288 section 5 The Financial Sector
Summary
1.Investment in physical capital is necessary for long -run
economic growth. So in order for an economy to grow,
it must channel savings into investment spending.
2.According to the savings–investment spending iden-
tity,savings and investment spending are always equal
for the economy as a whole. The government is a source
of savings when it runs a positive budget balance,also
known as a budget surplus;it is a source of dissavings
when it runs a negative budget balance, also known as a
budget deficit.In a closed economy, savings is equal to
national savings,the sum of private savings plus the
budget balance. In an open economy, savings is equal to
national savings plus capital inflowof foreign savings.
When a capital outflow, or negative capital inflow, oc-
curs, some portion of national savings is funding invest-
ment spending in other countries.
3.Households invest their current savings or wealth—
their accumulated savings—by purchasing assets. Assets
come in the form of either a financial asset,a paper
claim that entitles the buyer to future income from the
seller, or a physical asset,a claim on a tangible object
that gives the owner the right to dispose of it as desired.
A financial asset is also a liabilityfrom the point of
view of its seller. There are four main types of financial
assets: loans, bonds, stocks, and bank deposits.Each of
them serves a different purpose in addressing the three
fundamental tasks of a financial system: reducing
transaction costs—the cost of making a deal; reducing
financial risk—uncertainty about future outcomes that
involves financial gains and losses; and providing liq-
uidassets—assets that can be quickly converted into
cash without much loss of value (in contrast to illiquid
assets, which are not easily converted).
4.Although many small and moderate -size borrowers use
bankloansto fund investment spending, larger compa-
nies typically issue bonds. Bonds with a higher risk of
defaultmust typically pay a higher interest rate. Busi-
ness owners reduce their risk by selling stock. Although
stocks usually generate a higher return than bonds, in-
vestors typically wish to reduce their risk by engaging in
diversification,owning a wide range of assets whose
returns are based on unrelated, or independent, events.
Most people are risk -averse, viewing the loss of a given
amount of money as a significant hardship but viewing
the gain of an equal amount of money as a much less
significant benefit. Loan-backed securities,a recent
innovation, are assets created by pooling individual
loans and selling shares of that pool to investors. Be-
cause they are more diversified and more liquid than in-
dividual loans, trading on financial markets like bonds,they are preferred by investors. It can be difficult, how-
ever, to assess their quality.- Financial intermediaries—institutions such as mutual
funds, pension funds, life insurance companies,and
banks—are critical components of the financial system.
Mutual funds and pension funds allow small investors
to diversify and life insurance companies allow families
to reduce risk.
6.A bank allows individuals to hold liquid bank deposits
that are then used to finance illiquid loans. Banks can per-
form this mismatch because on average only a small frac-
tion of depositors withdraw their savings at any one time.
Banks are a key ingredient in long -run economic growth. - Moneyis any asset that can easily be used to purchase
goods and services. Currency in circulationand
checkable bank depositsare both considered part of
themoney supply.Money plays three roles: it is a
medium of exchangeused for transactions, a store of
valuethat holds purchasing power over time, and a
unit of accountin which prices are stated.
8.Over time, commodity money,which consists of goods
possessing value aside from their role as money, such as
gold and silver coins, was replaced by commodity -
backed money,such as paper currency backed by gold.
Today the dollar is pure fiat money,whose value de-
rives solely from its official role.
9.The Federal Reserve calculates two measures of the
money supply. M1 is the narrowest monetary aggre-
gate;it contains only currency in circulation, traveler’s
checks, and checkable bank deposits. M2 includes a
wider range of assets called near -moneys,mainly other
forms of bank deposits, that can easily be converted
into checkable bank deposits.
10.In order to evaluate a project in which costs or benefits
are realized in the future, you must first transform
them into their present valuesusing the interest rate,
r.The present value of $1 realized one year from now is
$1/(1+r), the amount of money you must lend out
today to have $1 one year from now. Once this transfor-
mation is done, you should choose the project with the
highestnet present value.
11.Banks allow depositors immediate access to their funds,
but they also lend out most of the funds deposited in
their care. To meet demands for cash, they maintain
bank reservescomposed of both currency held in
vaults and deposits at the Federal Reserve. The reserve
ratiois the ratio of bank reserves to bank deposits. A
T-accountsummarizes a bank’s financial position, with
loans and reserves counted as assets, and deposits
counted as liabilities.
Section 5 Review