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
Introduction
The following is a condensed balance sheet for Canada as of 2005, in millions:
Total non-financial (real) assets
Total financial assets
Total assets
$ 4,626,714
$ 9,040,104
$13,666,818
Total liabilities
$ 9,215,926
Net worth
$ 4,450,892
Notice also that:
Total non-financial (real) assets
Net international debt
$ 4,626,714
$ 175,822
Net worth
Finally, observe that:
$ 4,450,892
Total liabilities
$ 9,215,926
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Net international debt
$
175,822
Total financial assets
$ 9,040,104
We discover two very important observations from these facts:
1. Our collective net worth is equal to our real, but not our financial assets minus our
obligations to foreigners.
2. Our financial assets are exactly equal to the liabilities net of international debt.
Our assets are our own debts.
If we divide our economy into four sectors; households (H), business (B), government
(G) and the foreign sector (F), we can designate the financial assets as FAH, FAB,
FAG, and FAF and the liabilities of each sector as and LH, LB, LG, and FAF.
It must therefore be true that:
FAH+ FAB + FAG + FAF = LH +LB +LG + LF.
For those sectors which are net lenders, the household and foreign sectors:
FAH - LH > 0
FAF - LF > 0
For those sectors which are net borrowers, the business and government sectors:
FAB – LB < 0
FAG – LG < 0
Since total net lending must equal total net borrowing,
(FAH - LH ) + (FAF - LF ) = - ((FAB – LB ) + (FAG – LG ))
The purpose of this accounting exercise is to demonstrate that if businesses and
governments need to finance their activities, the funds must come from the savings of
the household sector augmented by foreign capital inflows.
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)
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(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
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. These 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.
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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
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 statement of
a) revenues and investments of a business during a given year.
b) the values of assets, liabilities and net worth at a given moment in time.
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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
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 for any particular sector.
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.
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PROBLEMS
1. Explain how the following sectors generate surpluses (or savings) that can add to the
flow of funds in the financial system?
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?
3. Suppose that we have a very small, simple economy with only two households, A and
B, no business sector, no government and no foreign sector.
a) Each household has $1000 of real, non-financial assets, no financial assets and no
liabilities. Calculate the net worth of households A and B.
b) During year 1, each household produces $100 worth of goods and consumes $100
worth of goods. Calculate the net worth of households A and B at the end of the year.
c) During year 2, household A decides to produce $100 but to consume $120 by
borrowing $20 from household B in exchange for a promissory note to which B is
agreeable. Calculate the net worth of households A and B at the end of that year.
d) During year 3, household A again wants to produce $100 but to consume $120 and
wants to borrow $20 from household B in exchange for a promissory note but
household B is only prepared to lend $10. Speculate what might occur in this
situation.
4. Suppose that we have a very small, simple economy with only two households, C and
D, one business, but no government and no foreign sector. Each household has $1000
of real, non-financial assets, no financial assets and no liabilities. Initially the business
has no assets and no liabilities but wants $20 worth of plant and equipment. Household
C normally produces $100 worth of consumer goods but is willing to produce only $90
of consumer goods and $10 in the form of a plant or factory and, will sell the plant to
the business in exchange for a $10 bond. Household D normally produces $100 worth
of consumer goods but is willing to produce only $90 of consumer goods and $10 in
the form of equipment and, will sell the plant to the business in exchange for a $10
worth of stock.
a) Determine net worth of household C after these transactions.
b) Determine net worth of household D after these transactions.
c) Prepare a simple balance sheet for the business after these transactions.
d) Prepare a simple balance sheet for the whole economy after these transactions.
e) Show that investment equals savings for the period in question.
5. Suppose that, in addition to the transactions described in question 4, the two
households elect a government and that government decides to tax each household $5
and spend $15 on new roads. Is that possible? Speculate as to what needs to happen to
adjust for this action by government.
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ANSWER SECTION
Answers to multiple-choice questions:
1. d (see page 174-5)
2. b (see page 174)
3. b (see page 175)
4. c (see page 175)
5. d (see page 176)
6. a (see page 177)
7. b (see page 177)
8. a* (see page 177)
9. a (see page 177)
10. d (see page 178)
* This contradicts the text, but the text is incorrect. Increases in liabilities are a source,
not a use of funds.
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.
3. a) The net worth of each household is $1000.
b) Since net savings is zero for both households, the net worth of each household is still
$1000.
c) Net worth of A is now $1000 - $20 = $980. Net worth of AB is now $1000 + $20 =
$1020.
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d) the demand for loanable funds exceeds the supply. The interest rate will rise and
either A will decrease their consumption and borrow less or B will decrease their
consumption and save and lend more, or both of these changes will occur.
4. a) Household C will now have a net worth of $1010 having saved $10 in the form of a
bond issued by the business.
b) Household D will now have a net worth of $1010 having saved $10 in the form of
stock issued by the business.
c) the balance sheet for the business will show $20 in assets, $10 in bonds and $10 in
stock.
d) the balance sheet for the economy as a whole will show $2020 in real assets, $20 in
financial assets, $20 in liabilities and stock and net worth of $2020.
(e) Household C saves $10 in the form of a bond and household D saves $10 in the
form of a stock for a total of $20. The business invests $20 in plant and equipment.
5. Based on the circumstances described this is not possible. To spend $5 more than it
raises in taxes the government has to borrow, but there are no additional surplus funds
to be borrowed. Rising interest rates may solve this disequilibrium situation by
encouraging more savings from the households.
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