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econ chapter 23.docx

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York University
PSYC 3420
Irwin Silverman

Finance, Saving and Investment Financial Institutions and Financial Markets • Finance is the term to describe the activity of providing the funds that finance expenditures on capital o 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 pays for goods and services and factors of production and to make financial transactions o Looks at how households and firms use money, how much of it do 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. o Capital means physical capital o The funds that firms use to buy physical capital are called financial capital  Quantity of capital is fixed Capital and Investment • The quantity of capital changes because of investment and depreciation. • Investment increases the quantity of capital and depreciation decreases it o Total amount spent on new capital is called gross investment o The change in the value of capital is called net investment o Net investment equals gross investment minus depreciation Wealth and Saving • Wealth is the value of all the things that people own • Income is the amount received during a given time period from supplying services of the resources you own • Saving is the amount of income that is not paid in taxes or spent on consumption goods and services o Saving increases wealth o Wealth also increases when the market value of assets rises (called capital gains) o Decreases when the market value of assets falls, called capital losses • The wealth of a nation at the end of a year equals its wealth at the start of the year plus its savings during the year, which equals income minus consumption expenditure o For GDP to grow, saving and wealth must be transformed into investment and capital Markets for Financial Capital • Funds from saving are used to finance investment, and they are supplied and demanded in three types of financial markets: 1. Loan Markets: mortgages, bank loans, household loans etc. 2. Bond Markets: a bond is a promise to make specified payments on specified dates a. Bonds issued by firms and governments are traded in the bond market b. Mortgage-backed security: another type of loan which entitles its holder to the income from a package of mortgages i. Holder is entitled to receive payments that derive from the payments received by the mortgage lender from the home buyer-borrower. c. Main case of the financial market collapse in 07-08 3. Stock Markets: a stock is a certificate of ownership and claim to the firm’s profit a. Different from terms of a bond b. A stock market is a financial market in which shares of stocks of corporations are traded Financial Institutions • It is a firm that operates on both sides of the market for financial capital. It is a borrower in one market and a lender in another o Banks: accepts deposits and use the funds to buy government bonds and other securities to make loans  14 banks and 33 foreign ones in Canada o Trust and Loan Companies: provide similar services as banks and the largest are owned by banks  Accept deposits, personal loans and mortgage loans  Large in number but small in size o Pension Funds: they are financial institutions that receive the pension contributions of firms and workers  Funds used to buy stocks and bonds  Income is used to pay pension benefits  Can be very large and play an active role in the firms whose stock they hold o Insurance Companies: provide risk-sharing services  They enter into agreements with households and firms to provide compensation in the event of accident, theft, fire, ill-health and a host of other misfortunes  They receive premiums from their customers and make payments against claims  They use funds they have received but not paid out as claims to buy bonds and stocks on which they earn an interest income  Also insure corporate bonds and other risky financial assets  Have a steady flow of funds comings in from premiums and interest on the financial assets they hold and a steady bit smaller flow of funds paying claims • Profit is the gap between the two flows • All institutions are at risk of solvency and liquidity problem Solvency and Liquidity • A financial institution’s net worth is the total market value of what it has lent minus the market value of it has borrowed o If the net worth is positive, the institution is solvent and can remain in business o If net worth is negative, the institution is insolvent and goes out of business • To limit the risk, financial institutions are regulated and a minimum amount of their lending must be backed by their net worth o 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 • Insolvency and illiquidity were at the core of the financial meltdown of 07-08 Interest Rates and Asset Prices • Stocks, bonds, short-term securities, and loans are collectively called financial assets o The interest rate on a financial asset is the interest
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