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KRUGMAN’S Economics for AP® S E C O N D E D I T I O N

Section 5 Module 22

What You Will Learn in this Module Describe the relationship between savings and investment spending Explain how financial intermediaries help investors achieve diversification Identify the purpose of the four principal types of financial assets: stocks, bonds, loans, and bank deposits What You Will Learn in this Module Section 5 | Module 22

The Savings–Investment Spending Identity In a simplified economy: (1) Total Income = Total Spending (2) Total income = Consumption spending + Savings Meanwhile, spending consists of either consumption spending or investment spending: (3) Total spending = Consumption spending + Investment spending Putting these together, we get: (4) Consumption spending + Savings = Consumption spending + Investment spending Subtract consumption spending from both sides, and we get: (5) Savings = Investment spending Section 5 | Module 22

Matching Up Savings and Investment Spending Adding government and economic interaction with the rest of the world to this simplified economy results in two changes: First, governments can save, too. Second, savings need not be spent on physical capital located in the same country. Section 5 | Module 22

Matching Up Savings and Investment Spending The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending. The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue. The budget balance is the difference between tax revenue and government spending. National savings, the sum of private savings plus the budget balance, is the total amount of savings generated within the economy. Capital inflow is the net inflow of funds into a country. Section 5 | Module 22

The Financial System A household’s wealth is the value of its accumulated savings. A financial asset is a paper claim that entitles the buyer to future income from the seller. A physical asset is a claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes. Section 5 | Module 22

The Financial System A liability is a requirement to pay income in the future. Transaction costs are the expenses of negotiating and executing a deal. Financial risk is uncertainty about future outcomes that involve financial losses and gains. Section 5 | Module 22

Three Tasks of a Financial System Reducing transaction costs ─ the cost of making a deal. Reducing financial risk ─ uncertainty about future outcomes that involves financial gains and losses. Providing liquid assets ─ assets that can be quickly converted into cash (in contrast to illiquid assets, which can’t). Section 5 | Module 22

Three Tasks of a Financial System An individual can engage in diversification by investing in several different things so that the possible losses are independent events. An asset is liquid if it can be quickly converted into cash. An asset is illiquid if it cannot be quickly converted into cash. Section 5 | Module 22

Types of Financial Assets There are four main types of financial assets: loans bonds Stocks In addition, financial innovation has allowed the creation of a wide range of loan-backed securities. Section 5 | Module 22

Types of Financial Assets A loan is a lending agreement between a particular lender and a particular borrower. A default occurs when a borrower fails to make payments as specified by the loan or bond contract. A loan-backed security is an asset created by pooling individual loans and selling shares in that pool. Section 5 | Module 22

Financial Intermediaries A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets. A mutual fund is a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors. A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members. Section 5 | Module 22

Financial Intermediaries A life insurance company sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies. A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded. A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers. Section 5 | Module 22

Summary Investment in physical capital is necessary for long-run economic growth. According to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole. The government is a source of savings when it runs a positive budget balance or budget surplus; it is a source of dissavings when it runs a negative budget balance or budget deficit. In a closed economy, savings is equal to national savings, the sum of private savings plus the budget balance. Section 5 | Module 22

Summary In an open economy, savings is equal to national savings plus capital inflow of foreign savings. Households invest their current savings or wealth by purchasing assets in the form of either a financial asset or a physical asset. There are four main types of financial assets: loans, bonds, stocks, and bank deposits. The three fundamental tasks of a financial system: reducing transaction costs; reducing financial risk; and providing liquid assets. Section 5 | Module 22

Summary Investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events. Loan-backed securities are assets created by pooling individual loans and selling shares of that pool to investors. Financial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify, and life insurance companies reduce risk. Section 5 | Module 22