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Chapter 23 Notes.docx

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Western University
Economics 1022A/B
Jeannie Gillmore

Chapter 23 Notes Finance and Money  finance describes the activity of providing the funds that finance expenditures on capital o the 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 to make financial transactions o the study of money looks at how firms and households use it, how much of it they hold, how banks create and manage it, and how its quantity influences the economy Physical Capital and Financial Capital  physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services (e/x raw materials, semi finished goods, components) o when economists use the term capital, they mean physical capital  the funds that firms use to buy physical capital is called financial capital o along the aggregate production function, the quantity of capital is fixed  an increase in the quantity of capital increases production possibilities and shifts the aggregate production function upward Capital and Investment  the quantity of capital changes because of investment and depreciation o investment increases the quantity of capital o depreciation decreases the quantity of capital  the amount spent on new capital is called gross investment o the change in the value of capital is called net investment  net investment equals gross investment minus depreciation Wealth and Saving  wealth is the value of all the things that people own o increases when the market value of assets rises o decreases when the market value of assets falls  saving is the amount of income that is not paid in taxes or spent on consumption goods and services o saving increases wealth  to make real GDP grow, saving and wealth must be transformed into investment and capital Loan Markets  business that want short-term finance to buy inventories or to extend credit to their customers seek finance in the form of a loan from a brank  households use the loan market to purchase big items (e/x cars, furniture, appliances) o also get finance to buy new homes (counted as part of investment), which is usually obtained as a loan that is secured by 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 payments (repayments and interest) Bond Markets  a bond is a promise to make specified payments on specified dates o the buyer of a bond makes a loan to the company and is entitled to the payments promised by the bond o bonds can be held until the borrower has repaid the amount borrowed or sell it to someone else o bonds issued by firms and governments are traded in the bond market  bond term can be short or long o firms often issue short-term bonds as a way of getting paid for their sales before the buyer is able to pay o e/x Bombardier sells VIA Rail $100 of trains  VIA doesn’t want to pay until they are in use  VIA promises to pay Bombardier $101 in 3 months  a bank is willing to buy this promise, and will give $100 now, and expects VIA to pay the bank $101 in 3 months  the GoC issues promises of these type, called Treasury Bills  mortgage-backed security entitles its holder to the income from a package of mortgages o mortgage lenders created 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 that derive from the payments received by the mortgage lender from the homebuyer-borrower 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 Financial Institutions  a financial institution is a firm that operates on both sides of the markets for financial capital o is a borrower in one market and a lender in another o ready to trade so that households with funds to lend and firms/households seeking funds can always find someone  banks o accept deposits and use the funds to buy government bonds and other securities and to make loans  trust and loan companies o largest firms are owned by banks o accept deposits and make personal loans and mortgage loans o administer estates, trusts, and pension plans  credit unions/caisses populaires o banks that are owned and controlled by their depositors and borrowers, regulated by provincial rules, and operate only inside their own provincial boundaries o large in number, small in size  pension funds o receive pension contributions of firms and workers o use the funds to buy a diversified portfolio of bonds and stocks that they expect to generate an income that balances risk and return  income used to pay pension benefits o can be very large and play an active role in the firms whose stock they hold  insurance companies o enter into agreements with households and firms to provide compensation in the event of accident o received premiums from their customers and make payments against claims o use the funds they have received but not paid out as claims to buy bonds and stocks on which they earn an interest income o some also insure corporate bonds and other risky financial assets o provide insurance that pays out if a firm fails and cannot meet its bond obligations o in normal times, insurance companies have a steady flow coming in, and a smaller flow of funds paying claims  in unusual times when widespread losses are being incurred, insurance companies can have difficulty in meeting their obligations Insolvency and Illiquidity  net worth is the market value of what it has lent minus the market value of what it has borrowed o if net worth is positive  solvent o if net worth is negative  insolvent  the owners of an insolvent institution bear the loss  a financial institution both borrows and lends, so it is exposed to the risk that its net worth might become negative o to limit that risk, firms are regulated and a minimum amount of their lending must be backed by their net worth  sometimes firms can be solvent, but illiquid o illiquid means that a firm 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, an illiquid firm can borrow from another  if all the firms are short, then the market for loans among financial institutions dries up Interest Rates and Asset Prices  the interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset o if the asset price rises, the interest rate falls (since it is a percentage)  the inverse relationship means that if the interest rate on an asset rises, the price of the asset falls, debts become harder to pay, and the net worth of the financial institution falls o insolvency can arise from a previously unexpected large rise in the interest rate Loanable Funds Market  the loanable funds market is the aggregate of all the individual financial markets  funds that finance investment: o household savings o government budget surplus o borrowing from the rest of the world  households’ income (Y), is spent on consumption (C), saved (S), or paid in net taxes (T) o net taxes are the taxes paid to the government minus the cash transfers received from governments (e/x unemployment benefits) o income is equal to the sum of consumer expenditure, saving, and net taxes (Y = C + S + T) ( ) ( ) o investment is financed by household savings (S), the government budget surplus (T – G), and borrowing from the rest of the world (M – X)  a government budget surplus (T > G) contributes funds to finance investment, but a government deficit (T < G) competes with investment for funds  if we export less than we import, we borrow (M – X) from the rest of the world to finance some of our investment  if we export more than we import, we loan (X – M) to the rest of the world and part of our saving finances investment in other countries  the sum of private saving (S) and government saving (T – G) is called national saving o national saving and foreign borrowing finance investment  the price in the loanable funds market that achieves equilibrium is an interest rate, which we also measure in real terms as the real interest rate o in the loanable funds market, there is just one interest rate, which is an average of the interest rates on all the different types of financial securities Real Interest Rate  the nominal interest rate is the number of dollar that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent o e/x if the annual interest paid on a $500 loan is $25, the nominal interest rate is 5% per year  the real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money o approximately equal to the nominal interest rate minus the inflation rate  e/x suppose you have $500 in bank earni
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