ECON CH 11-1 SAVINGS AND INVESTING

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Study the introduction to this unit. On the right, explain what you are expected to learn from this unit.
Review the vocabulary words. You will encounter them during this lesson. At the end of this lesson you will be tested on the meanings of the words.
Good luck

If you go to school today, you give up
your time now so that you will be
prepared for a career in the future. If a firm
builds a new plant, it spends money today
for the sake of earning more money in the
future. A government may spend money
today to build a dam to ensure that people
will have a source of hydroelectric power in
the future. All of these actions represent
investments.

In its most general sense, investment is the
act of redirecting resources from being
consumed today so that they may create
benefits in the future. In more narrow,
economic terms, investment is the use of
assets to earn income or profit.

Investing and Free Enterprise
As you have read, one of the chief advantages
of the free enterprise system is that
it allows people to make a profit. This
profit motive leads individuals and businesses
to make investments. Investing, in
fact, is an essential part of the free enterprise
system.

Investment promotes economic growth
and contributes to a nation’s wealth. When
people deposit money in a savings account
in a bank, for example, the bank may then
lend the funds to businesses. The businesses, in turn, may invest that money in
new plants and equipment to increase their
production. As these businesses use their
investments to expand and grow, they
create new and better products and provide
new jobs.

Mr. Schneemann takes out a loan from the bank and installs solar panels on his house so his electric bills will be lower. What is this an example of?

a.	diversification	c.	reckless spending
b.	divesting	d.	investing

If you use your assets to earn income you are

a.	investing	c.	divesting
b.	wasting resources	d.	most likely unemployed

What effect does investments have on economic growth?

a.	causes it to retract and shrink	c.	causes capitalists to become greedy
b.	causes it to expand and grow	d.	has no or little effect

What kind of economic system do we have in the United States?

a.	socialism	c.	communism
b.	free enterprise capitalism	d.	national socialism

The Financial System
In order for investment to take place, an
economy must have a financial system. A
financial system includes savers and
borrowers and allows the transfer of money
between them to take place.

Financial Assets
When people save, they are, in essence,
lending funds to others. As you read in
Chapter 10, people can save money in a
variety of ways. They may put money in a
savings account, purchase a certificate of
deposit, or buy a government or corporate
bond. In each case, savers obtain a
document that confirms their purchase or
deposit. These documents may be passbooks, computer printouts, bond certificates, or other records.

Such documents represent claims on the
property or income of the borrower. These
claims are called financial assets, or securities. If the borrower fails to pay back the
loan, these documents can serve as proof in
court that money was borrowed and that
repayment is expected.
For example, suppose you have $100 in
a savings account at your local bank. Your
passbook (or computer printout) is proof
of the money in your account.

The Flow of Savings and Investments

Figure 11.1 shows how the financial system
brings together savers and borrowers,
fueling investment and economic growth.
On one side are savers—households, individuals, and businesses that lend out their
savings in return for financial assets. On the other side are borrowers—governments
and businesses—who invest the money
they borrow to build roads, factories, and
homes. Borrowers may also use these funds
to develop new products, create new
markets, or provide new services.

Why does a successful economy need an economic system?

a.	it allows banks to remain stable by securing its money in vaults	c.	it protects the assets of rich people from poor people
b.	it allows for the well regulated transfer of money between savers and borrowers	d.	to protect itself from Obamacare

Saving is another form of

a.	borrowing	c.	pricing
b.	spending	d.	lending

If you put money in a savings account, purchase a certificate of deposit, or buy a government or corporate bond you will receive documents to prove your investment. What are these documents used for?

a.	to prove you did not steal the money used to purchase the investments	c.	to allow the borrowers to place claims against your financial assets in the event they are unable to repay the loans
b.	to place a claim on the financial assets of the people who borrow your investments.	d.	to open your finances to the general public for scrutiny

Which statement is true.

a.	Borrowers almost always waste the money they have borrowed	c.	Borrowers usually invest their money thereby helping to expand the economy.
b.	Borrowers usually do not repay their debts	d.	Borrowers are not permitted to use the money they have borrowed to invest in other projects

Financial Intermediaries

Savers and borrowers may be linked
directly. As you examine Figure 11.1, you
will notice that borrowers and savers may
also be linked through a variety of institutions
pictured as “in between ” the two.
These financial intermediaries are institutions
that help channel funds from savers
to borrowers. They include the following:

• Banks, Savings and Loan Associations,
and Credit Unions As you read in
Chapter 10, banks, S&Ls, and credit
unions take in deposits from savers, then
lend out some of these funds to businesses
and individuals.

• Finance companies Finance companies
make loans to consumers and small
businesses. Because finance companies
sometimes lend money to people who do
not repay their loans, they take on a
high degree of risk. Finance companies,
therefore, charge borrowers higher fees
and interest rates to cover their losses
from the loans that are not repaid.

• Mutual funds Mutual funds pool the
savings of many individuals and invest
this money in a variety of stocks, bonds,
and other financial assets. Mutual funds
allow people to invest in a broad range of
companies in the stock market. This way,

investors do not risk their savings by
purchasing the stock of only one or two
companies that might do poorly.

• Life insurance companies The main
function of life insurance is to provide
financial protection for the family or
other beneficiaries of the insured.
Working members of a family, for
example, may buy life insurance policies
so that if they die, money will be paid to
survivors to make up for lost income.
Insurance companies collect payments
called premiums from the people who
buy insurance. They lend out part of the
premiums they collect to investors.

• Pension funds A pension is income that
a retiree receives after working a certain
number of years or reaching a certain
age. In some cases, injuries may qualify
a working person for pension benefits.
Employers may contribute to the pension
fund on behalf of their employees, they
may withhold a percentage of workers ’
salaries to deposit in a pension fund, or
they may do both. Employers set up
pension funds to collect deposits and
distribute payments. Pension fund
managers invest these deposits in stocks,
bonds, and other financial assets.

Now that you know something about
the types of financial intermediaries, you
may wonder why savers don’t deal directly
with investors. The answer is that, in
general, dealing with financial intermediaries
offers three advantages. Intermediaries
share risks, provide information, and
provide liquidity to investors.

10.

What do financial intermediaries do?

a.	They help to transport money from savers to borrowers	c.	They take money out of the banking system to prevent inflation
b.	They take money from savers and deposit the funds in secure vaults	d.	They take money from borrowers to avoid taxes

11.

What to Banks, Savings and Loan Associations, Finance companies, Mutual funds, life insurance companies and pension funds do?

a.	They act as financial intermediaries	c.	They transport money from the poor to the rich
b.	They drain money from the public sector of the economy hurting the financial infrastructure.	d.	They do very little to support a stable banking system

12.

What do Banks, Savings and Loan Associations,and Credit Unions do with the money deposited with them?

a.	they allow it to sit, untouched, in their vaults	c.	they gamble it in the stock market
b.	they donate a portion of it to poor people	d.	they lend it to consumers and businesses

13.

Why do finance companies charge higher interest than banks?

a.	they make bigger loans than banks	c.	the people who borrow from finance companies do not always repay their debt
b.	they make smaller loans than banks	d.	the credit ratings of their borrowers tend to be higher than the general public.

14.

Which statement is true about insurance companies?

a.	they lend part of the premiums paid by investors.	c.	they are allowed to spend all of the money they have in any way they want
b.	they are required to keep all cash premiums to pay policy claims	d.	they are required by law to lend all of the premiums they receive to lenders

15.

Which statement is true about pension funds

a.	Pension funds are not allowed to be invested because the money has to be in reserve for people who retire	c.	Pension fund managers invest these deposits in stocks, bonds, and other financial assets.
b.	Pension funds do very little to help the over-all economy	d.	Most people do not care much about pension funds

16.

Which statement is true about mutual funds.

a.	Mutual funds represent investments in a single stock such as IBM or Microsoft	c.	Mutual funds are more risky that single stock investments
b.	Mutual funds are invested in a variety of stocks so the lose will be less if one stock fails	d.	There is no chance of loosing money in mutual funds

17.

What is the main purpose of Life Insurance Companies?

a.	To provide money for families after the insured dies	c.	To collect research money for organizations that fight life threatening diseases
b.	To insure the health of the person purchasing life insurance	d.	To provide money for consumer loans

18.

Do life insurance companies make loans?

yes

19.

What is the main purpose of pension funds?

a.	To provide insurance money to employers	c.	To provide money to workers if they get sick
b.	To provide medicare for the elderly	d.	To provide money for people after they retire from their jobs.

20.

What do Pension Fund Managers do with the money they collect from employers and employees?

a.	they place it in vaults to protect if	c.	There are no such things as Pension Fund Managers
b.	they invest it	d.	They protect the money by purchasing gold and silver bullion

21.

In general, dealing with financial intermediaries offers three advantages. (pick 3)

a.	they allow investors to deal directly with savers	c.	provide liquidity to investors
b.	provide information	d.	share risks

22.

Financial intermediaries, including banks and other financial institutions,

a.	receive investments but do not make loans	c.	make loans but do not take investments
b.	accept funds from savers and make loans to investors	d.	must keep gold or silver reserves that match the amount of money they lend to investors

Sharing Risk
As a saver, you may not want to invest
your entire life savings in a single company
or enterprise. For example, if you had
$500 to invest and your neighbor was
opening a new restaurant, would you give
her the entire $500? Since it is estimated
that more than half of all new businesses
fail, you probably would not want to risk
all of your money. Instead, you would
want to spread the money around to
various businesses to reduce the chances of
losing your entire investment.

This strategy of spreading out investments
to reduce risk is called diversification.
If you deposited $500 in the bank or
bought shares of a mutual fund, those institutions could pool your money with other
people’s savings and put your money to
work by making a variety of investments.
In other words, financial intermediaries
diversify your investments and thus reduce
the risk that you will lose all of your funds if
a single investment fails.

Providing Information
Financial intermediaries are also good
sources of information. Your local bank
collects information about borrowers by
monitoring their income and spending. So
do finance companies when borrowers fill
out credit applications. Mutual fund
managers know how the stocks in their
portfolios, or collections of financial assets,
are performing. As required by law, all
intermediaries provide this information
to potential investors in an investment
report called a prospectus. Financial intermediaries reduce the costs in time and
money that lenders and borrowers would
pay if they had to search out such information
about investment opportunities on
their own.

Providing Liquidity
Financial intermediaries also provide
investors with liquidity. (Recall that
liquidity is the ease with which people can
convert an asset into cash.) It is intermediaries that provide this liquidity in the financial
system.

Suppose, for example, that you decide to
invest in a mutual fund. You keep the
investment for two years, but then must
sell it to pay your college tuition. If you
had purchased an investment-quality
painting instead, you would need to find
another investor who would buy the art
from you. As you can see, financial intermediaries and the liquidity they provide
are crucial to meeting borrowers’ and
lenders’ needs in our increasingly complex
financial system.

23.

What is the main idea of the first paragraph above?

a.	It is wise for people to invest all of their savings in one enterprise	c.	It is not wise for people to invest all of their savings in one enterprise
b.	$500. is the most you should invest in any one business	d.	half the businesses fail during the first year of business

24.

What is diversification?

a.	making loans to minority business owners.	c.	spreading out investments to increase risk
b.	spreading out investments to reduce risk	d.	making investments without regard to risk

25.

Why is it important for financial intermediaries to provide information to their savers?

a.	so financial intermediaries can advertise their products	c.	so they can judge the risk of investing without spending a great deal of time and money
b.	so savers can have the maximum of M1 cash on hand	d.	so they can protect themselves against future law suits

26.

Who provides liquidity in the financial system

a.	financial intermediaries	c.	government agencies
b.	non government agencies	d.	FDIC

27.

Suppose you want to save money for college. Which investment would provide you with the greatest liquidity so the money would be there when you needed it?

a.	investment in a restaurant	c.	ownership in a basketball team
b.	a mutual fund	d.	real estate

Risk, Liquidity, and Return
As you have read, most decisions involve
trade-offs. For example, the trade-off for
going to a movie may be two additional
hours of sleep. Saving and investing
involves trade-offs as well.

Return and Liquidity
Suppose you save money in a savings
account. Savings accounts are good ways to
save when you need to be able to get to
your cash for immediate use. On the other
hand, savings accounts pay relatively low
interest rates, about 2 to 3 percentage
points below a certificate of deposit (CD).
In other words, savings accounts are liquid,
but they have a low return. Return is the money an investor receives above and
beyond the sum of money initially invested.
What if, however, you suddenly inherit
$5,000? You do not need ready access to
those funds, since your part-time job pays
your day-to-day expenses. If you are willing
to give up some degree of ready access to
your money, you can earn higher interest
rates than offered by a savings account. For
example, you can invest your money in a
certificate of deposit that pays 4 percent
interest. You would not be allowed to
withdraw your money for, say, two years
without paying a penalty. Therefore, before
buying the CD, you would want to weigh
the greater return on your investment
against the loss of liquidity.

Return and Risk
Certificates of deposit (up to $100,000) are
considered very safe investments because
they are insured by the federal government.
When you buy a CD, you are giving up
liquidity for a certain period of time, but
you are not risking losing any money. What
if, however, you decided to invest the
money in a new company that your friends
are starting? If the company succeeds, you could double your investment.
If it fails, however, you could lose all or part of the money you invested.

To take another example, suppose your savings account is earning 2 percent interest.
Would you be willing to lend money to your friend Emily for that same 2 percent interest rate, knowing that she rarely pays back loans on time? Probably not. For you to lend Emily the money, she would have to offer you a
higher return than the bank could offer. This higher return would help offset the greater risk that Emily will not repay the loan on time.
Likewise, investors and lenders must
consider the degree of risk involved in an
investment and decide what return they
would require to make up for that risk.

The higher the potential return, the
riskier the investment. Whenever individuals
evaluate an investment, they must
balance the risks involved with the rewards
they expect to gain from the investment.

28.

Which answer below is true regarding trade-offs

a.	going to college	c.	eating a big meal
b.	doing homework	d.	each of these activities involve trade-offs

29.

Which investment will provide you with the greatest return

a.	saving your money in a savings account	c.	placing your cash in a home safe so as not to loose it
b.	purchasing a certificate of deposit	d.	giving your cash to one of your parents to hold for you

30.

What is the trade-off in the paragraph above titled, “Return and Liquidity.”

a.	higher earning between real estate or CD’s	c.	cash or M1 money
b.	higher earnings vs the ability to get cash when you need it	d.	investing in gold or silver

a.	mutual fund	f.	financial asset
b.	investment	g.	diversification
c.	portfolio	h.	financial system
d.	return	i.	prospectus
e.	financial intermediary

31.

institution that helps channel funds from savers to borrowers

32.

spreading out investments to reduce risk

33.

the act of redirecting resources from being consumed today so that they may create benefits in the future; the use of assets to earn income or profit

34.

an investment report to potential investors

35.

fund that pools the savings of many individuals and invests this money in a variety of stocks, bonds, and other financial assets

36.

the system that allows the transfer of money between savers and borrowers

37.

the money an
investor receives above
and beyond the sum of
money initially invested

38.

claim on the property or income of a borrower

39.

a collection of financial assets

40.

The table 11.2 above describes 4 types of risk. Describe a real life experience you have had with one of the types of risk.
1. Type of risk
2. Your experience