Finance, Saving, and Investment

Financial Institutions and Markets

This section introduces the concepts of physical and financial capital, investment, wealth, and the role of financial markets and institutions in the economy.

• Physical capital: Tools, machines, buildings, and other constructions produced in the past and used to produce goods and services.

• Financial capital: Funds that firms use to buy and operate physical capital.

• Gross investment: Total amount spent on new capital goods.

• Net investment: Change in the quantity of capital; equals gross investment minus depreciation. Formula:

• Wealth (Net worth): Market value of what a household or firm owns minus what it owes.

• Saving: Income not paid in taxes or spent on consumption; adds to wealth.

• Capital gains: Increase in wealth when the market value of assets rises.

Example: If a firm spends $35,000 on new machines (gross investment) and its capital depreciates by $20,000, its net investment is $15,000.

Markets for Financial Capital

• Loan markets: Provide short-term loans for businesses and households (e.g., bank loans, credit cards).

• Bond markets: Firms and governments issue bonds to raise funds. A bond is a promise to pay specified sums on specified dates; the bond market trades these instruments.

• Stock markets: Corporations issue shares of ownership (stocks), traded on exchanges like NYSE, London, Frankfurt, and Tokyo.

Financial Institutions

• Financial institution: Firm that borrows in one market and lends in another.

• Key types: Investment banks, commercial banks, government-sponsored mortgage lenders, pension funds, insurance companies.

Interest Rates and Asset Prices

• The interest rate on a bond or stock is a percentage of its price.

• If the price rises, the interest rate falls; if the price falls, the interest rate rises.

• Example: A bond pays \frac{5}{200} = 0.025\frac{5}{100} = 0.05$ or 5%.

Economic Benefits of Financial Markets and Institutions

• Enable investment in capital

• Smooth consumption expenditure

• Trade risk

The Loanable Funds Market

The loanable funds market aggregates the markets for loans, bonds, and stocks, determining the average interest rate in the economy.

• Uses of loanable funds: Business investment, government budget deficit, international investment/lending.

• Sources: Private saving, government budget surplus, international borrowing.

Demand for Loanable Funds

• Total funds demanded to finance investment, government deficit, and international investment/lending.

• Investment: Major factor influencing demand.

• Real interest rate: Opportunity cost of funds used for capital purchases.

• Firms invest when expected profit exceeds real interest rate.

• As real interest rate rises, quantity of loanable funds demanded falls; as it falls, demand rises.

Demand for Loanable Funds Curve

• Shows relationship between quantity of investment demanded and real interest rate.

• Increase in expected profit shifts demand curve right; decrease shifts it left.

• Factors affecting expected profit: Business cycle, technological change, population growth, "animal spirits" (Keynes).

Supply of Loanable Funds

• Total funds available from private saving, government surplus, and international borrowing.

• Saving: Main item; depends on real interest rate, disposable income, wealth, expected future income, default risk.

• Higher real interest rate increases saving and supply; lower rate decreases them.

Supply of Loanable Funds Curve

• Relationship between quantity supplied and real interest rate.

• Opportunity cost of consumption expenditure is the real interest rate.

Factors Influencing Supply

• Disposable income: Income minus net taxes; higher disposable income increases saving.

• Wealth: Greater wealth decreases saving.

• Expected future income: Higher expected income decreases saving today.

• Default risk: Higher risk decreases supply.

Shifts of the Supply Curve

• Increase in disposable income, decrease in wealth, expected future income, or default risk shifts supply curve right.

• Decrease in disposable income, increase in wealth, expected future income, or default risk shifts supply curve left.

Equilibrium in the Loanable Funds Market

• Real interest rate is determined where quantity demanded equals quantity supplied.

• If rate is above equilibrium, surplus of funds causes rate to fall.

• If rate is below equilibrium, shortage causes rate to rise.

• At equilibrium, no shortage or surplus; rate is stable.

Changes in Demand and Supply

• Increase in demand raises real interest rate.

• Increase in supply lowers real interest rate.

Government in the Loanable Funds Market

Government budget surpluses and deficits affect the supply and demand for loanable funds, influencing real interest rates, saving, and investment.

Government Budget Surplus

• Increases supply of loanable funds.

• Leads to lower real interest rate, decreased private saving, increased investment and loanable funds demanded.

• Example: With a $1 trillion surplus, supply curve shifts right, rate falls from 6% to 4%, private saving decreases, investment increases.

Government Budget Deficit

• Increases demand for loanable funds.

• Raises real interest rate, increases private saving, decreases investment and loanable funds demanded by firms.

• Crowding-out effect: Tendency for deficit to raise interest rate and decrease investment.

• Example: With a $1 trillion deficit, demand curve shifts right, rate rises from 6% to 8%, saving increases, investment decreases.

Ricardo-Barro Effect

• Proposition that a government budget deficit has no effect on real interest rate or investment if private saving increases to offset the deficit.

• Most economists regard this as unlikely.

Fintech and Financial Markets

Fintech (financial technology) refers to internet-based financial services and apps that automate transactions, including cryptocurrencies.

• Fintech has grown rapidly since 2005, changing the landscape of financial markets.

• Traditional financial institutions' share of loanable funds has declined since the global financial crisis.

• By 2018, fintech accounted for 38% of personal loans, up from a much smaller share in 2013.

• Fintech loans are easier and faster to obtain, often offering lower interest rates for low and medium risk borrowers (4 percentage points below traditional lenders).

Fintech in Personal Loans Market

Example: Using a smartphone app to transfer money or apply for a loan is an example of fintech in action.

Additional info: Fintech is expected to continue reshaping financial markets, increasing accessibility and efficiency for consumers and businesses.