ECON 1BB3 Lecture Notes - Lecture 5: Government Debt, Demand Curve, Real Interest Rate

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Ideas covered:
The Financial System: Canadian reality
The Market for Loanable Funds
Saving and Investment Predictions in a Closed Economy
The Financial System: Canadian Reality
Financial Institutions in Canada bring borrowers and savers together.
Two financial institutions:
1. Financial markets: Directly bring together savers and borrowers.
Bond Market: A bond is simply a loan. Bonds are issued by large businesses
and by federal and provincial governments. Bonds are bought because is to
get a financial return i.e. the interest paid on the bond. The interest earned on
bonds depends on: (1) term of the bond and (2) risk. Term refers to the length
of the loan. A longer term means a higher interest rate. A riskier bond must
earn a higher rate of return than a safer bond.
Stock market: A stock issued by a company is a piece of paper that indicates
partial ownership of that company. The reason one may buy a stock is also to
get a financial return which may be obtained by: dividends (share of corporate
profits) or capital gain (occurs when the cost per share of the stock rises).
Unlike bonds, governments do not issue bonds because it is impossible for
one to own the government. In the stock market, there is also the risk of
capital loss which is a fall in the price of the stocks. Over longer periods of
time, the return on stocks is typically greater than the return on bonds because
of two reasons: (1) stocks are riskier than bonds partly because of the capital
loss possibility and (2) bankruptcy laws treat stock holders and bond holders
differently. Bond holders will be paid before stock holders, who are the last
people to be compensated when a corporation declares bankruptcy which
adds onto the risk.
2. Financial intermediaries: Indirectly bring together savers and borrowers.
Banks provide loans to borrowers and accept deposits from savers. Banks
lend to a variety of types of actors in our economy, such a governments,
households and firms. Small businesses are not likely to issue bonds, but they
are more likely to go to a bank for a loan. Large corporations can bypass
banks and borrow directly from the public.
Mutual funds gather together the small amounts saved by many people, join
them together and purchase stocks and bonds on behalf of the people in the
mutual funds. Most mutual funds are actively managed funds which have a
salaried person deciding which stocks and bonds will be purchased on behalf
the people in the mutual fund. The salary comes out from the fees that the
mutual funds owners pay. More recently, there is a rise of indexed funds that
move in the same directions as one of the large stock indices (such as Dow
Jones Industrial and S&P 500 which are American stock indices with 30 and
500 firms respectively and Toronto Stock Exchange) that combine together the
stock prices of many firms and provide us a snapshot of what is happening in
one of the stock markets overall. When the value of one of these indexes
rises, the value of the shares of the mutual fund tracking the index also rises.
Index funds have become more popular recently is because the fees to own
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shares in an indexed fund is much lower than that of an actively managed fund
since there are no day-to-day decisions being made.
The Market for Loanable Funds
GDP Components:
In a closed economy, the national income accounting identity is:
Y = C + I + G
A closed economy has no trade, and no borrowing and saving with individuals,
firms, or governments in other countries.
Types of Saving:
Private saving (Sp) are the saving by households. A large chunk of the income
earned by households is used to pay taxes. The Net Income (= Gross Income
Taxes) is spent on consumption goods and services or saved with the intention of
buying consumption goods and services at a later date.
Sp = Y T C where, T is the difference between taxes and
transfer payments (payments from the government
to the households that are not in exchange of a
good or service).
Public saving (Sg) is the saving by the government. The inflows of the government
budget are tax revenues and the outflows are government spending on goods and
services and transfer payments which is already encompassed in the T.
Sg = T G
The governments budget position each year depends upon G and T.
o A budget surplus occurs if T > G i.e. the government earns more than it spend.
o A budget deficit occurs if T < G i.e. the government spends more than it earns.
o Government debt is an accumulation of past government budget deficits. It is a
stock variable.
National Income Accounting Identity
Definition of Savings
Y = C + I + G
Y C G = I
S = Sp + Sg
Sp = Y T C
Sg = T G
S = (Y T C) + (T G)
S = Y C G
S = I
In a closed economy, total savings must equal to total investment.
Market for Loanable Funds:
o In reality, households, governments and firms save and households, governments
and firms borrow at times.
o In the market for loanable funds, we are artificially going to divide the transactions in
the market for simplification purposes and to make our supply-demand model easier
to use.
o Assumptions:
All borrowing in this market is done by firms who want to invest (purchase new
capital equipment).
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