ch 26 lecture

7/26/2019 Ch 26 Lecture

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© 2013 Pearson

7/26/2019 Ch 26 Lecture


© 2013 Pearson

What created the global

financial crisis?

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© 2013 Pearson

26When you have completed your

study of this chapter, you will be able to

1 Describe the financial markets and the key financialinstitutions.

2 Explain how borrowin and lendin decisions are made

and how these decisions interact in the loanable fundsmarket.

3 Explain how a o!ernment budet surplus or deficitinfluences the real interest rate" in!estment" and sa!in.

#$%P&E' #$E#()*+&

Finance, Saving,and nvestment

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© 2013 Pearson

Some Financial !efinitions

"hysical capital is the tools" instruments" machines"

buildins" and other constructions that ha!e beenproduced in the past and that are used to produce

oods and ser!ices.

Financial capital is the funds that firms use to buy and

operate physical capital.

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© 2013 Pearson

nvestment, &apital, Wealth, and Saving

/ross investment is the total amount spent on new

capital oods.

$et investment is the chane in the ,uantity of capital

-e,uals ross in!estment minus depreciation.

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iure 2/.1illustrates therelationship

between capitaland in!estment.

n anuary 1"2012"&oms DD

4urnin" *nc. hadDD recordinmachines !aluedat 530"000.

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Durin 2012" the!alue of &omsmachines fell by520"000"depreciation.

Durin 2012"&oms spent530"000 on newmachines-rossin!estment.

&oms net in!estment was 510"000" so at the end of

2012"&om had capital !alued at 560"000.

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Wealth is the !alue of all the thins that a person

owns.

Saving is the amount of income that is not paid in

taxes or spent on consumption oods and ser!ices7

sa!in adds to wealth.

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+ar0ets for Financial &apital

+a!in is the source of funds that are used to finance

in!estment" and these funds are supplied anddemanded by three types of markets8

9 )oans markets

9 4ond markets

9 +tock markets

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'oan +ar0ets

4usinesses often want short:term loans to buyin!entories or to extend credit to their customers.

+ometimes they et these funds in the form of a loanfrom a bank.

$ouseholds often want funds to purchase bi:ticket

items" such as automobiles or household furnishinsand appliances.

&hey et these funds as bank loans" often in the form ofoutstandin credit card balances.

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ond +ar0ets

ond is a promise to pay specified sums of money onspecified dates7 it is a debt for the issuer.

&he bond mar0et is a financial market in which bondsissued by firms and o!ernments are traded.

&he term of a bond miht be lon ;decades< or short;=ust a month or two<.

irms often issue !ery short:term bonds as a way ofettin paid for their sales before the buyer is able topay.

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%nother type of bond is a mortgage-backed security "which entitles the holder to the income from a packaeof mortaes.

>ortae:backed securities were at the center of thestorm in the financial markets of 200?@200A.

Stoc0 +ar0ets

Stoc0 is a certificate of ownership and claim to theprofits that a firm makes.

&he stoc0 mar0et is a financial market in whichshares of companies stocks are traded.

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Financial nstitutions

% financial institution is a firm that operates on both

sides of the markets for financial capital8 *t borrows inone market and lends in another.

&he key financial institutions are 8

9*n!estment banks9 #ommercial banks

9 Bo!ernment:sponsored mortae lenders

9 Pension funds

9 *nsurance companies

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nsolvency and lliuidity

$et worth is the total market !alue of what it has lent

minus the market !alue of what it has borrowed.*f net worth is positi!e" the institution is solvent and canremain in business.

4ut if net worth is neati!e" the institution is insolvent

and must stop tradin.

&he owners of an insol!ent financial institution-usuallyits stockholders-bear the loss when the assets aresold and debts paid.

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% firm is illiquid if it has made lon:term loans withborrowed funds and is faced with a sudden demand torepay more of what it has borrowed than its a!ailable

cash.

*n normal times" a financial institution that is illi,uid canborrow from another institution.

4ut if all financial institutions are short of cash" the marketfor loans amon financial institutions dries up.

*nsol!ency and illi,uidity were at the core of the financialmeltdown of 200?@200A.

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&he loanable funds mar0et is the areate of themarkets for loans" bonds" and stocks.

*n the market for loanable funds there is =ust one a!eraeinterest rate which we refer to as the interest rate.

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Flows in the 'oanable Funds +ar0et

)oanable funds are used for

1# 4usiness in!estment2# Bo!ernment budet deficit3# *nternational in!estment or lendin

)oanable funds come from

1# Pri!ate sa!in2# Bo!ernment budet surplus3# *nternational borrowin

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(he !emand for 'oanable Funds

&he quantity of loanable funds demanded is the total

,uantity of funds demanded to finance in!estment" theo!ernment budet deficit" and international in!estment

or lendin durin a i!en period.

*n!estment is the ma=or item that influences the demand

side of the market for loanable funds.

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*n!estment depends on

1. &he real interest rate

2. Expected profit

&he real interest rate is the opportunity cost of the fundsused to finance the purchase of capital.

+o firms compare the real interest rate with the rate ofprofit that they expect to earn on their new capital.

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7/26/2019 Ch 26 Lecture


© 2013 Pearson

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!emand for 'oanable Funds &urve

&he demand for loanable funds is the relationship

between the ,uantity of in!estment demanded and thereal interest rate" other thins remainin the same.

&he demand for loanable funds is shown by a demand

for loanable funds schedule or cur!e.

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iure 2/.2 showsthe demand forloanable funds.

Points A throuh E on the cur!e DLF

correspond to therows in the table.

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1# % rise in the realinterest ratedecreases the

,uantity ofloanable fundsdemanded.

2# % fall in the real

interest rateincreases the,uantity ofloanable fundsdemanded.

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&hanges in the !emand for 'oanable Funds

Chen the expected profit chanes" the demand for

loanable funds chanes.ther thins remainin the same" the reater the

expected profit from new capital" the reater is the

amount of in!estment and the reater is the demand of

loanable funds.

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7/26/2019 Ch 26 Lecture


© 2013 Pearson

26#2 (. '*%$%'. F)$!S +%-.(

iure 2/.3 shows8

1# %n increase in expectedprofit increases

in!estment and shifts thedemand for loanablefunds cur!e rihtward toDLF 1.

2# % decrease in expectedprofit decreasesin!estment and shifts thedemand for loanable fundscur!e leftward to DLF 2.

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(he Supply of 'oanable Funds

&he quantity of loanable funds supplied is the total fundsa!ailable from pri!ate sa!in" the o!ernment budetsurplus" and international borrowin durin a i!enperiod.

+a!in is the main item and it depends on

1. &he real interest rate2. Disposable income3. Cealth6. Expected future incomeG. Default risk

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© 2013 Pearson

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ther thins remainin the same"

9 &he hiher the real interest rate" the reater is the,uantity of sa!in and the reater is the ,uantity of

loanable funds supplied.9 &he lower the real interest rate" the smaller is the

,uantity of sa!in and the smaller is the ,uantity ofloanable funds supplied.

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7/26/2019 Ch 26 Lecture


© 2013 Pearson

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Points A throuhE on the cur!ecorrespond to therows in the table.

iure 2/.6 showssupply of loanable

funds.

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2# % fall in the

real interestrate decreasesthe ,uantity ofloanable fundssupplied.

1# % rise in the realinterest rateincreases the

,uantity ofloanable fundssupplied.

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&hanges in the Supply of 'oanable Funds

&he four main factors that influence sa!in and chane

the supply of loanable funds are1. Disposable income

2. Cealth

3. Expected future income

6. Default risk

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7/26/2019 Ch 26 Lecture


© 2013 Pearson

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Shifts of the Supply of 'oanable Funds &urve

9 %lon the supply of loanable funds cur!e" all theinfluences on sa!in other than the real interest

rate remain the same.9 % chane in any of these influences on sa!in

chanes sa!in and shifts the supply of loanablefunds cur!e.

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iure 2/.G shows a chane inthe supply of loanable funds.

1# &he supply of loanablefunds cur!e shifts rihtwardfrom SLF 0 to SLF 1 if

9 Disposable income

increases.9 Cealth" expected futureincome" or default riskdecreases.

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2# &he supply of loanablefunds cur!e shifts leftwardfrom SLF 0 to SLF 2 if

9 Disposable incomedecreases.

9 Cealth" expectedfuture income" ordefault risk increases.

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.uilibrium in the

'oanable Funds

+ar0et

iure 2/./ shows how

the real interest rate is

determined.

9 DLF is the demand forloanable funds cur!e

9 SLF is the supply of

loanable funds cur!e

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1# *f the real interest rate isA percent a year" the,uantity demanded is lessthan the ,uantity supplied.

&here is a surplus offunds. &he real interestrate falls.

2# *f the real interest rate is 6percent a year" the ,uantitydemanded exceeds the,uantity supplied. &here is ashortage of funds. &he real

interest rate rises.

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3# Chen the real interestrate is / percent a year"the ,uantity of loanable

funds demanded e,ualsthe ,uantity supplied.

&here is neither a shortaenor a surplus of funds" and

the real interest rate is at itse,uilibrium le!el.

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&hanges in !emand and Supply

1# *f the demand for

loanable funds

increases" the realinterest rate rises.

2# *f the supply of

loanable fundsincreases" the real

interest rate falls.

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© 2013 Pearson

% /overnment udget Surplus

% o!ernment budet surplus increases the supply ofloanable funds.

&o find the supply of loanable funds" we must add theo!ernment budet surplus to pri!ate sa!in supply.

%n increase in the supply of loanable funds brins a

lower real interest rate" which decreases the ,uantityof pri!ate funds supplied and increases the ,uantity ofin!estment and the ,uantity of loanable fundsdemanded.

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© 2013 Pearson

2# &he real interest rate fallsto 6 percent a year.

3# &he pri!ate supply of fundsdecreases to 51.G trillion.

5# &he ,uantity of loanablefunds demanded andin!estment increase to52.G trillion.

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7/26/2019 Ch 26 Lecture


© 2013 Pearson

iure 2/.H shows the effectsof o!ernment budet surplus.

Cith balanced o!ernment

budets" the real interestrate is / percent a year andthe ,uantity of loanablefunds is 52 trillion a year.

1# % o!ernment budet deficitof 51 trillion is added to thepri!ate demand todetermine the demand forloanable funds cur!e DLF .

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2# &he real interest raterises to A percent a year.

3# &he supply of loanablefunds increases to 52.Gtrillion.

5# &he ,uantity of loanable

funds demanded andin!estment decrease to51.G trillion.

*n!estment is crowded out.

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&he tendency for a o!ernment budet deficit to raisethe real interest rate and decrease in!estment is called

the crowdingout effect.

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7/26/2019 Ch 26 Lecture


7/26/2019 Ch 26 Lecture


© 2013 Pearson

E!ents in the market for loanable funds" on both the supplyside and demand side" created the lobal financial crisis.

%n increase in default risk decreased the supply of loanablefunds.

&he disappearance of some ma=or Call +treet institutionsand lowered profit expectations decreased the demand forloanable funds.

&hese institutions include 4ear +tearns" )ehman 4rothers"annie >ae and reddie >ac" >errill )ynch" and %*B.

What &reated the /lobal Financial &risis?

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7/26/2019 Ch 26 Lecture


&hen" in 200/" interest rates bean to rise and home pricesbean to fall.

People defaulted on mortaes and banks took losses.

+ome banks became insol!ent.

% downward spiral of lendin was under way.

What &reated the /lobal Financial &risis?

ch 26 lecture

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