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Economic Notes - Jan 30, 1.docx

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Department
Economics
Course
Economics 1022A/B
Professor
Jeannie A Gillmore
Semester
Winter

Description
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 activity  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 services  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 own o Wealth increases when the market value of assets rises – called capital gains o Wealth decreases when the market value of assets falls – called capital losses 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 capitalMarkets 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 market 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 business 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 paid  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 assets  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 markets 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 benefits) 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 saving 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 rateThe Real Interest Rate  The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent  The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money o The real interest rate is approximately equal to the nominal interest rate minus the inflation rate o The real interest rate is the opportunity cost of loanable funds  The real interest paid on borrowed funds is the opportunity cost of borrowing  The real interest forgone when funds are used either to buy consumption goods or services or to invest in new capital goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds The Demand for Loanable Funds  The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budge deficit, and international investment of lending during a given period  Two factors that determine investment and the demand for loanable funds to finance it are: o The real interest rate o Expected profits  Firms invest in capital only if they expect to earn a profit, and fewer projects are profitable at a high real interest rate than at a low real interest rate o Other things remaining the same, the higher the real interest rate, the smaller is the quantity of loanable funds demanded; and the lower the real interest rate, the greater is the quantity of loanable funds demanded Demand for Loanable Funds Curve  The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate, when all other influences on borrowing plans remain the same  The quantity of loanable funds demanded is greater, the lower is the real interest rate Changes in the Demand for Loanable Funds  When the expected profit changes, the demand for loanable funds changes o Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment and the gre
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