Almost everyone has to accept that they have limited resources. As with households, governments must deal with limitations related to the spending of monies they can expect to receive as revenue in the foreseeable future. The government has the option to increase revenue by increasing the percentage of income tax of private citizens and businesses or the government can chose to borrow funds by issuing bonds. The budget deficit is described as the difference between what the government spends and what the government earns in revenue. Government spending consists of salaries for government employees, defense spending, aid programs, and other cash outflows.
Question 1: The Northern Rock case demonstrates that financial regulators should not view modern banking separately from capital market developments. A) Describe the liquidity spiral at work in the Northern Rock case Liquidity spirals are loss spirals which start as a result of deprecation of asset value whereby the net value decreases faster than the gross value (because of their leverage). Assuming a constant leverage ratio, the drop in value of the asset will force the company to either raise more capital (not likely if the market is already tight) or to sell assets at a time when the prices have already dropped. The selling of the assets will push the prices down further which will inevitably result in more sales. The financial institutions’ capital erodes and, at the same time, lending standards and margins tighten.
The United State’s international status as a world superpower is typically associated with a thriving economy, and while American business is expanding, there exists a bubble of uncertainty which surrounds the future of retirees. Present day American retirees tend to rely on financial systems such as Social Security, pensions, and a 401(k) plan to fund their retirement. However, in today’s economy, the increasing number of retirees, coupled with a steady number of workers, has began a trend of deficit spending by the Social Security system. Furthermore, the increasing deficits of state legislatures owed to participants of pension plans present the issue of how to both reverse the current trend, while simultaneously continuing to provide for
Budget deficit occurs when the spending of a government exceeds that of its financial savings. On the other hand, it means the amount of spending exceeds its income over a particular period of time. Why it is important to understand the impact of budget deficit to the economy is related to whether it is harmful to the economy or not. The issue on budget deficit is important because it is with regards to the government policy and decision making. It reflects on how the country’s government spends efficiently as it is highly correlated to the economic growth.
Banks have a reserve requirement, which is set by the fed. A reserve requirement is the minimum percentage of a bank’s total reserves that they are required to keep, for security reasons. (Schiller) The fed can change the reserve requirement to allow a bank to loan more/less money, which is used to control the economy. Many critics use this to determine that annual deficit spending has a negative impact on the economic stability of our country. The fed has to set a lower reserve requirement, which allows banks to loan out more money, which generates more interest, which could lead to periods of inflation and could have worse consequences if the government does not react quickly enough.
1.4 Compare and contrast debt and equity as a source of funds for financial claims. Financial claims: written promises to pay a specific sum of money (the principal) plus interest for the privilege of borrowing money over a period of time. Financial claims are issued by DSUs (liabilities) and purchased by SSUs (assets). Debt Funds: Equity Funds: Funds supplied in the form of a loan. Classified into short-term or long-term facilities Short-term = money Long-term = capital Suppliers of loans or debt funds face credit risk Credit risk: the risk the borrower won’t pay back loan Funds supplied in the form of the acquisition of an ownership share of a business.
If anything affects these factors will result in affecting the demand. For example, if inflation is getting too high, interest rates will be increased to stabilize the economic growth in the economy. This is the result of having the economy already close to full capacity which means that a further increase in AD will mainly cause inflation. Demand side policies include monetary policy and Fiscal policy. Monetary policy are actions of central bank, currency board or other regulatory committee that determines the size and rate of growth of the money supply, which in turn affects interest rates.
On the other hand MI backed mainly by shareholders equity and performing assets and thus would be able to issue new debt increasing value for both shareholders and the corporation. Thus the shareholders would gain at the expense of bond holders and the equity value of the company would increase. b) Bondholders Bondholders had a lot to lose as according to Project Chariot almost all the debt would be assigned to HM. Given the problems in real estate and hotel markets there was a concern of HM’s ability to meet its debt payment and there was a high probability of default. This meant that the risk was issued at investment grade but now was not backed by valuable assets of the companies which were to be spun off to MI which was to be backed by equity.
The other reason was adjustable mortgage rates. Adjustable mortgages allowed banks to increase the monthly balance, when monthly payments were not large enough to cover principal and interest, which made loan takers to pay more payment that what they were not accepting. This caused owners to owe more on their loans than its market value with an inability to refinance. Lehman Brother’s was also in Commercial paper lending market and they were one of the largest commercial paper lending institutions in the world. Commercial paper lending market is short-term debt that big businesses and financial institutions sell primarily to money market fund managers and other institutional investors.
The Components for Aggregate Demand are C (consumption)+ I (income)+ G (government spending)+ (X-M) (net exports) and a change in the components of Aggregate demand will cause a shift of the curve. Fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economy’s growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand. Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control. There are two types of Fiscal policy put in place to alter the level of aggregate demand; Expansionary fiscal policy and Contractionary fiscal policy.