Ch. 10 Savings Investment, and Financial System

Saving-Investment Spending Identity

Saving and investment spending are always equal. This equilibrium occurs because every dollar saved is transformed into a dollar invested in capital goods.

Budget Surplus

The difference between tax revenue and government spending when tax revenue exceeds government spending. (More money for the government after expenses are paid.)

Budget Deficit

Difference between tax revenue and government spending when government spending exceeds tax revenue. (Government spent more than it gained from taxes)

Budget Balance

The difference between tax revenue and government spending.

National Savings

The sum of private savings plus the budget balance the total amount of savings in an economy. (private savings + budget balance = savings)

Capital Inflow

The net flow of funds into a country from foreign investors, contributing to domestic investment and savings.

Loanable Funds Market

A hypothetical market that shows how loans from savers are allocated among borrowers with investment spending projects.

Financial System

The set of institutions that connect savers with borrowers

Investment Spending vs Making an investment

Buying new physical capital (add to the economy’s stock of physical capital) vs Purchasing an asset such as a share of stock, a bod, or existing real estate.

Asset

Some item of value that is expected to provide the holder some future benefit

Liabilities

requirements to pay money in the future; a loan is a liability for the person who takes out a loan, but an asset to the person who loaned money out.

Real Asset

(AKA physical asset) a claim on a tangible object that gives the owner the right to use it as they wish. A house is a real asset that its owner can sell or rent out, and a factory is a real asset that a business can use to earn profits.

Financial Asset

A contractual claim to something of value; modern economies have four main types of financial assets: bank deposits, stocks, bonds, and loans. In reality, there are many more types of financial assets (like derivatives, calls, puts, and so on) But these are the main ones.

Financial Risk

When there is any uncertainty about the future value of an asset; for example, if you don't know how many lime smoothies you can buy with the money in your savings account next week, the value of your savings account has risk, because inflation can reduce its value.

Liquidity

How easily an asset converts to cash without loss of purchasing power.

Illiquid

Describes assets that cannot be easily converted to cash or are difficult to sell without a significant loss in value.

Return

The profit made on an asset, usually expressed as a percentage

Bank Deposits

Funds placed in a bank account that can be withdrawn by the account holder, typically earning interest.

Loan

A sum of money borrowed that is expected to be paid back with interest over a specified period.

Bonds

A form of an IOUs (a promise to pay back some amount in the future); Three key features: Par, Maturity, and Coupon payments

Stock

A slice of ownership in a company

Rate of Return

The gain or loss made on an investment relative to the amount invested, typically expressed as a percentage.

Interest Rate

The percentage of a principal loan amount charged by a lender to a borrower for the use of assets, or the percentage paid by a bank to a depositor.

Present Value (PV)

The current value of a sum of money that is to be received in the future, discounted at a specific interest rate.

Crowding out

An economic theory suggesting that increased government borrowing and spending can reduce, or "crowd out," private sector investment and consumption

Fisher Effect

An economic theory that describes how the relationship between nominal interest rates and inflation expectations adjusts to ensure that the expected real interest rate stays constant. This means that as inflation expectations rise, nominal interest rates will also increase by the same amount.

Loan-Backed Securities

Assets created by pooling individual loans and selling shares of that pool to investors.

Financial Intermediaries

(Institutions such as mutual funds, pension funds, life insurance companies, and banks)

Transaction Costs

The expenses and efforts of negotiating and executing a deal.

Diversification

The practice of spreading investments across various financial assets to reduce risk.

Default

The failure to meet the legal obligations or conditions of a loan or security. It typically occurs when a borrower is unable to make scheduled payments.

Efficient Markets Hypothesis

The theory that financial markets reflect all available information, making it impossible to consistently achieve higher returns than average.

Random Walk

The random walk theory suggests that stock price movements are unpredictable and follow a random path, making it impossible to predict future price movements based on past performance.