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Chapter 23

ECON 1010 - Textbook Notes - Chapter 23.docx

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ECON 1010
Jean Adams

Chapter 23: Finance, Saving, and Investment ECON 1010 Textbook Notes • Financial institutions and markets play a crucial role in the economy by providing channels for savings to flow to finance the investment in new capital that helps the economy grow • Difference between: o Finance and Money  Finance is used to describe the activity of providing the funds that finance expenditures on capital  Study of finance looks at how households and firms obtain and use financial resources and how they cope with the resulting risks  Money is what we use to pay for goods and services and to make other financial transactions  Finance and money are closely interrelated but must be differentiated o Physical capital and Financial capital  Physical capital: 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: Funds that firms use to buy physical capital  When financial capital increases (due to investment, saving, borrowing or lending decisions), real GDP grows • Capital and Investment o Quantity of capital changes due to investment and depreciation o Investment increases capital and depreciation decreases it o Total amount spent on new capital is called gross investment o Change in value of capital is called net investment (gross – depreciation) • Wealth and saving o Wealth is the value of all the things that people own; this is related to income o Saving is the mount of income that is not paid in taxes or spent on consumption o Saving increases wealth o Wealth also increases when market value of assets rises (capital gains) and vice versa o Wealth = Initial wealth + Savings; Savings = Income – Tax – Consumption expenditure o To make real GDP grow, saving and wealth must be transformed into investment and capital; takes place in the markets of financial capital and through the activities of financial institutions • Financial capital markets o Loan markets  Businesses want short-term finance to buy inventories or to extend credit to their customers  Households want finance to purchase big-ticket items (cars, houses)  Expenditure on new homes can be considered an investment due to long- term o Bond markets  Abond is a promise to make specified payments on specified dates  It is an alternate source of financing often used by governments  Bonds can be long or short term  Treasury bills are used as an intermediate when Party X sells something to Party Y which promises to pay later and Party I gives the money to Party X in exchange for the promise to pay  Amortgage-backed security entitles its holder to the income from a package of mortgages o Stock markets  Often used to finance large-scale things like expansions  Astock is a certificate of ownership and claim to a firm’s profits  Astock market is a financial market in which shares of stocks of corporations are traded • Financial Institutions o Afirm that operates on both sides of the markets for financial capital (a borrower in one, and a lender in another) o Stand ready to trade so that households and firms can interact by using it as an intermediary o Key Canadian financial institutions:  Commercial banks • Accept deposits and use funds to buy government bonds and other securities and to make loans • Banks hold more than 70% of total Canadian financial assets • Bank deposits are money – distinguishes them from other financial institutions  Trust and loan companies • Similar services to banks and most are owned by banks • Make loans and accept deposits • Administer estates, trusts, and pension plans  Credit unions and caisses populaires • Banks that are owned and controlled by customers • Regulated by provinces • Many small ones  Pension funds • Receive pension contributions of firms and workers • Use those funds to buy portfolios to generate income which can be paid as pension to members • Usually large in size and act as an active stock holder  Insurance companies • Provide risk-sharing services • Provide compensation in event of an accident in exchange for monthly premiums • Use funds that are not paid out as claims to buy bonds and stocks to earn income • Some also insure corporate bonds and other financial asssets • Usually have a steady flow of funds and income o All financial institutions face two problems:  Solvency problem • If a company’s net worth (market value of loans given – market value of loans received) is positive it is solvent and vice versa • Financial institutions both lend and borrow so they are exposed to the risk of net worth being negative  Liquidity problem • Financial institutions can be solvent but illiquid • Afirm is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay more than it has available • In normal times: financial institutions short on cash can borrow from other institutions • Interest rates andAsset prices: o Short-term securities, stocks, bonds, and loans are collectively called financial assets o Interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset o If asset price rises, interest rate falls and vice versa o The price of an asset and the interest rate are determined simultaneously; therefore if one rises the other falls • Loanable funds market is the aggregate of all the individual financial markets • Funds that finance investment o Household saving  Household saving is the income minus the consumption and tax expenditure (net taxes = taxes paid – refunds/social welfare)  Y = C+S+T C + I + G + X – M = C + S + T I = S + (T-G) + (M-X)  Therefore, investment is influenced by saving, the government budget surplus (Taxes paid to the government – Government expenditure), and international borrowing (M-X) o Government budget surplus  Asurplus contributes to investment, but a deficit competes with investment for funds o International borrowing o Sum of private saving (S) and government saving (T-G) is called national saving o National saving and foreign borrowing finance investment • Real Interest Rate o 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 o The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money (approx.. nominal – inflation rate) o Real interest rate is the opportunit
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