The Financial System: Structure, Institutions, and Saving in Macroeconomics

The Financial System

Introduction to the Financial System

The financial system is a network of institutions that facilitates the flow of funds between savers and 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 Institutions

Direct Finance: Financial Markets

Financial markets allow direct interaction between savers and borrowers. Two primary types are the bond market and the stock market.

• Bond Market: A bond is a certificate of indebtedness, representing a loan from the bondholder to the issuer.

• Stock Market: A stock is a claim to partial ownership in a firm, entitling the holder to a share of the firm's profits.

The Bond Market

Bonds are financial instruments that differ according to several key characteristics:

• 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.

• 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

Stocks represent ownership in a corporation and entitle owners to a share of the firm's profits. Corporations raise capital by selling stock (equity finance) or bonds (debt finance).

• Equity finance: Raising capital by selling stock.

• Debt finance: Raising capital by selling bonds.

• Stocks are traded on organized exchanges such as NYSE and NASDAQ after an initial public offering (IPO).

• Equity finance generally offers higher risk and higher average return compared to debt finance.

Reading Stock Tables

Stock tables provide key information for investors. 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 can be accessed online, for example at Bloomberg.

Indirect Finance: 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

Saving is a key concept in macroeconomics, representing income not used for immediate consumption.

• 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

Government budget outcomes affect public saving and the overall financial system.

• Budget surplus: An excess of tax revenue over government spending. Formula: $T - G$ (public saving is positive)

• Budget deficit: A shortfall of tax revenue from government spending. Formula: $G - T$ (public saving is negative)

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.

• National saving: Formula: $(Y - T - C) + (T - G) = Y - C - G$

National saving is crucial for funding investment in the economy.

Additional info:

• These notes cover foundational macroeconomic concepts related to the financial system, financial institutions, and saving, which are essential for understanding how economies allocate resources and promote growth.