Chapter 23: Finance, Saving and Investment Financial Markets and ...
Chapter 23: Finance, Saving and Investment Financial Markets and Institutions -financial markets and institutions play a critical role in the economy by providing the channels through which saving flows to finance the investment in new capital that makes the economy grow -in studying the economics of financial institutions and markets, we distinguish between 1. Finance and Money -finance describes the act of providing the funds that finance capital expenditures -study of finance looks at how households and firms obtain and use financial resources and how they cope with the risks that arise in this activity -money is what we use to pay for goods and services and factors of production and to make financial transactions -study of money looks at how households are firms use it, how banks create and manage it, and how its quantity influences the economy -finance and money are closely related -however by studying them separately, we will better understand our financial and monetary markets and institutions -for this chapter, finance is the topic of discussion 2. Physical Capital and Financial Capital -physical capital is the tools, instruments, machines, buildings, and other items that are used to produce goods and services -inventories, raw materials, WIP goods and services and components are part of physical capital -term “capital” = “physical capital” -funds used to purchase physical capital are called financial capital -along the aggregate production function an increase in the quantity of capital shifts the curve outward Capital and Investment -investment increases the quantity of capital while depreciation decreases the quantity of capital -total amount spent on new capital is called gross investment -the change in the value of capital is called net investment which is equal to gross investment less depreciation -see figure 23.1 on page 545 for a graph of this Wealth and Saving -wealth is the value of all the things that people own -people earn income but this is not related to what they own -saving is the amount of income that is not spent or paid in taxes -saving increases wealth and wealth also increases when the market value of assets increase (called capital gain) and decreases when market values fall (called capital loss) -the wealth of a nation at the end of a year equals its wealth at the beginning plus savings (which is equal to income less consumption) -to make real GDP grow, saving and wealth must be converted to capital and investment -this transformation takes place in the markets for financial capital and through the activities of financial institutions Financial Capital Markets -saving is the source of the funds that are used to finance investment, and these funds are supplied and demanded in three types of financial markets: 1. loan markets
-businesses and households use short-term financing to buy inventories or extend credit (former) and to purchase big ticket items such as cars and appliances (latter) -they can get this form of financing from banks in the form of loans -households can also get long-term financing for things like houses -in this case, households get a mortgage which is a legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payment (the home in this case is used as collateral) -these types of financing take place in loan markets 2. bond markets -a bond is a promise to make specified payments (interest) on specified dates with the principal being paid at maturity -bonds issued by firms and governments are traded in the bond market -the term of the bond can be long or short -firms often use very short-term bonds to get cash for sales before the buyer is able to pay -see pages 545-546 for an example of a short-term bond -another type of bond is a mortgage-backed security which entitles its holder to the income from a package of mortgages -mortgage lenders create mortgage-backed securities -they make mortgage loans to homebuyers and then create securities that they sell to obtain more funds to make more mortgage loans -the holder of a mortgage-backed security is entitled to receive payments the derive from the payments received by the mortgage lender from the homebuyer-borrower -mortgage backed securities were at the center of the financial market storm of 20072008 3. stock markets -a stock is a certificate of ownership and claim to the firm’s profits -a stock market is a financial market in which shares of stocks of corporations are traded (ex. TSX, NASDAQ) Financial Institutions -a financial institution is a firm that operates on both sides of the market for financial capital that is the financial institution is a borrower in one market and a lender in another -financial institutions also stand ready to trade so that households with funds to lend and firms or households seeking funds can always find someone on the other side of the market with whom to trade -five key Canadian financial institutions are: 1. commercial banks -banks accept deposits and use the funds to buy government bonds and other securities and to make loans -economists distinguish banks from other financial institutions because bank deposits are money 2. trust and loan companies -provide similar services to banks and the largest of them are owned by banks -they accept deposits and make personal loans and mortgage loans -they also administer estates, trusts, and pension plans 3. credit unions and caisses populaires -these are banks that are owned and controlled by their depositors and borrowers, are regulated by provincial rules and operate only inside their own provincial boundaries
-they are large in number but small in size 4. pension fund -receive the pension contribution of firms and workers -use the funds to buy a diversified portfolio of bonds are stocks that they expect to generate an income that balances risk and return -income is used to pay pension benefits -pension funds can be very large and play an active role in the firms whose stock they hold 5. insurance companies -provide risk-sharing services -enter into agreements with households and firms to provide compensation in the event of accident, theft, ill health, and a host of other misfortunes -receive premiums from customers and make payments against claims -insurance companies use the funds they have received but not paid out as claims to buy bonds and stocks on which they earn an interest income -in normal times insurance companies have a steady flow of funds coming in and a small amount going out -however in difficult times (i.e. 2008) the flow out exceeds the flow in and this is where insurance companies run into trouble -all financial institutions face risk and this risk poses two problems: Insolvency and Illiquidity -a financial institution’s net worth is the market value of what it has lent minus the market value of what it has borrowed -if net worth is positive the institution is solvent but if it is negative, the institution is insolvent -the owners of an insolvent institution (usually the shareholders) bear the loss -to limit risk of insolvency, financial institutions are regulated and a minimum amount of their lending must be backed my their net worth -a firm is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay more of what it has borrowed than its available cash -in normal times, a financial institution that is illiquid can borrow from another institution but if all institutions are short of cash, that market for loans dries up -insolvency and illiquidity were at the core of the global financial meltdown in 2007-2008 Interest Rates and Asset Prices -stocks, bonds, short-term securities and loans are collectively called financial assets -the interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset -if the asset price rises the interest rate falls and vice versa for a fall in asset price (same as bond prices) -see page 548 for an example if you don’t get it -this means that the price of an asset and the interest rate on that asset are determined simultaneously (one implies the other) -this also means that as interest rates rise, the price of the asset falls, debts become harder to pay and the net worth of a financial institution falls The Loanable Funds Market -the loanable funds market is the aggregate of all the individual financial markets -the circular flow model can be extended to include flows in the loanable funds market that finance investment (see figure 23.2 on page 549)
Funds the Finance Investment -come from three sources: 1. household saving (S) 2. government budget surplus 3. borrowing from the rest of the world -net taxes (T) are the taxes paid to governments minus the cash transfers received from governments (i.e. social security and unemployment benefits) -households income (Y) is equal to: C + S + T -from chapter 21, Y = C + I + G + X –M -setting these two equations equal to each other yields: I = S + (T-G) + (M-X) -this equation tells us that investment (I) is financed by household savings (S) the government budget surplus (T-G) and borrowing from the rest of the world (M-X) -a surplus (T>G) contributes to finance investment while a deficit (T
-businesses and households use short-term financing to buy inventories or extend credit (former) and to purchase big ticket items such as cars and appliances (latter) -they can get this form of financing from banks in the form of loans -households can also get long-term financing for things like houses -in this case, households get a mortgage which is a legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payment (the home in this case is used as collateral) -these types of financing take place in loan markets 2. bond markets -a bond is a promise to make specified payments (interest) on specified dates with the principal being paid at maturity -bonds issued by firms and governments are traded in the bond market -the term of the bond can be long or short -firms often use very short-term bonds to get cash for sales before the buyer is able to pay -see pages 545-546 for an example of a short-term bond -another type of bond is a mortgage-backed security which entitles its holder to the income from a package of mortgages -mortgage lenders create mortgage-backed securities -they make mortgage loans to homebuyers and then create securities that they sell to obtain more funds to make more mortgage loans -the holder of a mortgage-backed security is entitled to receive payments the derive from the payments received by the mortgage lender from the homebuyer-borrower -mortgage backed securities were at the center of the financial market storm of 20072008 3. stock markets -a stock is a certificate of ownership and claim to the firm’s profits -a stock market is a financial market in which shares of stocks of corporations are traded (ex. TSX, NASDAQ) Financial Institutions -a financial institution is a firm that operates on both sides of the market for financial capital that is the financial institution is a borrower in one market and a lender in another -financial institutions also stand ready to trade so that households with funds to lend and firms or households seeking funds can always find someone on the other side of the market with whom to trade -five key Canadian financial institutions are: 1. commercial banks -banks accept deposits and use the funds to buy government bonds and other securities and to make loans -economists distinguish banks from other financial institutions because bank deposits are money 2. trust and loan companies -provide similar services to banks and the largest of them are owned by banks -they accept deposits and make personal loans and mortgage loans -they also administer estates, trusts, and pension plans 3. credit unions and caisses populaires -these are banks that are owned and controlled by their depositors and borrowers, are regulated by provincial rules and operate only inside their own provincial boundaries
-they are large in number but small in size 4. pension fund -receive the pension contribution of firms and workers -use the funds to buy a diversified portfolio of bonds are stocks that they expect to generate an income that balances risk and return -income is used to pay pension benefits -pension funds can be very large and play an active role in the firms whose stock they hold 5. insurance companies -provide risk-sharing services -enter into agreements with households and firms to provide compensation in the event of accident, theft, ill health, and a host of other misfortunes -receive premiums from customers and make payments against claims -insurance companies use the funds they have received but not paid out as claims to buy bonds and stocks on which they earn an interest income -in normal times insurance companies have a steady flow of funds coming in and a small amount going out -however in difficult times (i.e. 2008) the flow out exceeds the flow in and this is where insurance companies run into trouble -all financial institutions face risk and this risk poses two problems: Insolvency and Illiquidity -a financial institution’s net worth is the market value of what it has lent minus the market value of what it has borrowed -if net worth is positive the institution is solvent but if it is negative, the institution is insolvent -the owners of an insolvent institution (usually the shareholders) bear the loss -to limit risk of insolvency, financial institutions are regulated and a minimum amount of their lending must be backed my their net worth -a firm is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay more of what it has borrowed than its available cash -in normal times, a financial institution that is illiquid can borrow from another institution but if all institutions are short of cash, that market for loans dries up -insolvency and illiquidity were at the core of the global financial meltdown in 2007-2008 Interest Rates and Asset Prices -stocks, bonds, short-term securities and loans are collectively called financial assets -the interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset -if the asset price rises the interest rate falls and vice versa for a fall in asset price (same as bond prices) -see page 548 for an example if you don’t get it -this means that the price of an asset and the interest rate on that asset are determined simultaneously (one implies the other) -this also means that as interest rates rise, the price of the asset falls, debts become harder to pay and the net worth of a financial institution falls The Loanable Funds Market -the loanable funds market is the aggregate of all the individual financial markets -the circular flow model can be extended to include flows in the loanable funds market that finance investment (see figure 23.2 on page 549)
Funds the Finance Investment -come from three sources: 1. household saving (S) 2. government budget surplus 3. borrowing from the rest of the world -net taxes (T) are the taxes paid to governments minus the cash transfers received from governments (i.e. social security and unemployment benefits) -households income (Y) is equal to: C + S + T -from chapter 21, Y = C + I + G + X –M -setting these two equations equal to each other yields: I = S + (T-G) + (M-X) -this equation tells us that investment (I) is financed by household savings (S) the government budget surplus (T-G) and borrowing from the rest of the world (M-X) -a surplus (T>G) contributes to finance investment while a deficit (T
