Finance and Money; Physical Capital and Financial Capital
Finance and money differ:
· Finance refers to providing the funds used for investment.
· Money refers to what is used to pay for goods and services.
Physical capital and financial capital differ:
· Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services.
· Financial capital is the funds that firms use to buy physical capital.
Capital and Investment; Wealth and Saving
The quantity of capital changes because of investment and depreciation. Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.
Wealth is the value of all the things people own; saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Wealth also changes when the market value of wealth changes.
Financial Capital Markets
Financial markets transform saving and wealth into investment and capital.
Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market.
Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgage-backed securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008.
Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit.
Financial Institutions
A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies.
Insolvency and Illiquidity
A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business.
A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.
Interest Rates and Asset Prices
Stocks, bonds, short-term securities, and loans are financial assets.
The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price.
· If an asset’s price is $50 and it pays $2.50 in interest, the interest rate is percent.
· If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.
percent.