The Financial System: Institutions, Saving, and Investment

The Financial System

Introduction to the Financial System

The financial system is the network of institutions that helps match the saving of one person with the investment of another. It plays a crucial role in channeling funds from savers to borrowers, thereby facilitating economic growth and development.

• Financial markets: Institutions where savers can directly provide funds to borrowers.

• Examples of financial markets:

  • The Bond Market: Where bonds (certificates of indebtedness) are bought and sold.

  • The Stock Market: Where stocks (claims to partial ownership in a firm) are traded.

Financial Markets

The Bond Market

A bond is an IOU or certificate of indebtedness, representing a loan made by an investor to a borrower. Bonds are characterized by several key features:

• Date of maturity: The date when the loan will be repaid.

• Yield: The interest rate paid to the bondholder.

• Principal: The amount originally borrowed.

Bonds differ according to three main characteristics:

• Term: The length of time until the bond matures (e.g., perpetuity, which never matures).

• Credit risk: The probability that the borrower will default on payments.

• Tax treatment: How tax laws view the interest income (e.g., municipal bonds may be tax-exempt).

The Stock Market

A stock entitles owners to a share of the firm's profits and assets. Stocks are a form of equity finance, while bonds are a form of debt finance.

• Equity finance: Raising capital by selling stock.

• Debt finance: Raising capital by selling bonds.

• Stocks generally offer higher risk and potentially higher average returns compared to bonds.

• After an Initial Public Offering (IPO), shares are traded on organized stock exchanges (e.g., NYSE, NASDAQ).

Reading Stock Tables

When tracking stock performance, pay attention to:

• Price: Cost of a single share.

• Dividend: Share of profits paid out to stockholders.

• P/E Ratio: Share price divided by earnings per share.

Stock tables are available online (e.g., Bloomberg).

Financial Institutions

Financial Intermediaries

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers.

• Commercial banks: Accept deposits and make loans; create a medium of exchange and reduce search/monitoring costs.

• Mutual funds: Sell shares to the public and use the proceeds to buy a diversified portfolio of stocks and bonds, allowing savers to diversify their investments.

Saving in the Economy

Different Kinds of Saving

• Private saving: The portion of households’ income not used for consumption or paying taxes.

  • Formula: $Y - T - C$

• Public saving: Tax revenue less government spending.

  • Formula: $T - G$

Budget Deficits and Surpluses

• Budget surplus: An excess of tax revenue over government spending.

  • Formula: $T - G$ (equals public saving)

• Budget deficit: A shortfall of tax revenue from government spending.

  • Formula: $G - T$ (equals negative public saving)

National Saving

National saving is the sum of private and public saving. It represents the portion of national income not used for consumption or government purchases.

• Formula: $\text{National Saving} = (Y - T - C) + (T - G) = Y - C - G$

Additional info: Applications and Examples

• Private saving can be used to buy corporate bonds, equities, certificates of deposit, mutual funds, or simply held in savings accounts.

• Investment in economics refers specifically to the purchase of new capital (e.g., factories, equipment, new houses), not the purchase of stocks and bonds.