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Midterm

ECON 1BB3 Study Guide - Midterm Guide: Loanable Funds, Autarky, Byrsonima Crassifolia


Department
Economics
Course Code
ECON 1BB3
Professor
Bridget O' Shaughnessy
Study Guide
Midterm

Page:
of 6
Savings, Investment and the Financial System
January 11, 2005
Reading: Chapter 13 of Mankiw et. al. (2002). [Chapter 8 of brief edition.]
1 Introduction
Financial system - the group of institutions in the economy that help to match one person’s
savings with another person’s investment.
some people want to save some of income for future.
some people want to borrow in order to finance investments in new and growing
businesses.
What brings two together?
What ensures that supply of funds (savings) equals demand for funds for investment.
2 Financial markets
- financial institutions through which savers can directly provide funds to borrowers.
Types of financial markets:
1. The Bond Market
firms/government can borrow money by selling bonds.
bond - a certificate of indebtedness.
date of maturity - time at which loan will be repaid.
bonds generally pay interest annually until loan matures.
Characteristics of bonds:
1
(a) term - length of time until bond matures
aperpetuity is a bond that never matures, pays interest forever.
(b) credit risk - probability borrower will fail to pay some of interest or principal.
borrowers need higher interest rate to buy risky bonds.
Bonds can be sold if holder requires principal before maturity, but may involve a
discounted price.
2. The Stock Market - firms sell stock in company.
stock - a claim to partial ownership in the firm.
shareholders have claim to share of firm’s profits if any
if firm fails, has financial difficulties, bondholders are paid what they are due before
stockholders receive anything.
Debt finance - money raised through sale of bonds.
Equity finance - money raised through sale of stocks.
stock prices depend in part on people’s expectations about a company’s future.
3 Financial Intermediaries
-financial institutions through which savers can directly provide funds to borrowers.
Types of financial institutions:
1. Banks - bank takes in deposit of those who wish to save and uses deposits to make
loans to those who wish to borrow.
higher interest charged to borrower than is paid to saver - difference is used to cover
operating costs, pay out profits to owners of bank.
2. Mutual Funds - an institution that sells shares to public and uses the proceeds to buy
a portfolio of stocks and bonds.
allows people with small amounts of money to diversify.
4 Savings and Investment in the National Accounts
Recall:
Y=C+I+G+N X (1)
This equation is an identity - always holds because of the way the variables are defined.
2
For now we will consider a closed economy - an economy that does not interact with other
economies.
In a closed economy, N X = 0 (i.e. no net exports). Hence
Y=C+I+G(2)
Every unit of output sold in a closed economy is either consumed, invested or brought by
gov’t.
Can rewrite as
YCG=I(3)
Left-hand side (YCG) is called national saving, or saving, and is denoted as S.
Hence
S=I(4)
National Saving (S) - total income in economy that remains after paying for consumption
and gov’t purchases. Saving can be divided into two parts. Adding and subtracting T (taxes)
to the right hand side of (3) yields
S= (YCT)+(TG) (5)
The first term (YCT) is called private saving and the second term (TG)is called
public saving.
private saving - income that households have left after paying for taxes and consumption.
public saving - tax revenues that gov’t has left after paying for goods and services.
If T=G, gov’t runs balanced budget.
If T < G, gov’t runs budget deficit.
If T > G, gov’t runs budget surplus.
4.1 The Meaning of Saving and Investment
In economics, setting aside unused income for future use (and interest income) is saving.
e.g. buying a stock in Ford is saving, not investment
In economics, investment refers to purchase of new capital.
e.g. when Ford using proceeds of new stock issues to purchase new factory, this is
investment.
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