Financial Institutions and Financial Markets
Finance and money differ:
Finance refers to providing the funds used for investment.
Money refers to what is used to pay for goods and services.
Physical capital and financial capital differ:
Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services.
Financial capital is the funds that firms use to buy physical capital.
Financial Capital Markets
Financial markets transform saving and wealth into investment and capital.
Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market.
Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgage-backed securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008.
Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit.
Financial Institutions
A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies.
Insolvency and Illiquidity
A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business.
A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.
Interest Rates and Asset Prices
Stocks, bonds, short-term securities, and loans are financial assets.
The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price.
If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.
The Market for Loanable Funds
The market for loanable funds is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.
The funds that finance investment are from household saving, the government budget surplus, and international borrowing.
Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X M). Combining shows that C + S + T = C + I + G + (X M), which can be rearranged to show how investment is financed:
I = S + (T G) + (X M).
This formula shows that investment is financed using private saving, a government budget surplus, (T G) and borrowing from the rest of the world, (X M).
The sum of private saving, S, plus government saving, (T G), is national saving.
If we export less than we import, (X M) is negative and we borrow (M X) from the rest of the world.
If we export more than we import, (X M) is positive and we loan (X M) to the rest of the world.
The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.
The Demand for Loanable Funds
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment.
Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit.
The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.
The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate.
Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism.
The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.
The Supply of Loanable Funds
The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving.
The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.
When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping.
Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward.
Equilibrium in the Market for Loanable Funds
As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied
Changes in either demand or supply change the real interest rate and the price of financial assets.
If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase.
If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase.
Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.
Government
in the Market for Loanable Funds
Changes in the government surplus can shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow. The surplus adds to private saving and so the supply of loanable funds curve becomes SLF.
Changes
in the government
deficit
can shift the demand for loanable funds curve. In the figure, PDLF
is the private demand for loanable funds curve. The government has a
budget deficit equal to the length of the arrow. The deficit adds to
private demand and so the demand for loanable funds curve becomes
DLF.
The tendency for a government budget deficit to decrease investment is called a crowding-out effect.
The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit. To the extent that the Ricardo-Barro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit.
A Government Budget Surplus ответ в предыдущем вопросе первый абзац первый график
A Government Budget Deficit то же самое ответ в том вопросе только уже второй абзац и второй график
The Global Loanable Funds Market
The loanable funds market is a global market. Lenders look worldwide to find the highest real interest rate; borrowers likewise look worldwide to find the lowest real interest. These actions bring the risk-adjusted real interest rate to equality throughout the world.
If
a country’s net exports are negative, X
< M,
then the country finances the shortfall in exports by borrowing from
the rest of the world. If a country’s net exports are positive, X
> M,
then the country uses the excess to loan to the rest of the world.
Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate.
A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country. The figure shows this situation.
With
international trade, the real interest rate in the country becomes
the world real interest rate. At this lower real interest rate, the
quantity of loanable funds supplied decreases and the quantity of
loanable funds demanded increases. The country has negative net
exports, with X
< M.
A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation.
With international trade, the real interest rate in the country becomes the world real interest rate. At this higher real interest rate, the quantity of loanable funds supplied increases and the quantity of loanable funds demanded decreases. The country has positive net exports, with X > M.