ECON 105 - Principles of Macroeconomics, 4th Canadian Edition - Chapters 8-13

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3 Apr 2012
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Chapter 8 Saving, Investment, and the Financial System
financial system institutions in the economy that help to match one person’s saving
with another person’s investment
savings and investment for economic growth
country’s saved large portion of GDP = more resources available for investment in
capital = higher capital = higher country productivity and living standard
Financial Institutions in the Canadian Economy
financial system moves scarce resources from savers (people who spend less than they
earn) to borrowers( people who spend more than they earn)
savers save to put child through post-secondary school, or retire
o supply money and expect to get interest back later
borrowers borrow to buy house, or start a business
o borrow money and required to pay interest later
Financial Markets
financial markets institutions through which savers can directly provide funds to
borrowers
The Bond Market:
o bond a certificate of indebtedness
specifies the obligations of the borrower to the holder of the bond (IOU)
identifies date of maturity (when the loan will be repaid)
rate of interest paid periodically until loan matures
buyer of bond gives money to company in exchange for interest and
repayment of principal (money borrowed)
buyer can hold the bond until maturity or sell it
o large corporations, federal government, provincial governments issues bonds
o two important characteristics:
term the length of time until bond matures
can be short (few months) or long (30 years)
perpetuity bond that never matures (interest paid forever,
principal never repaid)
long term bonds pay more because holder needs to wait longer for
repayment of principal; they risk having to sell the bond earlier at
reduced price if holder needs the money
credit risk probability borrower will fail to pay the interest or principal
default failure to pay
borrowers can default their loans by declaring bankruptcy
if probability is high, buyers demand higher interest rate
affected by the level of debt carried by issuer of bond, recent
changes in the amount of debt carried, and stability of issuer’s
revenue
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o provincial governments that issue bonds have greater credit risk than federal
government because of less diverse economy, therefore tax revenues are more
volatile; sudden fall in tax revenue = difficulty paying debts
o interest paid on provincial bonds are higher and varies by province
o corporate bonds pay higher rates because revenues are even more volatile
junk bonds financially shaky corporations raise money by paying
higher interest rates
The Stock Market:
o stock partial ownership in a firm; a claim to profits
o equity finance sale of stock to raise money
owner of stock becomes part owner of corporation
shareholders benefit from profits
higher risk and potentially higher return
o debt finance sale of bonds
owner of bond becomes creditor of corporation
bondholders only get interest paid from bonds
bondholders get paid first if corporation runs into financial difficulty
o after corporation issues stock and sell shares to public, shares trade on organized
stock exchanges; corporation receives no money when stock changes hands
New York Stock Exchange, American Stock Exchange, NASDAQ
Toronto Stock Exchange (TSX) and TSX Venture Exchange (junior)
o the prices at which shares trade on stock exchanges are determined by supply and
demand for stock
demand for stock (price) reflects people’s perception of the corporation’s
future profitability
o stock index computed as an average of a group of stock prices to monitor
overall level of stock prices
Dow Jones Industrial Average
S&P/TSX Composite Index over 200 major firms listed on TSX
stock indexes watched closely as indicators of future economic conditions
Newspaper’s Stock Tables:
o price price of share is the most important information
o volume number of shares sold during the past day of trading
o dividend - profits paid out to shareholders by corporations
o retained earnings profits not paid out and used for additional investment
o dividend yield dividend expressed as a percentage of the stock’s price
o price/earnings ratio (P/E):
corporations earnings amount of revenue minus cost of production
earnings per share total earnings divided by number of shares of stock
P.E. price of stock divided by amount earned per share
typical ratio is 15
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higher P/E indicates stock is expensive relative to earnings; people
expect earnings to rise or stock is overvalued
lower P/E indicates stock is cheap relative to earnings; people
expect earnings to fall or stock is undervalued
Financial Intermediaries
financial intermediaries financial institutions through which savers can indirectly
provide funds to borrowers
Banks:
o takes in deposits from people who want to save and use deposits to make loans to
people who want to borrow
o pays depositors interest and charge borrowers slightly higher interest to cover
bank costs and profit for bank owners
o second important role in economy facilitate purchases of goods and services by
allowing people to write cheques
creates a medium of exchange (item people can easily use to engage in
transactions)
o stocks and bonds are also a store of value but it’s not as easy to access as banks
Mutual Funds:
o mutual fund institution that sells shares to the public and uses proceeds to buy
a portfolio (selection) of stocks and bonds
shareholders accept all risks and return if value of portfolio rises,
shareholder benefits; if value of portfolio falls, shareholder suffers loss
o primary advantage is that it allows people with small amounts of money to
diversify
diverse portfolio face less risk because of small stake in each company
o company operating mutual fund charges shareholders usually between 0.5 to 3.0
percent of assets
o secondary advantage is that it gives ordinary people access to skills of
professional money managers
managers pay close attention to developments and prospects of companies
o index funds buys all stocks in a given stock index; performs better because
costs are low by buying/selling rarely and not having to pay salaries of
professional money managers
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