Summary of Lecture Notes from Chapter 8 and Practice Questions
1. The Canadian financial system is made up of many types of financial institutions, such as the bond
market, the stock market, banks, and mutual funds. All these institutions act to direct the resources
of households who want to save some of their income into the hands of households and firms who
want to borrow.
2. National income accounting identities reveal some important relationships among macroeconomic
variables. In particular, for a closed economy, national saving must equal investment. Financial
institutions are the mechanism through which the economy matches one person’s saving with
another person’s investment.
3. The interest rate is determined by the supply and demand for loanable funds. The supply of loanable
funds comes from households who want to save some of their income and lend it out. The demand
for loanable funds comes from households and firms who want to borrow for investment. To analyze
how any policy or event affects the interest rate, one must consider how it affects the supply and
demand for loanable funds.
4. National saving equals private saving plus public saving. A government budget deficit represents
negative public saving and, therefore, reduces national saving and the supply of loanable funds
available to finance investment. When a government budget deficit crowds out investment, it
reduces the growth of productivity and GDP.
I. Definition of financial system: the group of institutions in the economy that help to
match one person’s saving with another person’s investment.
II. Financial Institutions in the Canadian Economy
A. Financial Markets
1. Definition of financial markets : financial institutions through which
savers can directly provide funds to borrowers.
2. The Bond Market
a. Definition of bond : a certificate of indebtedness.
b. A bond identifies the date of maturity and the rate of interest that will be
paid periodically until the loan matures.
c. One important characteristic that determines a bond’s value is its term.
The term is the length of time until the bond matures. All else equal,
long-term bonds pay higher rates of interest than short-term bonds.
d. Another important characteristic of a bond is its credit risk, which is the
probability that the borrower will fail to pay some of the interest or
principal. All else equal, the more risky a bond is, the higher its interest
1 2 ☞ Chapter 8/Saving, Investment, and the Financial System
e. The Canadian government is considered a relatively safe credit risk,
while provincial governments and corporations are considered to be
somewhat greater credit risks. Corporations tend to pay higher interest
rates on their bonds compared to provincial and Government of Canada
3. The Stock Market
a. Definition of stock: a claim to partial ownership in a firm.
b. The sale of stock to raise money is called equity finance; the sale of
bonds to raise money is called debt finance.
c. Stocks are sold on organized stock exchanges (such as the New York
Stock Exchange, NASDAQ, or the Toronto Stock Exchange) and the
prices of stocks are determined by supply and demand.
d. The price of a stock generally reflects the perception of a company’s
e. A stock index is computed as an average of a group of stock prices.
B. Financial Intermediaries
1. Definition of financial intermediaries : financial institutions through
which savers can indirectly provide funds to borrowers.
a. The primary role of banks is to take in deposits from people who want to
save and then lend them out to others who want to borrow.
b. Banks pay depositors interest on their deposits and charge borrowers a
higher rate of interest to cover the costs of running the bank and provide
the bank owners with some amount of profit.
c. Banks also play another important role in the economy by allowing
individuals to use chequing deposits as a medium of exchange.
3. Mutual Funds
a. Definition of mutual fund : an institution that sells shares to the
public and uses the proceeds to buy a portfolio of stocks and
b. The primary advantage of a mutual fund is that it allows individuals with
small amounts of money to diversify. Chapter 8/Saving, Investment, and the Financial System ☞ 3
c. Mutual funds called “index funds” buy all of the stocks of a given stock
index. These funds have generally performed better than funds with
active fund managers. This may be true because they trade stocks less
frequently and they do not have to pay the salaries of fund managers.
III. Saving and Investment in the National Income Accounts
A. Some Important Identities
1. Remember that GDP can be divided up into four components: consumption,
investment, government purchases, and net exports.
Y = C + I + G + NX
2. We will assume that we are dealing with a closed economy (an economy that
does not engage in international trade or international borrowing and lending).
This implies that GDP can now be divided into only three components:
Y = C + I + G
3. To isolate investment, we can subtract C and G from both sides:
Y - C - G = I
4. The left-hand side of this equation (Y – C – G) is the total income in the
economy after paying for consumption and government purchases. This amount
is called national saving.
5. Definition of national saving (saving): the total income in the economy
that remains after paying for consumption and government purchases.
6. Substituting saving (S) into our identity gives us:
S = I 4 ☞ Chapter 8/Saving, Investment, and the Financial System
7. This equation tells us that saving equals investment.
8. Let’s go back to our definition of national saving once again:
S = Y - C - G
9. We can add taxes (T) and subtract taxes (T):
S = (Y - C - T)