Financial Institution and Financial Market
Financial market as well as financial institution is very important for economy. Through these the investment for the new capital is possible to get a good economy. For a perfect growth, these channels are important and along with them it is also important to understand the following points as –
- Finance and Money
- Physical Capital and Financial capital
Finance and Money
Finance in economics explains about the expenditures done on capital. This an exact activity of spending funds for fulfilling the requirements. With the help of study it is important to understand that how firms and households obtain? And, more than that these are also important to know about what financial resources are used to obtain the things and how they cope with different risks during these activities.
Money is another important factor in Economics. This is an exact thing that we use at the time of purchasing goods as well as services. If you go through the study of money, then it will be clear to you that how firms as well as households use it.
Economically, for individuals and for business, both money and finance are important as well as correlated to each other. There are some financial institution, like banks, provides the services of finance as well as money. As these terms, money and finance, is related with each other, thus it is important for students to go through together. This will explain each concept in a proper way.
Physical Capital and Financial Capital
Physical Capital means those machines, tools, instruments, buildings and other items which were produced in the past, but people still use these in this current time to produce goods and services. In economic point of view, Physical capital is different than a financial capital. Moreover, the different parts of Physical capital are raw material’s inventories, components and also semi finished goods etc. So, when the word ‘Capital’ is used in a normal way, then an economist considers it as physical capital. Now, how to buy these capitals? Purchasers use funds for that and this fund is known as Financial Capital. For an ‘aggregate production function’, the amount of funds is fixed.
In case of increasing quantity of capital, the probability of production possibilities increases. In addition, the product function aggregate shifts upward. There are different factors those like investment, borrowing, saving, and lending decisions affects the capital and enhance it to grow. So, the real GDP grow becomes possible.
Capital and investment
Depreciation and investments are important factors in changing quantity of capital. The capital’s quantity increases due to investment, but it decreases only due to depreciation. An exact amount expenditure on new capital is termed as Gross investment. However, the change in its value is known as net investment. Henceforth, net investment can be derived as
Net investment = Gross Investment – Depreciation
If a company invests $30,000 and its value decreases by 67%, then its depreciation is $20000. Now, the value of the assets or machines is $10,000. Now, again it invests $ 30000 on machines. It means the value of capital is now, $ 40,000. It means the value of capital has increased by $10,000. It means the net investment is $10,000 as gross investment of $30000 – initial capital of $ 20,000.
Wealth and Saving
Wealth is the economic term that is used to understand the value of those things that people own. Whatever people own is completely related to their earning. However, wealth and earn are different. Earning means income of money on behalf of working for a fixed time. Basically, this is the amount that each person receives when they work for a particular duration. They own resources by supplying their service.
Saving means you save from your income. So, this amount is completely free from taxes and along with that it is not the amount spent for purchasing anything or using for any services. In case of increasing value of assets in the market, the wealth increases. It directly indicates that saving is always important for increasing wealth. It can also be said that when wealth increases mean gain of capital. Wealth decreases at the time means the value of asset decreases. It is also known as capital losses. Whatever you keep aside that is completely away from your expenditure is your saving. It is also important to know that people save money to improve their economic condition, and thus whatever amount they save at the end of each month gets added.
At the same basis, wealth of a nation as well as national saving works. This is also like the saving of wealth of a person. The wealth of a nation in a year is very easy to calculate as it is the gaining of a year and saving throughout the year. Saving means you are not going to spend this amount. So, you can say that –
Saving = Income – Total expenditure
GDP grow is important, but how? To have a real GDP grow, a person must transform wealth and saving into capital and investment. So, financial capital is important to get this change in the markets by taking help of financial institutions. It is important to understand about these markets.
Financial capital markets
Finance investment depends on funds and saving is the chief source for that. Moreover, three types of financial markets are where the demands of these funds take place. These are –
- Loan market
- Bond market
- Stock market
Loan market – Business needs finance and sometimes it requires short- term finance. With the help of this businesses purchase inventories or they can also extend credit. At the time of essential requirement of a company or for individuals, they take as a form of loan.
So, loan is one of the most accurate steps to fulfill the financial requirement for a company or for an individual person. If you concentrate of household requirements, then purchasing car or house can easily be bought by getting finance from banks. Henceforth, funds are provided from bank. Loan market is thus one of the most perfect one for fulfilling the requirements.
It is also true that on behalf of some assets, loan is provided. This asset is used as mortgage that is a legal contract of taking ownership of house or land in case of the borrower is failed to pay the amount of loan in a particular time. Different kinds of loan come under loan market.
Bond market – A bond is the contract that promises to pay the specified or an exact amount on a specified date. If a person buys a Wal-Mart bond for getting paid $5.00 each year till 2025 and then $100 on the very next year or 2026 as a final payment. In case a person buys a bond and desires to take loan from Wal-Mart, then he will be applicable to take loan as an equal amount promised to pay by the bond.
If anyone buys the bond that is issued new, then he can hold that bond till the time he get repaid by the borrower to sell or borrow to someone else. In this way bonds are issued and borrowed by some organizations or firms as well as government. This is known as Bond market.
Many famous companies take loans when they desire to open a number of stores in the country or in the world. So, loan is the requirement of fulfilling the financial need. They may sell bonds and get that amount. Government sectors as municipal, federal and state also raise finance through issuing bonds.
The bonds can be used for short term or for the long term. Suppose GM sells a few bonds let bond of worth $100 million to a company Union specific. Now, suppose GM desires to get the payment just after shipping while Union Specific wants to pay after earning income to some extent. So, in this difficult situation, there must be an agreement of promising amount of $101 million within next three month and in this way the company GM is able to take payment of $ 100 million and the bank is there that takes $101 million. So, when there is a bill of promises, then it is known as a treasury bill. Bond market must be understandable to get an exact description.
Mortgage back is another way of getting bond and mortgage back security is thus very important to understand. It means the authorizations hold the income from mortgages’ package. The lenders are there to generate mortgage back security. There are different mortgage loans are provided to the lenders. These are facilitates to homebuyers and after that they get securities to sell to achieve more funds. The holder of this ‘mortgage back security’ is entitled to get payment from mortgage lender as the mortgage lender gets the payment from the home-buyer-borrower.
Stock Markets – A stock means getting certification of ownership and it indicates profit of the firm. The certificate of ownership is always there while you purchasing shares. In case a company has 100 million shares and you have purchased 100 shares, then you are the owner of its millionth part and you are able to enjoy profit of that part.
A stock market is nothing more than a financial market where shares are traded. In addition, there are different shares belong to the different corporations. There are different stock market as New York Stock Market, Frankfurt Stock exchange, London Stock Exchange and Tokyo Stock Exchange.
You may have understood that like stockholder gets ownership in the firm, bondholders are not able to acquire any ownership.
Financial institution plays an important for financial market as these markets are highly competitive. Financial Capital needs to get operated, and financial institution is nothing more than a firm, but it is able to operate both sides of the financial capital. Both sides mean the borrower from one side and lender from another side.
Financial institutions are always ready for providing an exact option to trade with. It does so that households and firms seeking funds must get someone to trade with. This part on the other side is always that part which is ready to get in contact to trade with someone as firms or individuals.
There are some keys of financial institutes and these are as follows –
- Commercial banks
- Government-sponsored mortgage lenders
- Pension funds
- Insurance companies
Commercial banks – This part of financial institutions work to accept deposits, provide loan services to the firms and households and provide the services for payment. The banking sector that is used to get credit card for banking service is a part of commercial bank. It means when you use different banking services from a bank, then it comes under a commercial bank. It indicates that in the monetary system this part plays a prime role.
Government-sponsored mortgage lenders – There are two important and large financial institutes as ‘Federal Home Loan Mortgage Corporation’ and ‘Federal national mortgage association’. These often buy mortgages and equivalent from banks. In addition, mortgage back securities are also there to get package as well as to sell them. Even US government had owned a large amount of worth as $ 6 trillion in 2008.
Pension funds – This one uses the contributions in terms of pension for workers and firms to purchase stocks and bonds. This is a part of Financial institution that use funds related to pension for a lot of work. Federal Home Loan Mortgage Corporation’ and ‘Federal national mortgage association’ are some assets of pension funds among many. There are many firms with large funds.
Insurance companies – Coping with firms and households in any risk situation is solved to some extent by insurance companies. So, in case of any higher risk misfortune come in this category. So, this is a very important part of financial institutions. Accident, fire, theft, ill-health and some other misfortunes can be there to create problems. However, claims are there and insurance companies get premiums from customers and then these companies pay claims.
These insurance companies only use funds that they have received, but they don’t go with the amount they received as an interests or income by using this capital amount. This amount is provided by stock. If you look or go through the premiums properly, you will get that incoming premiums are very high and thus getting interest or income through stock market becomes very high. But, if you go through the claims, then it will be clear that comparatively claims are not so risky to pay complete amount or a large sum. So, the coming funds and its flow are completely steady. There is a god profit and the exact profit is the subtraction between these two amounts.
Insolvency and Illiquidity
Net worth of a financial institution is an exact difference between whatever a business has lent market value and whatever it has borrowed (market value). If the difference is positive, then you can say that net worth is solvent, however in case of negative net worth, it is insolvency. It must get in satisfactory outcome and thus go out of business. So, the owner faces the loss if it is insolvent.
Generally, stock holders bear the loss in case of insolvency. The prime work of a financial institution is lending as well as borrowing. So, it is somehow risky if its net worth is negative. This must be limited and thus to limit its risk, regulation of financial institutions take place. In this way, the lending for the minimum amount gets backed for its net worth.
Illiquidity is another important matter for financial institution. Many times it is solvent, but illiquid. If a firm has loans of long term with borrowed funds and suddenly it faces the condition of repaying of that amount more than its available cash. Genuinely, in case of a financial institution that is illiquid may borrow some amount from any other institution. However, in case of short of money in all institutes, the market dries up for loans among institutions.
Interest Rates and Asset Prices
Bonds, short-term securities and loans are together termed as financial assets. A financial asset’s rate of interest is just equal to the price percent of that asset.
As the interest rate is just equal to the percentage of the price and thus, when the other things normal and there is an increase in asset value, then interest rate will decrease. If there is rise in value of other’s price and the value of asset is same, then its interest rate will rise.
You can easily understand this with an example. Suppose, there is a bond that promises to give $ 5 per year and its cost is $ 50. Now, Now, what would be the interest rate per year?
Interest rate = $5 / $50 * 100 = 10%
In case the price of that same bond increases to $200, then its interest rate would be
$ 5/ $200 * 100 = 2.5 %
Now, it is clear completely that when rate increases but the return of value is same, then interest price for that bond decreases. As asset rate and its interest rate are inversely proportional to each other, so you must understand that interest rate deceases with increase in value of the asset and vice versa. With large rise in insolvency the interest rate will increase. In this type of cases, it becomes difficult to pay the debts. Moreover, net worth for a financial institution also falls.
Links of Previous Main Topic:-
- Definition of Economics
- Economic Problem
- Market Equilibrium
- Employment and Unemployment
- Measuring GDP and Economic Growth
- Economic Growth Macroeconomics
- Policies for Achieving Faster Growth
- Finance Saving and Investment
Links of Next Macroeconomics Topics:-