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