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Pump Primer • 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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