Finances

Financial Markets

Institutions where a person who wants to wants to save can directly supply funds to a person who wants to borrow.

Bond Market - Debt Finance

Bond is a certificate of indebtedness, and IOU from the company to the buyer. The amount borrowed is called the principal and the time when the bond matures is called date of maturity.

Bonds have four parameters which indicate how valuable they are:

1. Term: time until a bond matures. Long term => more risk
2. Credit Risk: How likely is it that the company will not declare bankruptcy and default the bond.
3. Tax Laws
4. Inflation Protection: Are the bonds indexed?

Stock Market - Equity Finance

A stock is a partial ownership of the company. The gains and losses are shared by the stock owners proportional to the number of shares that they own in the company.

Stock Index: a measurement of overall stock prices.

Financial Intermediaries

Institutions where a borrower can indirectly take funds from a saver. There are two financial intermediaries.

Banks

….what we all know and love….

Mutual Funds and Index Funds

Mutual Funds operate with stocks and bonds, and offer indirect purchases at a fee. A benefactor for a mutual fund accepts the returns on the selection (portfolio) of shares bought by the funds, be it a profit or a loss.

Mutual Funds do active trading wheras Index funds just buy and hold from the companies with high index values.

Mathematics of Savings

We have already seen the expenditure approach for calculating the GDP of a nation. Consider the following equations for a closed economy: \(\begin{align*} \text{Y} &= \text{C}+\text{I}+\text{G} \\ \text{Y}-\text{C}-\text{G} &= I \\ \text{Savings} &= \text{Investment} \\ \end{align*}\) That is, the savings and investment are equal in a closed economy. Note that this is true for the economy as a whole, and not for every individual household. Also, a person buying bonds and stocks is not “investing”, but rather is “saving” his money as no capital is being purchased.

Define T to be the Taxes minus the Transfer payments. For this, we can manipulate the identity as follows: \(\begin{align*} \text{Savings} &= \text{Y} - \text{C} - \text{G} \\ &= (\text{Y}-\text{T}-\text{C})+(\text{T}-\text{G})\\ &= \text{(Private Savings) + (Public Savings)}\\ \end{align*}\) When Public savings are negative, the economy is said to be in Budget Deficit whereas when the public savings are positive, we say that the economy is in a Budget Surplus. The accumulation of deficits is called as Government Debt. Also, when Public Savings is 0, we say that the government has a balanced budget.

Market for Loanable Funds

“Loanable Funds” are the funds which are available to fund private investment. It can be clearly seen that it would be equal to the savings of the government, the national savings. The supply-demand graph for this hypothetical market has interest rates on the y-axis and funds people are willing to deposit on the x-axis. The supply of loanable funds are the national savings, and demand is the amount people/companies wish to borrow for investment. As interest increases, more people would like to save, increasing supply.

• Taxation on Investment Returns: Shifts the demand curve to the left as taxation is increased.
• Taxation on Savings: Shifts the supply curve to the left as taxation is increased.
• Budget Deficit: **Public savings are negative, meaning that the government sells bonds which reduces the funds available for investment. This phenomenon is called **crowding out, and would cause the supply curve to shift to the left.