Module Saving, Investment, and the Financial System by VWycS7P

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• List the four types of
  financial assets.
Module 22
Saving,
Investment, and
the Financial System
         KRUGMAN'S
    MACROECONOMICS for AP*
     Margaret Ray and David Anderson
What you will learn
in this Module:

• The relationship between savings and
  investment spending

• The purpose of the four principal types of
  financial assets: stocks, bonds, loans and
  bank deposits

• How financial intermediaries help
  investors achieve diversification
Biblical Integration

• The parable of the talents is a good
  passage indicating the priority of putting
  to good use the resources that God has
  entrusted to us. (Matt 25:14-30)

• Stewardship requires that we balance the
  marginal benefit of an investment
  strategy against the marginal cost (risk of
  loss) and make our decisions
  accordingly.
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.
Matching up Savings and
Investment Spending

• A. The Savings– Investment Spending
  Identity

  • (Note: Savings equals Investment. S=I)

  • This is known as the savings–
    investment spending identity.
The Savings-Investment Spending Identity

     We start with the simplest of economies, but it still
      holds when we bring in the public and foreign
      sectors.

     Simple economy: no government, no trade (zero
      imports and exports).

     Remember the very simple circular flow diagram.
     All money spent by consumers and firms ends up
     in another person’s pocket as income (including
     profit).
              Total income = Total spending = C + I
The Savings-Investment Spending Identity




      Now, what do people do with income? They
       either spend it on consumption (C) or save it
       (S).

      Total income = C + S = Total Spending = C + I

          C+S=C+I         Or   S=I
The Savings-Investment Spending Identity




     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 to pay for these things.
The Savings-Investment Spending Identity


     If the government budget is balanced: (What a
     concept!)

     Tax revenue = government spending + transfer
     payments

     Rearrange this equation and call it Budget
     Balance (BB)
The Savings-Investment Spending Identity



     Budget Balance = Tax Revenue – G – transfers

     If BB >0, the government has a budget surplus
     and is actually saving money.

     If BB<0, the government has a budget deficit and
     is borrowing money (dissaving).
The Savings-Investment Spending Identity

     We can now include public sector savings to the
     savings-investment identity.
     S + BB: simply total national savings.

                      S + BB = I

     • If BB>0 on the left side (a surplus), I must
       increase on the right side.

     • If BB<0 on the left side (a deficit), I must
       decrease on the right side.
The Savings-Investment Spending Identity



      Final level of complexity.
      Add the foreign sector.

      An American can save her money in the U.S. or
      in another nation.

      A foreign citizen can save his money in his home
      country, or in the U.S.
The Savings-Investment Spending Identity




     So, the U.S. receives inflows of funds—foreign
     savings that finance investment spending in the
     US.

     The U.S. also generates outflows of funds—
     domestic savings that finance investment
     spending in another country.
The Savings-Investment Spending Identity


    Let’s define:

    Capital inflow into the U.S. = total inflow of foreign
     funds - total outflow of domestic funds to other
     countries.

    Capital inflow (CI) can be positive or negative so it
     can increase or decrease the total funds available
     for investment in the U.S. economy.
The Savings-Investment Spending Identity


                 S + BB + CI = I

     • If CI > 0 on the left side (more foreign funds
       coming into the U.S., than U.S. funds going out),
       I must increase on the right side.

     • If CI < 0 on the left side (fewer foreign funds
       coming into the U.S., than U.S. funds going out),
       I must decrease on the right side.
The Financial System

• 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.

• There are four types of financial assets.

• Before we get into those specific assets, we look at the
  role the financial system plays in exchanging the assets
  from the seller to the buyer.
Three Tasks of a Financial System


    1. Reducing Transaction Costs
       Suppose a consumer wanted to buy a loaf of
       bread, a pound of apples, and a dozen eggs.
       One way to do this is to drive to the bakery, then
       drive to the orchard, and then drive to the farm.
       It is surely more convenient, and less costly, to
       buy from a firm that specializes in providing
       these items: the supermarket.
Three Tasks of a Financial System

     Suppose a firm wanted to borrow some money to
     build a factory. One way to borrow would be to go
     to Mr. Jones for a loan, Ms. Sanchez for another
     loan, the Johnson family for another… Or the firm
     could find a firm that specializes in providing
     these funds: a bank.

     The bank, and other financial services
     companies, is able to make it easier, and less
     costly, for firms to engage in financial transactions
     like borrowing to make investments.
Three Tasks of a Financial System

     2. Reducing Risk
        The future is uncertain so investments, like building a
        factory, have a risk that they will not be profitable.

        The owner of a firm may want to build the factory,
        but using his/her own money is risky because the
        factory might not be profitable. The owner could
        raise the money by selling shares of stock in the
        company. When a person buys a share of stock in a
        company, it gives that person a small stake in the
        ownership of the company. The primary owner of the
        business can pay for the factory, but does not need
        to risk his/her own money if the factory should fail to
        generate profits.
Three Tasks of a Financial System


     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.
Three Tasks of a Financial System

     3. Providing Liquidity
         Liquidity refers to the ease by which an asset can be
         converted to cash.
         A vintage Rolls Royce is a valuable asset, but isn’t very
         liquid.
         A savings account is very liquid.

        If a firm needs money to build a factory, that investment in a
        physical asset will not provide a stream of cash revenue for a
        long time. Until the factory begins to produce goods that
        generate revenue, the firm may need liquidity (cash) to
        purchase raw materials, hire some workers and pay the
        electric bill. The financial system can provide liquidity in a
        variety of ways: by issuing loans, bonds, or stocks.
Types of Financial Assets

     1. Loans - A loan is a lending agreement between an individual
       lender and an individual borrower.

     2. 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.

     3. Loan-backed Securities - Loan-backed securities are
       assets created by pooling individual loans and selling shares
       in that pool (a process called securitization).

     4. Stocks - A stock is a share in the ownership of a company.
Financial Intermediaries

     A financial intermediary is 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, and
     banks.
Financial Intermediaries

    1. 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.


    2. 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 to the policyholder’s beneficiaries (typically, the
       family) when the policyholder dies.
Financial Intermediaries


    3. Banks
      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.

								
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