Download Module 22 Financial Sector

Module 22
Financial Sector
Saving, Investment, and the Financial System
• Objectives:
• The relationship between savings and investment spending.
• The purpose of the five principal types of financial assets:
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Stocks
Bonds
Loans
Real Estate
Bank Deposits
• How Financial intermediaries help investors achieve diversification.
Key Concepts:
• The savings investment identity tells us that, in a simple economy without
government or foreign trade, private dollars saved must equal private dollars
invested.
• When the government is included, we discover that the government can also
contribute to national savings if there is a budget surplus
• The government can detract from national savings if there is a budget deficit.
• Money can also flow into the U. S. from foreign citizens and money can flow
from the U.S. into foreign economies.
• This inflow or outflow affects domestic saving and investment.
• If Americans save more in other nations than foreign citizens save in the U.S.,
there exists a negative capital inflow of money into the U.S.
Key Concepts:
• The financial system facilitates transactions between savers and
investors and provides three key roles in the process:
• Reducing transaction costs (expenses of actually putting
together and executing a deal)
• Reducing risk (Uncertainty about future outcomes that involve
financial losses or gains)
• Increasing Liquidity
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.
The Savings-Investment spending Identity
• Savings = Investment
• Remember: the very simple circular flow diagram:
• All money spent by consumers and firms end up in another person’s pocket as
income (including profit)
• Simple Economy – No Government, No Trade (0 imports and exports)
• Total Income = Consumption (C) + Investment (I)
• People can either spend (consume) or save (S) income
• Total Spending = C + I
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 = results in government
spending + Transfer payments.
The Financial Sector
• 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.
The Role the Financial System Plays in exchanging
the assets from the seller to the buyer.
• Three Tasks of a Financial System
• Reducing Transaction Costs
• Reducing Risk
• Providing Liquidity (The ease by which an asset can be converted to cash)
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.
Types of Financial Assets
• Loans:
• A loan is a lending agreement between an individual lender and an individual
borrower.
• 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.
• Loan-Backed Securities:
• Loan-backed securities are assets created by pooling individual loans and selling
shares in that pool (a process called securitization)
Types of Financial Assets
• Stocks:
• A stock is a share in the ownership of a company.
• Financial Intermediaries
• 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
• Banks.
Financial Intermediaries
• 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.
• 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 the policyholder’s
beneficiaries (typically the family) when the policy holder dies.
• 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