Chapter 8 (Saving, Investment, and the Financial System)

Question 1

The financial system consists of those institutions in the economy that

Answer 1

help to match one person’s saving with another person’s investment.

Question 2

At the broadest level, the financial system moves the economy’s scarce resources from

Answer 2

savers (people who spend less than they earn) to borrowers (people who spend more than they earn)

Question 3

Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date.

Answer 3

Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date

Question 4

The Office of the Superintendent of Financial Institutions (OSFI) is an independent agency of the federal government that reports to the Department of Finance Canada

Answer 4

The OSFI is the primary regulator of federally regulated banks, insurance companies, and pension plans in Canada.

Question 5

Credit unions and caisses populates, securities dealers, and mutual funds are largely regulated by provincial governments

Answer 5

Finally, Canada’s central bank, the Bank of Canada, also plays an important role in regulating the Canadian financial system.

Question 6

Financial institutions can be grouped into two categories

Answer 6

financial markets and financial intermediaries

Question 7

Financial markets

Answer 7

are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most important financial markets in our economy are the bond market and the stock market

Question 8

A bond is a

Answer 8

certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU.

Question 9

It identifies the time at which the loan will be repaid, called the

Answer 9

date of maturity and the rate of interest that will be paid periodically until the loan matures

Question 10

The buyer of a bond gives his or her money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the

Answer 10

principal).

Question 11

The first characteristic is a bond’s term

Answer 11

the length of time until the bond matures

Question 12

The British government has even issued a bond that

never matures, called a

Answer 12

perpetuity.

Question 13

Long-term bonds are riskier than short-term bonds because holders of long-term bonds have
to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually

Answer 13

pay higher interest rates than short-term bonds.

Question 14

The second important characteristic of a bond is its credit risk

Answer 14

the probability that the borrower will fail to pay some of the interest or principal.

Question 15

a borrowers failure to pay some of the interest or principal s called a

Answer 15

default

Question 16

Corporate bonds tend to pay higher rates of interest than provincial and territorial bonds because corporate revenues are likely to be more volatile than provincial and territorial revenues

Answer 16

Financially shaky corporations raise money by
issuing junk bonds—which, as the name suggests, pay considerably higher interest rates than the bonds issued by more secure corporations and by governments

Question 17

Buyers of bonds can judge credit risk by

Answer 17

checking with various private agencies, such as Standard & Poor’s or Dominion Bond Rating Service, that rate the credit risk of different bonds

Question 18

Stock represents

Answer 18

ownership in a firm and is, therefore, a claim to the profits that the firm makes.

Question 19

The sale of stock to raise money is called

Answer 19

equity finance

Question 20

the sale of bonds is called

Answer 20

debt finance.

Question 21

The most important stock exchanges in the U.S. economy are the

Answer 21

New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automatic Quotation system)

Question 22

The most important stock exchange in Canada

Answer 22

Toronto Stock Exchange (TSX)

Question 23

Price (of stock)

Answer 23

The single most important piece of information about a stock is the price of a share. The newspaper usually presents several prices. The “last” or “closing” price is the price of the last transaction that occurred
before the stock exchange closed the previous day. Many newspapers also give the “high” and “low” prices over the past day of trading and, sometimes, over the past year as well.

Question 24

Volume (of stock)

Answer 24

Most newspapers present the number of shares sold during

the past day of trading. This figure is called the daily volume

Question 25

Dividend (of stock)

Answer 25

Corporations pay out some of their profits to their shareholders; this amount is called the dividend. (Profits not paid out are called retained earnings and are used by the corporation for additional investment.) Newspapers often report the dividend paid over the previous year for each share of stock. They sometimes report the dividend yield, which is the dividend expressed as a percentage of the stock’s price.

Question 26

Price/earnings ratio (of stock)

Answer 26

A corporation's earnings, or profit, is the amount of revenue it receives for the sale of its products minus its costs of production as measured by its accountants. Earnings per share is the company’s total earnings divided by the number of shares of stock outstanding. Companies use some of their earnings to pay dividends to shareholders; the rest is kept in the firm to make new investments. The price/earnings ratio, often called the P/E, is the price of a corporation’s stock divided by the amount the corporation earned per share over the past year. Historically, the typical price/earnings ratio is about 15. A higher P/E indicates that a corporation’s stock is expensive relative to its recent earnings; this might indicate either that people expect earnings to rise in the future or that the stock is overvalued. Conversely, a lower P/E indicates that a corporation's stock is cheap relative to its recent earnings; this might indicate either that people expect earnings to fail or that the stock is undervalued.

Question 27

Financial intermediaries

Answer 27

are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers Banks and mutual funds)

Question 28

The small grocer, therefore, most likely finances his business expansion with a loan from a

Answer 28

local bank because it would be difficult for him to do so through stocks and bonds because it's a small business and unfamiliar

Question 29

A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow.

Answer 29

Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans

Question 30

Banks facilitate purchases of goods and services by allowing people

Answer 30

to write cheques against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange

Question 31

A medium of exchange

Answer 31

is an item that people can easily use to engage in transactions. A bank's role in providing a medium of exchange distinguishes it from many other financial institutions

Question 32

Stocks and bonds, like bank deposits, are a possible

Answer 32

Stocks and bonds, like bank deposits, are a possible

Question 33

A mutual fund is

Answer 33

an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks or bonds, or both stocks and bonds.

Question 34

If the value of the portfolio rises, the shareholder benefits

Answer 34

if the value of the portfolio falls, the shareholder suffers the loss.

Question 35

The primary advantage of mutual funds is that they

Answer 35

allow people with small amounts of money to diversify

Question 36

A second advantage claimed by mutual fund companies is that mutual funds

Answer 36

give ordinary people access to the skills of professional money managers

Question 37

Financial economists, however, are often skeptical of this second argument.

Answer 37

With thousands of money managers paying close attention to each company's prospects, the price of a company's stock is usually a good reflection of the company's true value

Question 38

Accounting refers to how

Answer 38

various numbers are defined and added up

Question 39

Recall that an identity is an

Answer 39

equation that must be true because of the way the variables in the equation are defined

Question 40

Recall that gross domestic product (GDP) is both total income in an economy and the total expenditure on the economy's output of goods and services. GDP (denoted as Y) is divided into four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX)

Answer 40

Y - C + I + G + NX This equation is an identity because every dollar of expenditure that shows up on the left-hand side also shows up in one of the four components on the right-hand side.

Question 41

A closed economy

Answer 41

is one that does not interact with other economies

Question 42

actual economies are open economies

Answer 42

that is, they interact with other economies around the world

Question 43

Because a closed economy does not engage in international trade, imports and exports are

Answer 43

exactly zero. Therefore, net exports (NX) are also zero. Y=C+I+G

Question 44

Y — C — G = I

Answer 44

The left-hand side of this equation (Y - C - G) is the total income in the economy that remains after paying for consumption and government purchases:

Question 45

national saving, or just saving, and is denoted S

Answer 45

Substituting S for Y — C — G, we can write the last equation as S = I This equation states that saving equals investment

Question 46

private saving

Answer 46

(Y - T - C)

Question 47

public saving

Answer 47

(T - G)

Question 48

Let T denote the amount that the government collects from households in taxes minus the amount it pays back to households in the form of transfer payments (such as Employment Insurance and social assistance). We can then write national saving in either of two ways:

Answer 48

s = y - c - g or S = ( Y - T - C ) + ( T - G)

Question 49

Private saving is

Answer 49

the amount of income that households have left after paying their taxes and paying for their consumption. In particular, because households receive income of Y, pay taxes of T, and spend C on consumption, private saving is Y - T - C

Question 50

the amount of tax revenue that the government has left after paying for its spending.

Answer 50

The government receives T in tax revenue and spends G on goods and services.

Question 51

If T exceeds G, the government runs a

Answer 51

budget surplus because it receives more money than it spends. This surplus of T - G represents public saving.

Question 52

If the government spends more than it receives in tax revenue, then G is larger than T. In this case, the government runs a

Answer 52

budget deficit, and public saving T - G is a negative number.

Question 53

The equation S = I reveals an important fact:

Answer 53

For the economy as a whole, saving must be equal to investment.

Question 54

Larry earns more than he spends and deposits his unspent income in a bank or uses it to buy a bond or some stock from a corporation. Because Larry's income exceeds his consumption, he adds to

Answer 54

the nation's saving. Larry might think of himself as "investing" his money, but a macroeconomist would call Larry's act saving rather than investment

Question 55

In the language of macroeconomics, investment refers to

Answer 55

the purchase of new capital, such as equipment or buildings.

Question 56

To keep things simple, we assume that the economy has only one financial market, called the

Answer 56

market for loanable funds

Question 57

All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. Thus, the term loanable funds refers to

Answer 57

all income that people have chosen to save and | lend out, rather than use for their own consumption

Question 58

The supply of loanable funds comes from those people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which in turn uses the funds to make loans. In both cases,

Answer 58

saving is the source of the supply of loanable funds.

Question 59

The supply of loanable funds comes from those people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which in turn uses the funds to make loans. In both cases,

Answer 59

saving is the source of the supply of loanable funds.

Question 60

The demand for loanable funds comes from households and firms who wish to borrow to make investments. This demand includes families taking out mortgages to buy homes. It also includes firms borrowing to buy new equipment or build factories. In both cases,

Answer 60

investment is the source of the demand for loanable funds

Question 61

The adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) and discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded).

Answer 61

Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders competed for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply and demand for loanable funds exactly balance

Question 62

when you see the term interest rate, you should remember that we are talking about

Answer 62

the real interest rate.

Question 63

Canadians save less than other people in other countries do and it is viewed as a problem

Answer 63

Another of the ten principles of economics is that people respond to incentives. Many economists have used this principle to suggest that the low saving rate in Canada is at least partly attributable to tax laws that discourage saving.

Question 64

In response to this problem, economists favor changes to the tax system that encourage greater saving.

Answer 64

The GST (a consumption tax)

Question 65

ideal GST

Answer 65

7%

Question 66

most support an increase in the amount that people | can contribute to registered retirement savings plans (RRSPs)

Answer 66

By buying an RRSP, people reduce the amount of their income that is subject to tax. In this way, saving is encouraged.

Question 67

For similar reasons, economists supported the introduction of Tax-free Savings Accounts (TFSAs) in 2009.

Answer 67

Income earned on savings that are held in a TFSA is not subject to tax, so people have yet another incentive to increase their savings.

Question 68

A change in the tax laws to encourage Canadians to save more would shift the supply of loanable funds to the right from S(1) to S(2)

Answer 68

As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $160 billion.

Question 69

Thus, if a reform of the tax laws encouraged greater saving, the result would be

Answer 69

lower interest rates and greater investments

Question 70

In essence, this is what Parliament does when it institutes an investment tax credit, which it does from time to time

Answer 70

An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment

Question 71

If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase

Answer 71

As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $140 billion.

Question 72

If a reform of the tax laws encouraged greater investment

Answer 72

the results would be higher interest rates and greater saving

Question 73

When a government spends more than it receives in tax revenue, the shortfall is called the government's

Answer 73

budget deficit

Question 74

When a government spends less than it receives in tax | revenue, the excess is called the government's

Answer 74

budget surplus.

Question 75

When a government spends exactly what it receives in tax revenue it is said to have a

Answer 75

balanced budget

Question 76

The sum of all past budget deficits minus the sum of all past budget surpluses is

Answer 76

called the government debt.

Question 77

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises.

Answer 77

Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $120 billion to $80 billion.

Question 78

The fall in investment because of government borrowing is called

Answer 78

crowding out and is represented in the figure by the movement along the demand curve from a quantity of $120 billion in loanable funds to a quantity of $80 billion. That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment.

Question 79

When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls.

Answer 79

Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate.

Question 80

Why does increased borrowing from the government shift the supply curve, while increased borrowing by private investors shifts the demand curve? To answer this question, we need to examine more precisely the meaning of loanable funds.

Answer 80

The model as presented here takes this term to mean the flow of resources available to fund private investment; thus, a government budget deficit reduces the supply of loanable funds. If, instead, we had defined the term loanable funds to mean the flow of resources available from private saving, then the government budget deficit would increase demand rather than reduce supply.

Question 81

In either case, a budget deficit increases the interest rate, thereby

Answer 81

crowding out private borrowers who are relying on financial markets to fund private investment projects.

Question 82

Long strings of government deficits such as those Canada experienced from 1975 to 1997 can push the economy into a vicious circle where deficits cause

Answer 82

lower economic growth that in turn leads to lower tax revenue and higher spending on Employment Insurance and other income-support programs.

Question 83

a budget surplus increases the supply of loanable funds, reduces the interest rate, and

Answer 83

stimulates investment. Higher investment, in turn, means greater capital accumulation and more rapid economic growth

Question 84

strings of government budget surpluses push the economy into a

Answer 84

a virtuous circle. In this case, by increasing the supply of loanable funds, reducing interest rates, and stimulating investment, surpluses encourage faster economic growth.

Question 85

Figure 8.5 shows the net debt of the federal government and the combined net debts of the provinces and territories as a percentage

Answer 85

of GDP. Government net debt is the difference between the value of the financial liabilities and the value of the financial assets it owns.