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Chapter 23

Economics 1022 Chapter 23 notes

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Economics 1022A/B
Jeannie Gillmore

Chapter 23 Financial Markets & Financial Institutions  Finance: Activity of providing the funds that finance expenditure on capital o Study of finance: Study of how households and firms obtain and use financial resources, and how they cope with the risks that arise in such activities  Money: What we use to pay for goods and services and factors of production to make financial transactions o Study of money: Study of how households and firms use it, how much of it they hold, how banks create and manage it, and how its quantity influences the economy  Physical capital (capital): Tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services  Financial capital: Funds that firms use to buy physical capital  Investment: Increases the quantity of capital o Depreciation: Decreases the quantity of capital o Gross investment: Total amount spent on new capital o Net investment: Change in the value of capital (equals gross investment minus depreciation)  Wealth: Value of all the things that people own o Income: Amount received during a given period for supplying the service of the resource they own o Saving: Amount of income that is not paid in taxes or spent on consumption goods and services o Wealth increase with saving and capital gains (increase in the market value of assets) and decrease with capital losses (decrease in the market value of assets) o To make real GDP grow, saving and wealth must be transformed into investment and capital, which takes place in markets for financial capital and activities in financial institutions.  Financial capital markets: o Loan markets:  Businesses often want short-term finance to buy inventories or extend credit to customers.  Households often get loans via credit cards or mortgages (legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payments) o Bond markets:  Bond: A promise to make specific payments on specific dates  Mortgage-backed security: Bond that entitles its holder to the income from a package of mortgages. The holder is entitled to receive payments that derive from the payments received by the mortgage lender from the borrower.  Treasury bill: Bond issued by the government  The buyer of the bond makes a loan to the company, and is entitled to payments promised in the bond, or to sell off the bond to somebody else.  Bond market: Market in which bonds issued by firms and governments are traded o Stock markets:  Stock: Certificate of ownership and claim to the firm’s profit  Stock markets: Financial market in which shares of stocks of corporations are traded  Financial institutions: A firm that operates on both sides of the markets (borrow/lend) for financial capital o Stand ready to trade so that households with funds to lend or firms or households seeking funds can always find someone on the other side of the market. o Commercial banks:  Banks accept deposits and use funds to buy government bonds and make loans.  Holds 70% of total assets of the Canadian financial sector. o Trust and loan companies: Mostly owned by banks, and provide similar services as them o Credit unions and Caisses Populaires: Banks that are controlled by their depositors and borrowers, regulated by provincial rules, and operate only inside the provincial boundaries. o Pension funds: Financial institutions that receive pension contributions of firms and use them to buy diversified portfolio of stocks and bonds, and uses the income to pay pension benefits. o Insurance companies: Companies that provide risk-sharing services in the event of accident, theft, fire, ill health, and other misfortunes and receive premiums.  Net worth: Market value of what a financial institution has lent minus the market value of what it has borrowed o If it is positive, the institution is solvent. o If it is negative, the institution is insolvent goes out of business, and the stockholders bear the loss. o To limit the risk of going negative, financial institutions have regulations to have a minimum amount of their lending be backed by their net worth. o Illiquid: A firm that has made long-term loans with borrowed funds and is faced with sudden demand to repay more of what has been borrowed than its available cash. Critical during financial meltdowns.  Financial assets: Collective stocks, bonds, short-term securities, and loans o Interest rate on a financial asset is the interest received as a percentage of the price of the asset o When the price of an asset rises other things remaining the same, the interest rate falls (vice versa) Loanable Funds Market  Loanable funds market: Aggregate of all the individual financial markets  Y = C + S + T o C = Consumer expendit
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