The Financial Sector Modules 22-29 Section 5 The Financial Sector Modules 22-29 AP Macro Nancy K. Ware Instructor Gainesville High School

Module 22 Saving, Investment, and the Financial System

Start Up 1. Which of the following is NOT a type of financial asset? Bonds Stocks Bank deposits Loans Houses

Module 22 Essential Questions What is the relationship between savings and investment spending? What is the purpose of the four principal types of financial assets: stocks, bonds, loans and bank deposits? How do financial intermediaries help investors achieve diversification?

Matching up Savings and Investment Spending What is Physical Capital? The Source of Physical Capital is…?

Matching up Savings and Investment Spending What is Physical Capital? The Source of Physical Capital is…? When a firm invests in physical capital (factories, shopping malls, large pieces of machinery, etc), the firm usually pays for these big projects by borrowing. Those funds have to come from somewhere….

The Savings-Investment Spending Identity Assume a simple economy Total Income = Total Spending Together:

The Savings-Investment Spending Identity Assume a simple economy Total Income = Total Spending Total Income = Consumer Spending & Savings Total Spending = Consumer Spending + Investment Spending Together: Consumer Spending & Savings = Consumer Spending + Investment Spending Savings = Investment Spending

The Savings-Investment Spending Identity: An Explanation (note page) Assume a Simple economy: no government, no trade (zero imports and exports).   The circular flow diagram shows all money spent by consumers and firms ends up in another person’s pocket as income (including profit). Total income = Total spending (where C + I) Now, what do people do with income? They either spend it on consumption (C) or save it (S). Total income = C + S = Total Spending = C + I C + S = C + I Or S = I

The Savings-Investment Spending Identity Terms & Concepts to Know Budget Surplus Budget Deficit Budget Balance National Savings v. Private Savings Capital Inflow

The Savings-Investment Spending Identity Terms & Concepts to Know Budget Surplus: Difference between tax revenue & G spending where revenue is more than spending Budget Deficit: Difference between tax revenue & G spending where spending is more than revenue Budget Balance: The difference between tax revenue & G spending National Savings: Private savings + budget balance (total savings within an economy) Capital Inflow: The net inflow of funds into a country

The Savings-Investment Spending Identity Terms & Concepts to Know OK, what if the economy isn’t so simple.? Add the government (public sector) to the private sector.   The government spends on goods and services (G ___________) and pays transfers to some. The government collects t______ revenue to pay for these things. If the government budget is balanced: T_______r________ = g____________s___________ + t___________ p__________ Rearrange this equation and call it B_______B________ (BB for short) Budget Balance = T______R________ – G________– T__________ If BB >0, the government has a budget s_________ and is actually saving money. If BB<0, the government has a budget d_________ and is borrowing money (dissaving).

The Savings-Investment Spending Identity Terms & Concepts to Know OK, what if the economy isn’t so simple.? Add the government (public sector) to the private sector.   The government spends on goods and services (G spending) and pays transfers to some. The government collects tax revenue to pay for these things. If the government budget is balanced: Tax revenue = government spending + transfer payments Rearrange this equation and call it Budget Balance (BB) Budget Balance = Tax Revenue – G – transfers If BB >0, the government has a budget surplus and is actually saving money. If BB<0, the government has a budget deficit and is borrowing money (dissaving).

The Savings-Investment Spending Identity Terms & Concepts to Know Now include public sector savings to the savings-investment identity. S + BB: simply total national savings. Savings + Budget Balance = Investment If National Savings>0 on the left side (a s________), Investment must increase on the right side. If National Savings<0 on the left side (a d__________), Investment must decrease on the right side. Final level of complexity. Add the foreign sector. An American can save her money in the US or in another n______. A foreign citizen can save his money in his home country, or in the ___. So the US receives inflows of funds—foreign s_______ that finance i_________ spending in the US. The US also generates outflows of funds—domestic s________that finance i__________ spending in another country.

The Savings-Investment Spending Identity Terms & Concepts to Know Now include public sector savings to the savings-investment identity. S + BB: simply total national savings. Savings + Budget Balance = Investment If National Savings>0 on the left side (a surplus), Investment must increase on the right side. If National Savings>0 on the left side (a deficit), Investment must decrease on the right side. Final level of complexity. Add the foreign sector. An American can save her money in the US or in another nation. A foreign citizen can save his money in his home country, or in the US. So the US receives inflows of funds—foreign savings that finance investment spending in the US. The US also generates outflows of funds—domestic savings that finance investment spending in another country.

The Savings-Investment Spending Identity Terms & Concepts to Know Capital inflow into the US = total i_______of foreign funds - total o________of domestic funds to other countries. Capital inflow (CI) can be p_______or n________ so it can increase or decrease the total funds available for i__________ in the US economy. S_______ + B_________B________ + C________ I_________ = Investment If CI > 0 on the left side (more foreign funds coming into the US, than US funds going out), Investment must i__________ on the right side. If CI < 0 on the left side (fewer foreign funds coming into the US, than US funds going out), Investment must d___________ on the right side.

The Savings-Investment Spending Identity Terms & Concepts to Know Capital inflow into the US = total inflow of foreign funds - total outflow of domestic funds to other countries. Capital inflow (CI) can be positive or negative so it can increase or decrease the total funds available for investment in the US economy. Savings + Budget Balance + Capital Inflow = Investment If CI > 0 on the left side (more foreign funds coming into the US, than US funds going out), Investment must increase on the right side. If CI < 0 on the left side (fewer foreign funds coming into the US, than US funds going out), Investment must decrease on the right side.

Four Types of Financial Assets Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets. A financial asset is a paper claim that…… W____________ example: _________ F_______________Asset example:___________ P_______________Asset example:___________ L________________ example:______________   What is the role the financial system plays in exchanging the assets from the seller to the buyer?

Four Types of Financial Assets Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets. A financial asset is a paper claim that entitles the buyer to future income from the seller. Wealth Financial Asset Physical Asset Liability   What is the role the financial system plays in exchanging the assets from the seller to the buyer?

Three Tasks of a Financial System Reducing Transaction Costs Reducing Risk Financial Risk Diversification Providing Liquidity Liquid Illiquid

Three Tasks of a Financial System 1. Reducing Transactions Costs 1. Reducing Transaction Costs Suppose a consumer wanted to buy a loaf of bread, a pound of apples, and a dozen eggs. One way to do this is to drive to the bakery, then drive to the orchard, and then drive to the farm. (ugh!) It is surely more convenient, and less costly, to buy from a firm that specializes in providing these items: the supermarket. Suppose a firm wanted to borrow some money to build a factory. One way to borrow would be to go to Mr. Moss for a loan, Ms. Arenas for another loan, the Kelley family for another… Or the firm could find a firm that specializes in providing these funds: a bank. The bank, and other financial services companies, is able to make it easier, and less costly, for firms to engage in financial transactions like borrowing to make investments.

Three Tasks of a Financial System: 2. Reducing Risk The future is uncertain so investments, like building a factory, have a risk that they will not be profitable. (what is risk?)   The owner of a firm may want to build the factory, but using his/her own money is risky because the factory might not be profitable. Or the owner could raise the money by selling shares of stock in the company. When a person buys a share of stock in a company, it gives that person a small stake in the ownership of the company. So the primary owner of the business can pay for the factory, but does not need to risk his/her own money if the factory should fail to generate profits. Diversification: investing in several assets with unrelated, or independent, risks—allows a business owner to lower his/her total risk of loss. The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market.

Three Tasks of a Financial System: 3. Providing Liquidity   Liquidity refers to the ease by which an asset can be converted to cash. Vintage Rolls Royce = valuable asset = liquid? Why? A savings account = valuable asset = liquid? Why? A firm needs $ & uses their $ to build a factory: that investment will not provide a stream of cash revenue for a long time. When will the factory be profitable? When the factory begins to produce goods that generate revenue…until then the business will need liquidity (cash) to purchase raw materials, hire some workers and pay the electric bill. The financial system can provide liquidity in a variety of ways: by issuing loans, bonds, or stocks.

Types of Financial Assets Loans Bonds Default Loan-backed Securities (Collateralized Debt Obligation - CDO) Stocks

Types of Financial Assets Loans Bonds Stocks Loan-backed Securities

Types of Financial Assets 1. Loans A loan is a lending agreement between an individual lender and an individual borrower.   2. Bonds The seller of a bond promises to pay a fixed sum of interest each year and to repay the principal—the value stated on the face of the bond—to the owner of the bond on a particular date. 3. Loan-backed Securities Loan-backed securities are assets created by pooling individual loans and selling shares in that pool (a process called securitization). 4. Stocks A stock is a share in the ownership of a company.

Financial Intermediaries Graphic Organizer Pension Funds Mutual Funds Life Insurance Companies Banks

Financial Intermediaries A financial intermediary is an institution that transforms funds gathered from many individuals into financial assets. The most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks.   1. Mutual Funds A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors. 2. Pension Funds and Life Insurance Companies Pension funds are nonprofit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire.

Financial Intermediaries   3. Life insurance companies sell policies which guarantee a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies. 4. Banks A bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers.

Close down w/Phone or Ipad What is are loan-backed securities (Collateralized Debt Obligation - CDO)? What role did this financial asset play in the housing crisis?

Module Review Questions p. 229- 230 Read Module 23 The Definition and Measurement of Money