Finance, Saving, and Investment

Introduction

This chapter explores the fundamental concepts of finance, saving, and investment in macroeconomics. It examines the roles of financial markets and institutions, the flow of funds in the economy, and the determination of interest rates and equilibrium in the loanable funds market.

Key Concepts in Finance and Money

Definitions and Distinctions

• Finance: The activity of providing funds that are used for investment, consumption, or government spending. In economics, finance refers to the management of funds and the markets and institutions that facilitate the flow of funds.

• Money: Any item that is generally accepted as payment for goods and services or repayment of debts. Money serves as a medium of exchange, a unit of account, and a store of value.

Capital and Investment

Types of Capital

• Physical Capital: Tangible assets such as machinery, buildings, and equipment used in production.

• Human Capital: The skills, knowledge, and experience possessed by individuals, contributing to productivity.

• Financial Capital: Funds available for investment, including money, stocks, and bonds.

Investment and Depreciation

• Investment: The purchase of new capital goods (physical capital) and additions to inventories.

• Depreciation: The decrease in the value of capital due to wear and tear or obsolescence.

• Gross Investment: Total amount spent on new capital and replacing depreciated capital.

• Net Investment: Gross investment minus depreciation.

Formula:

Example: If a firm spends $100,000 on new machines (gross investment) and $20,000 worth of machines wear out (depreciation), net investment is $80,000.

Wealth, Income, and Saving

Definitions and Relationships

• Wealth: The total value of all assets owned at a point in time.

• Income: The flow of earnings received over a period of time (e.g., wages, interest, rent).

• Saving: The portion of income not spent on consumption; it increases wealth.

• Capital Gains: Increases in the value of assets.

• Capital Losses: Decreases in the value of assets.

Relationship: Wealth changes through saving, capital gains, and capital losses.

Formula:

Financial Markets and Instruments

Types of Financial Markets

• Loan Markets: Where borrowers obtain funds directly from lenders (e.g., bank loans, mortgages).

• Bond Markets: Where firms and governments issue bonds to raise funds; bonds are tradable debt instruments.

• Stock Markets: Where shares of ownership in companies (stocks) are bought and sold.

Key Instruments:

• Mortgage: A loan to purchase real estate, secured by the property itself.

• Bond: A certificate of indebtedness promising to pay back with interest.

• Mortgage-Backed Security: A financial asset backed by a pool of mortgages.

• Stock: A share in the ownership of a company.

Financial Institutions

Role and Types

• Financial Institution: An organization that channels funds from savers to borrowers.

• Six Key Financial Institutions:

  • Commercial Banks

  • Government-Sponsored Mortgage Lenders

  • Pension Funds

  • Insurance Companies

  • Mutual Funds

  • Central Bank

Functions: Accept deposits, make loans, invest in securities, and facilitate payments.

Loanable Funds Market

Sources and Flow of Funds

• Three Sources of Loanable Funds:

  • Household Saving

  • Government Budget Surplus

  • Borrowing from the Rest of the World

Loanable Funds Market: The market where savers supply funds for loans to borrowers.

Connection to Circular Flow: The flow of loanable funds finances investment and is part of the broader circular flow of income and spending in the economy.

National Income, Saving, and Investment

Net Taxes and Household Income

• Net Taxes (T): Taxes paid to the government minus transfer payments received.

• Household Income Components: Consumption (C), Saving (S), and Net Taxes (T).

Formula:

Investment Calculation:

From the national income identity:

or

Setting the two equal and solving for investment (I):

National Saving: The sum of private and government saving.

Present Value and Financial Decision Making

Measuring Present and Future Value

• Present Value (PV): The value today of a sum of money to be received in the future, discounted at the interest rate.

• Future Value (FV): The amount a sum of money today will grow to in the future at a given interest rate.

Formulas:

where r is the interest rate and n is the number of periods.

• Net Present Value (NPV): The present value of all future cash flows minus the initial investment.

Financial Decision Rule: Invest if NPV > 0; do not invest if NPV < 0.

Financial Institution Solvency and Liquidity

Net Worth, Insolvency, and Illiquidity

• Net Worth: The value of assets minus liabilities.

• Insolvency: When liabilities exceed assets; the institution cannot meet its obligations.

• Illiquidity: When an institution cannot meet short-term obligations due to lack of liquid assets, even if net worth is positive.

Financial Assets and Interest Rates

Types and Relationships

• Financial Assets: Claims on future payments, such as bonds, stocks, and loans.

• Interest Rate: The return on a financial asset, usually expressed as a percentage of the price.

• Relationship: The price of a financial asset and its interest rate are inversely related.

Formula:

• Nominal Interest Rate: The stated interest rate, not adjusted for inflation.

• Real Interest Rate: The nominal rate adjusted for inflation.

Formula:

The real interest rate represents the opportunity cost of borrowing or lending funds.

Loanable Funds Market: Demand and Supply

Demand for Loanable Funds (DLF)

• Quantity Demanded: The amount of funds firms want to borrow at each interest rate.

• Price: The real interest rate.

• DLF Curve: Shows the relationship between the real interest rate and the quantity of loanable funds demanded.

• Movement Along DLF: Caused by changes in the real interest rate.

• Shifts in DLF: Caused by changes in expected profits or business conditions.

Supply of Loanable Funds (SLF)

• Quantity Supplied: The amount of funds households and others are willing to lend at each interest rate.

• SLF Curve: Shows the relationship between the real interest rate and the quantity of loanable funds supplied.

• Movement Along SLF: Caused by changes in the real interest rate.

• Shifts in SLF: Caused by changes in disposable income, expected future income, wealth, default risk, and government policies.

Five Factors Influencing SLF:

• Disposable Income

• Expected Future Income

• Wealth

• Default Risk

• Government Policy

Equilibrium in the Loanable Funds Market

Determination and Changes

• Equilibrium: Occurs where the quantity of loanable funds demanded equals the quantity supplied at the equilibrium real interest rate.

• Shifts in DLF or SLF: Changes in either curve will alter the equilibrium interest rate and quantity of funds.

Example: An increase in expected profits shifts DLF right, raising the equilibrium interest rate and quantity of funds.

Government Budget and Loanable Funds Market

Budget Surplus, Deficit, and Effects

• Budget Surplus: When government revenue exceeds spending; increases supply of loanable funds.

• Budget Deficit: When government spending exceeds revenue; increases demand for loanable funds.

• Crowding-Out Effect: Government borrowing raises interest rates, reducing private investment.

• Ricardo-Barro Effect: Suggests that government deficits may not affect interest rates or investment if households increase saving in anticipation of future taxes.

Summary Table: Key Financial Markets and Instruments

Additional info: This summary expands on the provided outline with definitions, formulas, and examples to ensure a comprehensive understanding of the chapter's key concepts.