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EC140 (417)

Chapter 23.doc

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Rizwan Tahir

Chapter 23: Finance, Saving and Investment Friday, February 22, 2013 2:35 PM Financial Institutions and Financial Markets • Finance: activity of providing funds that generate expenditure on capital goods • Money: medium of exchange used to pay for good and services, and to settle financial transactions Physical capital: tools, instruments, machines, buildings etc. produced in • the past and used today to produce other goods and services • Financial capital: funds that firms use to buy physical capital • Capital and Investment • Gross investment: spending on purchases of new capital and on replacing depreciated capital • Depreciation: decrease in quantity of capital that results from wear, tear, obsolescence • Net investment: change in quantity of capital • Net Investment = Gross Investment - Depreciation • Ex. firm starts with 30 in capital (beginning of 2011), 20 depreciates during 2011, investment in new capital is 30 during 2011,  Net investment (increase in capital during the year)= 30 - 20 = 10 10  End of year, total capital stock is 40 • Wealth and Saving • Wealth: value of all things that people own  Counts things like: money in bank accounts, value of assets (cars), equity in your home etc.  Not the same as income • Saving: amount of income that isn't paid in taxes or consumed • Wealth increases with saving, capital gains (increase in value of assets held) Markets for Financial Capital • Saving important because it's source of funds used to finance investment (in capital) • Financial markets to help link saving with investment, serves key role in econ • These funds supplied (by savers) and demanded (by investors) in 3 types of markets: • Loan Market  Market where only one party lends money to another party  Used mainly by consumers, sometimes business owners  Loans can be obtained from banks, credit unions, wealthy individuals, credit cards etc.  Loans paid back with interest over time  Sometimes loans secured by collateral (if house used as collateral- mortgage loan) • Bond Market  Bond is like loan in sense that bond issuer is borrower, bond holder is lender (bond has no claim to ownership)  An agreement to pay back amount of money, with interest  Usually used by firms, governments, to raise money to finance spending on capital goods  Can be viewed as claim to stream of payments over specific amount of time- varying maturities (1, 10, 30 years ~)  Can take different forms (ex. mortgage-backed securities) • Stock Markets  Stock is share of ownership (equity) in company  Owning stock entitles owner to share of profits- interest not accumulated on stocks but they may pay dividends  Stocks traded on stock markets Financial Institutions • Financial Institution: firm that operates on both sides of markets for financial capital • It's borrowing in one market, lender in another • Facilitates lending and borrowing of financial capital • Plays key role in well-functioning economies • Banks  Accept deposits, use money to make loans and buy securities, key to monetary policy • Trust & Loan Companies  Like banks, but differ slightly in terms of how they are regulated • Credit Unions  Like a "co-op" bank, owned by members • Pension Funds  Invest funds from contributions of firms/employees for retirement saving • Insurance Companies  Accept funds in exchange for payouts in case of uncertain future events, invest some of this money in markets Insolvency vs. Illiquidity • Net worth: market value of what it has lent - market value of what it has borrowed • Insolvency: financial institution is insolvent if it has negative net worth • Insolvent firms generally go out of business • Much more serious problem than illiquidity • Illiquidity: illiquid financial institution is one that currently lacks cash flow • Illiquid firm can have positive net worth but trouble generating funds to pay for current expenses • Usually not problem since firm can simply borrow money against it's net worth • But if credit is scarce, illiquidity becomes a problem Interest Rates and Asset Prices • Interest rate on financial asset is interest received expressed as percentage of price of asset • Inverse relationship between price of asset and its interest rate • Ex. asset price rises from $25 to $50, interest rate = (5/50) x 100% = 10% (interest rate falls) • Ex. asset price falls from $25 to $20, interest rate = (5/20) x 100% = 25% (interest rate rises) Market for Loanable Funds • Lending and borrowing from 3 sectors in the economy: households, government, rest of the world • All three sectors cannot simultaneously be saving/borrowing • When one sector saves, at least one other must be borrowing • Nominal Interest Rate: number of dollars that borrower pays and lender receives in interest in year expressed as percentage of number of dollars borrowed and lent o Ex. if annual interest paid on $500 loan is $25, nominal interest rate is 5% per year ($25/$500 x 100) • The Real Interest Rate: is nominal interest rate adjusted to remove effects of inflation on buying power of money o real interest rate ≈ nominal interest
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