Download Section 5 The Financial Sector Modules 22-29

Section 5
The Financial
Sector
Modules 22-29
AP Macro
Nancy K. Ware Instructor
Gainesville High School
Module 22
Saving,
Investment, and
the Financial System
Start Up
1. Which of the following is NOT a type of financial
asset?
A.
Bonds
B.
Stocks
C.
Bank deposits
D.
Loans
E.
Houses
Module 22 Essential Questions
1.
What is the relationship between savings and
investment spending?
2.
What is the purpose of the four principal types of
financial assets: stocks, bonds, loans and bank
deposits?
3.
How do financial intermediaries help investors
achieve diversification?
Matching up Savings and
Investment Spending
1.
What is Physical Capital?
2.
The Source of Physical
Capital is…?
Matching up Savings and
Investment Spending
1.
2.

What is Physical Capital?
The Source of Physical
Capital is…?
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
Assume a simple economy
Total Income = Total Spending
Together:
The Savings-Investment Spending Identity
Assume a simple economy
Total Income = Total Spending
Total Spending =
Consumer Spending +
Investment Spending
Total Income =
Consumer Spending &
Savings
Together:
Consumer Spending & Savings = Consumer Spending + Investment Spending
Savings = Investment Spending
The Savings-Investment Spending Identity:
An Explanation
(note page)
Assume a Simple economy: no government, no trade (zero imports and exports).
The circular flow diagram shows all money spent by consumers and firms ends up
in another person’s pocket as income (including profit).
Total income = Total spending (where C + I)
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
Terms & Concepts to Know
Budget Surplus
Budget Deficit
Budget Balance
National Savings v. Private Savings
Capital Inflow
The Savings-Investment Spending Identity
Terms & Concepts to Know
Budget Surplus:
Difference between tax revenue & G
spending where revenue is more than
spending
Budget Deficit:
Difference between tax revenue & G
spending where spending is more than
revenue
Budget Balance:
The difference between tax revenue & G
spending
National Savings:
Private savings + budget balance (total
savings within an economy)
Capital Inflow:
The net inflow of funds into a
country
The Savings-Investment Spending Identity
Terms & Concepts to Know
OK, what if the economy isn’t so simple.? Add the government (public
sector) to the private sector.
1.
2.
3.
4.
5.
6.
The government spends on goods and services (G ___________)
and pays transfers to some. The government collects t______
revenue to pay for these things.
If the government budget is balanced: T_______r________ =
g____________s___________ + t___________ p__________
Rearrange this equation and call it B_______B________ (BB for
short)
Budget Balance = T______R________ – G________–
T__________
If BB >0, the government has a budget s_________ and is
actually saving money.
If BB<0, the government has a budget d_________ and is
borrowing money (dissaving).
The Savings-Investment Spending Identity
Terms & Concepts to Know
OK, what if the economy isn’t so simple.? Add the government (public
sector) to the private sector.
1.
2.
The government spends on goods and services (G spending) and
pays transfers to some. The government collects tax revenue to
pay for these things.
If the government budget is balanced: Tax revenue =
government spending + transfer payments
3.
Rearrange this equation and call it Budget Balance (BB)
4.
Budget Balance = Tax Revenue – G – transfers
5.
6.
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
Terms & Concepts to Know
Now include public sector savings to the savings-investment identity.
S + BB: simply total national savings.
Savings + Budget Balance = Investment
1.
2.
If National Savings>0 on the left side (a s________), Investment
must increase on the right side.
If National Savings<0 on the left side (a d__________), Investment
must decrease on the right side.
Final level of complexity. Add the foreign sector.
•
•
•
•
An American can save her money in the US or in another n______.
A foreign citizen can save his money in his home country, or in the ___.
So the US receives inflows of funds—foreign s_______ that finance
i_________ spending in the US.
The US also generates outflows of funds—domestic s________that
finance i__________ spending in another country.
The Savings-Investment Spending Identity
Terms & Concepts to Know
Now include public sector savings to the savings-investment identity.
S + BB: simply total national savings.
Savings + Budget Balance = Investment
1.
2.
If National Savings>0 on the left side (a surplus), Investment must
increase on the right side.
If National Savings>0 on the left side (a deficit), Investment must
decrease on the right side.
Final level of complexity. Add the foreign sector.
•
•
•
•
An American can save her money in the US or in another nation.
A foreign citizen can save his money in his home country, or in the US.
So the US receives inflows of funds—foreign savings that finance
investment spending in the US.
The US also generates outflows of funds—domestic savings that
finance investment spending in another country.
The Savings-Investment Spending Identity
Terms & Concepts to Know
1.
2.
3.
4.
5.
Capital inflow into the US = total i_______of foreign
funds - total o________of domestic funds to other
countries.
Capital inflow (CI) can be p_______or n________ so it
can increase or decrease the total funds available for
i__________ in the US economy.
S_______ + B_________B________ + C________
I_________ = Investment
If CI > 0 on the left side (more foreign funds coming
into the US, than US funds going out), Investment
must i__________ on the right side.
If CI < 0 on the left side (fewer foreign funds coming
into the US, than US funds going out), Investment
must d___________ on the right side.
The Savings-Investment Spending Identity
Terms & Concepts to Know
1.
2.
3.
4.
5.
Capital inflow into the US = 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 US economy.
Savings + Budget Balance + Capital Inflow =
Investment
If CI > 0 on the left side (more foreign funds coming
into the US, than US funds going out), Investment
must increase on the right side.
If CI < 0 on the left side (fewer foreign funds coming
into the US, than US funds going out), Investment
must decrease on the right side.
Four Types of Financial Assets


1.
2.
3.
4.

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……
W____________ example: _________
F_______________Asset example:___________
P_______________Asset example:___________
L________________ example:______________
What is the role the financial system plays in
exchanging the assets from the seller to the
buyer?
Four Types of Financial Assets


1.
2.
3.
4.

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.
Wealth
Financial Asset
Physical Asset
Liability
What is 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
2. Reducing Risk
a) Financial Risk
b) Diversification
3. Providing Liquidity
a) Liquid
b) Illiquid
Three Tasks of a Financial System
1. Reducing Transactions Costs
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. (ugh!)
It is surely more convenient, and less costly, to buy from
a firm that specializes in providing these items: the
supermarket.
Suppose a firm wanted to borrow some money to build
a factory.
One way to borrow would be to go to Mr. Moss for a
loan, Ms. Arenas for another loan, the Kelley 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
Reducing Risk
The future is uncertain so investments, like building a factory,
have a risk that they will not be profitable. (what is risk?)
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.
Or 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.
So 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.
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.
2.
Three Tasks of a Financial System:
3. Providing Liquidity
3.
Providing Liquidity
Liquidity refers to the ease by which an asset can be converted to
cash.
Vintage Rolls Royce = valuable asset = liquid? Why?
A savings account = valuable asset = liquid? Why?
A firm needs $ & uses their $ to build a factory: that investment will
not provide a stream of cash revenue for a long time. When will
the factory be profitable?
When the factory begins to produce goods that generate
revenue…until then the business will 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
2. Bonds
a) Default
3. Loan-backed Securities (Collateralized Debt
Obligation - CDO)
4. Stocks
Types of Financial Assets
Loans
Loan-backed Securities
Bonds
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 Graphic Organizer
Mutual Funds
Life Insurance Companies
Pension Funds
Banks
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.
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.
Financial Intermediaries
3. Life insurance companies sell policies
which guarantee a payment to the
policyholder’s beneficiaries (typically, the
family) when the policyholder dies.
4. 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.
Close down w/Phone or Ipad

What is are loan-backed securities (Collateralized
Debt Obligation - CDO)? What role did this financial
asset play in the housing crisis?
Module Review Questions p. 229230
 Read Module 23 The Definition and
Measurement of Money
