Download part 3: decision-makers in the financial system

PART 3: DECISION-MAKERS IN THE
FINANCIAL SYSTEM
CHAPTER 9: Decision-Makers: Introduction
FOCUS OF THE CHAPTER
This chapter presents a brief introduction to the system of national accounts. Particular
attention is paid to the major sectors of the economy and their income-expenditure
statements and balance sheets. The connection between the flow of funds and the
national balance sheet accounts are described. Some limitations of the national balance
sheet accounts are also presented.
Learning Objectives:




Identify the main sectors in the Canadian economy
Describe how the system of national accounts is constructed
Determine how the flow of funds is evaluated and what it measures
Identify some of the limitations of the national balance sheet
SECTION SUMMARIES
Some Basic National Income Accounting Principles
For analytical purposes, the economy is divided into four major sectors: 1) households;
2) businesses; 3) government; and 4) the foreign sector. The household sector includes
persons and unincorporated businesses. The business sector includes both non-financial
private corporations, and financial corporations. The financial corporations are
subdivided into i) banks and near banks, ii) insurance companies and pension funds, and
iii) other private financial institutions. The government sector includes federal,
provincial, and municipal governments. The foreign sector is often referred to as the rest
of the world or the external sector. These sectors generate surpluses or deficits as the
difference between their current receipts (CR) and current expenditures (CE)
(i.e., CR - CE = surplus or deficit). Deficits generate a need for borrowing, while
surpluses generate funds for lending in the financial system.
For each of these sectors, income-expenditure statements, which show incomes
(or revenues) and expenditures during a given period of time, and balance sheets, which
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show assets and liabilities at a point in time, can be prepared. While the government
sector records indicate only financial assets and liabilities, the other sectors record both
real assets (physical or non-financial assets such as buildings, machinery, etc.) and
financial assets (such as bank deposits and loans given), as well as liabilities. The
difference between the value of assets (A) and liabilities (L) is net worth (NW):
A - L = NW
Surpluses and deficits are additions or subtractions to net worth. The values of assets,
liabilities, and net worth recorded in a balance sheet at a particular point in time are
stock measures. Flow measures which show changes in these values over time can be
calculated using successive balance sheets, as indicated below.
ΔA - ΔL = ΔNW
where Δ indicates change.
ΔA = At - At-1
ΔL = Lt - Lt-1
ΔNW = NWt - NWt-1
where the subscript t denotes current period and t-1 the previous period.
The Financial System in the Flow of Funds
The changes in assets and liabilities during a given period of time are the flows of funds.
The assets (A) consist of both financial assets (FA) and non-financial assets (NFA):
A = FA + NFA
This implies that ΔA = ΔFA + ΔNFA. Therefore, the change in net worth can be given
by:
ΔNW = ΔFA + ΔNFA - ΔL
The financial assets (FA) consist of money (M) and other financial assets (OFA) such as
bonds, and, therefore
ΔFA = ΔM + ΔOFA
ΔNW = ΔM + ΔOFA + ΔNFA – ΔL
Now consider ΔOFA for the four sectors. They represent sources of funds or
funds available for lending in the financial system. Changes in liabilities (ΔL) for the four
sectors represent the uses of funds or borrowing in the financial system.
A particular sector of the economy may be a net borrower or a net lender in the
financial system during the given period. However, the changes in financial assets have
to be equal to the changes in financial liabilities. The financial sector (financial markets
and intermediaries) makes possible the required movement in capital (funds) between
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lenders (savers) and borrowers ( investors) in the financial system. The financial sector
plays an important role in channelling savings into investments, so that total savings
equals total investments.
Limitations of the Data
The private sector (households, businesses, financial, and foreign sectors) accounts for
much of the change in other financial assets, which include stocks and bonds. The
smallest changes in other financial assets occur during periods of recession. Most
changes in liabilities are incurred by the business and financial sectors.
Real assets appear only on the balance sheet of the holder (owner). Financial
assets are assets to the holders, but liabilities to the issuers, and therefore appear in the
balance sheets of both the holders and issuers.
Households accumulate much of the economy’s net worth and are thus the
principal lenders of the economy.
It is important to know the following limitations of the national income
accounts— the information contained in income expenditure statements and balance
sheets:
1) Government budget statistics do not distinguish between spending on assets
and current spending.
2) Financial institutions and most businesses report historical values, not market
values, for their assets.
3) The income expenditure statements and balance sheets indicate nominal values
(current dollar values), not real values (constant dollar values).
4) The data can inform us only about the historical experience, and this may or
may not be a good guide to the future.
MULTIPLE-CHOICE QUESTIONS
1. According to the system of national accounts, the major sectors of the economy are
a) monetary, consumption, investment, and foreign sectors.
b) households, business, the federal government, and foreign sectors.
c) households, business, financial, and foreign sectors.
d) governments, households, businesses, and foreign sectors.
2. According to the system of national accounts, unincorporated businesses
a) are included in the business sector.
b) are included in the household sector.
c) are included in the rest of the world sector.
d) are not included in any sector.
3. The balance sheet is a record of
a) revenues and investments of a business during a given year.
b) the values of assets, liabilities, and net worth at a given point in time.
c) international transactions in a given year, and is also called balance payment.
d) borrowing and lending through the financial system.
4. In the balance sheet for the federal government
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a) both financial and non-financial assets, liabilities, and net worth are recorded.
b) only non-financial assets, liabilities, and net worth are recorded.
c) only financial assets, liabilities, and net worth are recorded.
d) only assets and net worth are recorded.
5. The net worth of a given sector
a) is the difference between total revenue and total expenditure.
b) is the difference between financial assets and liabilities.
c) is the net savings of the sector.
d) is the difference between total assets and total liabilities.
6. Changes in assets and liabilities between two periods
a) are flow measures.
b) are stock measures.
c) are neither stock measures nor flow measures.
d) are always equal to each other for any given year.
7. The flow of funds
a) refers to leakages and injections into the economy.
b) refers to changes in assets and liabilities of the major sectors of the economy.
c) refers to the circular flow of incomes.
d) refers to the country’s balance of payments.
8. Increases in liability holdings represent
a) the sources of funds.
b) the uses of funds.
c) both the uses and sources of funds.
d) neither the sources nor the uses of funds.
9. During a given year, the financial assets of the business sector increased by 200
million dollars, while non-financial assets decreased by 50 million dollars. If the net
worth of the sector remained the same, what is the change in liabilities?
a) an increase of 150 million dollars
b) a decrease of 150 million dollars
c) an increase of 250 million dollars
d) no change in the liabilities
10. The principal lenders in the economy are
a) businesses.
b) governments.
c) foreign governments.
d) households.
PROBLEMS
1. Explain how the following sectors generate surpluses (or savings) that can add to the
flow of funds in the financial system?
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a) households
b) businesses
c) government
d) the foreign sector
2. What is the difference between a stock variable and a flow variable? Is there any link
between stock variables and flow variables?
ANSWER SECTION
Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
d
b
c
c
d
a
b
b
a
d
(see page 167)
(see page 167)
(see page 168)
(see page 169)
(see page 169)
(see page 169)
(see page 170)
(see page 170)
(see page 170)
(see page 172)
Answers to problems:
1. The surplus of any sectors is the difference between its current receipts (CR) and
current expenditures (CE) (i.e., CR - CE = surplus). A negative surplus implies a deficit.
a) household: disposable income minus Consumption Expenditure equals household
saving (surplus).
b) businesses: undistributed (retained) profits plus capital consumption allowances
account for the surplus in gross terms (i.e., gross business saving).
c) government: total revenue minus current expenditure (government consumption)
equals government surplus.
d) foreign sector: capital inflows minus capital outflows equals foreign sector surplus
(i.e., net capital inflow).
2. A variable whose value is measured at a point in time is a stock variable and a variable
whose value is measured over time is a flow variable. For example, the level of assets (A)
and the level of liabilities (L) that measure the value of assets and liabilities at the end of
a given year are stock variables. The change in the level of assets (ΔA) and the change in
the level of liabilities (ΔL) over a given year (say, between the end of a given year and
the end of the following year) are flow variables.
Yes, the link between stock variables and flow variables is that changes in flow
variables lead to changes in stock variables. For instance, the level of assets in the current
period (At) is the sum of the level of assets in the past period (At-1 ) and the change in the
level of assets in the current period (ΔA t): At-1 + ΔA t = At. Therefore, an increase in ΔA t
leads to an increase in At.
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