MACRO CH.

10 FINANCE, SAVING, AND INVESTMENT

10.1 FINANCIAL MARKETS AND FINANCIAL INSITUTIONS
Financial markets and institutions are at the center of a digital technology revolution.

Some finance definitions:

Capital = a factor of production.
Financial capital = funds used to buy capital.
Investment = increases quantity of capital.
Depreciation = decreases the quantity of capital.
Gross investment = total spend on new capital.
Net investment = the change in the quantity of capital (gross investment – depreciation)

Wealth (AKA net worth) = the market value of what a household or firm owns minus what it
owes

Saving = amount of income not paid in taxes or spent on consumption.

wealth also increases through capital gains.

3 Types of financial markets

1. Loan markets
2. Bond markets
3. Stock markets

1.Loan markets
= where money is borrowed.
Ex: mortgage, business gets a bank loan.

2.Bond markets
=When a business or a government needs money to finance something, they will issue bonds.
Bond = promise to make specified payments on specified dates.
Bond coupon = interest payments.
Redemption date = final payment date.

Term to maturity = can be long or short.

Yield curve = the relationship between the term of a bond and the interest rate.
usually, the longer the term the higher the yield.
Inverted yield curve = shorter term bonds have higher yields than longer term ones.

3.Stock markets
When a company wants to expand its business, it issues stock.
Stock = certificate of ownership and claim to a firm’s profits.
Stock market = financial market where shares of companies are traded.
FINANCIAL INSTITUTIONS
Financial institution
= firm that operates on both sides of the markets for financial capital. (It borrows in one
market and lends in another.
Ex:

Investment banks = firms that help other financial institutions and governments raise funds
by issuing bonds and stock, as well as providing advice on transactions such as mergers and
acquisitions.

Commercial banks = The bank that the everyday person uses, issues your credit card and
savings accounts.

Government-sponsored mortgage lenders = two large financial institutions run by

government that buy mortgages from banks and packages them into mortgage back
securities  sells them back to banks and other financial institutions.

Pension funds = financial institutions that use pension contributions of large firms and
workers to buy bonds and stocks. Some are active and some are passive.

Insurance companies = enter into agreements with households and firms to provide
compensation in the event of an accident.
INTEREST RATES AND BOND AND STOCK PRICES
Interest rate = on a bond or stock is a percentage of its price.
If a bond or stock price rises, other things remaining the same, its interest rate falls.
inverse relationship between asset price and interest rate
- Ex: interest rate = (5 / 200) x 100 = 2.5%
- Ex: interest rate = (5 / 100) x 100 = 5%

THIS I ALREADY KNOW.

THE ECONOMIC BENEFITS OF FINANCIAL MARKETS AND INSTITUTIONS
Financial markets and institutions bring 3 economic benefits.
1. Investment in capital.
2. Smooth consumption expenditures.
3. Trade risk

1.Investment in capital
Family buying home.
Firm increasing scale.
Government constructing highway.
Financial markets and institutions make these investment expenditures possible.
2.Smoooth consumption expenditures
Our consumption expenditure is smooth overtime, our annual incomes are not.
financial markets and institutions make these investments expenditures possible.

3.Trade risk
Investing is risky, lending is risky.
Financial markets and institutions enable risks to be shared and spread among lenders.
(without these fewer risks would be taken)
10.2 THE LOANABLE FUNDS MARKET
Loanable funds market = aggregate of the markets for loans, bonds, and stocks.
there is just one average interest rate = the interest rate

Loanable funds are used for three purposes:

1. Business investment.
2. Government budget deficit.
3. International investment or lending.

Loanable funds come from three sources:

1. Private saving.
2. Government budget surplus.
3. International borrowing.
(firms often use retained earnings to pay for investments, however these earnings belong to
the stockholder and are borrowed from them)
HOW REAL FLOWS AND REAL INTEREST RATE ARE DETERMINED IN LOANABLE FUNDS
MARKET
1. The demand for loanable funds.
2. The supply of loanable funds.
3. Equilibrium in the loanable funds market.

1.The demand for loanable funds.

=total quantity of funds demanded to finance investment, the government budget deficit,
and international investment or lending during a given period.
investment (major part), government and international (minor part)

What determines investment and the demand for loanable funds?

1. The real interest rate. = opportunity cost of funds
2. Expected profit. = rate of profit expected to earn on their new capital
Firm invest when expected profit > real interest rate

- Fewer projects are profitable at a high real interest rate than at a low real interest
rate.
The higher the real interest rate the smaller the quantity of loanable funds demanded.
The lower the real interest rate the greater the quantity of loanable funds demanded.
(inverse relationship, negative slope, demand curve)
Demand loanable funds curve (DLF)= relationship between quantity of loanable funds
demanded (x axis) and real interest rate (y axis)

Other things that change DLF

- Expected profit changes, the DLF changes.
greater expected profit  greater the DLF.
(the entire curve shifts upwards or downwards)

- Expected profits can change from business cycle changes, when there is technological
change, growing population, or contagious swings of optimism or pessimism.

2.The supply of loanable funds.

=relationship between quantity of loanable funds supplied and real interest rate when all
other influences on lending remain the same.

Four things that change the supply of loanable funds

1. Disposable income.
2. Wealth.
3. Expected future income.
4. Default risk.

1.Disposable income.
=income – taxes
Greater the disposable income the greater the saving.

2.Wealth.
=household wealth is what it owns
A household with greater wealth will save less than a household with less wealth.

3.Expected future income.

As a households future expected income increases the less it will save today.

4.Default risk.
=risk that the loan will not be repaid.
The greater the risk of defaultthe higher the interest rate needed to induce a person to
lend and the smaller is the supply of loanable funds.

THESE 4 CHANGES DESCRIBED ABOVE CAUSE THE ENTIRE CURVE TO SHIFT

SLF = positive relationship
The higher the real interest rate the greater the quantity of loanable funds supplied.
The lower the real interest rate the smaller the quantity of loanable funds supplied.
3.Equilibrium in the loanable funds market.
Equilibrium of supply and demand for loanable funds = real interest rate

Market interest rate exceeds real interest rate:

Quantity of loanable funds supplied exceeds those demanded.
Suppliers = have a hard to time.
Demanders = have an easy time.
Goes back to equilibrium
(works vice versa)

Surplus = mkt > equil

Shortage = mkt < equil
10.3 GOVERNMENT IN LOANABLE FUNDS MARKET
- Government enters loanable funds market during deficit or surplus.

Government budget surplus:

increases the supply of loanable funds.
real interest rate falls.
decreases private saving.
decreases quantity of private funds supplied.

Government budget deficit:

increases the demand for loanable funds.
The real interest rate rises.
increases private saving and quantity of private funds supplied.

Crowding out effect = The tendency for a government budget deficit to raise the real interest
rate and decrease investment.

Ricardo barro effect = Government budget deficit has no effect on the real interest rate or
investment. Rational taxpayers will see the government deficit today and realize that their
future expected disposable income will be lower since they will have to pay higher taxes in
the future to combat this government deficit. As a result, there will be more saving to combat
lower future income which increases the supply of loanable funds by an amount equal to the
government deficit. Economists regard this effect as unlikely.
PRESENT VALUE
Present value = what a sum of money at a future date is worth today.
Discounting (DCF)
opposite of compound interest.

Present value of a future sum = the amount that if invested at a fixed interest rate will grow
as large as the future sum.

Compound interest = is the interest on initial investment plus the interest on the interest that
the investment has previously earned.
Future sum = present value + interest income.

Sum after n years = present value x (1 + r)^n

R = interest rate
Ex: 10%
R = .1

Discounting a future sum

Present value = (sum of money in n years) / (1 + r)^n

Present value in a sequence of future sums.

Ex: if you will pay $100 each year for the next 5 years at 10% rate.

PV = 100/1.1 + 100/1.1^2 + 100/1.1^3….

=$379.07