Macro Module 7

Financial Institution

A firm that operates on both sides of the market for financial capital: It borrows on one market and lends in another.

Loan Market

A loan market is where two parties agree to exchange funds for repayment in the future. Loans from banks are how many firms meet their short-term cash needs and where households find the money to buy a new home. The loan market is very diverse in both size and geography. Businesses today can get loans from a bank down the street or from around the world through the Internet.

Investment Bank

An investment bank helps businesses and governments raise funds by issuing and selling bonds and stocks.

Government sponsored Mortgage Lenders

Government-sponsored mortgage lenders, such as Fannie Mae and Freddie Mac, buy mortgages from banks and resell them as mortgage-backed securities.

Gross and Net Investment

Gross investment is the total amount spent on new capital goods. Net investment equals gross investment minus depreciation. For the economy as a whole, the change in the quantity of physical capital is net investment.

Pension Funds

Pension funds use the retirement savings of firms and workers to buy bonds and stocks in the financial markets.

Physical Capital

Physical capital includes all the tools, equipment, buildings, and other items that were produced in the past and are used today for the production of goods and services. We know that increases in physical capital lead to economic growth because worker productivity improves. We need to distinguish, however, physical capital from financial capital.

Financial Assets

Stocks, bonds, and loans are collectively called financial assets. The interest rate on a financial asset is a percentage of the price of an asset. There is an inverse relationship between an asset price and interest rate. If the asset price increases, then with all other things remaining equal, the interest rate decreases. Conversely, when the price of a financial asset decreases, the interest rate, or return on the asset, increases.

Demand For Loanable Funds

The demand for loanable funds is the relationship between the quantity demanded of loanable funds and the real interest rates when all other influences on borrowing are held constant. The real interest rate and expected profit will determine businesses' willingness to invest and therefore the demand for loanable funds. At high interest rates, few projects will be profitable. Firms invest only when the expected profit rate exceeds the real interest rate. This is true for individuals as well. Consider, for example, why it makes sense to take out student loans when you go to college. Financing your education by demanding loanable funds when you don't have all the necessary funds in savings makes sense if the higher income potential you will earn by getting a college degree increases your ability to pay back the loan. This is the same as saying that your expected profit from this investment exceeds the real interest rate. Because investment is inversely related to the real interest rate, the higher the real interest rate, the smaller the quantity of loanable funds demanded is. Graphically, we can say that the demand for loanable funds slopes downward.

Insurance Companies

insurance companies enter into agreements with households and firms to protect against the risk of loss. Insurance companies invest the premium payments from their customers in the financial markets.

A share of stock in a firm includes a promise to pay specified amounts on specified dates.

False

Financial capital is used to finance the consumption expenditures of households.

False

Other things being equal, as the real interest rate increases, firms will borrow more funds.

False

When the government has a budget deficit, it must raise taxes

False

Financial Capital

Financial capital is the funds businesses use to buy and operate physical capital. Many people think of financial capital, such as stock in a business or a mortgage to a new homeowner, as investments. However, in economics, investment doesn't occur until something that is physical capital is purchased. Investment is the amount of money businesses, households, and governments spend on capital goods, such as buildings and equipment.

Surplus:

Fiscal policy refers to the taxing and spending policies of the government. When the government takes in more than it spends, it is said to be running a budget surplus. When this happens, the excess funds will find their way to the financial markets. We can analyze the effect of this using the market for loanable funds. A government budget surplus increases the amount of saving in the economy. Budget surpluses add to the already existing private savings in an economy. This additional savings increases the supply of loanable funds and the real interest rate decreases. The lower real interest rate increases the quantity of loanable funds demanded and increases investment. If all else remains the same, a government budget surplus should lead to higher investment and greater economic growth. The U.S. government ran a fiscal-year budget surplus in each year from 1998 to 2001. Before this period, the United States had not had a budget surplus since 1969. Budget deficits are more common.

Bond Markets

Bond markets are where loans are traded amongst different lenders. A bond is a promise to pay a specified amount of money on specified dates in the future. A bond is a debt obligation for the issuer, or seller of the bond. Corporations and governments sell bonds to raise funds for many different investment purposes. Bonds trade amongst investors in all parts of the world. The largest bond market in the world is that for the debt obligations of the U.S. federal government. Treasury bills are short-term debt obligations issued by the U.S. Treasury. Treasury notes and bonds are long-term debt obligations of the United States. Home mortgages also trade as bonds in financial markets. Mortgage-backed securities are bonds that pay income to the buyer from a package of mortgages.

Commerical Bank

Commercial banks provide banking services, such as checking deposits, loans, and cards.

Equilibrium

Equilibrium in the financial markets occurs when demand equals supply. The loanable funds market is in equilibrium when the real interest rate is such that the quantity of loanable funds supplied equals the quantity of loanable funds demanded. There is neither a surplus nor a shortage of saving so that borrowers can get the funds they demand and lenders can lend all the funds they have available.

Defecit:

Let's consider the opposite scenario. Suppose the government spends more than it receives from taxes. In this case, the government is running a budget deficit. A government budget deficit will increase the demand for loanable funds because it will need to borrow the additional funds. The higher demand leads to an increase in the real interest rate and the quantity of private loanable funds supplied. At the same time, however, the higher real interest rate decreases investment and the quantity of loanable funds demanded by firms to finance investment. When government budget deficits raise the real interest rate and decrease investment, economists call it a crowding-out effect. With such an effect, investment declines and economic growth slows. Some economists argue that increased government spending from budget deficits outweighs the economic effects of crowding out. Another economic theory suggests that taxpayers expect higher future taxes when the government runs a budget deficit and will thereby increase their current saving. This increase in private savings and increase in the supply of loanable funds will more than offset the deficit. As a result, the real interest will not change and investment is not crowded out. For the fiscal year ending September 30, 2010, the U.S. government had a budget deficit of $1.3 trillion. This amounts to approximately 9% of the nation's income as measured by gross domestic product. There is a strong debate as to how much this deficit crowded out private investment.

Loanable Funds

Loanable funds are the monies used to finance business investment, a government's budget deficit, and international investment or lending. These groups form the source of demand in the market for loanable funds. In the and other developed countries, business investment dominates the demand for loanable funds. The supply of loanable funds comes from one of three sources: Private household saving Government budget surplus International borrowing These groups provide loanable funds to the financial markets. The largest source of funds is from private saving and what households save from their income.

Bond Markets

Sales of promises to pay specified amounts of money on specified dates in the future Where loans are traded among different lenders

Stock Market

The stock market is perhaps the most widely known and discussed financial market. A stock is a certificate of ownership and claim to the profits of a firm. Shares of companies' stocks trade between investors on stock exchanges such as the NYSE, the NASDAQ, the London Stock Exchange, the Frankfurt Stock Exchange, and the Tokyo Stock Exchange. The exchanges have physical locations, like the NYSE at Broad and Wall Streets in New York, but most trading of stocks today is done electronically. Unlike bonds, stock ownership gives the holder rights to the profits of the firm but no guarantee of payment. A firm that issues a bond is obligated to pay the interest and principal when due. The corporation that sells stock may pay out the profits to owners but is not obligated to do so.

Supply of Loanable Funds

The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate, with all other things being equal. Private saving is positively related to the real interest rate. When the real return on savings rises, households have a greater incentive to put away more of their income. Therefore, the higher the real interest rate, the greater the quantity of loanable funds supplied as private saving increases. Graphically, we can say that the supply of loanable funds slopes upward.

Stock Markets

Trading of certificates of ownership and claims to the profits of firms Perhaps the most widely known and discussed financial market

In the market for loanable funds, businesses and a government with a budget deficit are demanders, whereas households and a government with a budget surplus are suppliers.

True

When government budget deficits raise the real interest rate and investment falls, the government is crowding out private investment.

True

Loan Markets

Where two parties agree to exchange funds for repayment in the future The most diverse, in terms of size and geography