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EC140 (329)
Chapter 23

Chapter 23 EC140.docx

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Department
Economics
Course
EC140
Professor
Angela Trimarchi
Semester
Fall

Description
EC140 Chapter 23 – Finance, Saving, and Investment Week 10 Financial Institutions and Financial Markets -In studying the economics of financial institutions and markets, we distinguish between: -Finance and money -Physical capital and financial capital Finance and Money -Finance describes the activity of providing funds that finance expenditures on capital -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 activities -Money is what we use to pay for goods and services and factors of production and to make financial transactions -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, buildings, and other items that have been produced in the past and that are used today to produce goods and services -Financial capital is the funds that firms use to buy physical capital Capital and Investment -Investment increases the quantity of capital and depreciation decreases it -The total amount spend on new capital is called gross investment -The change in the value of capital is called net investment Wealth and Saving -Wealth is the value of all the things that people own. -Saving is the amount of income that is not paid in taxes or spent on consumption goods and services. Saving increases wealth 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, bond markets, stock markets Loan Markets -They provide short term finance – the loans people need to purchase big-ticket items -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 -A bond is a promise to make specified payments on specified date -The buyer of a bond makes a loan to the company and is entitled to the payments promised by the bond -Another type of bond is a mortgage-backed security – entitles its holder to the income from a package of mortgages Stock Markets -A stock is a certificate of ownership and claim to the firm’s profits EC140 Chapter 23 – Finance, Saving, and Investment Week 10 -A stock market is a financial market in which shares of stocks of corporations are traded -Ex. The Toronto Stock Exchange, the New York Stock Exchange, etc. Financial Institutions -A financial institution is a firm that operates on both sides of the markets for financial capital. It is a borrower in one market and a lender in another -The key financial institutions in Canada are: banks, trust and loan companies, credit unions and caisses populaires, pension funds, insurance companies Banks -Banks accept deposits and use the funds to buy government bonds and other securities and to make loans Trust and Loan Companies -Provide similar services to banks and the largest of them are owned by banks -They accept deposits and make personal loans and mortgage loans, but they ALSO administer estates, trusts, and pension plans Credit Unions and Caisses Populaires -Banks that are owned and controlled by their depositors and borrowers, are regulated by provincial rules, and operate only inside their own province -Institutions are large in number but small in size Pension Funds -Financial institutions that receive the pension contributions of firms and workers -They use these funds to buy a diversified portfolio of bonds and stocks that they expect to generate an income that balances risk and return Insurance Companies -Provide risk-sharing services -They enter into agreements with households and firms to provide compensation in the event of accident, theft, fire, etc. -Insurance companies use the funds they have received but not paid out as claims to buy bonds and stocks on which they earn an interest income 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 -If net worth is positive, the institution is solvent and can remain in business -If net worth is negative, the institution is insolvent and goes out of business -A financial institution borrows and lends, so it is exposed to the risk that its net worth may become negative -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 is has borrowed than its available cash Interest Rates and Asset Prices -Because the interest rate is a percentage of the price of an asset, if the asset price rises, the interest EC140 Chapter 23 – Finance, Saving, and Investment Week 10 rate falls -The price of an asset and the interest rate on that asset are determined simultaneously – one implies the other The Market for Loanable Funds -The market for loanable funds is the aggregate of all the individual financial markets Funds that Finance Investment 1. Household saving 2. Government budget surplus 3. Borrowing from the rest of the world -Income is equal to the sum of consumption expenditure, saving, and net taxes: Y=C + S + T Eventually you get: I = S + (T-G) + (M-X) The 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 in
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