Financing needs and capacities
Every player earns and spends. If income is bigger than spending, there is a financing capacity (spare money, saving). If spending is bigger than income, there is a financing need (a gap to fill).
Households usually have a capacity. Firms often have a need because they buy machines before they earn from them. The state often has a need when it runs a deficit.
Households: consumption and saving
A household splits its income: Income = Consumption + Saving. Consumption is spending on food, rent, travel. Saving is what is left. People save for emergencies, big purchases and old age. The savings can go to a bank account, bonds, shares or property.
Interest rate: the price of a loan
When you borrow, you pay a price: interest. The interest rate is that price as a percentage per year. Simple interest = Principal × rate × time. A higher rate means loans cost more, so fewer people borrow. A lower rate means loans are cheaper, so more people borrow. Savers also earn interest, but at a lower rate than borrowers pay; the gap is how the bank earns.
Firms: self-financing, loans, shares and bonds
A firm can fund an investment in four ways.
- Self-financing: use its own retained profit. No one else to pay.
- Bank loan: borrow and repay with interest.
- Shares: sell a small part of ownership. Buyers get a share of profit (dividend) and may vote. Nothing has to be repaid.
- Bonds: borrow from many savers; the firm pays fixed interest (a coupon) and returns the amount on a set date.
Direct and indirect finance
Indirect finance: savers deposit in a bank, the bank lends to borrowers. The bank takes the risk and the saver can usually take money out easily.
Direct finance: borrowers sell shares or bonds on a financial market; savers buy them. No bank stands between them, so the saver takes more risk but may earn more.
Banks also give services: payments by card or transfer, cheques, overdraft, foreign-money exchange and advice. Good businesses, such as hotels, keep a good relationship with their bank to get loans and payment tools.
The state: budget balance and public borrowing
Budget balance = revenue − spending. A negative balance is a deficit. To cover it the state borrows by selling government bonds. The total it owes is the public debt. Borrowing is not bad in itself (for a road that helps growth for 50 years), but too much debt makes interest payments heavy.
Stimulus versus crowding out
When the economy is weak, the state may borrow and spend to create demand and jobs. This is a stimulus.
But savings are limited. If the state borrows a lot, it may take the savings that firms would have borrowed, and interest rates can go up. Private investment falls. This is crowding out. Economists argue about which effect is larger; it depends on whether there are unused savings and workers.
Try it
In the 3D: in the last step set the interest rate to 0, then 15. What does a 1000 loan cost each year? Then raise state borrowing to 10 and watch the money left for firms.
At home: list your monthly pocket money, spending and saving. Is there a capacity or a need? If a friend borrows 100 for a month and returns 105, what rate did you earn?
Key formulas and definitions
- Income = Consumption + Saving
- Financing capacity = income − spending (> 0); need = spending − income
- Simple interest = P × r × t
- Budget balance = revenue − spending
- Real interest rate ≈ nominal rate − inflation
Worked examples
1. A household earns 30,000 a month and spends 24,000. How much does it save? Is it a need or a capacity?
Saving = 30,000 − 24,000 = 6,000. Income is bigger than spending, so it has a financing capacity.
2. A firm plans a 500 machine. It has 300 of retained profit. How much must it find from outside?
Need = 500 − 300 = 200. It can take a bank loan or sell shares or bonds worth 200.
3. Find the interest on a loan of 20,000 at 6% per year for 1 year.
Interest = 20,000 × 6 ÷ 100 × 1 = 1,200.
4. A state collects 800 and spends 950. What is the balance and what must it do?
Balance = 800 − 950 = −150, a deficit of 150. It must borrow 150, usually by selling bonds.
5. A bond has a face value of 1,000 and pays 5% every year. What does the holder get per year?
Coupon = 1,000 × 5 ÷ 100 = 50 per year, and 1,000 back on the final date.
6. The bank pays savers 3% and charges borrowers 8%. If it lends out 100,000 of deposits, what is its gross gain in a year?
It earns 8,000 and pays 3,000. Gross gain = 5,000 (before its costs and losses).
Common mistakes
- Thinking a share is a loan. A share is part-ownership; the firm does not have to repay it.
- Thinking a bank lends only its own money. It lends mostly the deposits of savers.
- Treating all state borrowing as harmful. Borrowing for useful projects can help; the problem is too much.
- Mixing a deficit (one year's gap) with debt (the total owed so far).