Finance, Saving, and Investment Chapter 25

Financial Institutions The conduit for which savings flows to finance investment in capital that ultimately causes the economy to grow. Affects all other markets

Finance vs. Money. Vs. Capital Finance: The lending and borrowing that moves funds from savers to spenders Money: the object that people use to make payments Capital: the tools, instruments, machines, buildings, inventories, and other items that have been produced in the past and that are used to produce goods and services

Types of Financial Markets 3 types of markets that provide funding for capital investments Loan Markets (Loanable Funds Markets) Bond Markets Stock Markets

Loanable Funds Market Loans from banks Consumers borrow money to buy things they want Producers borrow money to invest in capital

Bond Markets Bond: a promise to pay specified sums of money on specified dates Issued by governments and firms Traded in the bond market Ex. GM sells $100 million of railway locomotives to Union Pacific Union Pacific doesn’t want to pay for trains upfront Promises to pay $101 million in 3 months Bank purchases bond: gives GM $100 million today and Union Pacific pays bank $101 million in 3 months Treasury Bills: bonds issued by the US Treasury

Stock Markets Stock: a certificate of ownership and claim to a firm’s profits. Stock Market: a financial market in which shares in corporations’ stocks are traded Examples New York Stock Exchange London Stock Exchange Frankfurt Stock Exchange Tokyo Stock Exchange Hong Kong Stock Exchange Start Class Here

Financial Institutions Financial Institution: a firm that operates on both sides of the markets for financial capital: It borrows in one market and lends in another. Key financial institutions Investment banks Commercial banks Government-sponsored mortgage lenders Pension funds Insurance companies

Investment Banks Firms that help 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 Examples Goldman Sachs Lehman Brothers (shutdown) Merrill Lynch Morgan Stanley

Commercial Banks Banks that consumers use Examples Wells Fargo Bank of America HSBC Bank of China Capital One PNC Bank Citi Bank JP Morgan

Government-Sponsored Mortgage Lenders Buy mortgages from banks, package them into mortgage-backed securities, and sell them Examples Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac)

Pension Funds Financial institutions that use the pension contributions of firms and workers to buy bonds and stocks

Insurance Companies Enter into agreements with households and firms to provide compensation in the event of accident, theft, fire, ill-health, and a host of other misfortunes

Financial Assets Stocks, bonds, short-term securities, and loans Interest Rate: a percentage of the price of the asset, paid to the lender, in exchange for lending money Inverse relationship between asset price and interest rate Look at example from book

The market for Loanable Funds Chapter 25.2

Uses for Loanable Funds Business Investment Government Budget Deficit International Investment or Lending

Sources of Loanable Funds Private Savings (main source) Government Budget Surplus International Borrowing

Real Interest Rate The opportunity cost of the funds used to finance the purchase of capital Used by firms to compare the interest rate with the rate of profit Only borrow money when profit rate > real interest rate Ex. If you expect borrowing money to invest in capital will increase profits by 3%, but your real interest rate is 5%, then it doesn’t make sense to borrow.

Demand and Supply of Loanable Funds Demand for Loanable Funds: the relationship between the quantity of loanable funds demanded and the real interest rate Businesses demand loanable funds to expand their businesses. Consumers demand loanable funds to purchase expensive goods like houses and cars. Supply of Loanable Funds: the relationship between the quantity of loanable funds supplied and the real interest rate Consumers supply loanable funds by putting their money into savings.

Market for Loanable Funds Market Equilibrium Market for Loanable Funds SLF Real Interest Rate (r%) r DLF QLF Loanable Funds (LF)

Shifters Demand Supply Disposable Income Wealth Expected Future Income Expected Profit When high, D increases (shifts right) When low, D decreases (shifts left) Causes of Increased Expected Profit Rises with expansion, falls with recession Rises with technological change and innovation Growing population Public opinion (optimistic or pessimistic about future) Animal Spirits Bull: expansion Bear: contraction Disposable Income When high, savings is higher, increasing S Wealth When high, savings is lower, decreasing S Expected Future Income The higher the expected future income, the smaller the savings today Default Risk The higher the risk a person will default on a loan, the higher the interest rate, the lower the supply

Analyzing the Effects of Changes to the Mkt for Loanable Funds What is the impact of Market for Loanable Funds SLF Real Interest Rate r DLF QLF Loanable Funds

Impact of Changing Interest Rates on Economic Growth Crowding Out: When real interest rates increase, people and firms borrow less, slowing the rate of economic growth Remember, economic growth stems from sustained increases to GDP. GDP = C + I + G + NX When I decreases, GDP decreases, slowing economic growth When real interest rates decrease, people and firms borrow more, increasing the rate of economic growth