Credit Markets In Economics

These are my notes on credit markets in Economics.

The credit market matches borrowers and savers.

The credit market equilibrium determines the real interest rates.

Banks and other financial intermediaries have three key functions: identifying profitable lending opportunities, using short run deposits to make long run investments, and managing the amount and distribution of risk.

Banks become insolvent when the value of their liabilities exceeds the values of their assets.

Debtors, or borrowers, are economic agents who borrow funds.

Credit refers to the loans that the debtor receives.

The interest rate is the annual cost of a 1$ loan.

The real interest rate is the nominal interest rate minus the inflation rate.

The credit demand curve is the schedule that reports the relationship between the quantity of credit demanded and the real interest rate.

The credit supply curve is the schedule that reports the relationship between the quantity of credit supplied and the real interest rate.

The credit market is where borrowers obtain funds from savers.

Securities are financial contracts. They may allocate ownership rights of a company or promise payments to lenders. 

Financial intermediaries channel funds from suppliers of financial capital to users of financial capital. 

Bank reserves consist of vault cash and reserves held at the federal reserve bank. 

Demand deposits are funds that depositors can access on demand by withdrawing money from the bank, writing checks, or using their debit cards.

Stockholders’ equity is the difference between a bank’s total assets and its total liabilities.

Maturity refers to the time until debt must be repaid.

Maturity transformation is the process by which banks take short maturity liabilities and invest in long maturity assets.

A bank becomes insolvent when the value of the bank’s assets is less than the value of its liabilities.

A bank is solvent when the value of the bank’s assets is greater than the value of its liabilities. 

A bank run occurs when a bank experiences an extraordinarily large volume of withdrawals driven by a concern that the bank will run out of liquid assets with which to pay withdrawals.

Credit is essential for the efficient allocation of resources in the economy. Credit allows firms to borrow for investment or households to borrow to purchase a home.

The relevant price in the credit market is the real interest rate rather than the nominal interest rate. The real interest rate adjusts the price of borrowing or lending for the effects of inflation, thus reflecting the economic trade-off between the present or the future that borrowers and savers face.

Firms, households, and governments use the credit market for borrowing. The credit demand curve summarizes the relationship between the quantity of credit demanded by borrowers and the real interest rate. The credit demand curve results from the optimizing behavior of these borrowers.

The credit supply curve summarizes the relationship between the quantity of credit supplied and the real interest rate and also results from optimizing behavior, this time of savers. Savers trade off consumption today for consumption in the future, taking into account the reward for delaying consumption-the real interest rate.

The intersection of the credit demand curve and the credit supply curve is the credit market equilibrium. At the equilibrium real interest rate, the quantity of credit demanded is equal to the quantity of credit supplied.

Saving and borrowing in the credit market are intermediated by banks and other financial intermediaries. Banks play three key roles in the economy. They find credit worth borrowers and channel savings of depositors to them. They transform the maturity structure in the economy by collecting money from savers in the form of short term demand deposits and investing money in long term projects. They manage risk by holding a diversified portfolio and by transferring risk from depositors to stockholders.

Governments provide deposit insurance that reduces the likelihood of bank runs, and governments intervene to save failing banks in order to avert widespread crises. The US economy has experienced four major waves of bank failures since 1900.