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Chapter 8

Saving, Investment and the Financial System - Chapter 8.docx

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ECON 1010
Frank Miller

Saving, Investment, and the Financial System - Financial system: consists of those intuitions in the economy that help to match one person’s savings with another person’s investments; made up of various financial institutions - At any time, some people want to save income for the future and others want to borrow to finance investments Financial Intuitions in the Canadian Economy - Financial systems moves economy’s scarce resources from savers to borrows - Savers supply their money to financial system with expectation that they will get interest - Borrowers demand money; they are required to pay interest - Government regulators set rules guiding operation of financial system - Bank of Canada: regulates Canadian financial system Financial Markets - These are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow Bond Market - Bond is a certificate of indebtedness; specifies obligations of the borrower to holder of the bond; like an IOU - Date of maturity: time by which the loan must be repaid - Buyer of bond gives money in exchange for promise of interest and eventual payment of principal amount (initial amount borrowed) - Buyer can hold bold till maturity or sell to someone else - Characteristics of bonds: o Term: length of time until the bond matures  Perpetuity: bond pays interest forever, but interest is never repaid; bond never matures  Long term bonds risker because holders have to wait long time to receive principal  Long term bonds pay higher rate of interest o Credit risk: probability that the borrower till fail to pay some of the interest or principal (default)  If probability to default is higher, buyers want higher interest rate  Affected by level of debt carried by user, change in amount of debt carried, and stability of issuers revenues - Corporate revenues tend to be more volatile than those of provincial and federal governments; pay higher interest - Junk bonds: pay considerably higher interest rates than bonds issued by more secure corporations and governments; used by shaky corporations Stock Market - Stock is a claim to partial ownership in a firm; gives stockholders claim to profit that the firm makes - Equity finance: sale of stock to accumulate capital - Debt finance: sale of bond to accumulate capital - Shareholders are part owners of the corporation; bond owners are creditors - Shareholders enjoy benefits of profits; bond holders enjoy benefit of interest payments - Bond holders always paid what they are due, before stock holders receive anything; if company experiences financial difficulty - Stocks offer greater risk but higher returns - Corporation does not receive any money when stock changes hands - Demand for a stock represents people’s perception of company’s future profitability; fluctuates stock prices - Stock index: compute as average of a group of stock prices Reading Stock Tables 1) Price: closing price of the last transaction that occurred before the stock exchange closed the previous day - Most important information about a stock 2) Volume: number of shares sold during the past day of trading 3) Dividend: payout of some profit to their shareholders - Retained earnings: profits not paid out and used by the company for additional investment - Dividend yield: dividend expressed as percent of stock’s price 4) Price/earnings ratio: earrings per share is company’s total earnings divided by number of shares of stock outstanding - Price earnings ratio: price of the corporation’s stock divided by amount company earned per share Financial Intermediaries - Are financial institutions through which savers can indirectly provide funds to borrowers - intermediary reflects role of these institutions in standing between savers and borrowers - Normally banks and mutual funds Banks - Unlike large corporations, small businesses have hard time raising funds in bond and stock market; use banks to finance business activities - Banks take deposits from those who want to save and use them to make loans to people who want to borrow o Pay depositors interest on their deposits and charge borrowers slightly higher interest rate on loans o Difference between rates of interest covers banks’ cost and returns profit to bank owners - Banks facilitate purchases of goods and services by allowing people to write cheques against their deposits o Banks help create special asset that people can use as medium of exchange o Stocks and bonds like deposits are store of value for wealth that people have accumulated in past savings  Access to this wealth not easy, cheap and immediate as writing a cheque Mutual Funds - An institution that sells shares to the public and uses proceeds to buy selection/portfolio of various types of stocks, bonds or both - Shareholder accepts all risks and returns associated with the portfolio - Benefit: allow people with small amounts of money to diversify; essential to not put “all eggs in one basket” o Allows people to face less risk; only have a small stake in each company - Benefit: give ordinary people access to skills of professional money managers o Managers buy stock of those companies that they view as having profitable future and sell stocks of those companies with less promising prospects - Index funds: buy all the stocks in a given stock index Summing Up - Pension funds, credit unions, insurance companies, local loan shark and caisses populaires are other financial institutions - All financial institutions direct resources of savers into hands of borrowers Saving and Investment in the National Income Accounts - Accounting: refers to how various numbers are defined and added up - National income accounts include GDP - Identities: equation that must be true because of the way the variables are defined o Help clarify how different variables are related Important Identities 1) Y = C + I + G + NX: every dollar of expenditure that shows up on left side shows up in one of four components on the right - Closed economy: economy that does not interact with o
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