Transcript financial system

Saving, Investment,
and the Financial
System
Copyright © 2004 South-Western
Mod
22 &
24
The Financial System
• The financial system consists of the group of
institutions in the economy that help to match
one person’s saving with another’s investment.
• The financial system is made up of financial
institutions that coordinate the actions of savers
and borrowers.
• It moves the economy’s scarce resources from
savers to borrowers.
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The Expanded Circular-Flow
Diagram
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Why do we need to understand the
Financial Markets in Macro?
• Because in the Macro economy, growing
businesses takes financial capital to spend on
physical capital.
• Investment spending requires a source of
funding beyond a business’s financial
resources.
• Example:
• Upcoming Alibaba IPO—$15 B
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Theory behind the Savings-Investment
Identity
Recall that GDP is both total income in an
economy and total expenditure—
Remember Circular Flow!!
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Some Important Identities
• Assume a closed economy – one that does not
engage in international trade:
Total Income = Total Spending
Total Income = Consumption + Savings
Total Spending = Consumption + Investment
Consumption + Savings = Consumption + Investment
Savings = Investment
Savings is equal to Investment Spending
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Where Savings in the Macroeconomy comes from
Private Saving vs Public Saving
• Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
Private saving = (Y – T – C)
Public saving is the amount of tax revenue that the
government has left after paying for its spending.
Public saving = (T – G) The Budget Balance (BB)
So. . .
S = (Y – T – C) + (T – G)
S + BB = I
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One Other Source of Savings
Now, make the Macro Economy OPEN—to
foreign trade
In a global economy, savings can be either kept
within a country—domestically—or sent out to
other countries—abroad.
In the macro economy, this works like N(X)—
whichever inflow or outflow is bigger makes for
either a + or – number. The “net” is the Capital
Inflow
So… now we have S + BB + CI = I
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The Meaning of Saving and Investment
• In other words, the money available FOR
investment is whatever is left from Y as
savings, plus the net of the BB, plus the net of
CI.
• If people are not using all of their money to
consume or pay taxes, and if the government is
not using all of its tax money for spending, and
if CI is +, then we are left with money that
becomes the source of national savings.
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THE MARKET FOR LOANABLE
FUNDS
• Loanable funds refers to all income that is
available from entities that have chosen to save
and lend out, rather than use for their own
consumption
• The market for loanable funds is the market
in which those who want to save supply funds
and those who want to borrow to invest demand
funds.
• Financial markets coordinate the economy’s saving
and investment in the market for loanable funds.
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FINANCIAL INSTITUTIONS IN THE
U.S. ECONOMY
Financial institutions can be grouped into two different
categories:
• financial markets and financial intermediaries:
• Financial Markets: savers can directly provide funds
to borrowers.
• Stock Market
• Bond Market
• Financial Intermediaries: savers can indirectly
provide funds to borrowers.
• Banks, Credit Unions
• Mutual Funds, Pension Funds, Life Insurance
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Financial Markets and Assets:
The Stock Market
Stock represents a claim to partial ownership in a
firm and is therefore, a claim to the profits that
the firm makes.
• The sale of stock to raise money is called equity
financing. An IPO is the “Initial Public Offering”
or first sale of stock by a company to the public.
• Compared to bonds, stocks offer both higher risk
and potentially higher returns.
• The most important stock exchanges in the United
States are the NYSE, the NYSE AMEX, and
NASDAQ.
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Reading a Stock Ticker
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Financial Markets and Assets:
The Bond Market
A bond is a certificate of indebtedness that
specifies obligations of the borrower to
the holder of the bond.
IOU
In other words—an I.O.U!
Characteristics of a Bond:
• Term: The length of time until the bond matures.
• Credit Risk: The probability that the borrower will fail
to pay some of the interest or principal.
• Tax Treatment: The way in which the tax laws treat the
interest on the bond.
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Financial Intermediaries:
Mutual Funds
A mutual fund is a financial intermediary that
sells shares to the public and uses the proceeds
to buy a portfolio, of various types of stocks,
bonds, or both.
• They allow people with small amounts of money
to easily diversify.
• Other funds:
• Pension Funds
• Life Insurance
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Financial Intermediaries: Banks
• Banks
• take deposits from people who want to save and use
the deposits to make loans to people who want to
borrow.
• pay depositors interest on their deposits and charge
borrowers higher interest on their loans.
• Credit Unions
• Function as banks, but are jointly owned by the
depositors
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Tasks of Financial Institutions
• Reducing Transaction Costs
• Reducing Risks
• Providing Liquidity
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The Time Value of Money
• When you are doing investment spending to
expand business, it is important that you
understand the effect of time on cost/benefit
analysis for $$
• Want a $ today or a $ next year?
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Using Present Value
Net Present Value
Formula: PV = FV/(1+r)n
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Defining Present Value
• Let
fv = future value of $
pv = present value of $
r = real interest rate
n = # of years
• The Simple Interest Formula
pv = fv / (1 + r)n
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Sample AP Problem
If the annual interest rate is 5 percent, then the
present value of $1.00 received one year from
now is closest to
• (A) $1.50
• (B) $1.05
• (C) $1.00
• (D) $0.95
• (E) $0.05
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Time Value of Money
• Worksheet/practice
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