1. Finance, Saving, and Investment
Chapter 25

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

3. 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

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

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

6. 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

7. 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
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8. 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

9. 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

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

11. 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)

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

13. 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

14. 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

15. The market for Loanable Funds
Chapter 25.2

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

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

18. 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.

19. 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.

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

21. 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

22. 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

23. 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