Financial System, Saving and Investment – Comprehensive Notes

Introduction & Chapter Learning Goals

• The chapter sets out 5 core objectives:
  1. Describe pivotal financial institutions in the Canadian economy.
  2. Link the financial system to key macro‐variables such as saving, investment, GDP growth.
  3. Build a supply–demand model for loanable funds.
  4. Apply the model to a variety of government policies.
  5. Assess how government budget deficits/surpluses ripple through the economy.
• Narrative opener: You (a new econ-grad entrepreneur) must finance office computers, desks, etc.—illustrates how saving of one agent funds investment of another.

The Financial System in Broad Strokes

• Core function: match savers (income > spending) with borrowers (spending > income).
• Long-run growth link: More saving → larger capital stock → higher labour productivity → rising living standards.
• Key coordination question: How does the economy equate the supply of funds from savers with the demand from investors? Answer ➜ institutions + the market interest rate.

Institutional Landscape in Canada

Key Regulators

• OSFI (Office of the Superintendent of Financial Institutions): federal watchdog for banks, insurers, pension plans.
• Provincial regulators: oversee credit unions, caisses populaires, mutual funds, securities dealers.
• Bank of Canada: lender of last resort, monetary policy authority, regulator; coverage elaborated in Ch. 10.

Two Broad Institutional Categories

1. Financial markets (direct finance).
2. Financial intermediaries (indirect finance).

Financial Markets

1. Bond Market

• Bond = certificate of indebtedness (IOU) specifying:
  • Date of maturity.
  • Coupon rate / periodic interest.
  • Principal repayment.
• Important characteristics
  • Term (time to maturity): long-term bonds pay higher rates to compensate for greater price & liquidity risk (cf. British consol “perpetuity”).
  • Credit risk: probability of default.
    • Canadian federal bonds considered safest (ample tax capacity).
    • Provincial bonds riskier → higher yields; risk differs by province.
    • Corporate bonds pay still higher, esp. junk bonds (speculative grade).
  • Empirical snippet (Oct 2018, 2033–37 maturities):
    • Federal: $1.76\%$; Ontario: $3.02\%$; Loblaws Inc.: $5.06\%$.
• Bond ratings: Standard & Poor’s, Dominion Bond Rating Service, etc.

2. Stock Market

• Stock = ownership claim; equity finance vs. debt finance (bonds).
• Shareholders enjoy residual profits; bondholders receive fixed coupons and priority in distress → higher risk & potential return for stocks.
• Exchanges
  • U.S.: NYSE, NASDAQ.
  • Canada: TSX; junior issues on TSX-V (Calgary).
• How to read stock tables
  • Price (close, high, low, 52-week range).
  • Volume (daily turnover).
  • Dividend & dividend yield.
  • P/E ratio: $\text{Price}/\text{Earnings per share}$; historical norm ≈ 15.
    • High P/E ⇢ optimism or overvaluation; low P/E ⇢ pessimism or undervaluation.
• Stock indexes: Dow-Jones (30 U.S. giants, since 1896), S&P/TSX Composite (>200 firms). Serve as barometers of expected profitability & macro outlook.

Financial Intermediaries

1. Banks

• Accept deposits, extend loans.
• Earn the spread between deposit and loan rates.
• Provide chequing medium of exchange, making wealth highly liquid (role revisited in monetary-system chapter).

2. Mutual Funds

• Issue shares to public, use proceeds to buy a diversified portfolio of stocks/bonds.
• Benefits
  • Diversification for small savers (“don’t put all your eggs in one basket”).
  • Professional management (although index funds—buying the whole market—often outperform after fees because of low turnover & management cost).
• Fees: typically $0.5\%{-}3.0\%$ of assets annually.

Other intermediaries

• Pension funds, insurance companies, credit unions, caisses populaires, loan sharks—diverse in form, unified in purpose (channel saving to investment).

FYI: Financial Institutions in Crisis (2007-09)

• U.S. trigger: housing price collapse → sub-prime mortgage defaults → frozen interbank lending.
• Global shock: Dow fell ~49 %; S&P/TSX ~44 %; GM bankruptcy (Jun 1 2009).
• Canadian resilience: tighter mortgage regulation (Bank of Canada & OSFI) limited sub-prime exposure. Mark Carney appointed chair of FSB (2011).
• Lesson: Transparency & effective regulation vital as instruments grow complex; systemic risk hurts savers, borrowers, employment, growth.

National Income Accounting & Saving–Investment Links

Core Identities (closed economy)

• $Y = C + I + G$ (since $NX = 0$)
• Rearranged: $I = Y - C - G \equiv S$ (national saving).
• Private saving: $S_{\text{private}} = Y - T - C$.
• Public saving: $S_{\text{public}} = T - G$.
  • T>G ⇒ budget surplus (+ public saving).
  • T<G ⇒ budget deficit (negative public saving).
• National saving: $S = S<em>{\text{private}} + S</em>{\text{public}}$.
• Key macro fact: $S = I$; the financial system must reconcile the two sides.

Distinguishing Terms

• Saving (households forgo consumption, acquire assets) vs. Investment (purchase of new capital goods, incl. new housing).
  • Example: Buying corporate stock = saving, not investment from macro view; building a factory = investment.

The Market for Loanable Funds (Model)

• Definition: hypothetical single market where supply = national saving; demand = planned investment.
• Price variable: real interest rate $r$ (nominal minus inflation).
• Supply curve: upward sloping (higher $r$ incentivises saving).
• Demand curve: downward sloping (higher $r$ raises cost of capital → less investment).
• Equilibrium: $r^*$ adjusts to equalise $S$ and $I$.
• Shortage of funds (at low $r$) → lenders raise rates; surplus (high $r$) → rates fall.
• Interpretative flexibility: Whether deficit shifts S leftward or D rightward is semantic; substance is identical—higher $r$, lower private investment.

Policy Experiments Using the Model

1. Saving Incentives

• Policies: GST (consumption tax), larger RRSP room, introduction of TFSA.
• Effect ➜ supply curve $S<em>1\rightarrow S</em>2$ rightward.
  • $r$ falls (e.g., 5 → 4 %), $I$ rises (e.g., 120 → 160 B).
• Debate: Raises aggregate saving? Benefits skew to high-income households?

2. Investment Incentives

• Example: Investment tax credit.
• Demand curve $D<em>1\rightarrow D</em>2$ rightward.
  • $r$ rises (5 → 6 %), inducing more household saving (movement along S), $I$ increases (120 → 140 B).

3. Government Budget Balance

• Budget deficit: reduces public saving ⇒ supply left shift $S<em>1\rightarrow S</em>2$.
  • $r$ rises (5 → 6 %), private investment crowds out (120 → 80 B).
• Budget surplus: opposite: S shifts right, $r$ down, investment up → fosters growth.
• Dynamic feedbacks
  • Vicious circle: persistent deficits → slower growth → lower tax base → larger deficits.
  • Virtuous circle: surpluses → higher growth → rising revenue → larger surpluses.

Canadian Debt Case Study

• 1975-1997: consecutive federal deficits; federal debt-to-GDP climbed to ~73 % (1996).
• 1997-2008: surpluses; ratio fell to 32 % (2009).
• Post-2009: recession → renewed deficits; ratio stabilised near 36 % (2014-18).
• Provinces: debt-to-GDP about 6 % pre-1982 ➜ ~30 % by 2000; after respite, rising again post-2009.
• Aggregate (all levels): ~64 % of GDP in 2018.
• Creditworthiness: Canada retains triple-A with major agencies; U.S. & U.K. have lost at least one AAA.

FYI: Measuring Debt More Broadly

• Net debt = liabilities – financial assets (federal net debt 2017: 714\text{ B}$).
• Unfunded liabilities (implicit promises) ≠ captured in net-debt stats.
  • Demographics → rising health-care costs (44 % of public health spending for 65+).
  • Public sector pension plans (federal unfunded liability ≈ 246\text{ B}$ in 2018).

Ethical, Philosophical, Practical Themes

• Inter‐generational equity: deficits shift tax burden to future taxpayers.
• Regulation vs. innovation: need balance to foster transparency without stifling financial creativity.
• Diversification principle: mitigate idiosyncratic risk; raises question of employer-stock concentration risk for workers.

Connections & Real-World Relevance

• Builds directly on Ch. 7 growth theory (saving → capital accumulation).
• Provides analytical scaffold for later chapters on money (banks as money creators) & fiscal–monetary interactions.
• Historical episodes (2007-09 crisis, Canadian deficit cycles) ground the abstract model in lived macro outcomes.

Key Formulae & Numerical Anchors

• Output identity (closed): $Y = C + I + G$.
• Saving identities:
  $S = Y - C - G$
  $S = (Y - T - C) + (T - G) = S<em>{\text{private}} + S</em>{\text{public}}$.
• Equality: $S = I$.
• Real vs. nominal rate: $r = i - \pi$.

Core Vocabulary (must-know)

• Financial system, financial market, bond, stock, financial intermediary, mutual fund, national saving, private/public saving, budget surplus/deficit, market for loanable funds, crowding out, vicious/virtuous circle, government net debt.

Chapter Take-Aways

• Financial institutions efficiently allocate scarce resources across time & agents.
• National saving is the well-spring of investment; policies altering saving or investment incentives manifest through the loanable-funds market.
• Persistent deficits can jeopardise growth via higher interest rates and crowded-out capital formation; sustained surpluses can generate the opposite virtuous dynamic.
• Sound regulation and transparency are pre-conditions for the financial system to function as an effective intermediary—crises underscore this necessity.