CH8 - Saving, Investment, and the Financial System

Question 1

what does the financial system do

Answer 1

moves the economy’s scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn)

Question 2

Financial institutions that make up the financial system

Answer 2

1- government regulators (set the rules that guide the financial system)
2- office of the Superintendent of Financial Institutions (OSFI) (primary regulator of federally regulated banks, insurance companies, and pension plans in Canada)
3- Credit unions and caisses populaires, securitites dealers and mutual funds (regulated by provincial govs.)
4- Bank of Canada

Question 3

3 basic roles of the financial system

Answer 3

Intermediation: helps match one person’s saving (lender) with another person’s investment (borrower)

Provide liquidity: the ease at which an asset can be converted into cash

Diversify risk: the sharing of risk across assets and people

Question 4

2 major types of financial assets (claims on future funds or goods)

Answer 4

debt (bonds) and equity (stocks)

Question 5

2 types of financial institutions

Answer 5

financial markets and financial intermediaries

Question 6

Financial market def.

Answer 6

-> institutions through which a person who wants to save can directly supply funds to a person who wants to borrow
-> 2 most important are the bond and the stock market

Question 7

Bond (market) def

Answer 7

Bond = certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond (it is an IOU)
- date of maturity: the time at which the loan will be repaid
- rate of interest: paid periodically until loan matures

Question 8

Risk of buying bonds / credit risk

Answer 8

Credit risk: probability that the borrower will fail to pay some of the interest or principal

=> Failure to pay -> default, borrowers can (and sometimes do) default on their loans by declaring bankruptcy
=> If probability of default is high, the buyer demands a higher interest rate to compensate for this credit risk
=> Credit risk is affected by such things as the level of debt carried by the issuer of the bond, recent changes in the amount of debt carried, and the stability of the issuer’s revenues

Question 9

junk bonds

Answer 9

considerably high interest rate, issues by a financially shaky corp.

Question 10

Stock (market) def

Answer 10

Stock (or Equity) = represents partial ownership of a firm and is, therefore, a claim to the profits that the firm makes (vs. Bond holders who are creditors)
(Individual stock units are called shares )

=> if the corp. is profitable, the shareholders will enjoy benefits whereas bondholders only receive the interest and vice-versa if the corp runs into financial difficulties
= stocks have higher risk and potential higher return

Question 11

Most important stock exchanges

Answer 11

US - NYSE (New York) and NASDAQ (National Association of Securities Dealers Automatic Quotation system)

Canada – TSX (Toronto)

Question 12

How price of share is determined + stock index

Answer 12

The prices at which shares trade on stock exchanges are determined by the supply and demand for the stock in these companies.
-> demand for a stock (= its price) reflects people’s perception of the corporation’s future profitability, whether it is optimistic or not.

Stock Index: average group of stock prices (most famous is Dow Jones Industrial Average)
-> reflect expected profitability
-> watched closely as indicators of future economic conditions

Question 13

Derivatives def + 4 major players

Answer 13

Financial assets based on the value of some other asset
Ex. a futures contract

• The buyer agrees to pay the seller based on the future price of some asset
• Allows sellers to transfer risk relating to future prices to the contract partner

1) Savers : People and government who make funds available

2) Entrepreneurs and businesses : Borrow to finance investments

3) Speculators : People who buy and sell financial assets purely for financial gain

4) Financial intermediaries : Institutions through which savers provide funds indirectly to borrowers

Question 14

Financial intermediaries def

Answer 14

financial institutions through which savers can indirectly provide funds to borrowers.

intermediary - role of these institutions in standing between savers and borrowers

Question 15

5 types of financial intermediaries

Answer 15

1) Commercial banks and trust companies
- Pay depositors interest and charge borrowers higher interest on loans (to maximize profits)
- Act as a medium of exchange (facilitate purchases of goods and services by allowing people to write cheques against their deposit)

2) Investment banks
- Do not accept deposits and do not make typical loans
- Instead, they assist companies in issuing stocks and bonds by acting as market makers (match buyers and sellers)

3) Mutual funds
- Sell shares in the fund (called units) to the public and use the proceeds to buy portfolios of stocks and bonds of other companies
- Provide asset diversification and access to professional money managers who make decisions on behalf of clients (often “small investors”) for a fee

4) Pension funds
- A professionally managed portfolio that provides income to retirees
- Two types: defined benefit and defined contribution
-> Defined benefit plan (e.g., a pension): you know what to expect in terms of a payout when you retire
-> Defined contribution plan (e.g., a 401(k) or IRA): you choose how much to pay in without knowing what the retirement benefit will be

5) Insurance companies
- Provide financial protection against possible future losses in exchange for premiums

Question 16

2 ways to classify risk

Answer 16

-> Market (systematic) risk: risk that is broadly shared by the entire market or economy
-> Idiosyncratic risk: risk that is unique to a particular company or asset

Question 17

3 methods / approaches to choosing stock

Answer 17

principle of asset valuation: the value of any financial asset is the present value of its expected future cash flows

1) Fundamental analysis
- Conduct research on an individual company to predict future profits
- Net present value (NPV) is a measure of the current value of a stream of expected future cash flows

2) Technical analysis
- Computer analysis of movements in stock prices to predict future movements

3) Throw a dart
- At random – studies suggest that it is as successful as the other approaches

Question 18

The efficient market hypothesis (EMH) def

Answer 18

EMH states that market prices always incorporate all available information, and therefore represent stock value as correctly as possible
=> An argument against the EMH is that the same asset can trade at different prices in different markets

Question 19

3 different kinds of saving

Answer 19

1) private saving S: the portion of household’s income (including transfers) that is not used for consumption or paying taxes
2) Public saving, B (budget balance): Net tax revenue (TA – TR) minus government purchases
3) National Saving, NS: Private saving + public saving

Question 20

What is the relationship between Saving and Investment in a closed economy

Answer 20

Investment = private saving + public saving = national saving
Investment = National Saving

Question 21

Saving vs Investment

Answer 21

Private saving: the income households do not use to pay taxes or consume
Examples of what households do with savings:
- Buy corporate bonds or equities
- Purchase a certificate of deposit at the bank
- Buy shares of a mutual fund
- Let interest accumulate in a savings account

Investment: the purchase of new capital
Examples of (physical) investment:
- X spends $250 million to produce a new line of steel products
- You buy $5,000 worth of computer equipment for your business
- Your parents spend $400,000 to have a new house built

=> in economics, investment is NOT the purchase of stocks and bonds

Question 22

Accounting + identity def

Answer 22

how various numbers are defined and added up
-> a national income accountant adds up the nation’s income and expenses (includes GDP)

Identity = equation that must be true because of the way the variable in the equation are defined

Question 23

National and private saving identity equations

Answer 23

National Saving
Y – C – G = I
-> total income in the economy that remains after consumption and gov purchases = national saving (S)
S = I
S = Y – C – G or S = (Y – T – C) + (T – G) (they are the same because the Ts cancel out)

Private saving: Y – T – C (amount households have after taxes and consumption)

Question 24

Public saving - budget identity equations

Answer 24

Budget balance, B: The difference between tax revenue and government spending
1) Budget surplus, B > 0: surplus of net tax revenue (TA – TR) over government purchases
= public saving
2) Budget deficit, B < 0: shortfall of net tax revenue (TA –TR) relative to government purchases
= public dissaving
3) Balanced Budget, B = 0: net tax revenue (TA – TR) equals to government purchases

Question 25

Effect of a tax cut on saving and investment

Answer 25

The effects of a tax cut on national saving and investment depend on the behaviour of consumers
- If there is no change in consumption (private saving increases by the amount of the tax cut), then there will be no change in either national saving or investment
- However, if consumption increases (private saving increases by less than the amount of the tax cut), then national saving and investment will both fall

-> consumers as a whole typically spend at least part of the proceeds of the tax cut, so a tax cut typically reduces investment

How a tax cut causes investment to fall in a closed economy: raising interest rates

Question 26

The market for loanable funds def.

Answer 26

Def = describes how that borrowing happens (model where it is the only financial market – one interest rate for borrowing and lending)

Loanable funds = all income that people have chosen to save and lend out, rather than use for their own consumption

Question 27

Factors that would cause a shift in supply of loanable funds

Answer 27

Any factor (other than interest rate) that affects saving will a shift the supply curve for loanable funds:

1) Culture: the supply curve for loanable funds will be further to the eft when people are more consumer-oriented (save less at any r)

2) Social welfare policies: the supply curve for loanable funds will be further to the left when policies relating to unemployment, poverty, health and retirement are more generous (save less at any r)

3) Wealth: the supply curve for loanable funds will be further to the left when house holds are poorer (save less at any r)

4) Current economic conditions: the supply curve for loanable funds will be further to the left when there is a recession (save less at any r)

5) Expectations about future economic conditions: the supply curve for loanable funds will be further to the left when people are optimistic about the future (save less at any r)

Question 28

How government policies affect savings and investment decisions

Answer 28

1) Saving incentives
2) Investment incentives
3) Government budget deficits and surpluses

Question 29

Saving incentives (gov. policy)

Answer 29

2 types:

A) Sales Tax
-> GST (1991), goods and service tax -> consumption tax = income that is saved is not taxed, so the tax clearly encourages greater saving, sales tax that provinces use to collect revenue is another example of a consumption tax

B) Income Tax
-> Registered Retirement Saving Plans (RRSP) = reduces the amount of the income that is subject to tax
-> Tax-Free Savings Accounts (TFSA) = income earned on savings that are held in a TFSA is not subject to tax
=> investment tax credits reduce the cost of purchasing certain types of machinery in certain industries in certain regions

Question 30

Investment Incentives (gov. policy)

Answer 30

Investment tax credit = federal tax incentive for business investment. They let individuals or businesses deduct a certain percentage of investment costs from their taxes.

Question 31

Gov budget deficit and surpluses (gov. policy affect saving and investment)

Answer 31

Government starts with a balanced budget and because of a tax cut, starts running on a budget deficit: a change in the government budget balance represents a change in public saving and, thereby, in the supply of loanable funds
-> left shift of supply curve, equilibrium moves along demand curve

Question 32

Crowding out def + effects

Answer 32

def= fall of investment because of government borrowing (it crowds out private borrowers who are trying to finance investment

When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls -> reduces the economy’s growth rate

Increased borrowing from the government shifts the supply curve, while increased borrowing by private investors shifts the demand curve
- Long strings of government deficit can push the economy into a vicious circle,
=> deficits cause lower economic growth -> lower tax revenue and higher spending on Employment Insurance and other income-support programs
=> Only way to break out of this vicious circle is to raise tax rates and cut spending on government programs to eliminate the deficit and halt the circle of deficits, but this leads to slower economic growth and even higher deficits.

Question 33

effect of a gov. surplus

Answer 33

work in the opposite way as deficits

-> gov saves the difference by retiring some of the outstanding government debt = contributes to national saving

A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Can push the economy into a virtuous circle:
- increasing the supply of loanable funds, reducing interest rates, and stimulating investment, surpluses encourage faster economic growth
- This leads to higher tax revenues and lower spending on income-support programs = the government surplus grows over time