Money: Banking, Spending, Saving, and Investing Financial Markets Financial Markets and Intermediaries Page 1 of 3

We have been talking about the money market, and the decision that households make about how to hold their wealth. How much of your wealth do you want to hold in the form of transactions balances; that is cash and checks and things that you can go shopping with? And how much of your wealth do you want to hold in the form of interest- bearing assets? See the money market is about making the decision about how to divide your wealth between these two forms. So, in order to understand the money market better, let’s focus our attention now on the world of interest- bearing assets. And that means that we are going to be talking about finance.

Finance means any activity that involves borrowing, lending, or sharing risks. Let’s look at what happens in a financial market. In a financial market, we have borrowers meeting lenders. Borrowers are any agents who have investment opportunities, but who lack the cash to get those projects started. For instance, businesses might have and opportunity to make a profit if they could only borrow the money the build a factory. The government has the opportunity to build roads and bridges, but it is going to need to borrow the money to get those projects done. And finally, homeowners; that is, people who would like to buy a house and live in it, would be happy to do the transaction, but they are going to have to borrow money in the form of a mortgage before they can get their house off of the ground. So borrowers are people who have projects, ideas, but don’t have cash on hand to pull them off.

Lenders on the other hand are people who have surplus cash and are looking for an opportunity to earn interest. They are looking for an opportunity to earn a rate of return on their money, but they don’t have projects that they would like to do themselves. Therefore, getting lenders and borrowers together is an opportunity to make the economic pie bigger, and once these projects are underway, the borrowers can share their profits with the lenders. That is what happens in a financial market.

Let’s look at the flow of funds in a financial market. What happens in this financial market is that lenders send cash to borrowers, so that they can purchase plant, equipment, houses, road crews, and things like that, to create the assets out of which profits are made. In return, the borrowers give the lenders an IOU. Now this term, IOU is not an acronym that stands for anything, it’s a rebus, and it’s a word picture, IOU money. And an IOU is a financial security, or a financial instrument. That is, it’s a contract that explains what the lender is entitled to, at what date in the future, under what circumstances. That is, it tells the world and the lender what money to expect in the future as a result of this deal that the lender and the borrower have made. Now there are all different kinds of IOU’s. There are bonds, which are debt contracts that entitle the lender to a fixed interest payment in the future. And, that is the way that most other loans work too, even if it is not a bond, the loan entitles you to a fixed interest payment if it is a debt instrument. There are also particular kinds of loans called treasury bills that are issued by the United States Government. These are short -term instruments that the government uses to finance its debt, and they entitle the lender to an interest payment within a year. There are also stock instruments, and stock or equity contracts entitle the lender to a share of the profits of this business venture at some date in the future (usually paid in the form of dividends).

Now, the borrower and the lender can get together directly, in which case they are engaging in a transaction we call direct finance. That is what would happen if you bought a share of IBM stock directly yourself, from a broker; or if you lent your sister money so that she could buy a car. That is direct finance, where the borrower and lender deal with one another directly, face to face; or through a broker. However, rather than going into the world of direct finance, you may want to reduce your search cost. That is, you may not want to spend time going out and looking for someone with a good project, plus there are risks involved, if you don’t want to put all of your eggs in one basket. On top of that you are going to have to draw up a contract, and monitor compliance and all of that is going to involve a lot of transactions effort that you may want to spare yourself. Therefore, you are going to go through what is called a financial intermediary. And that is an agent in the economy that specializes in bringing lenders and borrowers together.

A financial intermediary is defined by its balance sheet. So lets take a look here at a balance sheet. A balance sheet tells you two things. It tells you what you own, that is your assets, and it tells you what you owe, that is your liabilities. That is, if you own something, then the money to purchase that came from somewhere; that is, you probably borrowed it. A financial intermediary is an institution that simultaneously borrows and lends. In particular, a financial intermediary is an agent that borrows from the ultimate lenders. That is, households put money on deposit with the financial intermediary; and the financial intermediary then funnels that money, or lends it to the people in the economy, the borrowers who have the projects who can earn profits from this savings.

Money: Banking, Spending, Saving, and Investing Financial Markets Financial Markets and Intermediaries Page 2 of 3

Lets look at some examples of financial intermediaries and I think it will make clearer what’s going on in this process. One example of a financial intermediary is a bank, this is one you are probably very familiar with. A bank borrows money from households, and it gets households to lend money by offering them deposits in a form that’s attractive. What people want when they go to a bank are transactions balances like checking accounts, or opportunities to earn a little bit of interest by putting your money in a savings account that you can take out whenever you want. People are attracted to savings accounts and checking accounts because they are liquid. Liquid means easily convertible into cash without any risk.

Now, when the bank gets all of its money deposited by households it goes and makes loans: loans to businesses; loans to people who are building houses in the form of mortgages; and sometimes they will even hold treasury bills, which means they are indirectly making a loan to the government. Now, if you are in a savings and loan institution, you are probably lending most of your money to houses, because savings and loan institutions typically lend at-least three-fourths of their money in the form of mortgages. There are also credit unions, which lend most of their money to their own members and mutual savings banks, which are less and less common. So, banks are one kind of financial intermediary–they stand between lenders and borrowers.

Another example of a financial intermediary is a mutual fund. Now, here is the way a mutual fund works. People go to a mutual fund and they invest their money there, they put money there on deposit because the mutual fund offers them a diversified portfolio. That is you get a mutual fund statement which tells the funds you are invested in and once you look at the prospectus for that fund you can see that it involves the holding of thousands of shares of stock in thousands of different companies. What the mutual fund typically does, is it buys stock in thousands of different companies and since you own a share of the mutual fund you own a little piece of each of these thousands of companies. Rather than putting all of your eggs in one basket, by making a big loan to one company you can put your money in a mutual fund, get a statement and a share of that mutual fund and own a little piece of the stocks of thousands of different companies. The mutual fund diversifies for you that is, it goes to the trouble of locating lots of good investments and gives you a little piece of each one so as to minimize your risk.

Another example of a financial intermediary is an insurance company. And an insurance company works this way: the insurance company buys bonds of companies, and it offers the people who have deposited there insurance policies, many of which have an annuity component. An annuity is like a financial instrument; it’s like a savings account. You have heard of life insurance policies maturing. Well when you buy a whole life policy, what you are dong is you’re engaging in a kind of savings activity. When your whole life policy matures, you’re entitled to receive your savings with interest at a date in the future. So the insurance company takes the money that you have deposited and pays you a rate of return on the money that you have paid in. All of the money that you have paid in in the form of premiums and annuity investments, gets invested in companies as the insurance companies buys bonds. Now insurance companies work on the principle of actuarial science, that is they look at the statistics on accidents and life expectancy, and they can calculate pretty precisely, exactly how much money they are going to have to pay out each year. That means they can afford to invest the bulk of the money that’s deposited there into very long term investments that typically pay higher rates of return. That’s why insurance company annuities are usually a relatively attractive investment for lenders. Also, they have good tax consequences and protection from certain kinds of taxes.

One more kind of financial intermediary is the pension fund. The pension fund, again, stands between lenders and borrowers, and it offers lenders retirement accounts and pensions. That is, it plays a role in peoples retirement planning. Then the pension plan itself invests this money into the stocks of lots of companies; that is, it engages in diversification. The pension fund knows when it is going to have to have money to pay people who are approaching their retirement years, so it can also do some long term planning and leave its money in the stock market looking for the best possible return.

Now, you’ve seen several examples of financial intermediaries. Financial intermediaries engage in bringing lenders and borrowers together; and doing so in a form that makes the terms more attractive for both sides. Well, think about what’s happening here, people are putting money into financial intermediaries where they’re buying bonds. What they are doing is they are saving; and all of the money that goes into financial markets comes out the other side. That is, it’s borrowed by businesses or the government or households, who are making investment decisions. Building

Money: Banking, Spending, Saving, and Investing Financial Markets Financial Markets and Intermediaries Page 3 of 3

houses, building factories, building roads. Savings equal investments: everything that goes in comes out. With that insight, it’s easy to see how the financial system is related to the rest of the economy.

Consider these equations. Let Y stand for income. Now what can you do with your income? You can consume it, save it, or spend it on taxes. And since everyone in the economy is in the same position, all income in the economy winds up as consumer spending, savings, or tax payments. Now think also about income. Income is received whenever you produce goods and services, and all of the goods and services that are produced have to be purchased by someone; whether consumers, businesses in the form of investment spending, the government or foreigners in the form of our net exports. Now this income, that’s equal to the sum of its uses, and this income, that’s equal to the total of all spending, are the same income. So set them equal to each other and you get these equations. This equation’s set equal to this one. Cancel the C off, and do a little rearrangement and you get this remarkable statement: which is, that all of the investment spending, all the money businesses are borrowing in order to purchase plant, equipment and other capital goods, all of that business spending is someone else’s saving. Whether the saving of households, the saving of the government (that is the amount by which tax payments exceed government or the governments budget surplus), or whether it’s our trade deficit, that is the money foreigners are lending us, so that we can buy more of their goods than they buy of ours. These three forms of savings, private saving, public saving and foreign saving have to be equal, by accounting, to the amount of investment spending that businesses do. And that’s the link between the real economy and the financial system.