For an economic system to grow, it must produce capital - the equipment, tools, and machinery used in production. In order for this to happen, saving must take place. To the economist, saving means the absence of spending, while savings refers to the dollars that become available when people abstain from consumption.
Saving and economic growth
The financial system brings savers and borrowers together and helps the economy grow.
Savers and Financial Assets
Savers and Financial Assets
- People can save in a number of ways.
- They can open a savings account, buy a bond, or purchase a certificate of deposit - a document showing that an investor has made an interest bearing loan to a bank.
- Economists call these documents financial assets - claims on the property and the income of the borrower.
- The documents are assets because they are property that has value.
- They represent claims on the borrower because they specify the amount loaned and the terms at which the loan was made.
- Stocks, or ownership claims on a corporation, are another type of financial asset.
- In order for people to use the savings of others, the economy must have a financial system - a network of savers, investors, and financial institutions that work together to transfer savings to investors.
- The financial system has three parts.
- The first part is made up of the funds that a saver transfers to a borrower.
- The second consists of the financial assets that certify conditions of the loan.
- The third comprises the organizations that bring the surplus funds and financial assets together.
- Financial intermediaries are the institutions that lend the funds that savers provide.
- Financial intermediaries include depository institutions such as banks and credit unions, life insurance companies, pension funds, and other institutions that channel savings to borrowers.
- Any sector of the economy can borrow, but governments and businesses are the largest borrowers.
- If a corporation borrows directly from savers - or indirectly from savers through financial intermediaries - the corporation will issue a bond or other financial asset to the lender.
- When the government borrows, it issues government bonds or other financial assets to the lender.
- Any sector of the economy can supply savings, but households and businesses are the biggest sources of funds.
- Savers can provide some funds directly to borrowers, as when households or businesses purchase bonds directly from government or businesses.
- Capital formation depends on saving and borrowing.
- When households borrow, they invest some of the funds in homes.
- When businesses borrow, they invest some of the funds in tools, equipment, and machinery.
- When governments borrow, they invest some of the funds in highways, hospitals, universities, and other public goods.
- In the end, everyone benefits from the financial system.
- The smooth flow of funds through the system helps ensure that savers will have an outlet for their savings.
- Borrowers, in turn, will have a source of financial capital that can be invest in capital goods to benefit future economic growth.
nonbank financial intermediaries
Organizations other than banks can transfer money from savers to borrowers.
Another important group of financial intermediaries is called nonbank financial institutions - or nondepository institutions that also channel savings to borrowers. Finance companies, life insurance companies, and pension funds are examples of nonbank financial institutions.
Finance Companies
Another important group of financial intermediaries is called nonbank financial institutions - or nondepository institutions that also channel savings to borrowers. Finance companies, life insurance companies, and pension funds are examples of nonbank financial institutions.
Finance Companies
- A finance company is a firm that specializes in making loans directly to consumers.
- It also buys installment contracts from merchants who sell goods on credit.
- Some finance companies make loans directly to consumers.
- These companies generally check a consumer's credit rating and will make a loan only if the individual qualifies.
- Because they make some risky loans and pay more for the funds they borrow, finance companies charge more than commercial banks for loans.
- Another financial institution that does not get its fund through deposits is the life insurance company.
- Although its primary purpose is to provide financial protection for the people who are insured, it also collects a great deal of cash.
- The head of the family, for example, may purchase a life insurance policy to leave money for a spouse and children incase of his or her death.
- The premium is the price the insured pays for this policy, usually paid monthly, quarterly, or annually for the length of the protection.
- Because insurance companies collect cash for these premiums on a regular basis, they often lend surplus funds to others.
- The pension fund is another nondepository financial institution.
- A pension is a regular payment intended to provide income security to someone who has worked a certain number or years, reached a specified age, or suffered a particular kind of injury.
- A pension fund is a fund set up to collect income and disburse payments to those persons eligible for retirement, old age, or disability benefits.
- In the case of private pension funds, employers regularly withhold a percentage of workers' salaries to deposit in the fund.
- During the 30 to 40 year lag between the time the savings are deposited and the time the workers generally use them, the money is usually invested in high quality corporate stocks and bonds.
Basic investment considerations
Investors should consider several factors before investing their money.
Consistency
Consistency
- Most successful investors invest consistently over long periods of time.
- In many cases, the amount invested is not as important as investing on a regular basis.
- Most analysis advise investors to stay with what they know.
- Thousands of investments are available, and many are quite complicated.
- Knowing a few fundamental principles can help you make good choices among these options.
- One rule that many investors follow is to ignore any investment that seems too complicated.
- Another often cited rule is that an investment that seems too good to true probably is.
- A few investors do get lucky, but most build wealth because they invest regularly, and they avoid the investments that seem too far out of the ordinary.
- Another important factor is the relationship between risk and return.
- Risk is the degree to which the outcome is uncertain but a probable outcome can be estimated.
- Investors realize that some investments are riskier than others, so they normally demand higher returns as compensation.
- As an investor, you must consider the level of risk that you can tolerate.
- If you are comfortable with high levels of risk, then you may want to purchase risky investments that promise high outcomes.
- Otherwise, consider lower risk investments instead.
- Investment Objectives
- Finally, you need to consider your reason for investing.
- Investors have a large number of stocks, financial assets, and other investments from which to choose.
- The investor's knowledge of his or her own needs is important in making these decisions.