Download Finance , Saving, And Investment,

Finance , Saving, and
Investment,
Chapter 10
What do you mean by – Finance
• Finance is the lending and borrowing, that
moves
funds
spenders.
(money)
from
savers
to
Finance & Money – The Difference
Money is the object that people use to make •
payments.
Example
I am going to borrow some money to buy a car.
Your borrowing and someone else’s lending is a
financial transaction – Finance. You pay for the
new car – is called Money.
Role of Financial Institutions and
Markets
• financial institutions and markets provide the
channels through which saving flows to
finance investment in capital that make our
economy grow.
• When financial institutions and markets are
working well , a high level of investment
brings a rapidly growing economy and rising
standard of living
Physical Capital
• They are the tools, instruments,
machines, buildings, other items that
have been produced in the past and
that are used to produce goods and
services.
Financial Capital
• They are the funds used to buy
physical capital.
What is Gross Investment?
• The total amount spent on new
capital is called gross investment.
What is Net Investment?
The change in the quantity of capital is •
called net investment.
What is Saving?
Saving is the amount of income that •
is not paid in taxes or spent on
consumption, which in turn adds to
wealth.
What is Wealth?
Wealth: is the value of all the things •
that the people own.
Saving ,the amount of income that is •
not paid in taxes or spent on
consumption ,adds to wealth. wealth
also increases when market value of
assets rises,which is called capital
gains.
Example of Wealth:
At the end of the year, you have SR 250 in
bank and a textbook of SR 300, therefore
your wealth is SR 550.
Later you get SR 5,000 as salary in your
bank account, of which you use (spend) SR
1,000, therefore your wealth in the bank
will be SR 250 + SR 4,000 = SR 4,250.
Hence your wealth now is SR 4,250 (in
bank) + SR 300 (textbook) = SR 4,550.
Markets for Financial Capital
There are three types of financial
markets.
1. Loan Markets
2. Bond Markets
3. Stock Markets
Loan Markets
• Businesses often want short-term loans to buy
inventories or to extend credit to their
customers. Sometimes they get these funds in
the form of a loan from the bank.
• Households often want funds to purchase bigticket items, such as an automobiles or
household furnishings and appliances.
Just For Understanding:
Credit: money available for a client to borrow.
Inventories: a detail list of all items in the stock.
Loan: a sum of money or any valuable asset which an
individual or group borrows from an individual or
group, with the condition that it be returned or repaid at
a later date.
Mortgage: A mortgage is an agreement by which a loan
is granted for the purchase of a property and the
property itself is assurance as security.
Bond & Bond Markets
• Bond: A bond is a promise to make specified
payments on specified dates (maturity).
Example
You buy a Western Union bond that promises
to pay SR 6.20 every year until 2035 and then
to make a final payment of SR 100 in 2036.
• Bonds issued by firms and governments are
traded in the Bond Market.
Stock Markets
• Stock: is a certificate of ownership and claim
to the profits that a firm makes.
Example
Boeing has issued 900 million shares of its stock. If
you owned 900 Boeing shares, you would own 1
millionth of Boeing and be entitled to receive 1
millionth of its profit.
• Stock Market: is a financial market in which
shares of corporations’ stock are traded.
Financial Institutions
• A financial institution is a firm that operates on both
sides of the market for financial capital. It borrows
from one market and lends in the other.
Key Financial Institutions
1. Investment Banks
2. Commercial Banks
3. Government Sponsored Mortgage
lenders
4. Pension Funds
5. Insurance Companies
Key Financial Institutions
1. Investment Banks
Investment banks are firms that help
other financial institutions and
governments raise funds by issuing and
selling bonds and stocks. They also
assist on transactions such as mergers
and acquisitions.
Key Financial Institutions
2. Commercial Banks
The bank that you use for your own
banking services and that issue your
credit card is a Commercial Bank.
Key Financial Institutions
3. Government Sponsored Mortgage
lenders
are government sponsored enterprises
that buy mortgages from the banks,
package them into mortgage-backed
securities, and sell them.
Key Financial Institutions
4. Pension Funds
Are financial institutions that use the
pension contribution of firms and
workers to buy bonds and stocks.
Key Financial Institutions
5. Insurance Companies
Insurance companies enter into
agreements with households and firms
to provide compensation in the event of
accident, theft, fire, ill-health, and host
of other misfortunes.
Net Worth
Insolvency & Illiquidity
• The total market value of what a financial
institution has lent minus the market value
of what it has borrowed.
• Net worth: if positive, the institution is
solvent and can remain in business.
• Net worth: if negative, the institution is
insolvent and must stop trading.
Net Worth
Example
The owners of the insolvent financial
institution bear the loss when the assets are
sold in order to pay the debts.
How to limit the risk
• A financial institution borrows and
lends, so it is exposed to the risk
that the net worth becomes negative.
To limit that risk, institutions are
regulated and a minimum amount of
their lending must be backed by
their net worth.
Illiquidity
• A firm is illiquid if it has made long
term loans with borrowed funds and
it is faced with a sudden demand to
repay more of what it has borrowed,
than its available cash.
Interest Rates & Assets Prices
•
1.
2.
3.
4.
What are financial Assets?
Stocks
Bonds
Short-term securities, &
Loans
Interest Rates & Assets Prices
• The interest rate on a financial asset, is
a percentage of the price of the asset.
• If the asset price rises, other things
remain the same, the interest rate falls.
• If the asset price falls, other things
remain the same, the interest rate rises.
• (There is an inverse relationship
between an asset price and interest rate.)
Interest Rates & Assets Prices
Example 1
If the price of the share, was $25.
And the owner of each share get $0.50 cents of the profit.
Then the interest rate will =
x 100 = 2 % 0.50
25
-
Interest Rates & Assets Prices
Example 2
If the price of the share, was $50.
- And the owner of each share get $0.50
cents of the profit.
- Then the interest rate will =
0.50 x 100 = 1 %
50
The Market for Loan-able Fund
• The demand for the Loan-able funds
• The supply of the Loan-able funds
• Equilibrium in the market for Loanable funds
The Demand for Loan-able Fund
The quantity of loan-able funds •
demanded is the total quantity of
funds demanded to financial
investment, the government budget
deficit, and international investment
or lending during a given period.
Factors that influence the demand
for loan-able funds:
1. The real interest rate
2. Expected Profit
• Other things remaining the same, the higher
the real interest rate, the smaller is the
quantity of loan-able funds demanded.
• The lower the interest rate, the greater is the
quantity of loan-able funds demanded.
Demand for Loan-able Funds
Curve
The demand for loan-able funds is the relationship
between the quantity of loan-able funds demanded and
the real interest rate when all other influences on
borrowing plans remain the same.
The figure (1.1) shows, the quantity of loan-able funds
demanded at five real interest rates. The graph shows
the demand for loan-able funds curve, DLF. Points A to
E correspond to the rows of the table.
Figure: 1.1
Changes in the Demand for Loan-able
Funds
When expected profit changes, the demand for loan-able
funds changes. Other things remaining the same, the
greater the profit from new capital, the greater is the
amount of investment and the greater is the demand for
loan-able funds.
Figure (1.2), shows how the demand for loan-able funds
curve shifts when the expected profit changes. With average
profit expectations, the demand for loan-able funds is DLF0.
A rise in expected profit shifts the demand curve
rightwards to DLF1 and a fall in expected profit shifts the
demand curve leftwards to DLF2.
Figure 1.2:
The Supply of Loan-able Funds
The quantity of loan-able funds
supplied is the total funds available
from private saving, the government
budget surplus, and international
borrowing during a given period.
Factors that influence the supply
for loan-able funds:
1.
2.
3.
4.
5.
The real interest rate
Disposable income
Wealth
Expected future income
Default Risk
Factors that influence the supply
for loan-able funds:
• Other things remain the same, the higher the
real interest rate, the greater is the quantity of
loan-able funds supplied.
• The lower the interest rate, the smaller is the
quantity of loan-able funds supplied.
• Figure (1.3) shows, the quantity of loan-able funds
supplied at five real interest rates. The shows, the supply
curve SLF. Points A to E correspond to the rows of the
table.
Figure 1.3:
Factors: Disposable Income
1. Disposable Income: a household’s disposable
income is the income earned minus net taxes.
Income
Earned
Net
Income
• The greater a household’s disposable income, other
things remaining the same, the greater is the saving.
Disposable Income: Example
• A student whose disposable income is $10,000 a year
spends the entire $10,000 and saves nothing.
• An economics graduate whose disposable income is
$50,000 a year spends $40,000 and saves $ 10,000.
Factors: Wealth
2. Wealth: a household’s wealth is what it owns.
• The greater a household\s wealth, other things
remaining the same, the less it will save.
• Example: Patty has $15,000 in the bank and no
debts: She decides to spend $5,000 on a
vacation and save nothing this year.
• Tony has nothing in the bank and owes $10,000
on his credit card: He decides to cut
consumption and start saving.
Factors: Expected Future Income
• The higher a household’s expected future
income, other things remaining the same, the
smaller is its saving today.
• If two households have the same current
disposable income, the household with the
larger expected future disposable income will
spend a larger portion of its current disposable
income on consumption goods and services
and so save less today.
Expected Future Income: Example
• Considering the above example of Patty &
Tony. Patty has been promoted and will
receive a $ 10,000 pay raise next year. Tony
has just been told that he will be sacked at the
end of the year.
• On receiving this news, Patty buys a new car
– increases her consumption expenditure and
cuts her saving.
• Whereas, Tony sells his car and takes the bus
– decreases his consumption expense and
increases his savings.
Factors: Default Risk
• Default Risk is the risk that a loan will not be
paid, or not repaid in full. The greater that
risk, the higher is the interest rate needed to
induce a person to lend and the smaller is the
supply of loan-able funds.
• In normal times, default risk is low but in
times of financial crisis when asset prices
tumble, default can become widespread as
financial institutions become illiquid or
insolvent.
Shifts of the Supply of Loan-able
Funds Curve
• When any of the four factors (mentioned
above) changes, the supply of loan-able funds
changes and the supply curve shifts.
• An increase in disposable income, or a
decrease in wealth, expected future income, or
default risk increases the supply of loan-able
funds.
Shifts of the Supply of Loan-able Funds
Curve
• Figure (1.4) shows, how the supply of loan-able
funds curve shifts. Initially, the supply of loan-able
funds is SLF0.
 An increases in disposable income or a decreases
in the wealth, expected future income, or default risk
increases the supply of loan-able funds and shifts
the curve rightwards from SLF0 to SLF1.
 A decrease in disposable income or an increase in the
wealth, expected future income, or default risk decreases
the supply of loan-able funds and shifts the curve leftwards
from SLF0 to SLF1.
Figure 1.4:
Equilibrium in the Market for Loanable Funds
• There is one interest rate at which the quantity
of loan-able funds demanded and supplied are
equal, and that interest rate is the equilibrium
real interest rate.
Equilibrium in the Market for Loanable Funds
• When the real interest rate exceeds 6 % a year,
the quantity of loan-able funds supplied (SLF)
exceeds the quantity demanded (DLF).
• Which means borrowers find the funds they want, but
lenders are unable to lend all the funds available.
• The real interest rate keeps falling until the quantity of
funds supplied equals the quantity of funds demanded.
Equilibrium in the Market for Loan-able
Funds
• Alternatively, when the real interest rate less
than 6 % a year, the quantity of loan-able
funds supplied (SLF) is less than the quantity
demanded (DLF).
• Which means borrowers cannot find the funds they
want, but lenders are able to lend all the funds
available.
• The real interest rate keeps rising until the quantity of
funds supplied equals the quantity of funds demanded.
Figure 1.5:shows how the demand for and supply of
loan-able funds determine the real interest rate.
Figure 1.5: Explanation
1. If real interest rate is 8 % a year, the quantity of loanable fund demanded is less than the quantity supplied.
There is surplus of funds and real interest rate falls.
2. If real interest rate is 4 % a year, the quantity of loanable fund demanded is more than the quantity supplied.
There is shortage of funds and real interest rate rises.
3. If real interest rate is 6 % a year, the quantity of loanable fund demanded equals the quantity supplied. There
is neither surplus nor shortage of funds and real
interest rate is at its equilibrium level.
Changes in Demand and Supply
• Fluctuations in either the demand or supply
of loan-able funds bring fluctuations in the
real interest rate and in the equilibrium
quantity of funds lent and borrowed. Figure
(1.6) illustrates:
1. If the demand for loan-able funds increases and the
supply remains the same, the real interest rate rises
and the equilibrium quantity of funds increases.
2. If the supply for loan-able funds increases and the
demand remains the same, the real interest rate
falls and the equilibrium quantity of funds
increases.
Figure 1.6: