1. Module 22 Financial Sector

2. Saving, Investment, and the Financial System
Objectives:
The relationship between savings and investment spending.
The purpose of the five principal types of financial assets:
Stocks
Bonds
Loans
Real Estate
Bank Deposits
How Financial intermediaries help investors achieve diversification.

3. Key Concepts:
The savings investment identity tells us that, in a simple economy without government or foreign trade, private dollars saved must equal private dollars invested.
When the government is included, we discover that the government can also contribute to national savings if there is a budget surplus
The government can detract from national savings if there is a budget deficit.
Money can also flow into the U. S. from foreign citizens and money can flow from the U.S. into foreign economies.
This inflow or outflow affects domestic saving and investment.
If Americans save more in other nations than foreign citizens save in the U.S., there exists a negative capital inflow of money into the U.S.

4. Key Concepts:
The financial system facilitates transactions between savers and investors and provides three key roles in the process:
Reducing transaction costs (expenses of actually putting together and executing a deal)
Reducing risk (Uncertainty about future outcomes that involve financial losses or gains)
Increasing Liquidity

5. Matching Up Savings and Investment Spending
When a firm invests in physical capital (factories, shopping malls, large pieces of machinery, etc.), the firm usually pays for these big projects by borrowing.
Those funds have to come from somewhere.

6. The Savings-Investment spending Identity
Remember: the very simple circular flow diagram:
All money spent by consumers and firms end up in another person’s pocket as income (including profit)
Simple Economy – No Government, No Trade (0 imports and exports)
Total Income = Consumption (C) + Investment (I)
People can either spend (consume) or save (S) income
Total Spending = C + I

7. What if the economy isn’t so simple?
Add the government (public sector) to the private sector.
The government spends on goods and services (G) and pays transfers to some.
The government collects tax revenue = results in government spending + Transfer payments.

8. The Financial Sector
Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.
A financial asset is a paper claim that entitles the buyer to future income from the seller.

9. The Role the Financial System Plays in exchanging the assets from the seller to the buyer.
Three Tasks of a Financial System
Reducing Transaction Costs
Reducing Risk
Providing Liquidity (The ease by which an asset can be converted to cash)
Diversification:
Investing in several assets with unrelated or independent risks – allows a business owner to lower his/her total risk of loss
The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market.

10. Types of Financial Assets
Loans:
A loan is a lending agreement between an individual lender and an individual borrower.
Bonds:
The seller of a bond promises to pay a fixed sum of interest each year and to repay the principal – the value stated on the face of the bond – to the owner of the bond on a particular date.
Loan-Backed Securities:
Loan-backed securities are assets created by pooling individual loans and selling shares in that pool (a process called securitization)

11. Types of Financial Assets
Stocks:
A stock is a share in the ownership of a company.
Financial Intermediaries
An institution that transforms funds gathered from many individuals into financial assets.
The most important types of financial intermediaries are
Mutual Funds
Pension Funds
Life Insurance Companies
Banks.

12. Financial Intermediaries
Mutual Funds:
A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.
Pension Funds and Life Insurance Companies:
Pension funds are nonprofit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire.
Life insurance companies sell policies which guarantee a payment the policyholder’s beneficiaries (typically the family) when the policy holder dies.
A bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers