Chapter 20 Financial Aspects of Household and Firm Behavior ©2000 South-Western College Publishing

2 Portfolio The collection of real and financial assets and liabilities

3 Net Worth The difference between assets and liabilities at a point in time

4 Balance Sheet of the Household Sector December 31, 2000 Assets Liabilities Real estate Real estate mortgages Other real assets Installment debt Money Other personal debt Other financial assets Net worth Total assets Total liabilities plus net worth net worth Exhibit

5 Household Portfolio Changes over Time J.P. Young (thousands $) (1) January 1, 2000 Real Assets $100 Money $ 3 Other Financial Assets $ 30 Total Assets $133 Total Liabilities $ 53 Net Worth $ 80 Exhibit

6 Household Portfolio Changes over Time J.P. Young (thousands $) (2) Actions During Year Purchase computer, stereo, TV $5 Increase in money holdings $.3 Acquisition of stocks & bonds $2.7 Change in Total Assets $8 Change in Total Liabilities $2 Change in Net Worth $6 Exhibit cont.

7 Household Portfolio Changes over Time J.P. Young (thousands $) (3) December 31, 2000 Real Assets $105 Money $ 3.3 Other Financial Assets $ 32.7 Total Assets $141 Total Liabilities $ 55 Net Worth $ 86 Exhibit cont.

8 Household Asset Accumulation: spending and saving Real AssetsReal Assets - durable goods and houses Financial AssetsFinancial Assets - stocks, bonds, money

9 Financial Liabilities Debt incurred by borrowing

10 Borrowing Constraint The impediment to continuous borrowing that may come from the lender’s unwillingness to keep lending or the borrower’s unwillingness to keep borrowing

11 Household Portfolio Choices Households accumulates real and financial assets and liabilities in an attempt to maximize their well-being. Changes and expected changes in income, wealth, and interest rates change the economic and financial environment. In response to the changing environment, households change their desired portfolios of assets and liabilities Households will spend more or less and accumulate more or less real and financial assets and liabilities in an attempt to reach their desired portfolios. Exhibit 20-3

12 Flow of Funds A social accounting system that divides the economy into sectors and constructs a sources and uses of funds statement for each sector

13 Sources and Uses of Funds Statement A statement for each sector of the economy, such as the household, firm, government, or foreign sectors, that lists its sources and uses of funds...

14 The Sources and Uses of Funds for Households Sources of FundsUses of Funds Sources of Funds Uses of Funds Disposable income Consumption spending + borrowing = nondurables and services + Consumption spending on durables and investment spending on houses (changes in real assets held) + Changes in financial assets held (Eq )

15 Subtract borrowing from both sides of equation: Sources of FundsUses of Funds Sources of Funds Uses of Funds Disposable income = Consumption spending nondurables and services + Consumption spending on durables and investment spending on houses (changes in real assets held) + Net Changes in financial assets held (Eq )

16 What is net financial investment? The increase in net financial assets

17 Y = Household disposable income W = Household wealth or net worth r = The yield or return on real assets; the sum of the value of the flow of services from real assets plus any capital gain, all divided by the price of the real asset i = The market interest rate (return) on financial assets – Demand for Real Assets= f(Y, W, r, i) Demand for Real + + – Money Balances = f(Y, W, i) Net Demand for Nonmonetary – Financial Assets= f(Y, W, r, i) (Eq , 4, 5)

18 Household Demand for Real & Financial Assets Increase i Increase net demand for nonmonetary financial assets Decrease demand for real assets Decreases demand for real money balances Increase Y or W Increase net demand for nonmonetary financial assets Increase demand for real assets Increase demand for real money balances Decrease net demand for nonmonetary financial assets Increase demand for real assets Increase r Exhibit

19 Marginal Revenue The additional revenue from selling an additional unit of output Marginal Cost The additional cost of selling an additional unit of output

20 Investment Spending For businesses, spending on new equipment and capital or net additions to inventories

21 Assets Liabilities Assets Liabilities Real Assets Equity Capital Goods Common Stock Inventories Financial Assets Debt Currency, checkable deposits Long-term Money Market Mutual Funds Short-term CD’s Mutual Funds Trade Credit Other Financial Assets Other Financial Liabilities Total Assets Total Liabilities plus Net Worth The Balance Sheet of the Business Sector Exhibit

22 Net Investment Gross investment minus depreciation

23 Exhibit 20-6 Business Investment To replace worn out or obsolete capital (plant, equipment, and machinery) To increase the capital stock (plant, equipment, and machinery) To add to inventories (raw materials, goods in process, finished goods)

24 Opportunity Cost The return one could have earned by using funds in the next best alternative; for investment spending, the real interest rate

25 Internal Financing The spending of money balances on hand or the liquidation of financial or real assets to finance spending that exceeds current receipts

26 External Financing Financing spending that exceeds current receipts by expanding either debt or equity

27 Business Finance Financing Need Internal Retained Earnings External EquityDebt Short-Term Debt Long-Term Debt Exhibit 20 -7

28 A firm’s balance sheet can be summarized as follows: (20-6) A = L + NW (20-7)  A =  L +  NW (20-8)  L =  A – RE

29 Corporate Financing Gap The increase in a firm’s liability, which is equal to the increase in assets held minus retained earnings

30 Leverage Ratio The ratio of debt to equity on a firm’s balance sheet

31 Sources of Funds Uses of Funds Net Revenues + Borrowing = Net Spending on real assets such as plant and equipment + Net Spending on real assets such as inventories + Changes in financial assets held Sources And Uses Of Fund For The Business Sector (Eq. 20-9)

32 Sources of Funds Uses of Funds Net revenues + Net borrowing = Net spending on real assets such as plant and equipment + Net spending on real assets such as inventories Subtract the “changes in other financial assets held” from both sides of Equation: Eq. (20-10)