Chapter 26: Saving, Investment, and the Financial System

The financial system is defined as the group of institutions in the economy that help to match one person’s saving with another’s investment. They move money from savers to borrowers.

Financial markets are financial institutions where savers can directly provide funds to borrowers. The first market is the bond market, where borrowers state the time they would repay the savers, which is called the date of maturity. Bonds have three main characteristics: the term (the length of time until the bond matures), the credit risk (the probability that the borrower will fail to pay back the money, junk bonds are offered by sharky corporations, but have high interest rates), and the tax treatment (the way the tax laws treat the interest earned on the bond, such as how municipal bonds issued by governments do not require the borrowers to pay federal income tax). Sale of bonds are called debt finance.

Another financial market is the stock market, where people would buy claims to partial ownership of a firm. Sale of stocks is called equity finance. When companies sell bonds to buyers, they are exchanged on the stock exchange, and people who buy them buy off of speculation, where they try to perceive the corporation’s future profitability.

Financial intermediaries are institutions where savers can indirectly provide funds to borrowers. These include banks and mutual funds. Banks, as well as being an intermediary, they create a medium of exchange, where people can easily engage in transaction. Mutual funds sell shares to the public and uses the money to buy a selection, or portfolio, or many stocks and/or bonds.

A closed economy is one that does not interact with other economie, whereas open economies interact with economies around the world. National saving (or just saving) is equal to income, or GDP-consumption-government expenses. Private saving is the income that households have left after paying for taxes and consumption, measured by GDP-transfer payments-consumption. Public saving is the tax revenue the government has left after paying for its spending, calculated by transfer payments-government expenses. Budget surpluses occur when transfer payments exceed government expenses, and budget deficits occur when it does not exceed government expenses.