I used to think… With a neighbor, brainstorm for a couple of minutes what you know about financial assets and financial intermediaries. What is their purpose and function in the financial system?

Savings, Investment, and the Financial System An intro to the Financial System

I. The Savings- Investment Spending Identity Savings = Investment spending A. Why this is true In an economy without interaction of government or other countries: Total income = Total Spending Total income = Consumer spending + Savings Total spending = Consumer spending + Investment spending So… Consumer spending + Savings = Consumer spending + Investment spending THEREFORE, SAVINGS = INVESTMENT SPENDING for the economy as a whole.

B. How the government and rest of the world complicate things 1. Government budget balance Surplus – the difference between tax revenue and government spending when tax revenue exceeds government spending. Deficit – the difference between tax revenue and government spending when government spending exceeds tax revenue. National savings = private savings + the budget balance (total amount of savings generated by the economy)

B. How the government and rest of the world complicate things 2. Capital inflow Savings are sometimes spent on physical capital in another country, resulting in inflows and outflows of capital Capital inflow (net effect) = total inflow of foreign funds – total outflow of domestic funds to other countries Negative capital inflow is not good for a country in the long-run because… some portion of national savings is funding investment spending in other countries.

B. How the government and rest of the world complicate things 3. The Macro view of the Savings-Investment Identity Investment spending = savings, whereas savings = national savings + capital inflow

II. The Financial System A. Financial assets versus physical assets Financial asset – a paper claim that entitles the buyer to future income from the sellers Physical asset – a claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes

II. The Financial System B. Three Tasks of the Financial System 1. Reducing transaction costs Transaction costs – expenses of negotiating and executing a deal How the financial market reduces these: Instead of dealing with the high costs of negotiating individual loans from thousands of different people, a business or household can avoid large transaction costs by involving only a single borrower and a single lender. (Ex. Getting a loan or selling bonds or stock)

B. Three Tasks of the Financial System 2. Reducing risk Risk – uncertainty about future outcomes that involve financial losses and gains How the financial market reduces this: A well-functioning financial system helps people reduce their exposure to risk by allowing others to share the risk of investment, even if that requires sharing some of the profit. The goal in combating risk is achieving diversification. Diversification – investing in several assets with unrelated, or independent, risks

B. Three Tasks of the Financial System 3. Providing Liquidity Liquidity – the ability for an asset to quickly be converted into cash without much loss of capital How the financial market provides this: There is always a danger of needing to get money back before the term of a loan is up. Investing in stocks and bonds are a partial answer to the problem of liquidity.

III. Types of Financial Assets Loans – a lending agreement between an individual lender and an individual borrower Purpose How these function Advantages/Disadvantages Loan-backed securities – assets created by pooling individual loans and selling shares in that pool (a process called securitization)

III. Types of Financial Assets Bonds – an IOU issued by the borrower (firm) Purpose How these function Advantages/Disadvantages

III. Types of Financial Assets Stocks – a share in the ownership of a company Purpose How these function Advantages/Disadvantages

III. Types of Financial Assets Bank deposits – a claim on a bank that obligates the bank to give the depositor his or her cash when demanded Purpose How these function Advantages/Disadvantages

IV. Financial Intermediaries Mutual funds – a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors Purpose How these function Advantages/Disadvantages

IV. Financial Intermediaries Pension Funds – nonprofit institutions that collect the savings of their members in order to provide retirement income to its members. Life Insurance Companies — sell policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies. Purpose How these function Advantages/Disadvantages

IV. Financial Intermediaries Banks – financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needed of borrowers. Purpose How these function Advantages/Disadvantages

Now I think… With your same neighbor, compare any misunderstandings, or new understanding you did not have before this lesson. What is the purpose and function of financial assets and financial intermediaries in the financial system?