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Chapter 20
Financial Aspects of
Household and
Firm Behavior
©2000 South-Western College Publishing
Portfolio
The collection of real and
financial assets and liabilities
2
Net Worth
The difference between
assets and liabilities at a
point in time
3
Balance Sheet of the Household Sector
December 31, 2000
Assets
Real estate
Other real assets
Money
Other financial
assets
Liabilities
Real estate mortgages
Installment debt
Other personal debt
Net worth
Total assets
Total liabilities plus
net worth
4
Exhibit 20 - 1
Household Portfolio Changes over
Time J.P. Young (thousands $)
(1)
January 1, 2000
Real Assets
Money
Other Financial Assets
Total Assets
Total Liabilities
Net Worth
Exhibit 20 - 2
$100
$ 3
$ 30
$133
$ 53
$ 80
5
Household Portfolio Changes over
Time J.P. Young (thousands $)
(2)
Actions During Year
Purchase computer,
stereo, TV
$5
Increase in money holdings
$ .3
Acquisition of stocks & bonds $2.7
Change in Total Assets
$8
Change in Total Liabilities
$2
Change in Net Worth
$6
Exhibit 20 - 2 cont.
6
Household Portfolio Changes over
Time J.P. Young (thousands $)
(3)
December 31, 2000
Real Assets
Money
Other Financial Assets
Total Assets
Total Liabilities
Net Worth
Exhibit 20 - 2 cont.
$105
$ 3.3
$ 32.7
$141
$ 55
$ 86
7
Household Asset Accumulation:
spending and saving
•Real Assets - durable goods
and houses
•Financial Assets - stocks,
bonds, money
8
Financial Liabilities
Debt incurred by
borrowing
9
Borrowing Constraint
The impediment to continuous
borrowing that may come from
the lender’s unwillingness to
keep lending or the borrower’s
unwillingness to keep
borrowing
10
Household Portfolio Choices
Exhibit 20-3
Households accumulates real and financial
assets and liabilities in an attempt to
maximize their well-being.
Changes and expected changes in income,
wealth, and interest rates change the
economic and financial environment.
In response to the changing environment,
households change their desired portfolios
of assets and liabilities
Households will spend more or less and
accumulate more or less real and financial
assets and liabilities in an attempt to reach
their desired portfolios.
11
Flow of Funds
A social accounting system
that divides the economy into
sectors and constructs a
sources and uses of funds
statement for each sector
12
Sources and Uses of
Funds Statement
A statement for each sector of
the economy, such as the
household, firm, government, or
foreign sectors, that lists its
sources and uses of funds...
13
The Sources and Uses of Funds for Households
Sources of Funds
Uses of Funds
Disposable income
+ borrowing =
Consumption spending
nondurables and services
+
Consumption spending on
durables and investment
spending on houses
(changes in real assets
held)
+
Changes in financial
assets held
(Eq. 20 - 1)
14
Subtract borrowing from both sides of equation:
Sources of Funds
Disposable income =
Uses of Funds
Consumption spending
nondurables and services
+
Consumption spending on
durables and investment
spending on houses
(changes in real assets
held)
+
Net Changes in financial
assets held
(Eq. 20 - 2)
15
What is
net financial investment?
The increase in net
financial assets
16
Y = Household disposable income
W = Household wealth or net worth
r = The yield or return on real assets; the sum of the
value of the flow of services from real assets plus any
capital gain, all divided by the price of the real asset
i = The market interest rate (return) on financial
assets
•Demand for Real Assets
=
•Demand for Real
Money Balances
=
•Net Demand for Nonmonetary
Financial Assets
=
+ + + –
f(Y, W, r, i)
+ + –
f(Y, W, i)
+ + + –
f(Y, W, r, i)
17
(Eq. 20 - 3, 4, 5)
Household Demand for Real & Financial Assets
•Increase net demand for
nonmonetary financial assets
Increase i
•Decrease demand for real assets
•Decreases demand for real money
balances
Increase Y
or W
•Increase net demand for
nonmonetary financial assets
•Increase demand for real assets
•Increase demand for real
money balances
Increase r
•Decrease net demand for
nonmonetary financial assets
•Increase demand for real assets
Exhibit 20 - 4
18
Marginal Revenue
The additional revenue from
selling an additional unit of
output
Marginal Cost
The additional cost of selling
an additional unit of output
19
Investment Spending
For businesses, spending on new
equipment and capital or net
additions to inventories
20
The Balance Sheet of the Business Sector
Assets
Liabilities
Real Assets
Capital Goods
Inventories
Equity
Common Stock
Financial Assets
Currency, checkable deposits
Money Market Mutual Funds
CD’s
Mutual Funds
Trade Credit
Other Financial Assets
Debt
Long-term
Short-term
Total Assets
Total Liabilities
plus Net Worth
Other Financial Liabilities
21
Exhibit 20 - 5
Net Investment
Gross investment
minus depreciation
22
Business Investment
To replace worn
out or obsolete
capital (plant,
equipment, and
machinery)
To add to
inventories (raw
materials, goods
in process,
finished goods)
To increase the
capital stock
(plant,
equipment, and
machinery)
Exhibit 20-6
23
Opportunity Cost
The return one could have
earned by using funds in the
next best alternative; for
investment spending, the real
interest rate
24
Internal Financing
The spending of money balances
on hand or the liquidation of
financial or real assets to finance
spending that exceeds current
receipts
25
External Financing
Financing spending that
exceeds current receipts
by expanding either debt
or equity
26
Business Finance
Financing Need
External
Internal
Retained
Earnings
Equity
Short-Term
Debt
Exhibit 20 -7
Debt
Long-Term
Debt
27
A firm’s balance sheet can be
summarized as follows:
(20-6)
A = L + NW
(20-7)
 A =  L +  NW
(20-8)
 L =  A – RE
28
Corporate Financing Gap
The increase in a firm’s
liability, which is equal to the
increase in assets held minus
retained earnings
29
Leverage Ratio
The ratio of debt to equity on
a firm’s balance sheet
30
Sources And Uses Of Fund For
The Business Sector
Sources of Funds
Uses of Funds
Net Revenues +
Borrowing
=
Net Spending on real assets
such as plant and equipment
+
Net Spending on real assets
such as inventories
+
Changes in financial
assets held
31
(Eq. 20-9)
Subtract the “changes in other financial assets held”
from both sides of Equation:
Sources of Funds
Net revenues
Uses of Funds
+
Net borrowing
=
Net spending on real
assets such as plant and
equipment
+
Net spending on real
assets such as
inventories
Eq. (20-10)
32