Chapter 13- Saving, Investment, & The Financial System

Financial system

group of institutions in economy that help to match one person’s saving with another person’s investment

Financial institutions

savers can directly provide funds to borrowers

Two types of financial institutions

Financial markets and financial intermediaries

Two types of financial markets

Bond and stock markets

Bond

certificate of indebtedness to someone

Principal

the amount borrowed

Date of maturity

the time at which the loan’s principal will be repaid

Rate of interest

what the borrower will pay periodically until the loan matures

Bond buyer=

lender (he can wait til it matures or sell the bond to someone else)

Stock

partial ownership in a firm (you get claim to some of the profit)

a stock carries increased risk but offers increased returns

Stock exchange

trading stock shares

In the stock exchange, how much money does the business that issued the stock receive?

none

What determines the prices of shares of stocks?

Supply and demand

Demand of a stock

reflects people’s perception of a company’s future profitability

Stock index

average of a group of stock prices

Two main stock indexes

Dow Jones (30) and S&P (500)

debt finance

sale of bonds to raise money

equity finance

sale of stock to raise money

4 characteristics of bonds

term, credit risk, tax treatment, and inflation protection

Bond term

length of time until the bond matures

Long term vs short term bonds

Long term- risker so higher interest

Short term- less risky so lower interest

Perpetuity

When the borrower never pays the money back so the loan never matures (the lender only receives the interest, not the principal)

Bond credit risk

probability of borrower default

If there’s a higher probability of default, what happens to the interest?

It increases

junk bonds

issued by financially shaky corporations and pay high interest rates

Tax treatment

how the interest earned on the bond is taxed

What bonds have taxable interest?

Most bonds

Municipal bonds

issued by state and local government, they have no tax and lower interest rates

Nominal bond

When the loan matures you receive a specific amount of money (inflation isn’t accounted for)

Inflation-indexed bond

A bond that accounts for inflation (when prices rise, payments rise proportionately)

Do inflation-indexed bonds have higher or lower interest rates?

Lower

Financial intermediaries

financial institutions through which savers can indirectly provide funds to borrowers

Two types of financial intermediaries

Banks and mutual funds

Primary role of banks

taking in deposits from savers then using these deposits to make loans to borrowers

When banks take deposits, is the interest rate high or low?

Low

When banks give loans, is the interest rate high or low?

High

Secondary role of banks

facilitate purchase of goods/services

Mutual funds

sell shares to public and use proceeds to buy portfolio of stocks and bonds

Advantages of mutual funds

1. allow people with small amounts of money to diversify their holdings (less risk)

2. give ordinary people access to skills of professional money managers

In a closed economy, NX=

0

In a closed economy, national saving (S)=

private saving + public saving

investment (I)

Y-C-G

National saving definition

total income in the economy that remains after paying for consumption/government purchases

T=

taxes - transfer payments

private saving and formula

income that households have after paying taxes/consumption

Y-T-C

Public saving and formula

tax revenue that government has left after paying for its spending

T-G

Budget surplus

excess of tax revenue over government spending

T > G

public saving = budget surplus

Budget deficit

shortfall of tax revenue from government spending

T < G

public saving = -budget deficit

What can households do with private saving?

1. buy corporate bonds/equities

2. get certificates of deposit at bank

3. buy shares of mutual funds

4. let accumulate in savings account

market for loanable funds

supply/demand model of financial system- those who want to save supply funds and those who want to borrow to invest demand funds

supply of loanable funds

saving

Two sources of supply

1. households with extra money loan it out to earn interest

2. public saving (if positive it adds to national saving, if negative it reduces national saving)

On the supply curve, an increase in IR __ quantity of loanable funds

increases

demand of loanable funds

investment

Two sources of demand

1. firms borrow the funds they need for equipment/factories

2. households borrow funds for new houses

On the demand curve, an increase in IR ___ quantity of loanable funds

decreases

Equilibrium

where investment = saving

In a shortage, the IR has ___ and needs to ___ to return to equilibrium

decreased, increase

In a surplus, the IR has ___ and needs to ___ to return to equilibrium

increased, decrease

Tax incentives

an incentive to save, increases supply, decreases IR

Investment tax credit

an incentive for spending, it increases demand, which increases IR

government debt

accumulation of past government borrowing

balanced budget

G = T

How does a budget deficit affect national saving/supply/IR/Q?

decreases national saving/supply, increases IR, decreases Q

How does a budget surplus affect national saving/supply/IR/Q?

increases national saving/supply, decreases IR, increases Q

When does debt rise?

during wartime, economic downturns

During an economic downturn, taxes

decrease

Solution for financial crises

Print more money so individuals can spend it (but be cautious printing too much and causing inflation)