Chapter 23 – Finance, Saving, Investment
Financial Institutions and Markets
channels through which saving flows to finance investment in new capital that grows the economy
Finance vs. Money
Finance: providing the funds that finance expenditures on capital. The study of finance looks at how
households and firms obtain and use financial resources, how they cope with the risks
Money: used to pay for goods& services and FoP and to make financial transactions; how we use it,
how much we hold, how banks create and manage it, and how its quantity influences the economy.
Physical capital vs. financial capital
Physical capital: items produced in the past and are used to produce goods/services. Inventories of
raw materials, semi-finished goods, and components are part of physical capital
Financial capital: funds that firms use to buy physical capital
Along the aggregate production function, the quantity of capital is fixed. An increase in the quantity
of capital increases production possibilities and shifts the function upward.
Capital and Investment
Investment increases the quantity of capital; depreciation decreases the quantity of capital
Gross investment: total amount spent on new capital and on replacing depreciated capital
Net investment: change in value of capital = gross investment – depreciation
Wealth and saving
Wealth: value of all things that people own; related to what they earn (income: amount received
during a given time period from supplying the services of the resources they own)
- Increases when market value of assets rises (capital gains) and vice versa (capital losses)
Saving: income not paid in taxes or spent on consumption goods/ services. Saving increases wealth.
National wealth: wealth at start year + saving during the year = income – consumption expenditure
To make real GDP grow, saving and wealth must be transformed into investment and capital.
Firm that operates on both sides of financial capital markets borrower in one, lender in another.
Financial markets are highly competitive because financial institutions stand ready to trade so
people with funds to lend and people seeking funds can always find someone with whom to trade
1. Banks: accept deposits and use the funds to buy government bonds and other securities to make
loans. Distinguished from other financial institutions because bank deposits are money.
2. Trust and loan companies: similar services to banks. Largest of them are owned by banks. They
accept deposits, make personal and mortgage loans, & administer estates, trusts, pension plans.
3. Credit unions& Caisses Populaires: banks owned/controlled by their depositors& borrowers.
Regulated by provincial rules, operate only in their provincial boundaries. Large number, small size.
4. Pension funds: receive pension contributions of firms and workers. They buy bonds and stocks that
they expect to generate an income that balances risk and return. The income pays pension benefits.
Some pension funds invest in mortgage-backed securities.
5. Insurance companies: provide risk-sharing services. Enter into agreements to provide compensation
in event of accidents. They receive premiums from customers and make payments against claims.
- Use the funds to buy bonds/stocks on which they earn an interest income
- Insure corporate bonds and other risky financial assets if a firm cannot meet bond obligations.
- Normal times: steady flow of funds from premiums and interest on the financial assets they
hold and a steady but smaller flow of funds paying claims. Profit is the gap between the 2 flows.
- Unusual times: when large losses are being incurred, they face difficulty meeting obligations. Solvency vs. Liquidity problems
A financial institution’s net worth: total market value of what it has lent minus what it has borrowed.
- If positive, the institution is solvent and can remain in business
- If negative, it is insolvent and goes out of business. The owners of an insolvent financial
institution (usually its stockholders) bear the loss when the assets are sold and debts paid.
A financial institution borrows and lends, so its net worth might become negative. To limit that risk,
institutions are regulated and a minimum amount of their ending must be backed by their net worth
Firm is illiquid if it made long-term loans with borrowed funds and is faced with demand to repay
more of what it has borrowed than its available cash. In normal times, an illiquid financial institution
can borrow. But if all are short of cash, market for loans among financial institutions dries up.
Markets for financial capital
Saving is the source of the funds used to finance investment, and these funds are
supplied/demanded in 3 types of financial markets
1. Loan markets: bank loans, sometimes in form of outstanding credit card balances
- Business often want short-term finance to buy inventories or extend credit to their customers
- Households often want finance to purchase big-ticket items
- Households also buy new homes (investment) funds usually obtained as a loan secured by a
mortgage: legal contract that gives ownership of a home to the lender in the event that the
borrower fails to meet the agreed loan payments (repayment + interest)
2. Bond markets: bond is a promise to make specified payments on specified dates
- Government of Canada issues promises called Treasury bills raise finance by issuing bonds
- Buyer of a bond loans to the company and is entitled to payments promised by the bond. When
a person buys a new bond, he may hold bond until borrower has repaid, or sell the bond.
- The term of a bond might be long or short (decades vs. few months). Firms often issue short
term bonds as a way of getting paid for their sales before the buyer is able to pay.
- Conventional bonds: promise a stated payment of principal on specific date, + periodic
payments (coupon rate) until that date
- Mortgage-backed security: bond entitles its holder to income from a package of mortgages.
Mortgage lenders create mortgage backed securities. They make mortgage loans to home
buyers, and then create securities that they sell to obtain more funds to make mortgage loans.
The holder of a mortgage backed security is entitled to receive payments that derive from the
payments received by the mortgage lender from the home buyer/borrower.
- Treasury bills (strips): carry no stated coupon rate. Return from buying and holding a Treasury
bill derived from difference between price paid to acquire the bond, and the face value (to be
received at stated future date). The smaller the price, the larger the return. Strip = principal.
- Discount factor = (1/interest rate) perio= xperio payment – discount factor = PV
3. Stock markets: financial market in which shares of stocks of corporations are traded
- Stock: certificate of ownership and claim to the firm’s profits
- Ownership of the company = entitled to some of its profits Interest rates and asset prices
The interest rate of a financial asset is the interest received expressed as a % of the asset’s price
Stocks, bonds, short-term securities and loans are collectively called financial assets
Price of an asset and the interest rate of the asset are determined simultaneously
Negative relationship between interest rates and asset prices
1. The market interest rate is negatively related to the price of a bond
2. The market interest rate is positively related to the yield on any given bond
If interest rate rises, price falls, debts are harder to pay, net worth of financial institution falls
insolvency can arise from previously unexpected large rises in the interest rate
The higher the interest rate, the smaller the PV of a specific future sum at a specific future date
- PV is the amount we need to deposit/lend at interest that will compound to 1000 in a year
- PV = FV / [(1 + i) ] highest price willing to pay now to own future stream of payments. At
any price lower than PV, there’s excess D for the asset, driving up the price. Hence, the
equilibrium maTket price will be the PC of the income stream that the asset produces.
- FV = PV(1 + i)
Market for Loanable Funds
Aggregate of all financial markets where households, firms, G, financial institutions borrow/lend
Funds that finance investment
1. Household saving (S)
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X)
Y = C + S + T Household income Y is spent on consumption goods C, saved S, or paid in net taxes T
- T = taxes paid minus cash transfers
Using Y = C + I + G + X – M, and Y = C + S + T, you can see that I + G + X = M + S + T
- I = S + (T – G) + (M – X) Investment is financed by household saving, government budget
surplus, and borrowing from the rest of the world
National saving NS: sum of private saving S, and government/public saving (T – G)
- In the LR, when real GDP = Y*, private saving = Y* - T – C
- Public saving = combined budget surpluses of federal, provincial, and municipal governments
- NS = Y* - T – C + (T – G) = Y* - C – G save what we don’t consume individually or collectively
- National saving (S + (T – G)) and foreign borrowing finance investment
- As national income rises, public saving (budget surplus) and private saving (saving function) rise
- Desired private saving is the difference between disposable income and desired consumption
Real Interest Rate
The price in market for loanable funds that achieves equilibrium =real interest rate. In market for
loanable funds, the in