Chapter 7 Finance, Saving, and Investment

Financial Markets and Financial Institutions

• Finance studies how households and firms obtain and use financial resources, managing associated risks.
• Money studies usage, holding, bank creation/management, and the influence of quantity on the economy.
• Physical capital includes tools, instruments, machines, and buildings used to produce goods and services.
• Financial capital refers to the funds firms use to acquire physical capital.
• Gross investment is the total expenditure on new capital and replacement of depreciated capital.
• Depreciation is the reduction in capital quantity due to wear, tear, and obsolescence.
• Net investment represents the change in capital quantity, calculated as gross investment minus depreciation.
• Wealth is the total value of possessions owned by people.
• Saving is the portion of income not used for taxes or consumption, therefore increases wealth.
• Wealth is increased by capital gains (asset value increase) and decreased by capital losses (asset value decrease).
• Financial capital markets: Financial Capital, bonds and stock.
• Financial institutions operate on both sides of financial capital markets, acting as borrowers and lenders.
• Key financial institutions include banks, trust and loan companies, credit unions, mutual funds, pension funds, and insurance companies.
• A financial institution's net worth is the difference between the market value of its loans and its borrowings.
• It is solvent with positive net worth, but is insolvent with negative net worth.
• The interest rate on an asset is the interest received expressed as a percentage of the asset's price.
• Funds that finance investment come from household saving (S), government budget surplus (T – G), and borrowing from the rest of the world (M – X).
• The nominal interest rate is the percentage of dollars a borrower pays and a lender receives annually on a loan.
• With a $500 loan at $25 annual interest, the nominal interest rate is 5 percent a year.
• The real interest rate is the nominal interest rate adjusted for inflation's effect on buying power.
• It's approximately the nominal interest rate minus the inflation rate and represents the opportunity cost of borrowing.
• If the nominal interest rate is 5% and inflation is 2%, the real interest rate is 3% per year.

The Loanable Funds Market

• The market for loanable funds aggregates all individual financial markets to determine the real interest rate, funds loaned, saving, and investment.
• The quantity of loanable funds demanded depends on the real interest rate and expected profit.
• The demand for loanable funds represents the relationship between the quantity demanded and the real interest rate, influenced mainly by business investment.
• A rise in the real interest diminishes quantity of loanable funds demanded.
• A fall in the real interest rate grows the quantity of loanable funds demanded.
• With changes in expected profit, the demand also shifts.
• Greater expected profit from new capital leads to increased investment and demand.
• The quantity of loanable funds supplied depends on the real interest rate, disposable income, expected income, wealth, and default risk.
• An increase in disposable income, decrease in expected future income, wealth, or default risk increases saving, therefore boosting funds supply.
• The supply of loanable funds represents the relationship between the quantity supplied and the real interest rate, influenced primarily by saving.
• Loanable funds market equilibrium occurs at the real interest rate where quantity demanded equals quantity supplied.
• Financial markets is volatile in the short term but stable mostly long term.
• Volatility arises from fluctuations in loanable funds demand and supply, leading to interest rate and equilibrium quantity variations.
• Expected profit increase leads to increased demand, a rise in the real interest rate, and an increase in saving and funds supplied.
• An increase in funds supply results from changes in saving plans, the real rate falls, and investment rises.

Government in the Loanable Funds Market

• Government involvement occurs via budget surpluses or deficits.
• Budget surpluses increase funds supply whereas budget deficits increase demand.
• A government budget surplus increases the funds supply, decreasing the real interest rate and encouraging investment, but reduces private saving.
• A government budget deficit increases the funds demand, increasing the real interest rate, and decreasing investment, but increases private saving.
• The Ricardo-Barro effect suggests budget deficits increase funds demand while rational taxpayers increase savings, which increases funds supply.
• With the Ricardo-Barro effect, crowding-out(less investment due to budget deficit) is avoided and the deficit is financed by increased saving.