Chapter 20Financial Aspects of

Household and Firm Behavior

©2000 South-Western College Publishing

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Portfolio

The collection of real and financial assets and liabilities

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Net WorthNet Worth

The difference between assets and liabilities at a point in time

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Balance Sheet of the Household SectorDecember 31, 2000

Assets Liabilities

Real estate Real estate mortgagesOther real assets Installment debtMoney Other personal debtOther financial

assets Net worthNet worth

Total assets Total assets Total liabilities plus Total liabilities plus net worthnet worth

Exhibit 20 - 1

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Household Portfolio Changes over Time J.P. Young (thousands $)

(1)January 1, 2000

Real Assets $100Money $ 3Other Financial Assets $ 30Total Assets $133Total Liabilities $ 53Net Worth $ 80

Exhibit 20 - 2

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Household Portfolio Changes over Time J.P. Young (thousands $)

(2)Actions During Year

Purchase computer,stereo, TV $5

Increase in money holdings $ .3Acquisition of stocks & bonds $2.7Change in Total Assets $8Change in Total Liabilities $2Change in Net Worth $6

Exhibit 20 - 2 cont.

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Household Portfolio Changes over Time J.P. Young (thousands $)

(3)December 31, 2000

Real Assets $105Money $ 3.3Other Financial Assets $ 32.7Total Assets $141Total Liabilities $ 55Net Worth $ 86

Exhibit 20 - 2 cont.

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Household Asset Accumulation: spending and saving

•Real AssetsReal Assets - durable goods and houses•Financial AssetsFinancial Assets - stocks, bonds, money

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Financial Liabilities

Debt incurred by borrowing

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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

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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

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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

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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...

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The Sources and Uses of Funds for Households

Sources of FundsSources of Funds Uses of FundsUses 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. 20 - 1)

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Subtract borrowing from both sides of equation:

Sources of FundsSources of Funds Uses of FundsUses 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. 20 - 2)

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What isnet financial investment?

The increase in net financial assets

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Y = Household disposable incomeW = Household wealth or net worthr = 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 asseti = 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. 20 - 3, 4, 5)

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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 20 - 4

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Marginal RevenueThe additional revenue from selling an additional unit of output

Marginal Cost

The additional cost of selling an additional unit of output

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Investment Spending

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

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AssetsAssets LiabilitiesLiabilities

Real Assets EquityCapital Goods Common StockInventories

Financial Assets DebtCurrency, checkable deposits Long-termMoney Market Mutual Funds Short-termCD’sMutual FundsTrade CreditOther Financial Assets Other Financial Liabilities

Total Assets Total Liabilities plus Net Worth

The Balance Sheet of the Business Sector

Exhibit 20 - 5

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Net Investment

Gross investment minus depreciation

23Exhibit 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)

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Opportunity Cost

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

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Internal Financing

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

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External Financing

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

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Business Finance

Financing Need

Internal

Retained Earnings

External

Equity Debt

Short-Term Debt

Long-Term Debt

Exhibit 20 -7

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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

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Corporate Financing Gap

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

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Leverage Ratio

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

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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 Sources And Uses Of Fund For The Business SectorThe Business Sector

(Eq. 20-9)

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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)