1. 1 Chapter 4 Analysis of the Financial System and the Economy © 2000 South-Western College Publishing

2. 2 Bonds are Financial claims on DSUs IOUs issued by DSUs

3. 3 Disposable Personal Income Income available to households to spend on consumption or to save

4. 4 Financial Statement, J.P. Young, January 1, 1999 through December 31, 1999 Consumption Saving (acquisition of summer home) (acquisition of financial claims) Consumption plus Saving $34,000 $7,000 $4,000 $3,000 $41,000 Wages and Salaries Dividends Interest Rent Disposable Income $37,000 $2,000 $0 $41,000 Expenditures (Uses)Receipts (Sources) Exhibit 4-1

5. 5 Consumption Household spending on goods and services

6. 6 Financial Statement, All Purpose Enterprise Inc., January 1, 1999 through December 31, 1999 (in millions) (A) Total Expenses - Wages and salaries - Interest on debt - Cost of Raw materials purchased from other firms (B) Net Income (Sales - Expenses) - minus dividends - equals Retained Earnings (C) Business Investment Spending (new capital goods, plant and equipment,and/or additions to inventories) $44,000 $3,200 $200 $1,000 $400 $200 $200 $500 Total Sales Financing: new bonds issued Retained earnings $48,000 $300 $200 $500 Exhibit 4-2

7. 7 Investment is Spending by households on newly constructed houses plus spending by business firms on capital or additions to inventories

8. 8 National Income and Expenditures for Hypothetical Economy, 1999 (in billions of dollars) RECEIPTS – EXPENDITURES = DEFICIT or SECTORINCOMEEXPENDITURESSURPLUS HOUSEHOLDS HOUSEHOLDSDisposable Consumption personal expenditures $3,400 income Investment $4,100 expenditures $400Surplus $300 BUSINESS BUSINESS FIRMS FIRMSRetained Investment earnings $200 expenditures $500Deficit –$300 ECONOMY ECONOMYNational Domestic income $4,300Product $4,300 Exhibit 4-3

9. 9 Product Market The market for consumption spending by households and investment spending by households and firms

10. 10 Factor Market The market for inputs such as labor, capital, and natural resources

11. 11 National Income The sum of the earnings of each sector

12. 12 National Expenditures The sum of the expenditures of each sector

13. 13 Circular Flow Diagram A diagram that shows the real and financial flows between households and business firms

14. 14 Financial Markets Exhibit 4-4 Factor Markets Firms Product Markets Households $ $ $ $ $ $ $ $

15. 15 Aggregate Supply The total quantity of goods and services that will be supplied at various prices

16. 16 Aggregate Demand The total quantity of goods and services that will be demanded at various prices

17. 17 $4,300 A Price Index Real GDP (in billions) 1.0 AS AD Product Market: Aggregate Demand & Aggregate Supply Exhibit 4-5

18. 18 200 B Wage Rate/Hour Labor Hours (in billions) $18.50 S D Factor Market: Demand & Supply for Labor Exhibit 4-6

19. 19 $300 C Interest Rate (Percent) Loanable Funds (in billions) 4 S D Financial System: Supply & Demand for Loanable Funds Exhibit 4-7

20. 20 Utility is The satisfaction that households receive over time from consuming goods and services

21. 21 Goals of Various Spending Units Households Maximize Utility (Satisfaction) Firms Maximize Profits Exhibit 4.8

22. 22 Constrained Maximization The course of action that leads to the highest utility for households or the greatest profits for firms, given the constraints that each faces

23. 23 Liquidity Preference The theory of interest rate determination based on the supply and demand for money; it was first developed by Keynes

24. 24 Stocks are Quantities that are measured at a point in time

25. 25 Flows are Quantities that are measured through time