Economics 1022A/B Chapter Notes -Loanable Funds, Real Interest Rate, Nominal Interest Rate

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24 Apr 2012
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Economics Textbook Notes
Chapter 23 Finance, Saving, and Investment
Financial Institutions and Financial Markets
Finance and Money
Finance is used to describe the activity of providing the funds that finance
expenditures on capital
o The study of finance looks at how households and firms obtain and use
financial resources and how they cope with the risks that arise in this
Money is what we use to pay for goods and services and factors of production and
to make financial transactions
o The study of money looks at 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 and Financial Capital
Physical capital is the tools, instruments, machines, building, and other items that
have been produced in the past and that are used today to produce goods and
The funds that firms use to buy physical capital are called financial capital
Capital and Investment
The quantity of capital changes because of investment and depreciation
o Investment increases the quantity of capital and depreciation decreases it
The total amount spent on new capital is called gross investment
The change in the value of capital is called net investment
o Net investment = gross investment depreciation
Wealth and Saving
Wealth is the value of all the things that people own
o What people own is related to what they earn, but it is not the same thing
People earn an income, which is the amount they receive during a
given time period from supplying the services of the resources they
o Wealth increases when the market value of assets rises called capital
o Wealth decreases when the market value of assets falls called capital
o Wealth = initial wealth + savings consumption expenditure
Saving is the amount of income that is not paid in taxes or spent on consumption
goods and services
o Saving increases wealth
To make GDP grow, saving and wealth must be transformed into investment and
Markets for Financial Capital
Saving is the source of the finds that are used to finance investment, and these funds are
supplied and demanded in three types of financial markets:
Loan Markets
o Funds are usually obtained as a loan that is secured by a mortgage a
legal contract that gives ownership of a home to the lender in the event
that the borrower fails to meet the agreed loan payments
Bond Markets
o A bond is a promise to make specified payments on specified dates
The buyer of a bond makes a loan to the company and is entitled to
the payments promised by the bond
Bonds issued by firms and governments are traded in the bond
o Another type of bond is a mortgage-backed security, which entitles its
holder to the income form a package of mortgages
The holder of a mortgage-backed security is entitles to receive
payments that derive form the payments received by the mortgage
lender from the home buyer-borrower
Stock Markets
o A stock is a certificate of ownership and claim to the firm’s profits
Unlike a stockholder, a bondholder does not own part of the firm
that issued the bond
o A stock market is a financial market in which shares of stocks of
corporations are traded
Financial Institutions
A financial institution is a firm that operates on both sides of the markets for
financial capital
o It is a borrower in one market and a lender in another
The key Canadian financial institutions are:
o Banks
o Trust and Loan Companies
o Credit Unions and Caisses Populaires
o Pension Funds
o Insurance Companies
All financial institutions face risk and this risk poses two problems: a solvency
problem and a 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 what it has borrowed
o If net worth is positive, the institution is solvent and can remain in
o If net worth is negative the institution is insolvent and goes out of business
The owners of an insolvent financial institution usually the
stockholders bear the loss when the assets are sold and debts are
A financial institution both borrows and lends, so it is exposed to the rick that its
net worth might become negative
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
o In normal times, it will just borrow from another institution
Interest Rates and Asset Prices
Stocks, bonds, short-term securities, and loans are collectively called financial
The interest rate on a financial asset is the interest received expressed as a
percentage of the price of the asset
o If the price of the asset rises, the interest rate falls
o If the price of the asset falls, the interest rate increases
Debts become harder to pay, and the net worth of the financial
institution falls
Insolvency can arise from previously unexpected large rises in the
interest rate
The Market for Loanable Funds
The market for loanable funds is the aggregate of all the individual finance
Funds that Finance Investment
Funds that finance investment come from three sources:
1. Household saving
2. Government budget surplus
3. Borrowing from the rest of the world
Household income is spent on consumption goods and services, saved, or paid in
net taxes
o Net taxes are the taxes paid to governments minus the cash transfers
received form governments (such as social insurance and unemployment
o Income is equal to Y = C + S + T
Y = C + I + G + (X M)
o Therefore, I = S + (T G) + (M X)
The sum of private savings, S, and government saving, (T G), is called national
o National saving and foreign borrowing finance investment
The price in the market for loanable funds that achieves equilibrium, is an interest
rate, which we also measure in real terms as the real interest rate