Finance , Saving, and Investment ,

Chapter 10

What do you mean by – Finance

• Finance is the lending and borrowing, that

moves funds (money) from savers to

spenders.

Finance & Money – The Difference

•Money is the object that people use to make payments.

Example

Role of Financial Institutions and Markets

• financial institutions and markets provide the channels through which saving flows to finance investment in capital that make our economy grow.

• When financial institutions and markets are working well , a high level of investment brings a rapidly growing economy and rising standard of living

Physical Capital

• They are the tools, instruments, machines, buildings, other items that have been produced in the past and that are used to produce goods and services.

Financial Capital

• They are the funds used to buy physical capital.

What is Gross Investment?

• The total amount spent on new capital is called gross investment.

What is Net Investment?

•The change in the quantity of capital is called net investment.

What is Saving?

•Saving is the amount of income that is not paid in taxes or spent on consumption, which in turn adds to wealth.

What is Wealth?•Wealth: is the value of all the things

that the people own .

•Saving ,the amount of income that is not paid in taxes or spent on consumption ,adds to wealth. wealth also increases when market value of assets rises,which is called capital gains.

Example of Wealth:Example of Wealth:

Markets for Financial Capital

There are three types of financial markets.

1.Loan Markets

2.Bond Markets

3.Stock Markets

Loan Markets

• Businesses often want short-term loans to buy inventories or to extend credit to their customers. Sometimes they get these funds in the form of a loan from the bank.

• Households often want funds to purchase big-ticket items, such as an automobiles or household furnishings and appliances.

Just For Understanding:

Credit: money available for a client to borrow.

Inventories: a detail list of all items in the stock.

Loan: a sum of money or any valuable asset which an individual or group borrows from an individual or group, with the condition that it be returned or repaid at a later date.

Mortgage: A mortgage is an agreement by which a loan is granted for the purchase of a property and the property itself is assurance as security.

Just For Understanding:

Credit: money available for a client to borrow.

Inventories: a detail list of all items in the stock.

Loan: a sum of money or any valuable asset which an individual or group borrows from an individual or group, with the condition that it be returned or repaid at a later date.

Mortgage: A mortgage is an agreement by which a loan is granted for the purchase of a property and the property itself is assurance as security.

Bond & Bond Markets

• Bond: A bond is a promise to make specified payments on specified dates (maturity).

• Bonds issued by firms and governments are traded in the Bond Market.

You buy a Western Union bond that promises to pay SR 6.20 every year until 2035 and then

to make a final payment of SR 100 in 2036.

You buy a Western Union bond that promises to pay SR 6.20 every year until 2035 and then

to make a final payment of SR 100 in 2036.

Example

Stock Markets

• Stock: is a certificate of ownership and claim to the profits that a firm makes.

• Stock Market: is a financial market in which shares of corporations’ stock are traded.

Boeing has issued 900 million shares of its stock. If you owned 900 Boeing shares, you would own 1 millionth of Boeing and be entitled to receive 1

millionth of its profit.

Boeing has issued 900 million shares of its stock. If you owned 900 Boeing shares, you would own 1 millionth of Boeing and be entitled to receive 1

millionth of its profit.

Example

Financial Institutions

• A financial institution is a firm that operates on both sides of the market for financial capital. It borrows from one market and lends in the other.

Key Financial Institutions

1. Investment Banks

2. Commercial Banks

3. Government Sponsored Mortgage lenders

4. Pension Funds

5. Insurance Companies

Key Financial Institutions

1. Investment Banks

Investment banks are firms that help other financial institutions and governments raise funds by issuing and selling bonds and stocks. They also assist on transactions such as mergers and acquisitions.

Key Financial Institutions

2. Commercial Banks

The bank that you use for your own banking services and that issue your credit card is a Commercial Bank.

Key Financial Institutions

3. Government Sponsored Mortgage lenders

are government sponsored enterprises that buy mortgages from the banks, package them into mortgage-backed securities, and sell them.

Key Financial Institutions

4. Pension Funds

Are financial institutions that use the pension contribution of firms and workers to buy bonds and stocks.

Key Financial Institutions

5. Insurance Companies

Insurance companies enter into agreements with households and firms to provide compensation in the event of accident, theft, fire, ill-health, and host of other misfortunes.

Net Worth Insolvency & Illiquidity

• The total market value of what a financial institution has lent minus the market value of what it has borrowed.

• Net worth: if positive, the institution is solvent and can remain in business.

• Net worth: if negative, the institution is insolvent and must stop trading.

Net Worth

The owners of the insolvent financial institution bear the loss when the assets are sold in order to pay the debts.

The owners of the insolvent financial institution bear the loss when the assets are sold in order to pay the debts.

Example

How to limit the risk

• A financial institution borrows and lends, so it is exposed to the risk that the net worth becomes negative. To limit that risk, institutions are regulated and a minimum amount of their lending must be backed by their net worth.

Illiquidity

• A firm is illiquid if it has made long term loans with borrowed funds and it is faced with a sudden demand to repay more of what it has borrowed, than its available cash.

Interest Rates & Assets Prices

• What are financial Assets?

1. Stocks

2. Bonds

3. Short-term securities, &

4. Loans

Interest Rates & Assets Prices

• The interest rate on a financial asset, is a percentage of the price of the asset.

• If the asset price rises, other things remain the same, the interest rate falls.

• If the asset price falls, other things remain the same, the interest rate rises.

• (There is an inverse relationship between an asset price and interest rate.)

Interest Rates & Assets Prices

If the price of the share, was $25.- And the owner of each share get $0.50

cents of the profit.

-Then the interest rate will =

0.50x 100 = 2% 25

If the price of the share, was $25.-And the owner of each share get $0.50

cents of the profit.

-Then the interest rate will =

0.50x 100 = 2% 25

Example 1

Interest Rates & Assets Prices

If the price of the share, was $50.- And the owner of each share get $0.50

cents of the profit.

- Then the interest rate will =

0.50 x 100 = 1 % 50

If the price of the share, was $50.- And the owner of each share get $0.50

cents of the profit.

- Then the interest rate will =

0.50 x 100 = 1 % 50

Example 2

The Market for Loan-able Fund

• The demand for the Loan-able funds

• The supply of the Loan-able funds

• Equilibrium in the market for Loan-able funds

The Demand for Loan-able Fund

•The quantity of loan-able funds demanded is the total quantity of funds demanded to financial investment, the government budget deficit, and international investment or lending during a given period.

Factors that influence the demand for loan-able funds:

1. The real interest rate

2. Expected Profit• Other things remaining the same, the higher

the real interest rate, the smaller is the quantity of loan-able funds demanded.

• The lower the interest rate, the greater is the quantity of loan-able funds demanded.

Demand for Loan-able Funds Curve

The demand for loan-able funds is the relationship between the quantity of loan-able funds demanded and the real interest rate when all other influences on borrowing plans remain the same.

The figure (1.1) shows, the quantity of loan-able funds demanded at five real interest rates. The graph shows the demand for loan-able funds curve, DLF. Points A to E correspond to the rows of the table.

Figure: 1.1

Changes in the Demand for Loan-able Funds

When expected profit changes, the demand for loan-able funds changes. Other things remaining the same, the greater the profit from new capital, the greater is the amount of investment and the greater is the demand for loan-able funds.

Figure (1.2), shows how the demand for loan-able funds curve shifts when the expected profit changes. With average profit expectations, the demand for loan-able funds is DLF0. A rise in expected profit shifts the demand curve rightwards to DLF1 and a fall in expected profit shifts the demand curve leftwards to DLF2.

Figure 1.2:

The Supply of Loan-able Funds

The quantity of loan-able funds supplied is the total funds available from private saving, the government budget surplus, and international borrowing during a given period.

Factors that influence the supply for loan-able funds:

1. The real interest rate

2. Disposable income

3. Wealth

4. Expected future income

5. Default Risk

Factors that influence the supply for loan-able funds:

• Figure (1.3) shows, the quantity of loan-able funds supplied at five real interest rates. The shows, the supply curve SLF. Points A to E correspond to the rows of the table.

• Other things remain the same, the higher the real interest rate, the greater is the quantity of loan-able funds supplied.

• The lower the interest rate, the smaller is the quantity of loan-able funds supplied.

Figure 1.3:

Factors: Disposable Income

1. Disposable Income: a household’s disposable income is the income earned minus net taxes.

• The greater a household’s disposable income, other things remaining the same, the greater is the saving.

Income Earned

Net Income

Disposable Income: Example

• A student whose disposable income is $10,000 a year spends the entire $10,000 and saves nothing.

• An economics graduate whose disposable income is $50,000 a year spends $40,000 and saves $ 10,000.

Factors: Wealth2. Wealth: a household’s wealth is what it owns.

• The greater a household\s wealth, other things remaining the same, the less it will save.

• Example: Patty has $15,000 in the bank and no debts: She decides to spend $5,000 on a vacation and save nothing this year.

• Tony has nothing in the bank and owes $10,000 on his credit card: He decides to cut consumption and start saving.

Factors: Expected Future Income

• The higher a household’s expected future income, other things remaining the same, the smaller is its saving today.

• If two households have the same current disposable income, the household with the larger expected future disposable income will spend a larger portion of its current disposable income on consumption goods and services and so save less today.

Expected Future Income: Example• Considering the above example of Patty &

Tony. Patty has been promoted and will receive a $ 10,000 pay raise next year. Tony has just been told that he will be sacked at the end of the year.

• On receiving this news, Patty buys a new car – increases her consumption expenditure and cuts her saving.

• Whereas, Tony sells his car and takes the bus – decreases his consumption expense and increases his savings.

Factors: Default Risk• Default Risk is the risk that a loan will not be

paid, or not repaid in full. The greater that risk, the higher is the interest rate needed to induce a person to lend and the smaller is the supply of loan-able funds.

• In normal times, default risk is low but in times of financial crisis when asset prices tumble, default can become widespread as financial institutions become illiquid or insolvent.

Shifts of the Supply of Loan-able Funds Curve

• When any of the four factors (mentioned above) changes, the supply of loan-able funds changes and the supply curve shifts.

• An increase in disposable income, or a decrease in wealth, expected future income, or default risk increases the supply of loan-able funds.

Shifts of the Supply of Loan-able Funds Curve

• Figure (1.4) shows, how the supply of loan-able funds curve shifts. Initially, the supply of loan-able funds is SLF0.

An increases in disposable income or a decreases

in the wealth, expected future income, or default risk increases the supply of loan-able funds and shifts the curve rightwards from SLF0 to SLF1.

A decrease in disposable income or an increase in the wealth, expected future income, or default risk decreases the supply of loan-able funds and shifts the curve leftwards from SLF0 to SLF1.

Figure 1.4:

Equilibrium in the Market for Loan-able Funds

• There is one interest rate at which the quantity of loan-able funds demanded and supplied are equal, and that interest rate is the equilibrium real interest rate.

Equilibrium in the Market for Loan-able Funds

• When the real interest rate exceeds 6 % a year, the quantity of loan-able funds supplied (SLF) exceeds the quantity demanded (DLF).

• Which means borrowers find the funds they want, but lenders are unable to lend all the funds available.

• The real interest rate keeps falling until the quantity of funds supplied equals the quantity of funds demanded.

Equilibrium in the Market for Loan-able Funds

• Alternatively, when the real interest rate less than 6 % a year, the quantity of loan-able funds supplied (SLF) is less than the quantity demanded (DLF).

• Which means borrowers cannot find the funds they want, but lenders are able to lend all the funds available. • The real interest rate keeps rising until the quantity of funds supplied equals the quantity of funds demanded.

Figure 1.5:shows how the demand for and supply of loan-able funds determine the real interest rate.

Figure 1.5: Explanation

1. If real interest rate is 8 % a year, the quantity of loan-able fund demanded is less than the quantity supplied. There is surplus of funds and real interest rate falls.

2. If real interest rate is 4 % a year, the quantity of loan-able fund demanded is more than the quantity supplied. There is shortage of funds and real interest rate rises.

3. If real interest rate is 6 % a year, the quantity of loan-able fund demanded equals the quantity supplied. There is neither surplus nor shortage of funds and real interest rate is at its equilibrium level.

Changes in Demand and Supply• Fluctuations in either the demand or supply

of loan-able funds bring fluctuations in the real interest rate and in the equilibrium quantity of funds lent and borrowed. Figure (1.6) illustrates:

1. If the demand for loan-able funds increases and the supply remains the same, the real interest rate rises and the equilibrium quantity of funds increases.

2. If the supply for loan-able funds increases and the demand remains the same, the real interest rate falls and the equilibrium quantity of funds increases.

Figure 1.6: