1 Chapter 13 Saving, Investment, and the Financial System

2 Outline Coordination of savings and investment by the economy  Working of the financial system and its constitution  Develop a model of supply and demand for funds  Impact of government policies on interest rate

3 Financial System in Canada  Financial system is a group of institutions in the economy that help to match one person’s saving with another person’s investment.  It is made up of a number of financial institutions. Broadly of two types  Financial markets  Financial Intermediaries

4 Financial Markets  Financial markets are institutions through which savers can directly provide funds to borrowers  The bond market  The stock market  The bond is a certificate of indebtedness and has two important characteristics  Term of the bond (date of maturity)  Credit risk- probability of default by the borrower  Tax assessment: Interest rate on most bonds is subject to a tax

5 Financial Markets  The stock market: Stock is a claim to partial ownership of firm and issue of stock is done through sale of shares to the public  Equity finance versus debt finance  The prices at which shares trade on stock exchange are determined by the supply and demand for the stock in the company  Equity premium- bonus paid by the market to shareholders  Stock index is the average of a group of stock prices

6 Financial Intermediaries  Financial intermediaries are financial institutions through which savers ca indirectly provide funds to borrowers  Banks  Mutual funds  Banks help create a special asset (cheques against deposits) that functions as a medium of exchange

7 Financial Intermediaries  Mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds  The shareholder of the mutual fund accepts the risks and returns associated with the mutual fund  Helps small savers to diversify risk

8 Reading the Newspaper’s stock tables

9 Reading an online Quote

10 S and I in the National Income Accounts  S and I are important determinants of LR growth in GDP and standards of living of a nation  Recall: Y = C + I + G + NX  Assume a closed economy  There are two components to national saving:  Public saving  Private saving

11 S and I in the National Income Accounts  For the economy as a whole, saving must be equal to investment  The concept and calculation of Present Value

12 The Market For Loanable Funds  Financial markets co-ordinate the economy’s saving and investment in the Loanable Funds Market  Saving represents the supply of loanable funds  Investment represents demand for loanable funds  The supply and demand for loanable funds depends on the real interest rate  Equilibrium determines the real interest rate in the economy

13 Government Policy and Economy’s Saving and Investment  Policies that influence the loanable funds market:  Tax incentives and Saving  Tax incentives that encourage savings would result in lower interest rates and greater investment  Tax credits and Investment  Tax credits that encourage investment would result in higher interest rates and greater saving  Government Budget Deficits/Surpluses

14 Government Policy and Economy’s Saving and Investment  Government Budget Deficits  Impacts adversely on national saving  Government borrowing crowds out private investment  Budget deficits and vicious circle  Budget surplus and virtuous circle  Accumulation of government debt in Canada  Policies undertaken by the federal and provincial governments

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16 FEDERAL GOVT: BUDGET SURPLUS and BUDGET DEFICIT

17 PROVINCIAL GOVT: BUDGET SURPLUS and BUDGET DEFICIT

18 Savings and Investment in Canada as % of GDP