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Chapter 23

ECON 1010 Chapter Notes - Chapter 23: Orgone, Business Cycle, Savings Account


Department
Economics
Course Code
ECON 1010
Professor
Simin Seury
Chapter
23

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Financial'Institutions'and'Financial'Markets'
Finance'and'Money
In#economics#we#use#the#term#finance'to#describe#the#activity#providing#
the#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#activity
§
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
§
In#the#economic#lives#of#individuals#and#businesses,#finance#and#money#
are#closely#interrelated
Some#of#the#main#financial#institutions,#such#as#banks,#provide#both#
financial#services#and#monetary#services
§
-
Physical'Capital'is#the#tools#,#instruments,#machines,#buildings#and#other#
items#that#have#been#produced#in#the#past#and#are#used#today#to#produce#
goods#and#services
Inventories#of#raw#materials,#semi-finished#goods,#and#components#
are#part#of#physical#capitals
§
The#funds#that#firms#use#to#buy#capital#are#called#financial'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#aggregate#production#function#upward
§
-
Capital'and'Investment
The#quantity#of#capital#changes#because#of#investment#and#depreciation
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'
§
Net#investment#=#gross#investment#-depreciation
§
-
Wealth'and'Saving
Wealth'is#the#value#of#all#things#that#people#own
What#people#own#is#related#to#what#people#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
§
Saving'is#the#amount#of#income#that#is#not#paid#in#taxes#or#spent#on#
consumption#goods#and#services
Saving#increases#wealth
§
Wealth#also#increases#when#the#market#value#of#assets#rises#-called#
capital'gains'and#decreases#when#the#market#value#of#assets#fall#-called#
capital'losses'
The#wealth#of#a#nation#at#the#end#of#the#year#equals#its#wealth#at#the#start#
of#the#year#plus#its#savings#during#the#year,#which#equals#income#-
consumption#expenditure
To#make#real#GDP#grow,#saving#and#wealth#must#be#transformed#into#
investment#and#capital
This#transformation#takes#place#in#the#markets#for#financial#capital#
and#through#the#activities#of#financial#institutions
§
-
Financial'Capital'Markets
Saving#is#the#source#of#the#funds#that#are#used#to#finance#investment,#and#
these#funds#are#supplied#and#demanded#in#three#types#of#financial#
markets
Loan'Markets
Business#often#want#short-term#finance#to#buy#inventories#or#
to#extend#credit#to#their#customers
Sometimes#they#get#this#finance#in#the#form#of#a#loan#
from#a#bank
®
Households#often#want#to#finance#to#purchase#big#ticket#
items,#such#as#cars#or#household#furnishings#and#appliances
They#get#this#finance#as#banks#loans,#often#in#the#form#
of#outstanding#credit#card#balances
®
Household#also#get#finance#to#buy#new#homes#-
expenditure#on#new##homes#is#counted#as#investment
These#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
When#Walmart#expands#its#business#and#opens#new#stores,#it#
gets#the#finance#it#needs#by#selling#bonds.
Governments#-federal,#provincial#and#municipal#also#
raise#finance#by#issuing#bonds
®
A#bond'is#a#promise#to#make#specified#payments#on#specified#
dates
For'Example:' you#can#buy#a#McDonald's#Corp.#bond#
that#promises#to#pay#$3.50#every#year#until#2020#and#
then#to#make#a#final#payment#of#$100#on#July#15,#2020
®
The#buyer#of#a#bond#from#McDonald's#makes#a#loan#t#
the#company#and#is#entitled#to#the#payments#promised##
by#the#bond
®
When#a#person#buys#a#newly#issued#bond,#he#or#she#may#hold#
the#bond#until#the#borrower#has#repaid#the#amount#borrowed#
or#sell#it#to#someone#else
Corporations#and#governments#sell#bonds#in#the#bond'market'
Another#type#of#bond#is#a#Mortgage-backed'security'which#
entitles#the#holder#to#the#income#from#a#package#of#
mortgages
Mortgage#lenders#can#create#mortgage#backed#
securities
®
They#mortgage#loans#to#home#buyers#and#then#create#
securities#that#they#sell#to#obtain#more#funs#to#make#
more#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
®
§
Stock'Markets'
When#Petro-Canada#wants#finance#to#expand#its#business,#it#
issues#stock
A#stock'is#a#certificate#of#ownership#and#claims#to#the#firms#
profits
Petro-Canada#has#issued#484#million#shares#of#its#stock,#so#if#
you#owned#484#Petro-Canada#shares,#you#would#own#one#
millionth#of#its#profits
Unlike#a#stockholder,#a#bondholder#does#not#own#part#of#the#
firm#that#issued#the#bond
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#markets#for#financial#capital
The#financial#institution#is#a#borrower#in#one#market#and#a#lender#in#
another#market
Financial#Institutions#also#stand#ready#to#trade#so#that#households#with#
funds#to#lend#and#firms#or#households#seeking#funds#can#always#find#
someone#on#the#other#side#of#the#market#with#whom#to#trade
The#key#Canadian#financial#institutions#are:
Banks
Banks#accept#deposits#and#use#the#funds#to#buy#government#
bonds#and#other#securities#and#to#make#loans
Economists#distinguish#banks#from#other#financial#institutions#
because#bank#deposits#are#money
§
Trust'and'loan'companies
Trust#and#loan#companies#provide#similar# services#to#banks#
and#the#largest#of#them#are#owned#by#banks
They#accept#deposits#and#also#administer#estates,#trusts#and#
pension#plans
§
Credit'unions'and'caisses'populaires
Are#banks#that#are#owned#and#controlled#by#they#depositors#
and#borrowers,#are#regulated#by#provincial#rules#and#operate#
only#inside#their#own#provincial#boundaries
These#institutions#are#large#in#numbers#but#small#in#size
§
Pension'funds
Are#financial#institutions#that#receive#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
The#income#is#used#to#pay#pension#benefits
Pension#funds#can#be#very#large#and#play#an#active#role#in#the#
firms#whose#stock#they#hold
§
Insurance'companies
Insurance#companies#provide#risk-sharing#services
They#enter#into#agreements#with#households#and#firms#to#
provide#compensation#in#the#event#of#accident,#theft,#fire,#and#
a#host#of#other#misfortunes
They#receive# premiums#from#their#customers#and#make#
payments#against#claims
Insurance#use#the#funds#they#have#received#but#not#paid#out#
as#claims#to#buy#bonds#and#stocks#in#which#they#earn#an#
interest#income
Some#insurance#companies#also#insure#corporate#bonds#and#
other#risky#financial#assets
They#provide#insurance#that#pays#out#if#a#firms#fails#and#
cannot#meet#its#bond#obligations
®
In#normal#times,#insurance#companies#have#a#steady#flow#of#
funds#coming#in#from#premiums#and#interest#on#the#financial#
assets#they#hold#and#a#steady,#but#smaller,#flow#of#funds#
paying#claims
Their#profit#is#the#gap#between#the#two#flows
®
All#financial#institutions#face#risk,#which#poses#two#problems:#
solvency'&'liquidity'problems'
§
-
Insolvency'and'Illiquidity
A#financial#institutions#net'worth'is#the#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'
§
If#the#net#worth#is#negative,#the#institution#is#insolvent'
An#insolvent#business#cannot#pay#its#debts#and#must#go#out#of#
business
The#owner#of#an#insolvent#business#-usually#its#stock#holders#-
bear#the#loss#but#the#firms#and#individuals#who#are#owed#
payments#by#an#insolvent#business#incur#a#loss
§
A#financial#institution#both#borrows#and#lends,#so#it#is#exposed#to#
the#risk#that#its#net#worth#might#become#negative
To#limit#that#risk,#financial#institutions#are#regulated#and#a#
minimum#amount#of#their#lending#must#be#backed#by#their#
net#worth
§
Sometimes#a#financial#institution#is#solvent#but#illiquid
§
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
In#normal#times#a#financial#institution#that#is#illiquid#can#
borrow#from#another#institution,#but#if#all#the#financial#
institutions#are#short#of#cash#,#the#market#for#loans#among#
financial#institutions#dries#up
§
-
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
Because#the#interest#rate#is#a#percentage#of#the#price#of#an#asset,#if#the#
asset#price#rises,#other#things#remaining#the#same,#the#interest#rate#falls
Also#,#if#the#asset#price#falls#the#interest#rate#rises
§
For'Example:'consider#a#bond#that#promises#to#pay#its#holder#$5#a#year#
forever.#-What#is#the#rate#of#return#-the#interest#rate#on#this#bond?
The#answer#depends#on#the#price#of#the#bond
§
If#we#buy#this#bond#for#$50#the#interest#rate#would#be#10#percent#a#
year:
Interest#rate#=#($5#/#$50)#x#100#=#10%
§
But#if#the#price#of#the#asset#rises#to#$200,#the#interest#rate#would#be#
2.5%
Interest#Rate#=#($5#/#$200)#x#100#=##2.5%
§
-
The'Loanable'Funds'Market'
The#loanable'funds'Is#the#aggregate#of#all#the#individual#financial#markets
-
Funds'that'Finance'investment
Household#savings
Government#budget#surplus
Borrowing#from#the#rest#of#the#world
House#holds#incomes,#Y#is#spent#on#consumption#goods#and#services#-C#,#
saved#-## S#or#paid#in#net#taxes#- T
Net'Taxes'are#the#Taxes#paid#to#governments#minus#the#cash#transfers#
received#from#governments#(such#as#social#security#and#unemployment#
benefits)#so#income#is#equal#to#the#sum#of#consumptions#expenditure,#
saving#and#net#taxes
Y#=#C#+#S#+#T
§
We#have#seen#that#Y#also#equals#the#sum#of#the#items#of#aggregate#
expenditure:#consumption#expenditure#-C#,#investment#-I#government#
expenditure#-G#and#exports#-X#minus#imports#- M
Y#=#C#+#I#+#G#+#X#- M
§
By#using#these#two#equations#you#can#see#that
I#+#G#+#X#=#M#+#S#+#T
§
Subtract#G#and#X#from#both#sides#of#the#last#equation#to#obtain
I#=#S#+#(T#-G)#+#(X#-M)
§
This#equation#tells#us#that#investment#-I#is#financed#by#household#saving#-
S#,#the#government#budget#surplus##-(T#-G),#and#borrowing#from#the#rest#
of#the#world#-(X#-M)
The#sum#of#private#saving#-S#and#government#saving#-(T#-G)#is#called#
national'saving
-
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#lend
For'Example:'if#the#annual#interest#paid#on#a#$500#loan#is#$25,#the#
nominal#interest#is#5#percent#per#year:
$25#/#$500##x#100#=#5%
§
The#real'interest'rate'is#the#nominal#interest#adjusted#to#remove#the#
effects#of#inflation#on#the#buying#power#of#money
The#real# interest#rate#is#approximately#equal#to#the#nominal#interest#
rate#minus#the#inflation#rate
§
For'Example:' suppose#that#you#have#put#$500#away#into##a#savings#
account#that#earns#you#5#percent#of#interest#a#year.#At#the#end#of#
the#year#$525#in#your#savings#account
Suppose#that#the#inflation#rate#is#2#percent#a#year#-during#the#
year,#all#prices#increased#by#2#percent
Now#at#the#end#of#the#year,#it#costs#$510#to#buy#what#$500#
would#have#bought#one#year#ago
Your#money#in#the#bank#has#really#only#increased#by#$15,#from#
$510#to#$525
That#$15#is#equivalent#to#a#real#interest#rate#of#3#percent#a#
year#on#your#original#$500#
So#the#real#interest#rate#is#the##5#percent#nominal#interest#rate#
minus#the#two#percent#inflation#rate
§
The#real# interest#is#the#opportunity#cost#of#loanable#funds
The#real# interest#paid%on#borrowed#funds#is#the#opportunity#cost#of#
borrowing
§
And#the#real#interest#forgone%when#funds#are#used#either#to#buy#
consumption#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#budget#deficit,#and#
international#investment#or#lending#during#a#given#period
Our#focus#here#is#on#investment
What#determines#investment#and#the#demand#for#loanable#funds#to#
finance#it?#Many#details#influence#this#decision,#but#we#can#summarize#
them#into#two#factors:
§The'Real'Interest'rate
§Expected'profit
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,#so:
§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#the#quantity#of#loanable#
funds#demanded
Demand'for'Loanable'funds'curve
§The#demand#for#loanable#funds#curve#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
§For'Example:'to#understand#the#demand#for#loanable#funds#think#
about#Amazon.com's#decision#to#borrow#$100#million#to#build#new#
warehouses
If#Amazon#expects#to#earn##a#return#of#$5million#a#year#from#
this#investment#before#paying#interest#costs#and#the#real#
interest#rate#is#less#than#5#percent#a#year,#Amazon#would#
make#a#profit,#so#it#build#warehouses
But#if#the#interest#rate#if#more#than#5#percent#a#year,#Amazon#
would#incur#a#loss,#so#it#doesn't#build#the#ware#houses
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
§Other#things#remaining#the#same,#the#greater#the#expected#profit#
from#new#capital,#the#greater#is#the#amount#of#investment#and#the#
greater#is#the#demand#for#loanable#funds
§Expected#profit#rises#during##business#cycle#expansion#and#falls#
during#a#recession
Rises#when#technological#change#creates#profitable#new#
products
Rises#as#a#growing#population#brings#increased#demands#for#
goods#and#services
Fluctuates#with#contagious#swings#of#optimism#and#pessimism#
called#'animal#spirits'#by#Keynes#and#'irrational# exuberance'#by#
Alan#Greenspan
§When#expected#profit#changes,#the#demand#for#loanable#funds#
curve#shifts
-
-The'Supply'for'Loanable'Funds
The#quantity%of%loanable%funds%supplied%is#the#total#funds#available#from#
private#saving,#the#government#budget#surplus#and#international#
borrowing#during#a#given#period
Our#focus#here#is#saving
How#does#one#decide#how#much#of#their#income#to#save#and#supply#in#the#
loanable#funds#markets?#Your#decision#is#influenced#by#many#factors:
§The'Real'Interest'Rate
§Disposable'Income
§Expected'future'income
§Wealth
§Default'risk
We#begin#by#focusing#on#the#real#interest#rate,
§Other#things#remaining#the#same,#the#higher#the#real#interest#rate,#
the#greater#the#quantity#of#loanable#funds#supplied;#the#lower#the#
real#interest#rate,#the#smaller#the#quantity#of#loanable#funds#
supplied
The'Supply'of'loanable'funds'curve
§The#supply%of%loanable%funds%curve%is#the#relationship#between#the#
quantity#of#loanable#funds#supplied#and#the#real#interest#rate,#when#
all#other#influences#on#lending#plans#remain#the#same
§For'Example:'think#about#a#students#decision#to#save#some#of#what#
she#earns#from#her#summer#job,#she#decides#that#with#a#real#
interest#rate#of#2#percent#a#year,#she#decides#it#is#not#worth#saving#
much#-better#to#spend#the#income#and#take#a#student#loan#if#funds#
run#out#during#the#semester
But#if#the#real#interest#rate#jumped#to#10#percent#a#year,#the#
pay#off#form#saving#would#be#high#enough#to#encourage#her#
to#cut#back#on#spending#and#increase#the#amount#she#saves
Changes'in'the'supply'of'loanable'funds
§A#change#in#disposable#income,#expected#future#income,#wealth#or#
default#risk#changes#the#supply#of#loanable#funds
§Disposable'Income'
A#households#disposable#income#is#the#income#earned#minus#
net#taxes
When#disposable#income#increases,#other#things#remaining#
the#same,#consumption#expenditure#increases#by#less#than#
the#increase#in#income.#Some#of#the#increase#in#income#is#
saved
So#the#greater#a#households#disposable#income,#the#greater#is#
their#saving
§Expected'Future'income
The#higher#a#households#expected#future#income,#the#smaller#
is#its#saving#today
§Wealth
The#higher#a#households#wealth,#other#things#remaining#the#
same,#the#smaller#is#its#saving
If#a#person's#wealth#increases#because#of#capital#gain,#the#
person#sees#less#need#to#save
§Default'Risk
The#risk#that#a#loan#will#not#be#repaid#is#called#default%risk%
The#greater#this#risk,#the#higher#interest#rate#needed#to#
induce#a#person#to#lend#and#the#smaller# is#the#supply#of#
loanable#funds
Shifts'of'the'Supply'of'Loanable'Funds'Curve
§When#any#of#the#four#influences#on#the#supply#of#loanable#funds#
changes,#the#supply#of#loanable#funds#curve#shifts
§An#increase#in#disposable#income,#a#decrease#in#expected#future#
income,#a#decrease#in#wealth,#or#fall#in#default#risk#increases#savings#
and#increases#the#supply#of#loanable#funds
-Equilibrium'in'the'Loanable'funds'market
You've#seen#that,#other#things#remaining#the#same,#the#higher#the#real#
interest#rate,#the#greater#is#the#quantity#of#loanable#funds#supplied#and#
the#smaller#is#the#quantity#of#loanable#funds#demanded
There#is#one#real#interest#rate#at#which#quantities#of#loanable#funs#
demanded#and#supplied#are#equal,#and#that#interest#rate#is#the#
equilibrium'real'interest'rate'
If#the#equilibrium#real#interest#rate#rises#above#the#equilibrium#level,#then#
there#is#a#surplus#of#funds
If#the#equilibrium#real#interest#rate#falls#below#the#equilibrium#level,#then#
there#is#a#shortage#of#funds
Regardless#of#whether#there#is#a#shortage/surplus#of#loanable#funds,#the#
real#interest#rate#changes#and#is#pulled#towards#an#equilibrium#level
-Changes'in'Demand'and'Supply
Financial#markets#are#highly#volatile#in#the#short#run#but#stable#in#the#long#
run
Volatility#in#markets#come#from#fluctuations#in#either#demand#or#supply#
for#loanable#funds
These#fluctuations#bring#fluctuations#in#real#interest#rate#and#the#
equilibrium#quantity#of#funds#lent#and#borrowed
§Also#bring#fluctuations#in#asset#prices
An'Increase'in'demand
§If#the#profits#that#firms#expect#to#earn#increase,#they#increase#their#
planned#investment#and#increase#their#demand#for#loanable#funds#
to#finance#this#investment
§With#an#increase#in#the#demand#for#loanable#funds,#but#no#change#
in#the#supply#of#loanable#funs,#there#is#a#shortage#of#funds
§As#borrowers#compete#for#funds,#the#interest#rate#rise#and#lenders#
increase#the#quantity#of#funds#supplied
An'increase'in'supply'
§If#one#of#the#influences#on#saving#plans#changes#and#increases#
saving,#the#supply#of#loanable#funds#increases
§With#no#change#in#the#demand#for#loanable#funds,#the#market#is#
flush#with#loanable#funds
§Borrowers#find#bargains,#and#lenders#find#themselves#accepting#a#
lower#interest#rate
§At#the#lower#interest#rate,#borrowers#find#additional#investment#
projects#profitable#and#increase#the#quantity#of#loanable#funds#that#
they#borrow
§An#increase#in#supply#shifts#the#curve#rightward#from#SLF0#to#SLF1.#
Long'Run'Growth'of'Demand'and'Supply
§Over#time,#both#demand#and#supply#in#the#loanable#funds#market#
fluctuate#and#the#real#interest#rate#rises#and#falls
§Both#the#supply#and#demand#of#loanable#funs#tend#to#increase#over#
time
§On#average#they#increase#at#a#similar#pace,#so#although#demand#and#
supply#trend#upward,#the#real#interest#rate#has#no#trend#-it#
fluctuates#around#a#constant#average#level
Governments'in'the'Loanable'Funds'Market
-Governments#enters#the#loanable#funds#markets#when#it#has#a#budget#surplus#or#
a#budget#deficit.
-A#government#budget#surplus#increases#the#supply#of#loanable#funds#and#
contributes#to#financing#investment
-A#government#budget#deficit#increases#the#demand#for#loanable#funds#and#
competes#with#businesses#for#funds
-Government'Budget'Surplus
A#government#budget#surplus#increases#the#supply#of#loanable#funds
The#real# interest#rate#falls,#which#decreases#household#saving#and#
decreases#the#quantity#of#private#funds#supplied
The#lower#the#real#interest#rate#increases#the#quantity#of#loanable#funds#
demanded#and#increases#investment
-Government'Budget'Deficit
A#government#budget#deficit#increases#the#demand#for#loanable#funds
The#real# interest#rate#rises,#which#increases#household#saving#and#increase#
the#quantity#of#private#funds#supplied
But#the#higher#the#real#interest#rate#decreases#investment#and#the#
quantity#of#loanable#funds#demanded#by#firms#to#finance#investment
-The'Crowding-Out'effect
The#tendency#for#a#government#budget#deficit#to#raise#the#real#interest#
rate#and#decrease#investment#is#called# the#crowding%out%effect%
The#crowding#out#effect#does#not#decrease#investment#by#full#amount#of#
the#government#budget#deficit#because#a#higher#real#interest#rate#induces#
an#increase#in#private#saving#that#partly#contributes#toward#financing#the#
deficit
-The'Ricardo-Barro'Effect
First#suggest#by#English#economist#David#Ricardo#and#refined#by#Robert#
Barro,#the#Ricardo-Barro#effect#holds#that#both#of#the#effects#we've#just#
spoken#about#are#wrong#and#the#government#budget#has#no#effect#on#
either#the#real#interest#rate#or#investment
Barro#says#that#taxpayers#are#rational#and#can#see#that#a#budget#deficit#
today#means#that#future#taxes#will#be#higher#and#future#disposable#
incomes#will#be#smaller
With#smaller#expected#future#disposable#incomes,#saving#increases#today.
The#private#supply#of#loanable#funds#increases#to#match#the#quantity#of#
loanable#funds#demanded#by#the#government
So#the#budget#deficit#has#no#effect#on#either#real#interest#rate#or#
investment
Chapter(23:(Finance,(Saving(and(Investment
Sunday,#February#12,#2017
2:22#PM

Only pages 1-3 are available for preview. Some parts have been intentionally blurred.

Financial'Institutions'and'Financial'Markets'
Finance'and'Money
In#economics#we#use#the#term#finance'to#describe#the#activity#providing#
the#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#activity
§
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
§
In#the#economic#lives#of#individuals#and#businesses,#finance#and#money#
are#closely#interrelated
Some#of#the#main#financial#institutions,#such#as#banks,#provide#both#
financial#services#and#monetary#services
§
-
Physical'Capital'and'Financial'Capital
Physical'Capital'is#the#tools#,#instruments,#machines,#buildings#and#other#
items#that#have#been#produced#in#the#past#and#are#used#today#to#produce#
goods#and#services
Inventories#of#raw#materials,#semi-finished#goods,#and#components#
are#part#of#physical#capitals
§
The#funds#that#firms#use#to#buy#capital#are#called#financial'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#aggregate#production#function#upward
§
-
Capital'and'Investment
The#quantity#of#capital#changes#because#of#investment#and#depreciation
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'
§
Net#investment#=#gross#investment#-depreciation
§
-
Wealth'and'Saving
Wealth'is#the#value#of#all#things#that#people#own
What#people#own#is#related#to#what#people#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
§
Saving'is#the#amount#of#income#that#is#not#paid#in#taxes#or#spent#on#
consumption#goods#and#services
Saving#increases#wealth
§
Wealth#also#increases#when#the#market#value#of#assets#rises#-called#
capital'gains'and#decreases#when#the#market#value#of#assets#fall#-called#
capital'losses'
The#wealth#of#a#nation#at#the#end#of#the#year#equals#its#wealth#at#the#start#
of#the#year#plus#its#savings#during#the#year,#which#equals#income#-
consumption#expenditure
To#make#real#GDP#grow,#saving#and#wealth#must#be#transformed#into#
investment#and#capital
This#transformation#takes#place#in#the#markets#for#financial#capital#
and#through#the#activities#of#financial#institutions
§
-
Financial'Capital'Markets
Saving#is#the#source#of#the#funds#that#are#used#to#finance#investment,#and#
these#funds#are#supplied#and#demanded#in#three#types#of#financial#
markets
Loan'Markets
Business#often#want#short-term#finance#to#buy#inventories#or#
to#extend#credit#to#their#customers
Sometimes#they#get#this#finance#in#the#form#of#a#loan#
from#a#bank
®
Households#often#want#to#finance#to#purchase#big#ticket#
items,#such#as#cars#or#household#furnishings#and#appliances
They#get#this#finance#as#banks#loans,#often#in#the#form#
of#outstanding#credit#card#balances
®
Household#also#get#finance#to#buy#new#homes#-
expenditure#on#new##homes#is#counted#as#investment
These#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
When#Walmart#expands#its#business#and#opens#new#stores,#it#
gets#the#finance#it#needs#by#selling#bonds.
Governments#-federal,#provincial#and#municipal#also#
raise#finance#by#issuing#bonds
®
A#bond'is#a#promise#to#make#specified#payments#on#specified#
dates
For'Example:' you#can#buy#a#McDonald's#Corp.#bond#
that#promises#to#pay#$3.50#every#year#until#2020#and#
then#to#make#a#final#payment#of#$100#on#July#15,#2020
®
The#buyer#of#a#bond#from#McDonald's#makes#a#loan#t#
the#company#and#is#entitled#to#the#payments#promised##
by#the#bond
®
When#a#person#buys#a#newly#issued#bond,#he#or#she#may#hold#
the#bond#until#the#borrower#has#repaid#the#amount#borrowed#
or#sell#it#to#someone#else
Corporations#and#governments#sell#bonds#in#the#bond'market'
Another#type#of#bond#is#a#Mortgage-backed'security'which#
entitles#the#holder#to#the#income#from#a#package#of#
mortgages
Mortgage#lenders#can#create#mortgage#backed#
securities
®
They#mortgage#loans#to#home#buyers#and#then#create#
securities#that#they#sell#to#obtain#more#funs#to#make#
more#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
®
§
Stock'Markets'
When#Petro-Canada#wants#finance#to#expand#its#business,#it#
issues#stock
A#stock'is#a#certificate#of#ownership#and#claims#to#the#firms#
profits
Petro-Canada#has#issued#484#million#shares#of#its#stock,#so#if#
you#owned#484#Petro-Canada#shares,#you#would#own#one#
millionth#of#its#profits
Unlike#a#stockholder,#a#bondholder#does#not#own#part#of#the#
firm#that#issued#the#bond
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#markets#for#financial#capital
The#financial#institution#is#a#borrower#in#one#market#and#a#lender#in#
another#market
Financial#Institutions#also#stand#ready#to#trade#so#that#households#with#
funds#to#lend#and#firms#or#households#seeking#funds#can#always#find#
someone#on#the#other#side#of#the#market#with#whom#to#trade
The#key#Canadian#financial#institutions#are:
Banks
Banks#accept#deposits#and#use#the#funds#to#buy#government#
bonds#and#other#securities#and#to#make#loans
Economists#distinguish#banks#from#other#financial#institutions#
because#bank#deposits#are#money
§
Trust'and'loan'companies
Trust#and#loan#companies#provide#similar# services#to#banks#
and#the#largest#of#them#are#owned#by#banks
They#accept#deposits#and#also#administer#estates,#trusts#and#
pension#plans
§
Credit'unions'and'caisses'populaires
Are#banks#that#are#owned#and#controlled#by#they#depositors#
and#borrowers,#are#regulated#by#provincial#rules#and#operate#
only#inside#their#own#provincial#boundaries
These#institutions#are#large#in#numbers#but#small#in#size
§
Pension'funds
Are#financial#institutions#that#receive#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
The#income#is#used#to#pay#pension#benefits
Pension#funds#can#be#very#large#and#play#an#active#role#in#the#
firms#whose#stock#they#hold
§
Insurance'companies
Insurance#companies#provide#risk-sharing#services
They#enter#into#agreements#with#households#and#firms#to#
provide#compensation#in#the#event#of#accident,#theft,#fire,#and#
a#host#of#other#misfortunes
They#receive# premiums#from#their#customers#and#make#
payments#against#claims
Insurance#use#the#funds#they#have#received#but#not#paid#out#
as#claims#to#buy#bonds#and#stocks#in#which#they#earn#an#
interest#income
Some#insurance#companies#also#insure#corporate#bonds#and#
other#risky#financial#assets
They#provide#insurance#that#pays#out#if#a#firms#fails#and#
cannot#meet#its#bond#obligations
®
In#normal#times,#insurance#companies#have#a#steady#flow#of#
funds#coming#in#from#premiums#and#interest#on#the#financial#
assets#they#hold#and#a#steady,#but#smaller,#flow#of#funds#
paying#claims
Their#profit#is#the#gap#between#the#two#flows
®
All#financial#institutions#face#risk,#which#poses#two#problems:#
solvency'&'liquidity'problems'
§
-
Insolvency'and'Illiquidity
A#financial#institutions#net'worth'is#the#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'
§
If#the#net#worth#is#negative,#the#institution#is#insolvent'
An#insolvent#business#cannot#pay#its#debts#and#must#go#out#of#
business
The#owner#of#an#insolvent#business#-usually#its#stock#holders#-
bear#the#loss#but#the#firms#and#individuals#who#are#owed#
payments#by#an#insolvent#business#incur#a#loss
§
A#financial#institution#both#borrows#and#lends,#so#it#is#exposed#to#
the#risk#that#its#net#worth#might#become#negative
To#limit#that#risk,#financial#institutions#are#regulated#and#a#
minimum#amount#of#their#lending#must#be#backed#by#their#
net#worth
§
Sometimes#a#financial#institution#is#solvent#but#illiquid
§
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
In#normal#times#a#financial#institution#that#is#illiquid#can#
borrow#from#another#institution,#but#if#all#the#financial#
institutions#are#short#of#cash#,#the#market#for#loans#among#
financial#institutions#dries#up
§
-
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
Because#the#interest#rate#is#a#percentage#of#the#price#of#an#asset,#if#the#
asset#price#rises,#other#things#remaining#the#same,#the#interest#rate#falls
Also#,#if#the#asset#price#falls#the#interest#rate#rises
§
For'Example:'consider#a#bond#that#promises#to#pay#its#holder#$5#a#year#
forever.#-What#is#the#rate#of#return#-the#interest#rate#on#this#bond?
The#answer#depends#on#the#price#of#the#bond
§
If#we#buy#this#bond#for#$50#the#interest#rate#would#be#10#percent#a#
year:
Interest#rate#=#($5#/#$50)#x#100#=#10%
§
But#if#the#price#of#the#asset#rises#to#$200,#the#interest#rate#would#be#
2.5%
Interest#Rate#=#($5#/#$200)#x#100#=##2.5%
§
-
The'Loanable'Funds'Market'
The#loanable'funds'Is#the#aggregate#of#all#the#individual#financial#markets
-
Funds'that'Finance'investment
Household#savings
Government#budget#surplus
Borrowing#from#the#rest#of#the#world
House#holds#incomes,#Y#is#spent#on#consumption#goods#and#services#-C#,#
saved#-## S#or#paid#in#net#taxes#- T
Net'Taxes'are#the#Taxes#paid#to#governments#minus#the#cash#transfers#
received#from#governments#(such#as#social#security#and#unemployment#
benefits)#so#income#is#equal#to#the#sum#of#consumptions#expenditure,#
saving#and#net#taxes
Y#=#C#+#S#+#T
§
We#have#seen#that#Y#also#equals#the#sum#of#the#items#of#aggregate#
expenditure:#consumption#expenditure#-C#,#investment#-I#government#
expenditure#-G#and#exports#-X#minus#imports#- M
Y#=#C#+#I#+#G#+#X#- M
§
By#using#these#two#equations#you#can#see#that
I#+#G#+#X#=#M#+#S#+#T
§
Subtract#G#and#X#from#both#sides#of#the#last#equation#to#obtain
I#=#S#+#(T#-G)#+#(X#-M)
§
This#equation#tells#us#that#investment#-I#is#financed#by#household#saving#-
S#,#the#government#budget#surplus##-(T#-G),#and#borrowing#from#the#rest#
of#the#world#-(X#-M)
The#sum#of#private#saving#-S#and#government#saving#-(T#-G)#is#called#
national'saving
-
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#lend
For'Example:'if#the#annual#interest#paid#on#a#$500#loan#is#$25,#the#
nominal#interest#is#5#percent#per#year:
$25#/#$500##x#100#=#5%
§
The#real'interest'rate'is#the#nominal#interest#adjusted#to#remove#the#
effects#of#inflation#on#the#buying#power#of#money
The#real# interest#rate#is#approximately#equal#to#the#nominal#interest#
rate#minus#the#inflation#rate
§
For'Example:' suppose#that#you#have#put#$500#away#into##a#savings#
account#that#earns#you#5#percent#of#interest#a#year.#At#the#end#of#
the#year#$525#in#your#savings#account
Suppose#that#the#inflation#rate#is#2#percent#a#year#-during#the#
year,#all#prices#increased#by#2#percent
Now#at#the#end#of#the#year,#it#costs#$510#to#buy#what#$500#
would#have#bought#one#year#ago
Your#money#in#the#bank#has#really#only#increased#by#$15,#from#
$510#to#$525
That#$15#is#equivalent#to#a#real#interest#rate#of#3#percent#a#
year#on#your#original#$500#
So#the#real#interest#rate#is#the##5#percent#nominal#interest#rate#
minus#the#two#percent#inflation#rate
§
The#real# interest#is#the#opportunity#cost#of#loanable#funds
The#real# interest#paid%on#borrowed#funds#is#the#opportunity#cost#of#
borrowing
§
And#the#real#interest#forgone%when#funds#are#used#either#to#buy#
consumption#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#budget#deficit,#and#
international#investment#or#lending#during#a#given#period
Our#focus#here#is#on#investment
What#determines#investment#and#the#demand#for#loanable#funds#to#
finance#it?#Many#details#influence#this#decision,#but#we#can#summarize#
them#into#two#factors:
§The'Real'Interest'rate
§Expected'profit
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,#so:
§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#the#quantity#of#loanable#
funds#demanded
Demand'for'Loanable'funds'curve
§The#demand#for#loanable#funds#curve#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
§For'Example:'to#understand#the#demand#for#loanable#funds#think#
about#Amazon.com's#decision#to#borrow#$100#million#to#build#new#
warehouses
If#Amazon#expects#to#earn##a#return#of#$5million#a#year#from#
this#investment#before#paying#interest#costs#and#the#real#
interest#rate#is#less#than#5#percent#a#year,#Amazon#would#
make#a#profit,#so#it#build#warehouses
But#if#the#interest#rate#if#more#than#5#percent#a#year,#Amazon#
would#incur#a#loss,#so#it#doesn't#build#the#ware#houses
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
§Other#things#remaining#the#same,#the#greater#the#expected#profit#
from#new#capital,#the#greater#is#the#amount#of#investment#and#the#
greater#is#the#demand#for#loanable#funds
§Expected#profit#rises#during##business#cycle#expansion#and#falls#
during#a#recession
Rises#when#technological#change#creates#profitable#new#
products
Rises#as#a#growing#population#brings#increased#demands#for#
goods#and#services
Fluctuates#with#contagious#swings#of#optimism#and#pessimism#
called#'animal#spirits'#by#Keynes#and#'irrational# exuberance'#by#
Alan#Greenspan
§When#expected#profit#changes,#the#demand#for#loanable#funds#
curve#shifts
-
-The'Supply'for'Loanable'Funds
The#quantity%of%loanable%funds%supplied%is#the#total#funds#available#from#
private#saving,#the#government#budget#surplus#and#international#
borrowing#during#a#given#period
Our#focus#here#is#saving
How#does#one#decide#how#much#of#their#income#to#save#and#supply#in#the#
loanable#funds#markets?#Your#decision#is#influenced#by#many#factors:
§The'Real'Interest'Rate
§Disposable'Income
§Expected'future'income
§Wealth
§Default'risk
We#begin#by#focusing#on#the#real#interest#rate,
§Other#things#remaining#the#same,#the#higher#the#real#interest#rate,#
the#greater#the#quantity#of#loanable#funds#supplied;#the#lower#the#
real#interest#rate,#the#smaller#the#quantity#of#loanable#funds#
supplied
The'Supply'of'loanable'funds'curve
§The#supply%of%loanable%funds%curve%is#the#relationship#between#the#
quantity#of#loanable#funds#supplied#and#the#real#interest#rate,#when#
all#other#influences#on#lending#plans#remain#the#same
§For'Example:'think#about#a#students#decision#to#save#some#of#what#
she#earns#from#her#summer#job,#she#decides#that#with#a#real#
interest#rate#of#2#percent#a#year,#she#decides#it#is#not#worth#saving#
much#-better#to#spend#the#income#and#take#a#student#loan#if#funds#
run#out#during#the#semester
But#if#the#real#interest#rate#jumped#to#10#percent#a#year,#the#
pay#off#form#saving#would#be#high#enough#to#encourage#her#
to#cut#back#on#spending#and#increase#the#amount#she#saves
Changes'in'the'supply'of'loanable'funds
§A#change#in#disposable#income,#expected#future#income,#wealth#or#
default#risk#changes#the#supply#of#loanable#funds
§Disposable'Income'
A#households#disposable#income#is#the#income#earned#minus#
net#taxes
When#disposable#income#increases,#other#things#remaining#
the#same,#consumption#expenditure#increases#by#less#than#
the#increase#in#income.#Some#of#the#increase#in#income#is#
saved
So#the#greater#a#households#disposable#income,#the#greater#is#
their#saving
§Expected'Future'income
The#higher#a#households#expected#future#income,#the#smaller#
is#its#saving#today
§Wealth
The#higher#a#households#wealth,#other#things#remaining#the#
same,#the#smaller#is#its#saving
If#a#person's#wealth#increases#because#of#capital#gain,#the#
person#sees#less#need#to#save
§Default'Risk
The#risk#that#a#loan#will#not#be#repaid#is#called#default%risk%
The#greater#this#risk,#the#higher#interest#rate#needed#to#
induce#a#person#to#lend#and#the#smaller# is#the#supply#of#
loanable#funds
Shifts'of'the'Supply'of'Loanable'Funds'Curve
§When#any#of#the#four#influences#on#the#supply#of#loanable#funds#
changes,#the#supply#of#loanable#funds#curve#shifts
§An#increase#in#disposable#income,#a#decrease#in#expected#future#
income,#a#decrease#in#wealth,#or#fall#in#default#risk#increases#savings#
and#increases#the#supply#of#loanable#funds
-Equilibrium'in'the'Loanable'funds'market
You've#seen#that,#other#things#remaining#the#same,#the#higher#the#real#
interest#rate,#the#greater#is#the#quantity#of#loanable#funds#supplied#and#
the#smaller#is#the#quantity#of#loanable#funds#demanded
There#is#one#real#interest#rate#at#which#quantities#of#loanable#funs#
demanded#and#supplied#are#equal,#and#that#interest#rate#is#the#
equilibrium'real'interest'rate'
If#the#equilibrium#real#interest#rate#rises#above#the#equilibrium#level,#then#
there#is#a#surplus#of#funds
If#the#equilibrium#real#interest#rate#falls#below#the#equilibrium#level,#then#
there#is#a#shortage#of#funds
Regardless#of#whether#there#is#a#shortage/surplus#of#loanable#funds,#the#
real#interest#rate#changes#and#is#pulled#towards#an#equilibrium#level
-Changes'in'Demand'and'Supply
Financial#markets#are#highly#volatile#in#the#short#run#but#stable#in#the#long#
run
Volatility#in#markets#come#from#fluctuations#in#either#demand#or#supply#
for#loanable#funds
These#fluctuations#bring#fluctuations#in#real#interest#rate#and#the#
equilibrium#quantity#of#funds#lent#and#borrowed
§Also#bring#fluctuations#in#asset#prices
An'Increase'in'demand
§If#the#profits#that#firms#expect#to#earn#increase,#they#increase#their#
planned#investment#and#increase#their#demand#for#loanable#funds#
to#finance#this#investment
§With#an#increase#in#the#demand#for#loanable#funds,#but#no#change#
in#the#supply#of#loanable#funs,#there#is#a#shortage#of#funds
§As#borrowers#compete#for#funds,#the#interest#rate#rise#and#lenders#
increase#the#quantity#of#funds#supplied
An'increase'in'supply'
§If#one#of#the#influences#on#saving#plans#changes#and#increases#
saving,#the#supply#of#loanable#funds#increases
§With#no#change#in#the#demand#for#loanable#funds,#the#market#is#
flush#with#loanable#funds
§Borrowers#find#bargains,#and#lenders#find#themselves#accepting#a#
lower#interest#rate
§At#the#lower#interest#rate,#borrowers#find#additional#investment#
projects#profitable#and#increase#the#quantity#of#loanable#funds#that#
they#borrow
§An#increase#in#supply#shifts#the#curve#rightward#from#SLF0#to#SLF1.#
Long'Run'Growth'of'Demand'and'Supply
§Over#time,#both#demand#and#supply#in#the#loanable#funds#market#
fluctuate#and#the#real#interest#rate#rises#and#falls
§Both#the#supply#and#demand#of#loanable#funs#tend#to#increase#over#
time
§On#average#they#increase#at#a#similar#pace,#so#although#demand#and#
supply#trend#upward,#the#real#interest#rate#has#no#trend#-it#
fluctuates#around#a#constant#average#level
Governments'in'the'Loanable'Funds'Market
-Governments#enters#the#loanable#funds#markets#when#it#has#a#budget#surplus#or#
a#budget#deficit.
-A#government#budget#surplus#increases#the#supply#of#loanable#funds#and#
contributes#to#financing#investment
-A#government#budget#deficit#increases#the#demand#for#loanable#funds#and#
competes#with#businesses#for#funds
-Government'Budget'Surplus
A#government#budget#surplus#increases#the#supply#of#loanable#funds
The#real# interest#rate#falls,#which#decreases#household#saving#and#
decreases#the#quantity#of#private#funds#supplied
The#lower#the#real#interest#rate#increases#the#quantity#of#loanable#funds#
demanded#and#increases#investment
-Government'Budget'Deficit
A#government#budget#deficit#increases#the#demand#for#loanable#funds
The#real# interest#rate#rises,#which#increases#household#saving#and#increase#
the#quantity#of#private#funds#supplied
But#the#higher#the#real#interest#rate#decreases#investment#and#the#
quantity#of#loanable#funds#demanded#by#firms#to#finance#investment
-The'Crowding-Out'effect
The#tendency#for#a#government#budget#deficit#to#raise#the#real#interest#
rate#and#decrease#investment#is#called# the#crowding%out%effect%
The#crowding#out#effect#does#not#decrease#investment#by#full#amount#of#
the#government#budget#deficit#because#a#higher#real#interest#rate#induces#
an#increase#in#private#saving#that#partly#contributes#toward#financing#the#
deficit
-The'Ricardo-Barro'Effect
First#suggest#by#English#economist#David#Ricardo#and#refined#by#Robert#
Barro,#the#Ricardo-Barro#effect#holds#that#both#of#the#effects#we've#just#
spoken#about#are#wrong#and#the#government#budget#has#no#effect#on#
either#the#real#interest#rate#or#investment
Barro#says#that#taxpayers#are#rational#and#can#see#that#a#budget#deficit#
today#means#that#future#taxes#will#be#higher#and#future#disposable#
incomes#will#be#smaller
With#smaller#expected#future#disposable#incomes,#saving#increases#today.
The#private#supply#of#loanable#funds#increases#to#match#the#quantity#of#
loanable#funds#demanded#by#the#government
So#the#budget#deficit#has#no#effect#on#either#real#interest#rate#or#
investment
Chapter(23:(Finance,(Saving(and(Investment
Sunday,#February#12,#2017 2:22#PM

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Financial'Institutions'and'Financial'Markets'
Finance'and'Money
In#economics#we#use#the#term#finance'to#describe#the#activity#providing#
the#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#activity
§
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
§
In#the#economic#lives#of#individuals#and#businesses,#finance#and#money#
are#closely#interrelated
Some#of#the#main#financial#institutions,#such#as#banks,#provide#both#
financial#services#and#monetary#services
§
-
Physical'Capital'and'Financial'Capital
Physical'Capital'is#the#tools#,#instruments,#machines,#buildings#and#other#
items#that#have#been#produced#in#the#past#and#are#used#today#to#produce#
goods#and#services
Inventories#of#raw#materials,#semi-finished#goods,#and#components#
are#part#of#physical#capitals
§
The#funds#that#firms#use#to#buy#capital#are#called#financial'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#aggregate#production#function#upward
§
-
Capital'and'Investment
The#quantity#of#capital#changes#because#of#investment#and#depreciation
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'
§
Net#investment#=#gross#investment#-depreciation
§
-
Wealth'and'Saving
Wealth'is#the#value#of#all#things#that#people#own
What#people#own#is#related#to#what#people#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
§
Saving'is#the#amount#of#income#that#is#not#paid#in#taxes#or#spent#on#
consumption#goods#and#services
Saving#increases#wealth
§
Wealth#also#increases#when#the#market#value#of#assets#rises#-called#
capital'gains'and#decreases#when#the#market#value#of#assets#fall#-called#
capital'losses'
The#wealth#of#a#nation#at#the#end#of#the#year#equals#its#wealth#at#the#start#
of#the#year#plus#its#savings#during#the#year,#which#equals#income#-
consumption#expenditure
To#make#real#GDP#grow,#saving#and#wealth#must#be#transformed#into#
investment#and#capital
This#transformation#takes#place#in#the#markets#for#financial#capital#
and#through#the#activities#of#financial#institutions
§
-
Financial'Capital'Markets
Saving#is#the#source#of#the#funds#that#are#used#to#finance#investment,#and#
these#funds#are#supplied#and#demanded#in#three#types#of#financial#
markets
Loan'Markets
Business#often#want#short-term#finance#to#buy#inventories#or#
to#extend#credit#to#their#customers
Sometimes#they#get#this#finance#in#the#form#of#a#loan#
from#a#bank
®
Households#often#want#to#finance#to#purchase#big#ticket#
items,#such#as#cars#or#household#furnishings#and#appliances
They#get#this#finance#as#banks#loans,#often#in#the#form#
of#outstanding#credit#card#balances
®
Household#also#get#finance#to#buy#new#homes#-
expenditure#on#new##homes#is#counted#as#investment
These#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
When#Walmart#expands#its#business#and#opens#new#stores,#it#
gets#the#finance#it#needs#by#selling#bonds.
Governments#-federal,#provincial#and#municipal#also#
raise#finance#by#issuing#bonds
®
A#bond'is#a#promise#to#make#specified#payments#on#specified#
dates
For'Example:' you#can#buy#a#McDonald's#Corp.#bond#
that#promises#to#pay#$3.50#every#year#until#2020#and#
then#to#make#a#final#payment#of#$100#on#July#15,#2020
®
The#buyer#of#a#bond#from#McDonald's#makes#a#loan#t#
the#company#and#is#entitled#to#the#payments#promised##
by#the#bond
®
When#a#person#buys#a#newly#issued#bond,#he#or#she#may#hold#
the#bond#until#the#borrower#has#repaid#the#amount#borrowed#
or#sell#it#to#someone#else
Corporations#and#governments#sell#bonds#in#the#bond'market'
Another#type#of#bond#is#a#Mortgage-backed'security'which#
entitles#the#holder#to#the#income#from#a#package#of#
mortgages
Mortgage#lenders#can#create#mortgage#backed#
securities
®
They#mortgage#loans#to#home#buyers#and#then#create#
securities#that#they#sell#to#obtain#more#funs#to#make#
more#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
®
§
Stock'Markets'
When#Petro-Canada#wants#finance#to#expand#its#business,#it#
issues#stock
A#stock'is#a#certificate#of#ownership#and#claims#to#the#firms#
profits
Petro-Canada#has#issued#484#million#shares#of#its#stock,#so#if#
you#owned#484#Petro-Canada#shares,#you#would#own#one#
millionth#of#its#profits
Unlike#a#stockholder,#a#bondholder#does#not#own#part#of#the#
firm#that#issued#the#bond
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#markets#for#financial#capital
The#financial#institution#is#a#borrower#in#one#market#and#a#lender#in#
another#market
Financial#Institutions#also#stand#ready#to#trade#so#that#households#with#
funds#to#lend#and#firms#or#households#seeking#funds#can#always#find#
someone#on#the#other#side#of#the#market#with#whom#to#trade
The#key#Canadian#financial#institutions#are:
Banks
Banks#accept#deposits#and#use#the#funds#to#buy#government#
bonds#and#other#securities#and#to#make#loans
Economists#distinguish#banks#from#other#financial#institutions#
because#bank#deposits#are#money
§
Trust'and'loan'companies
Trust#and#loan#companies#provide#similar# services#to#banks#
and#the#largest#of#them#are#owned#by#banks
They#accept#deposits#and#also#administer#estates,#trusts#and#
pension#plans
§
Credit'unions'and'caisses'populaires
Are#banks#that#are#owned#and#controlled#by#they#depositors#
and#borrowers,#are#regulated#by#provincial#rules#and#operate#
only#inside#their#own#provincial#boundaries
These#institutions#are#large#in#numbers#but#small#in#size
§
Pension'funds
Are#financial#institutions#that#receive#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
The#income#is#used#to#pay#pension#benefits
Pension#funds#can#be#very#large#and#play#an#active#role#in#the#
firms#whose#stock#they#hold
§
Insurance'companies
Insurance#companies#provide#risk-sharing#services
They#enter#into#agreements#with#households#and#firms#to#
provide#compensation#in#the#event#of#accident,#theft,#fire,#and#
a#host#of#other#misfortunes
They#receive# premiums#from#their#customers#and#make#
payments#against#claims
Insurance#use#the#funds#they#have#received#but#not#paid#out#
as#claims#to#buy#bonds#and#stocks#in#which#they#earn#an#
interest#income
Some#insurance#companies#also#insure#corporate#bonds#and#
other#risky#financial#assets
They#provide#insurance#that#pays#out#if#a#firms#fails#and#
cannot#meet#its#bond#obligations
®
In#normal#times,#insurance#companies#have#a#steady#flow#of#
funds#coming#in#from#premiums#and#interest#on#the#financial#
assets#they#hold#and#a#steady,#but#smaller,#flow#of#funds#
paying#claims
Their#profit#is#the#gap#between#the#two#flows
®
All#financial#institutions#face#risk,#which#poses#two#problems:#
solvency'&'liquidity'problems'
§
-
Insolvency'and'Illiquidity
A#financial#institutions#net'worth'is#the#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'
§
If#the#net#worth#is#negative,#the#institution#is#insolvent'
An#insolvent#business#cannot#pay#its#debts#and#must#go#out#of#
business
The#owner#of#an#insolvent#business#-usually#its#stock#holders#-
bear#the#loss#but#the#firms#and#individuals#who#are#owed#
payments#by#an#insolvent#business#incur#a#loss
§
A#financial#institution#both#borrows#and#lends,#so#it#is#exposed#to#
the#risk#that#its#net#worth#might#become#negative
To#limit#that#risk,#financial#institutions#are#regulated#and#a#
minimum#amount#of#their#lending#must#be#backed#by#their#
net#worth
§
Sometimes#a#financial#institution#is#solvent#but#illiquid
§
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
In#normal#times#a#financial#institution#that#is#illiquid#can#
borrow#from#another#institution,#but#if#all#the#financial#
institutions#are#short#of#cash#,#the#market#for#loans#among#
financial#institutions#dries#up
§
-
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
Because#the#interest#rate#is#a#percentage#of#the#price#of#an#asset,#if#the#
asset#price#rises,#other#things#remaining#the#same,#the#interest#rate#falls
Also#,#if#the#asset#price#falls#the#interest#rate#rises
§
For'Example:'consider#a#bond#that#promises#to#pay#its#holder#$5#a#year#
forever.#-What#is#the#rate#of#return#-the#interest#rate#on#this#bond?
The#answer#depends#on#the#price#of#the#bond
§
If#we#buy#this#bond#for#$50#the#interest#rate#would#be#10#percent#a#
year:
Interest#rate#=#($5#/#$50)#x#100#=#10%
§
But#if#the#price#of#the#asset#rises#to#$200,#the#interest#rate#would#be#
2.5%
Interest#Rate#=#($5#/#$200)#x#100#=##2.5%
§
-
The'Loanable'Funds'Market'
The#loanable'funds'Is#the#aggregate#of#all#the#individual#financial#markets
-
Funds'that'Finance'investment
Household#savings
Government#budget#surplus
Borrowing#from#the#rest#of#the#world
House#holds#incomes,#Y#is#spent#on#consumption#goods#and#services#-C#,#
saved#-## S#or#paid#in#net#taxes#- T
Net'Taxes'are#the#Taxes#paid#to#governments#minus#the#cash#transfers#
received#from#governments#(such#as#social#security#and#unemployment#
benefits)#so#income#is#equal#to#the#sum#of#consumptions#expenditure,#
saving#and#net#taxes
Y#=#C#+#S#+#T
§
We#have#seen#that#Y#also#equals#the#sum#of#the#items#of#aggregate#
expenditure:#consumption#expenditure#-C#,#investment#-I#government#
expenditure#-G#and#exports#-X#minus#imports#- M
Y#=#C#+#I#+#G#+#X#- M
§
By#using#these#two#equations#you#can#see#that
I#+#G#+#X#=#M#+#S#+#T
§
Subtract#G#and#X#from#both#sides#of#the#last#equation#to#obtain
I#=#S#+#(T#-G)#+#(X#-M)
§
This#equation#tells#us#that#investment#-I#is#financed#by#household#saving#-
S#,#the#government#budget#surplus##-(T#-G),#and#borrowing#from#the#rest#
of#the#world#-(X#-M)
The#sum#of#private#saving#-S#and#government#saving#-(T#-G)#is#called#
national'saving
-
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#lend
For'Example:'if#the#annual#interest#paid#on#a#$500#loan#is#$25,#the#
nominal#interest#is#5#percent#per#year:
$25#/#$500##x#100#=#5%
§
The#real'interest'rate'is#the#nominal#interest#adjusted#to#remove#the#
effects#of#inflation#on#the#buying#power#of#money
The#real# interest#rate#is#approximately#equal#to#the#nominal#interest#
rate#minus#the#inflation#rate
§
For'Example:' suppose#that#you#have#put#$500#away#into##a#savings#
account#that#earns#you#5#percent#of#interest#a#year.#At#the#end#of#
the#year#$525#in#your#savings#account
Suppose#that#the#inflation#rate#is#2#percent#a#year#-during#the#
year,#all#prices#increased#by#2#percent
Now#at#the#end#of#the#year,#it#costs#$510#to#buy#what#$500#
would#have#bought#one#year#ago
Your#money#in#the#bank#has#really#only#increased#by#$15,#from#
$510#to#$525
That#$15#is#equivalent#to#a#real#interest#rate#of#3#percent#a#
year#on#your#original#$500#
So#the#real#interest#rate#is#the##5#percent#nominal#interest#rate#
minus#the#two#percent#inflation#rate
§
The#real# interest#is#the#opportunity#cost#of#loanable#funds
The#real# interest#paid%on#borrowed#funds#is#the#opportunity#cost#of#
borrowing
§
And#the#real#interest#forgone%when#funds#are#used#either#to#buy#
consumption#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#budget#deficit,#and#
international#investment#or#lending#during#a#given#period
Our#focus#here#is#on#investment
What#determines#investment#and#the#demand#for#loanable#funds#to#
finance#it?#Many#details#influence#this#decision,#but#we#can#summarize#
them#into#two#factors:
§The'Real'Interest'rate
§Expected'profit
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,#so:
§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#the#quantity#of#loanable#
funds#demanded
Demand'for'Loanable'funds'curve
§The#demand#for#loanable#funds#curve#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
§For'Example:'to#understand#the#demand#for#loanable#funds#think#
about#Amazon.com's#decision#to#borrow#$100#million#to#build#new#
warehouses
If#Amazon#expects#to#earn##a#retu