Econ 2010 chapter 23
- Financial institutions and financial markets, the market describes how the firms
are financed and the financial structures that sustains the economy.
o Finance and money – finance describes the activity of providing the funds
that finance expenditures on capital. Examines how households manage
their financial resources and cope with risks. Money is what we use to
pay for goods and services and factors of production and to make
financial transactions. We examine its presence and how individuals and
banks manages it.
o Physical capital and financial capital – physical capital is the tools
instruments, machines, buildings, and other items that have been
produced in the pat and that are used today to produce goods and
services. Such as inventory, raw material, semi finished goods, etc.
capital means physical capital. The firm uses financial capital to purchase
o Capital and investment – quantity of capital changes due to investment
Investment increases the quantity of capital and depreciation
decrease it. The amount spent on new capital is called gross
investment. The change in the value of capital is called net
investment. Net investment equals gross investment minus
o Wealth is the value of all the things that people own. This is different from
income, which is the amount earned during a given period from supplying
the service of the resources they own. Savings is the amount of income
that is not paid in taxes or spent on consumption goods and services.
Savings increase wealth and wealth also increases when market value of
assets rises, called capital gains and decreases called capital losses.
National wealth equals income minus consumption expenditure.
- Market for financial capital
o Loan markets – loans are made to firms and individuals to help them
finance personal expenditures and adapt to financial problems. A
mortgage is 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.
o Bond market – is a promise to make specified payments on specified
dates. The bonds are traded on bond markets and is a method of
borrowing financial capital from the public. Mortgage backed security
which entitles its holder to the income from a package of mortgages. Money is lent to individuals and the payments are drawn from the
repayments of the mortgages.
o Stock markets – a stock is a certificate of ownership and claim to the
firm’s profits. Bond owners do not own a part of the firm. A stock market is
a financial market in which shares of stocks of corporations are traded.
- Financial institutions – is a firm that operates on both sides of the market for
financial capital. It is a borrower in one market and a lender in another. They link
the demand and supply for financial needs.
o Banks – banks accept deposits and use the funds to buy government
bonds and other securities to make loans, they control more than 70
percent of the total Canadian financial service sector.
o Trust and loan companies - very similar to banks and make loans, also
administer estates, trusts, and pension plans.
o Credit unions and Caises populaires – banks that are owned and
controlled by depositors and borrowers, regulated by provincial rules, and
operate only in the provincial boundaries. The firm is large in number but
small in size.
o Pension funds – firms that receive pension contribtutions of firms and
workers. They invest the deposits to make profit and use it to pay pension
o Insurance companies – provide risk sharing services. They are paid
premiums in exchange for protection and assurance in the case of
misfortunes for individuals and firms. There are a large insurance network
and earn 70% of their income outside Canada.
- 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 is has borrowed. If the
net worth is positive then it is solvent and if its negative its insolvent and goes out
of business. The owners of an insolvent business usually the stock holders bear
the losses when the asets are sold and debts paid. To reduce risk, a minimum
amount of their lending must be backed by their net worth. 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.
- Interest rates and Asset prices – stocks, bonds, loans are collectively called
financial assets. The interest rate is expressed as a percentage of the price of
the asset. If the asset price rises, other things remaining the same, the interest
rate falls. Conversely if the asset price falls, the interest rate rises.
The market for loanable funds is the aggregate of all the individual financial
markets. - Funds that finance investments
o Household savings
o Government budger surplus
o Borrowing from the rest of the world Y is household income, C is spent on
consumption goods and services, S is saved, paid in net taxes T.
o Net taxes are the taxes paid to government minus the cash transfers
received from the government. Such as social insurance and
unemployment benefits. Income is equal to the sum of consumption on
expenditure savings and net taxes Y = C + S + T. I = S + (T – G) + (M –
X). the government surplus is outlined by T – G, and borrowing from the
rest of the world is (M-X). if a T > G government contributes to the finance
investment and if T