The Financial System: Institutions, Saving, and Investment

The Financial System

Introduction to the Financial System

The financial system is a network of institutions that facilitates the flow of funds from savers to borrowers, helping match the saving of one person with the investment of another. It plays a crucial role in the functioning of modern economies by allocating resources efficiently.

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

• Examples include the Bond Market and the Stock Market.

Financial Markets

The Bond Market

The bond market is a primary financial market where bonds are issued and traded. A bond is a certificate of indebtedness, representing a loan made by an investor to a borrower (typically corporate or governmental).

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

• Yield: The interest rate paid to the bondholder.

• Principal: The amount originally borrowed.

Bonds differ according to three key characteristics:

• Term: The length of time until the bond matures (e.g., perpetuity).

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

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

The Stock Market

The stock market is a financial market where shares of ownership in firms are bought and sold. A stock entitles owners to a share of the firm's profits and assets.

• 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 exchanges such as NYSE and NASDAQ.

Reading Stock Tables

Stock tables provide key information for investors tracking stock performance. The three most important numbers are:

• Price: The cost of a single share.

• Dividend: The share of profits paid out to stockholders.

• PE Ratio: The share price divided by earnings per share.

Stock tables can be accessed online, for example at Bloomberg.

Financial Institutions

Financial Intermediaries

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers. They play a vital role in the financial system by pooling resources and reducing transaction costs.

• Commercial banks: Accept deposits and make loans, creating a medium of exchange and reducing 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 that is not used for consumption or paying taxes. Formula: $Y - T - C$ Where: $Y$ = National income (GDP) $T$ = Taxes $C$ = Consumption

• Public saving: Tax revenue less government spending. Formula: $T - G$ Where: $G$ = Government spending

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, representing the portion of national income not used for consumption or government purchases.

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

National saving is a key determinant of investment and long-run economic growth.

Type of Saving	Formula	Description
Private Saving	$Y - T - C$	Household income not used for consumption or taxes
Public Saving	$T - G$	Tax revenue minus government spending
National Saving	$Y - C - G$	Total saving in the economy

Additional info: These notes cover the foundational concepts of the financial system, including the roles of financial markets and institutions, and the measurement of saving in the macroeconomy. Understanding these concepts is essential for analyzing investment, economic growth, and fiscal policy in macroeconomics.