Chapter 7: Finance, Saving and Investment

What are the main types of financial institutions in Canada? / 2 sides of the market

Demand and supply

2 groups

• Borrowers/spenders

• Lenders/savers

The financial market branches into 2 markets:

• Bond market

• Stock market

Who partakes in direct/indirect finance? (4)

• Households

• Firms

• Government

• Foreigners

What is DIRECT finance?

Direct transfer of funds from the lender to borrower. 

What is INDIRECT finance?

Transfer from lenders to borrowers with the help of an intermediary.

Examples of financial intermediaries:

• Banks

• Finance and insurance companies

Finance vs. Money

Finance: providing funds to purchase capital goods

Money: A set of assets people regularly use to buy goods/services

Money has 3 functions

1. Medium of exchange

2. Store of value

3. Unit of account

2 types of money:

1. Commodity (intrinsic value)

2. Fiat (no intrinsic value)

The study of finance vs. The study of money

Study of finance: Financial markets and how they operate

Study of money: Money demand/supply, functions and types

What is barter economy?

No money, so you trade goods for goods

Double coincidence of wants

I have something you want, you have something I want

Physical vs. Financial capital

Physical: Produced products used to make other products (ex. buildings, tools, equipment)

Financial: Funds that firms use to BUY physical capital (ex. money, stock, bond)

Characteristics of physical capital

1. Productive

2. Produced

3. Depreciates overtime

4. Earns a return

5. Use is limited

The law of motion for capital 

Resource constraint of economy:

K t+1 = Kt - depreciation rate*Kt + It

Asset vs. Wealth

Asset: Financial claim or property that is a store of value

Wealth: = Assets - Liabilities   

Asset is a ____ variable

flow

Wealth is a ____ variable

stock

Value of money increases or decreases when price goes up?

Decreases

Saving vs. Investing

Saving: Lending

Investing: Borrowing

Saving is a ___ of funds

source

Investing is a ____ of funds

use

Bond is…

certificate of indebtedness (IOU), debt financing

In the bond market, who is the issuer?

Borrowers / spenders

In the bond market, who is the holder?

Lenders / savers

Characteristics of a bond

1. Risk

2. Liquidity

3. Expected return

Types of credit instruments

• Coupon bond

• Discount bond

• Fixed payment loan

• Consol

• Simple loans

Who’s paid first? Bondholder or stockholder?

Bondholder

EEL curve is…

Upward sloping

Primary markets

• Newly issued stocks/ bonds

• Underwriting

Secondary markets

• Trading stock that has already been issued

• Over the counter or official (TSX, S&P)

As r goes up,

price goes down

Net worth =

Assets - Liabilities

Positive vs negative net worth

Positive = solvent

Negative = insolvent

Liquidity: Enough funds vs not enough

Enough funds —> Liquid

Not enough funds —> Illiquid

What’s a bank run?

When everyone wants funds from the bank, but the bank is illiquid. They all withdraw at the same time, usually caused by a panic.

Closed economy formula

S = I

Open economy formula

S = NX + I

The market for loanable funds

1. Loan demand

2. Loan supply

Loan demand comes from…

borrowers

Loan supply comes from…

lenders

Equilibrium happens when…

D = S, investment = savings

Supply: as interest goes up,

Qs goes up

Demand: as interest goes up,

Qd goes down

Crowding out effect

Government is borrowing too much, which increases inflation and decreases investment value

SUPPLY factors of loanable market

1. Disposable income

2. Expected future income

3. Wealth

4. Default risk

DEMAND factor of loanable market

1. Expected price

What is the loanable funds market?

Aggregate of all individual financial markets

Demand for loanable funds is…

Negative relationship between Qd and real interest rate

Supply of loanable funds is…

Positive relationship between Qs and real interest rate

What causes a movement along the curve?

change in r

What causes a shift in the DEMAND curve?

change in expected profit

Profit goes up, curve shifts…

right

Profit goes down, curve shifts…

left

What causes a shift in the SUPPLY curve?

• Disposable income

• Expected future income

• Wealth

• Default risk

As saving goes up, 

Supply goes down

As saving goes down,

Supply goes up

Shortage is when…

Qd > Qs

Surplus is when…

Qs > Qd

Government surplus is when…

revenue > spending

Government deficit is when…

spending > revenue

Crowding out effect

The government spends too much, which makes interest rate higher, and private sectors won’t want to spend. Demand goes UP.

What’s the counter argument to the crowding out effect?

Ricardo-Barro effect: says that when demand goes UP, supply goes DOWN and it balances out