate rose from 5% to a peak of 10.1%. Four years after the recession officially ended, unemployment was still stubbornly high, at 7.6%, and 11.8 million people were still unemployed.

As the world’s leading consumer, if the United States goes into recession, it usually drags other countries down with it. The Great Recession was no exception. With few exceptions, U.S. trading partners also entered into recessions of their own, of varying lengths, or suffered slower economic growth. Like the United States, many European countries also gave direct financial assistance, so-called bailouts, to the institutions that make up their financial markets. There was good reason to do this. Financial markets bridge the gap between demanders and suppliers of financial capital. These institutions and markets need to function in order for an economy to invest in new financial capital.

However, much of this bailout money was borrowed, and this borrowed money contributed to another crisis in Europe. Because of the impact on their budgets of the financial crisis and the resulting bailouts, many countries found themselves with unsustainably high deficits. They chose to undertake austerity measures, large decreases in government spending and large tax increases, in order to reduce their deficits. Greece, Ireland, Spain, and Portugal have all had to undertake relatively severe austerity measures. The ramifications of this crisis have spread; the viability of the euro has even been called into question.

Key concepts and summary

It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price is going to rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life.

Problems

How much money do you have to put into a bank account that pays 10% interest compounded annually to have $10,000 in ten years?

Got questions? Get instant answers now!

Many retirement funds charge an administrative fee each year equal to 0.25% on managed assets. Suppose that Alexx and Spenser each invest $5,000 in the same stock this year. Alexx invests directly and earns 5% a year. Spenser uses a retirement fund and earns 4.75%. After 30 years, how much more will Alexx have than Spenser?

Got questions? Get instant answers now!

References

U.S. Department of Commerce: United States Census Bureau. “Income: Table H-13. Educational Attainment of Householder—Households with Householder 25 Years Old and Over by Median and Mean Income.” http://www.census.gov/hhes/www/income/data/historical/household/.

United States Department of Labor. Bureau of Labor Statistics. 2015. “Table 9. Quartiles and Selected Deciles of Usual Weekly Earnings of Full-Time Wage and Salary Workers by Selected Characteristics, 2014 Annual Averages.” Accessed April 1, 2015. http://www.bls.gov/news.release/wkyeng.t09.htm.

Questions & Answers

how is economics not a science subject
Adio Reply
i need the main definition of economics
Okafor Reply
what does it mean to say that market equilibrium is stable?
Ayesha Reply
what is the practical significance of cross price elasticity of demand?
Ayesha
what is economic
Azolingo Reply
what is the practical significance of cross price elasticity of demand?
Ayesha
economics is a social science that deals with human behaviour relating with end and scares means
Okafor
why is economics not a pure science?
AHUMBE Reply
it is not a pure science because it only studies human behavior
Ayaane
economics is a social science cause it is relating to ends and scares means🙂
Okafor
what is management of human resources?
Ibrahim Reply
how is economics a science?
Mei Reply
economics is not a science subject either is a social science subject
Okafor
4. It is a hot day, and Bert is thirsty. Here is the value he places on each bottle of water: Value of first bottle $7 Value of second bottle $5 Value of third bottle $3 Value of fourth bottle $1 a. From this information, derive Bert’s demand schedule. Graph his demand curve for bottled w
Tahmina Reply
hello
Lukman
what is the law of diminishing marginal utility
Samuel Reply
The law of diminishing marginal utility state that as a consumer consumes a successive units of a commodity, a point is eventually reached where consumption of additional unit yields less satisfaction.
raheem
what is demand
Isatu Reply
other things can be equal an certain amount paid for the goods by consumer in the market called demand.
Dhanishhwar
demand is the amount of a commodity a consumer is willing and able buy at a given price at a particular point in time
Samuel
Demand is the quantity of commodity a consumer is willing and able to buy at a given price and a particular time.
raheem
what is economics
Owusu Reply
economics is a social science subject, which study human behaviors as a relationship btw end ND scarce means
Joseph
what utility
Isatu
Utility is the satisfaction a consumer derives from consuming a particular commodity.
raheem
meaning of economics
Agyei Reply
what is a columnist
Owusu
what are the four basic assumptions of perfect competition
Liyanda Reply
There is a well known maximum by economic that states that the birthd of money is the deaths of batter system discuss the statement
PHILIP Reply
how does price elasticity increase
Anuoluwapo Reply

Get Jobilize Job Search Mobile App in your pocket Now!

Get it on Google Play Download on the App Store Now




Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Principles of economics' conversation and receive update notifications?

Ask