National Economic Policy Objectives

• Economic Growth
function of increasing stock of productive
resources (labor force and stock of capital) and
improved technology and skills
• High Employment
• Price Stability
occurs when an increase in the price of goods or
services is not offset by an increase in quality
• Balance in International Transactions

1
Gross Domestic Product (GDP) and
Capital Formation

• GROSS DOMESTIC PRODUCT: Measures the

output of goods and services in an economy
• CAPITAL FORMATION: Process of
constructing real property, manufacturing
producers’ durable equipment, and increasing
business inventories

2
 Gross Domestic Product (GDP)
Components
GDP is composed of:
• Personal Consumption Expenditures
• Government Expenditures including Gross
Investment
• Gross Private Domestic Investment
• Net Exports of Goods and Services

3
 Gross Domestic Product (GDP)
Components (continued)
• EQUATION:
GDP = PCE + GE + GPDI + NE
• PERSONAL CONSUMPTION EXPENDITURES
(PCE):
Expenditures by individuals for durable goods,
nondurable goods, and services
• GOVERNMENT EXPENDITURES (GE):
Purchases of goods and services by the
government
4
 Gross Domestic Product (GDP)
Components (continued)
• EQUATION:
GDP = PCE + GE + GPDI + NE
• GROSS PRIVATE DOMESTIC INVESTMENTS
(GPDI):
Investments in residential & nonresidential
structures, producers’ durable equipment, &
business inventories
• NET EXPORTS (NE): Exports
minus imports of goods & services
5
 Government Influence on the
Economy

• FISCAL POLICY:
Government influences economic activity
through taxation and expenditure plans
• FUNDRAISING ACTIVITIES:
Government raises funds to pay for its
activities by: levying taxes, borrowing, or
printing money for its own use

6
 Transferring Savings into Investments

• Savings-Investment Process:
involves the direct or indirect transfer of
individual savings to business firms in
exchange for their securities

7
 Savings-Investment Process
Direct Transfers:
Savers Money Business
Securities Firm
Indirect Transfers:
Money Investment Money
Savers Banking Firm Business
Securities Securities
Firm

Savers Money Financial Money Business

Intermed’s Firm’s
Intermediary Firm
Securities Securities

8
 Historical Role and Creation
of Savings

• Foreign investors initially purchased large

amounts of the securities sold by government &
private promoters
• The family later took over the function of
providing savings for the capital formation
process

9
 Creation of Savings
• Financial System’s Three Basic Economic Units:
--individuals
--business firms (including financial
institutions)
--governments (national and local)
• Savings:
Income that is not consumed but is held in the form
of cash and other financial assets

10
 Creation of Savings (Continued)
• Savings Surplus:
Occurs when current income exceeds investment
in real assets
• Savings Deficit:
Occurs when investment in real assets exceeds
current income
• Importance of Individuals:
Individuals represent an important savings
surplus economic unit
11
 Major Sources of Savings
[Personal Income-Personal
• Personal Savings: Current Taxes] - Personal
Outlays (expenses)
Personal Saving = Personal Income – Personal
Current Taxes – Personal Outlays
• Corporate Savings: [Profits after taxes] -
Dividends
Undistributed Profits = Profits After Taxes –
Dividends

12
Two Types of Personal Savings

• VOLUNTARY SAVINGS:
Financial assets set aside for future use
• CONTRACTUAL SAVINGS:
Savings accumulated on a regular schedule by
prior agreement (e.g., reserves in insurance and
pension plans)

13
 Personal Savings
• PERSONAL SAVINGS DEFINITION:
• Personal income 100

Less: taxes and other payments 10

Equals: disposable personal income 90

Less: personal outlays 75

Equals: personal savings 15

• SAVINGS RATE DEFINITION:

• Savings Rate = (Personal Savings)/ (Disposable
Personal Income) 15/90 =
16.67%

14
Types of Personal Savings

• Cash balances
• Time and savings deposits
• Insurance reserves and pension funds
• Securities

15
 Corporate Savings
• UNDISTRIBUTED PROFITS DEFINITION:
Profits before taxes 1,000,000

300,000
Less: tax liabilities
Equals: profits after taxes 700,000

Less: dividends 100,000

Equals: undistributed profits 600,000

• RETENTION RATE DEFINITION:

Retention Rate = (Undistributed Profits)/(Profits
After Taxes) 600,000/700,000 =
85.7%

16
Factors Affecting Savings

• Levels of income
• Economic expectations
• Cyclical Influences (economic cycles)
• Life stage of the individual saver or
corporation

17
Life Stages of the Individual Saver
and the Corporation
• Individual Saver
--Formative/education developing
--Career starting/family creating
--Wealth building
--Retirement enjoying
• Corporation
--Start-up stage
--Survival stage
--Rapid growth stage
--Maturity stage
18
 Types of Assets
• REAL ASSETS:
(real or personal)
Physical assets ^that provide value or wealth to
their owners
• FINANCIAL ASSETS:
Contractual assets often backed by real assets
that provide value or wealth to their owners
• INDIVIDUAL NET WORTH:
An individual’s money, real assets, and other
financial assets less the individual’s debt
obligation
19
End of Lecture
 Types of Financial Instruments with
Maturities Up to 1 Year
Instrument: Issuer:
• Treasury bills government
• Negotiable certifi- Commercial banks
cates of deposit (CDs)
• Commercial paper Corporations
• Bankers’ acceptances Commercial banks
• Eurodollar deposits Commercial banks

21
Short-term (Maturities Up to 1 Year) Financial
Instruments

• Treasury bill:
Short-term debt obligation issued by the
government
• Negotiable certificate of deposit (CD):
Short-term debt instrument issued by depository
institutions that can be traded in secondary markets

22
 Short-term (Maturities Up to 1 Year) Financial
Instruments (Cont’d)

• Commercial paper:
Short-term unsecured promissory note issued by a
corporation with high-quality credit
• Bankers’ acceptance:
Promise of future payment for credit purchases by a
firm and guaranteed by a bank
• Eurodollar deposit:
Funds placed in a foreign bank that remain
denominated in U.S. dollars
23
 Types of Financial Instruments or
Securities with Long-term or No
Maturities
Instrument/Security: Issuer:
• Mortgages Fin. intermediaries
• Treasury bonds government
• Municipal bonds national/local gov’ts.
• Corporate bonds Corporations
• Corporate stocks Corporations

24
 Long-term (No Maturities or Up to 30 Years)
Financial Instruments or Securities
• Mortgage:
Loan against which a borrower pledges real
property as collateral for the loan
• Treasury bond:
Long-term debt instrument issued by the
government
• Municipal bond:
Long-term debt instrument issued by the national
or local government

25
Long-term (No Maturities or Up to 30 Years)
Financial Instruments or Securities (Cont’d)

• Corporate bond:
Debt instrument issued by a corporation to raise
long-term funds
• Common stock:
Ownership interest in a corporation

26
 Types of Financial Markets: General

• PRIMARY MARKETS:
Markets in which financial instruments and
securities are initially offered or sold with the
proceeds going to the issuer
• SECONDARY MARKETS:
Markets in which previously issued or “seasoned”
instruments or securities are traded

27
 Types of Financial Markets: General
(Cont’d)

• MONEY MARKETS:
Where debt instruments of one year or less are
traded
• CAPITAL MARKETS:
Markets for debt securities with maturities longer
than one year, and corporate stocks

28
 Four Specific Types of Financial
Markets

• SECURITIES MARKETS:
Physical locations or electron forums where
debt and equity securities are sold and traded
• MORTGAGE MARKETS:
Where mortgage loans, backed by real
property are originated and sometimes traded

29
 Four Specific Types of Financial
Markets (Cont’d)
• DERIVATIVES MARKETS:
Facilitate purchase and sale of derivative
securities, which are financial contracts that
derive their values from underlying securities
• CURRENCY EXCHANGE MARKETS:
Electronic markets in which financial
intermediaries buy and sell various currencies
on behalf of businesses and other clients

30
 Supply and Demand for
Loanable Funds
Basic Interest Rate Concepts:
• INTEREST RATE: Price that equates the demand
for and supply of loanable funds
• ROLE OF FINANCIAL MARKETS: Interest rates
are determined by the supply and demand for
loanable funds in financial markets

31
 Loanable Funds Theory
• Loanable Funds Theory: States that interest
rates are a function of the supply of and
demand for loanable funds
• Two Basic Sources of Loanable Funds:
--current savings
--expansion of deposits by depository institutions

32
 Factors Affecting the Supply of
Loanable Funds
• Volume of Savings
Major factor is the level of national income
• Expansion of Deposits by Depository Institutions
Amount of short-term credit available depends on lending
policies of depository institutions and the BSP
• Liquidity Attitude
Refers to how lenders see the future

33
 Determinants of Market
Interest Rates
• NOMINAL INTEREST RATE (r):
Interest rate that is observed in the marketplace
• BASIC EQUATION: (3)
r = RR + IP + DRP
• REAL RATE OF INTEREST (RR):
Interest rate on a risk-free debt instrument when
no inflation is expected (usually based on 3month Treasury
bills rate)

34
 Determinants of Market
Interest Rates (continued)
• BASIC EQUATION:
r = RR + IP + DRP
• INFLATION PREMIUM (IP):
Average inflation rate expected over the life of
the security
• DEFAULT RISK PREMIUM (DRP): (subjective)
sayo
- risk rating

Compensation for the possibility of the

borrower’s failure to pay interest and/or
principal when due
35
 Determinants of Market
Interest Rates (concluded)
• BASIC EQUATION EXPANDED: (3+2)
r = RR + IP + DRP + MRP + LP
• MATURITY RISK PREMIUM (MRP):
Compensation expected by investors due to
interest rate risk on debt instruments with
longer maturities
• LIQUIDITY PREMIUM (LP):
Compensation for securities that cannot easily
be converted to cash without major price
discounts 36