Economic Terms

Is a contract that legally prescribes individuals tied to the contract to obey all the clauses and conditions contained in the legally binding contract. In financial markets, banks often draw up restrictive covenants when lending sums of money to businesses to reduce the probability of the business defaulting on that loan. It is called a restrictive covenant as the bank can prevent the business from paying out extra dividends to shareholders and taking more equity to finance investment plans until the loan has been paid back to the bank. These types of contracts are drawn up to reduce the problem of moral hazard.

A theory of economic innovation identified by Joseph Schumpeter, which describes the "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one" i.e. new technology replaces old processes, similtaneously creating and destroying jobs and markets.

Below is an illustration of what creative innovation and invention leads to but also how it can offet these effects by destroying some exisintg markets and jobs that go with it. A modern example of this is the Uber taxi service putting pressure on traditional taxi service companies in the largest cities in the world.

 

Where one party to provides money to another party where that second party does not reimburse the first party immediately (thereby generating a debt), but instead arranges either to repay or return those resources (or other materials of equal value) at a later date. The most common form of credit created in the financial sector are loans/advances.

 

A period of financial crisis when loan repayment uncertainties mean banks become reluctant to lend money to each other, causing interest rates to rise and for sources of credit to diminish. Such periods will be characterised by central bank intervention to ensure the banking system can continue to operate by providing additional liquidity (credit) until normal lending resumes.

Is a model that illustrates how banks can create money. The rate at which credit is created depends on the reserve ratio and the capital ratio for banks.

Below is the formula to calculat the credit multiplier i.e. the change in deposits divided by the change in reserves.

An evaluation of the credit worthiness of an individual, firm, government or other organisation. Stronger credit ratings will provide access to lower rates of interest on loans.

Below is a table of some of the countries credit ratings - in terms of the perception of their ability to repay and meet their debt obligations. In this instance Australia has the highest rating according to S&P meaning they are a very safe and secure country to lend too. In contrast to this Puerto Rico have an extremely low credit rating and therefore if they are to secure finance they will have to pay huge interest on top of the principal. This often leads to the trend that countries that need to borrow cannot do so due to their deteriorating credit ratings. These ratings are correct as of October 2015.

Credit ratings are usually undertaken by specialist credit ratings agencies and are considered by financial organisations in the day to day management of assets. S&P, Moody's and Fitch are probably the three most well known credit rating agencies. There is s strong relationship between a sovereign nation's credit rating and the rate of interest that needs to be paid on new borrowings. The best credit ratings (AAA) are able to command the lowest rate of interest on financial markets.

A mutually organised, non-profit depository institution which aims to provide finance for individuals as well as setting up accounts for individuals to store their savings and wages.

Is a judgement about an economic agent's current and future ability to honour debt obligations. Bank's often use credit ratings provided by external credit rating agencies to analyse the credit ratings of business and countries to decide whether they should provide a loan for a particular entity.

Below is a list of countries credit ratings for debt they hold, as rated by Standard & Poor's as of Ocotber 2015.

The proportionate change in the quantity demanded of a good in response to a proportionate change in the price of another good.

The formula for this is given below:

If the XED value is positive, the two goods in question can be classed as substitutes as the rise in the price of one good leads to a rise in the quantity of the other good. As consumers switch away from consuming the higher priced good and buy the other good instead e.g. Pepsi and Coke. If the XED value exceeds 1 this indicates that the two goods in question are close substitutes i.e. as the price of Good B rises by 1% then the quantity demanded of Good B will rise by more than 1%. The closer the substitutability between products the greater the positive XED value becomes.

If the XED value is negative, the two goods in question can be classed as compliments as the rise in the price of one good leads to a fall in the quantity of the other good. This is because as the goods are goods which should be consumed together, if one becomes more expensive consumers will stop buying both goods e.g. pasta and pasta sauce. If the XED value lies below -1, the goods in question are very complimentary and therefore the quantity demanded of Good A will respond sensitively to the price of Good B.

Cross elasticity of demand can be used to show the relationship between related goods and can provide useful information for firms that are competing in markets with a high level of interdependence. 

 

The benefits associated with increased government spending funded by borrowing money may be offset by reduced consumption and investment if this reduces the credit available to firms and individuals.

Below is a diagram to illustrate the crowding-out effects of financing a budget deficit. When the government wishes to finance a budget deficit they have to borrow from the private financial sector. By doing this it pushes the demand for loanable funds outwards putting presurre on interest rates to rise. Given that investment is a component of aggregate demand and is negatively related to the interest rate (as the interest rate represents the opportunity cost of investing), a higher interest rate causes individual investment projects to be less profitable and therefore investment falls. Also given the fact that interest rates are higher it makes consumption lower due to difficulties trying to acquire finance from financial institutions. Therefore despite the government stimulating the economy by running a larger budget deficit the effect on real output will be muted due to lower consumption and investment offsetting these expansionary effects. This is shown by the position of the final AD3 curve.