chap7 - Econ. 1A. Chapter 7. Finance, Saving and Saving...

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Unformatted text preview: Econ. 1A. Chapter 7. Finance, Saving and Saving Financial Institutions and Financial Markets 1. Financial institutions and markets play a crucial role in the economy, because they provide the channels through which saving (S) flow to finance the investment in new capital that make the economy grow. 2. To study the economics of financial institutions and markets, we first distinguish between (a) Finance and Money; and (b) Physical capital and Financial capital. ***** 3. Finance describes the activity of providing the funds that finance expenditure on capital (K). The study of finance focuses at how households and firms obtain and use financial resources and how they cope with the risks that arise in this activity. 4. Money is what we use to pay for goods and services and factors of production and to make financial transactions. The study of money focuses at how households and firms use it, and much of it they hold, how banks create and manage it, how its quantity influences the economy. *****_ 5. Physical capital (K) is the tools, instruments, machines, building, and other items that have been produced in the past and that are used today to produce goods and services. 6. Financial capital is the funds that firms or households use to buy physical capital. Note that (1) economists use the term “capital”, they mean “physical capital”; and (2) KT—> YT & wT, LT ——> Y/LT, i.e., the standard ofliving rises. ** * ** ' 7. There are two important concepts in macroeconomics: (i) a flow is a quantity per unit of time and (ii) a stock is a quantity that exists at a given point of time. 8. There are two important macroeconomic stocks: (i) capital (K) and (ii) wealth (A). 9. Two flows change the stock of capital: (i) net investment (I) and (ii) depreciation. (a) Gross investment is the total amount spent on adding to the stock of capital (net investment) and on replacing depreciated capital. (b) Depreciation is the decrease in the value of capital from wear & tear. (c) Net investment (I) is the amount by which the value of capital increase. That is net investment (I) = gross investment — depreciation. Note that AK = I. 10. Wealth (A) is the stock of things held by people that yields or has potential for yielding income. Income (Y) is the amount that people receive during a given time period from supplying the services of resources. People’s income (flow) is dependent upon the wealth (stock) that they own. 11. Savings (S) is the amount of income that is not paid in taxes or spent on consumption goods and services. It adds to wealth, i.e., AA = S. 12. To make Y grow, saving (S) and wealth (A) must be transformed into investment (I) and capital (K). This transformation takes place in (l) the markets for financial capital and through (2) the activities of financial of institutions. 13. Financial markets: The collection of households, firms, governments, banks, and other financial institutions that lend and borrow financial funds. Saving (S) is the sources of the funds that are used to finance investment (I) and these funds are supplied and demanded in three types of financial markets. (1) Loan markets Loans are commitments of fixed amount of money for agree—upon periods of time. Loans are borrowing ofa sum of money by one person, firm, government or other organization from another. (a) Businesses want short—terrn loans from a bank to buy equipments or to extend credit to the customers. (b) Households want loans from a bank to purchase big ticket items, such as auto, household furnishings and appliances. Most of them also get a loan that is secured by a mortgage (a legal contract that gives ownership of a home to the lender in the event that the borrowrar fails to meet the agreed loan payment: repayment + interest). (2) Stock market: A financial market in which shares of companies’ stock are traded. A stock is a certificate of ownership and claim to the profits that a firm makes. (3) Bond market: A financial market in which bonds issued by firms and governments are traded. (Bond is a promise to pay specified sums of money on specified dates; it is a debt for issuer.) A bond is a promise to make specified payments on specified dates. For example, you buy a Wal-Mart 10 year bond with face value $100 and interest rate i z 6.5% in 1/1/99. Wal-Mart promises to pay $6.5 in 12/31 each year and makes a final payment $100 + $6.45 in 12/31/08. Note that the buyer of a bond issued by company or government (federal, state, municipal) makes a loan to the company or government and is entitled to the payment promised by the bond. ******** Types of bonds: (1) Corporation bonds; (2) Treasury bonds; (3) State bonds; (4) Municipal bonds; (4) a mortgage—backed security (which entitles its to the income from a package of mortgages). *********' 14. A financial institution is a firm that operates on both sides of the financial markets for financial capital (funds). It is a borrower on one market and a lender in another. The objective of a financial institution is to make the maximum profits. There are five types of financial institutions. . (1) Investment banks: Investment banks are firms that help company, other financial institutions and governments raise funds by issuing and selling bonds and stocks as well as providing advice on transactions such as mergers and acquisitions. Before summer 2008, five big Wall Street investment firms, Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley provided investment ban services. (2) Commercial Banks: The bank, like BoA, Well—Fargo, City Bank, Chase, that we use for our own banking services (we deposit the cash into or withdraw the cash from checking or saving account). The bank also issues our credit card. (3) Government-Sponsored Mortgage Lenders: Two large financial institutions, the Federal National Mortgage Association (Fannie Mac), and the Federal Home Loan Mortgage Corporation (Freddie Mac), were government—sponsored enterprises that bought mortgage from banks, packaged them into mortgage-backed securities and sold king them to the investors. On Sept 7, 2008, they were taken over by the federal government. (4) Pension Funds: Pension fiinds use the pension contributions of firms and workers to buy bonds, stocks and mortgage-backed securities. (5) Insurance Companies: Insurance companies provide risk—sharing services. Insurance companies use the funds they received but not paid out as claims to buy bonds and other financial assets. *****I 15. A financial institution may face (a) insolvency, and (b) illiquidity problems. (a) Insolvency: a financial institution’s net worth = (the total market value of what it has lent) e (the total market value of what it has borrowed). If net worth > 0 (0), the institution is solvent (insolvent). If the institution will go out of business and stockholders bear the loss. (b) Illiquidity: An institution makes long-term loans with borrows short—term funds. It will face “illiquidity” if a sudden demand to repay more of what it has borrowed than its available cash. Note that “insolvency” and “illiquidity” were at the core of the financial meltdown of 2007—2008. 16. Interest rate (i) and asset prices. (a) The interest rate (i) on a financial asset (stock, bond, short—term security and loan) is the interest received expressed as a percentage of the price of the asset. For example, in Oct 2008, the price of Microsoft share was $26 and each share entitled its owner to $0.48. Thus, the interest rate of Microsoft stock = (0.48/26)x100% = 1.85%. (b) The relationship between an asset price and the interest rate (i) is negative. That is, if the asset price rises (falls), other things remaining the same, the interest rate falls (rises). For example, if the price of Microsoft stock increased to $30 and each share still entitled its owner $0.48, the interest rate = (0.48/30)x100% = 1.6%. The Market for Loanable Funds In Macroeconomics, we group all the financial market into a single market for loanable funds. The loanable funds are money which is available for lending to households, firms government and institutions. " FIGURE 7.2 Financial Flows and the Circular Flow of Expenditure and Income K Households use their Income Housmows r ,_ n 1, For consumption expenditure ' [C], savmg E5], and net taxes {T}. Firms borrow to finance their Investment expenditure. Governments barrow to finance a budget deficit or repay debt it they have a budget surplus. The rest of the world barrows to Finance its deficit or lends JIS surplus. 17. The flows of loanable funds come from three sources: (1) household saving; (2) government budget surplus; (3) borrowing from the rest of the world. This can be seen from the national account. Recall in chapter 4, the aggregate expenditure = aggregate income, i.e., (a) Y=C+I+G+(X—M) Households income, Y, is spent on consumption (C), saving (S) and net taxes (T), i.e., (b) Y=C+S+T—>C=Y‘S-T where T = taxes paid to government 7 the cash transfer received from governments (such as social security and unemployment benefits). Substituting C = Y — S a T into (a), we obtain (c) I=S+(T—G)+(M—X) where Households saving: S Government budget surplus (deficit): (T e G) > (<) 0 Trade deficit (surplus): (M — X) > (<) 0 18. S + (T — G) = private saving + government saving = national saving. National saving + borrowing from the rest of the world = S + (T — G) + (M — X) = the flow of funds that finance investment (I). ***** Example: 2008, in US, I = 2063billion. This comes from the following flow of funds. S = 2,045 billion, (T r G) = — 707 billion, and (M k X) = 718 billion. The flow of funds that finance the investment (I) = 2,045 i 707 + 718 = 2063. *$*** Economic Model: Loanable Funds Market 19. Demand for loanable funds (DLF): The negative relationship between the quantity of loanable funds demanded (Q1) and the real interest rate ( r) when other things remaining the same during a given time period. Qd : Qd(r; the expected rate of profit, technology). (a) A change in the real interest rate (r), other things remaining the same, there is a movement along DLF curve. (1)) An increase (decrease) in the expected rate of profit or technology shifts DLF rightward (leftward). *******I Nominal interest rate (i) is the number of dollar that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed or lent. For example, if we deposit $100 in a saving account in 1/1/08, with i = 10%, we will have, interest ($100x0.1 : $10) + deposit ($100) = $110, in our account in 12/31/08. Real interest rate (r) is the nominal interest rate (i) adjusted to remove the effects of inflation on the buying power of money. Suppose that from 1/1/08 to 12/31/08 the inflation rate is II = 10%. We need $110 to buy what a year earlier cost $100. 80 r = i —71:= 10%- 10%:0. ****** 20. Supply of loanable funds (SLF): The positive relationship between the quantity of loanable funds supplied (Q5) and the real interest rate ( r) when other things remaining the same during a given time period. S I S(r; Yd, eprd, A, default risk). where Yd : disposable income 2 Y — net taxes, A = wealth, exp Yd 2 expected future disposable income. (a) A change in r, other things remaining the same, there is a movement along SLF curve. (b) An increase in disposable income (YdT), a decrease in wealth (At) or a decrease in expected future disposable income (eprdl) or a decrease in default risk will increase SLF and shift SLF rightward —>an increase in SLF. (c) A decrease in disposable income (Ydi), an increase in wealth (AT) or an increase in expected future disposable income (eprdT) or an increase in default risk will decrease SLF and shift SLF leftward —> a decrease in SLF. 21. Equilibrium in the market for loanable funds Assumptions (1) Other influences remain the same DLF: expected rate of profit, technology. SLF: Yd, A, Eprd, default risk (2) Given a time period. (3) The laws of DLF and SLF apply. Table l' d . (% per year) (trillions of 2000$) 1 0 8 12 8 9 1 1 6 10 10 4 1 1 9 ' 2 1 2' 8 o 8 Saflngqand imelsznleflt (11::llons of Loauable funds market Equilibrium is a situation where Qd = Q3, i.e., the intersection ofDLF and SLF. (a) equilibrium real interest rate: r = 6 where Qd = Q5 = 10. (b) equilibrium quantity of Ioanable funds: Qd : QS = 10. 22. Changes in Demand and Supply (1) An increase in demand {F FIGURE 7'6 Demand Cause: DLFT ' i E i ‘ MGM”: savmg i '1' _‘——-‘ i a E a; -&El 2 g E Rn incremle in Ilia g ldsmond for loanublal r fund: mm: the real i } imam! min and SLF 3. Effect: rT, OT. 3 7 DEF‘ / 5 DH: t ' l— o to 1.5 2.0 2.5 3 c 3 5 Launuble lung‘s millium at 2000 dollars] ‘ [a] An incum- in demand (2) An increase in supply Cause: SLFT Effect: r1, QT. 23. Application: Government in the loanable funds marker (1) a government budget surplus Cause: T — G > 0 —-> government savingI—>SLFT Effect: r1 and QT. (2) a government budget deficit Cause: T — G < 0 —> government demand for loanable fundsT—> it adds to the private demand for loanable funds (PDLF) —>DLFT. Effect: rT, QT but private investment 1 (an up movement along PDLF due to rT). ****** The crowding— out effect: The tendency for a government budget deficit to raise real interest and decrease investment. ****** (3) The Ricardo-Barre effect Cause: (a) T — G > 0 ~—> DLFT (b) People see a budget deficit today mean that future tax will be higher and future income will be lower, with smaller expected future disposable ' income —+ people will save more today —> SLFT. Effect: Since DLFT = SLFT, r—r, QT but private investment remains the same. 5 gm. supply 2‘ E |ullocmnhla fundslmrs 3 . the ma] mtlnur ram and E increase: investment j 5”: U , E i 51;. j ? E . | g ,3 . . . ......... .. i ll 0‘ 5 i i . . . . . . . . . . . .. “ l DLF / / I ' :4 J._._ 0 l1) l .5 2 O 2 5 3 O 15 mnnnble Funds Ilriiiium ol 2000 dollars) (b) An inmau in lupupr '“ HGURE 7.7 AGovernment i Budget Surplus lGovummnI budge! surpiu: muse-am: 5 L m mppi, 9f Ioonahll funds IPle 7 HF Raul interesr rule Epercem per year] I ‘ Jaw-rah: ' fecllll'ulfili l m _ J bl _s.. .... .. A i Dir ‘ ducraum .. mtreunal , anew , gluing u o 10 1.5 20 2.5 3.0 a? bananas funds who.“ as 2000 dollars] 5— FIGURE 7.8 A Government Budget Deficit Edit-9mm“? budge! dnficlt e l- iinzreasu the demand For qunnble funds . . 5;} “Jul”: I'm - I 1 mui "mm! . a '- 13»... i Real Inlalesl [0'5 [purcenl par yeul] DLF . i "—1 ; Z...undcruwc'sl' 3 Emu investment “ = ‘ n ~—u = . DiF ; y i a l . i . 4559-1 . a 0 LG I S 2.0 2.5 3 0 3.5 I Lnunanla funds (trillion: 9F 2000 deviant 7 FIGURE 7.9 The Ricardo-Burro Effect ! i i Gov-"Imam deficn l [Roliunal taxpayers—i i, i increases the domain! for ‘ sip“ inflame savng I ‘ioonabll Fund: ‘ T Real miemr mte [percem pen year] 51.9 7 E 5 ........ . 5 r 4 i DlF , PD“: 7 .—......._j . D I .5 2 D 2.5 3.0 3.5 A G launabls funds [fliilions of 2000 u‘uiuuvsl The Global Loanable Funds Market The loanable funds market is global, not national. Lenders on the supply side of the market want to earn the highest possible real interest (r) and they will seek it by looking everywhere in the world. Borrowers on the demand side of the market want to pay the lowest possible real interest (r) and they will seek it by looking everywhere in the world. This indicates that financial capital is mobile: It move to the best advantage of lenders and borrowers. 24. International capital mobility Suppose there are two countries: Home country (H) and Foreign country (F*). r = home country’s real interest and r* = foreign country’s real interest. (1) r > r* —> financial capital will flow from F * to H. (2) r < r* —> financial capital will flow from H to F*. 25. International borrowing and lending (1) (X — M) > 0, the country is a net supplier of funds to the rest of the world and I < S + (T — G), i.e., the quantity of loanable funds is less than national saving. (2) (X e M) < 0, the rest of the world supplies funds to this country and I > S + (T i G), i.e., the quantity of loanable funds is greater than national saving. 26. Demand and Supply in the Global and National Market (a) The equiIibrium r is determined by demand for loanable funds (DLFw) [which is the sum of the demands in all countries] and supply of loanable funds (SLFW)[which is the sum of the supplies in all countries]. (b) If r1 > r, i.e., country 1’s real interest rate is greater than the equilibrium r. country 1 will be an international borrower. At r, quantity demanded for loanable funds > quantity supplied of loanable funds. (0) If r; < r, i.e., country 2’s real interest rate is less than the equilibrium r, country 2 will be an international lender. At r, quantity demanded for loanable funds < quantity supplied of loanable funds. * FIGURE 7.10 Borrowing and Lending in the Global Loonable Funds Market 7 Waridoqurllbnumr str9 mulmlefealmfl I l fvTrSrid aqurlibriuml rm lnrelgn r |rent rntemr rate Illndtrtg wtti‘ll imsrtiva riII iupom \r 7 ‘ Twain equrlihriumt stFw ‘rml intulut rate srr Reul trllalcsl rule lperuenl per year) Real Interest rate [percent per year] Real lnleresl rare [percent per year} 4 Equirigrfi 4 t 4 r Ndioreign r g own” a; i bolmwmg g or! mebb I m mh' ‘ -‘_‘-fi 3 Funds 3 w‘ m“ - Equilibrium qwnmy ,, 3/; Dlrw 1i; Meier‘an lonwnflbbmnda l f M I 01F 4' __r | - r r J__..._ l 0 W 90 15 10.0 105 ll 0 [IL—5 0 1.0 l 5 2.0 25 30 3.5 0 L QOF‘JHLfIb‘IZ‘ifM signalidlio‘hfl l loanable lurid: ltrilllnns al 2000 dollars} Luunuble Funds (billions of 2000 dollars] damn I t in" glnbul market [b] An inf-mattequ bermwer [cl An international lander I a '- i I t[cri the demand lor loanable luncis DLF and the rows irom the rest at the world The country has nega rve i rt pcrr , . . : l I ' l exports. ' , (F, determine the equrlronurn real interest rre I supply tori +erl‘r‘jlsmlglonrtubla Funds market. fire country In purl [c] has n surulus cl funds at the world I l'cl‘r'e m :9 'n part [b] has a shortage of Fund: at the equtiibrrum real interest rate and the country lend: to the a noun y r t' net ex arts world equilibrium real interest rate and the country bore rest at the world. The country has post me p ...
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chap7 - Econ. 1A. Chapter 7. Finance, Saving and Saving...

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