Module 22

1. The relationship between savings and investment spending 2. The purpose of the 5 principal types of financial assets: stocks, bonds, loans, real estate, and bank deposits 3. How financial intermediaries help investors achieve diversification

1. The savings investment identity tells us that, in a simple economy without government or foreign trade, that private dollars saved must equal private dollars saved. 2. When the government is included, we discover that the government can also contribute to national savings if there is a budget surplus, and can detract from national savings if there is a budget deficit. 3. Money can also flow into the U.S. from foreign citizens, and money can flow from the U.S. into foreign economies. This inflow or outflow affects domestic saving and investment.

4. If foreign citizens save more money in the U.S. than Americans save in other nations, there exists positive capital inflow of money into the U.S. This decreases domestic investment. 5. If Americans save more in other nations than foreign citizens save in the U.S., there exists a negative capital inflow of money into the U.S. This decreases domestic investment. 6. The financial system facilitates transactions between savers and investors. It provides 3 key roles in the process: reducing transaction costs, reducing risk, and increasing liquidity.

 It is intuitive for you to understand that you have 2 choices with your income: consume or save. However, it is more difficult to understand that the government and foreign sectors also have those options.

 When a firm invests in physical capital, it usually pays for these projects by borrowing. Where do those funds come from?

S = I Simple economy = no govt., no trade Remember the circular flow:  Total income = C + S = Total Spending = C + I  Therefore, S = I

 Add Government to the economy G direct spending G pays transfers to some  Where does the government get this money? IF budget is balanced = tax revenue  Tax revenue = govt spending + transfer payments Budget Balance (BB) = Tax Revenue – G - transfers

 BB > 0 = surplus Govt saving money  BB < 0 = deficit Govt borrowing money (dissaving)

S + BB = total national savings S + BB = I  If BB>0 (surplus), the I must increase  If BB < 0 (deficit), then I must decrease

Add the foreign sector  You can save your $$ in the U.S. or in another nation.  A foreigner can save her money in her home country or in the U.S.

 Capital inflow: the U.S. receives flows of funds (foreign savings that finance investment spending in the U.S.)  Capital outflow: the U.S. generates outflows of funds (domestic savings that finance investment spending in other country). CI = total inflow of foreign funds – total outflow of domestic funds to other countries

S + BB + CI = I  If CI > 0 (more foreign funds coming in then U.S. funds going out), I must increase  If CI < 0, (fewer foreign funds coming in than U.S. funds going out, then I must decrease.

 Financial markets: where households invest current savings and accumulated savings (wealth), by purchasing financial assets

 Financial asset: a paper claim that entitles the buyer to future income from the seller 1. Loans 2. Bonds 3. Loan-backed securities 4. Stocks

1. Reducing transaction costs 2. Reducing risk 3. Providing Liquidity

A lending agreement between an individual and an individual borrower

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

Assets created by pooling individual loans and selling shares in that pool (a process called securitization) -finance-domain/core-finance/derivative- securities/mort-backed-secs- tut/v/mortgage-back-security-overview

An institution that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors 1. Mutual Funds 2. Pension Funds and Life Insurance Companies 3. Banks