How Financial Assets are Created?
Financial assets are created by households and businesses in two ways. i) From internal financing ii) From external financing
Internal Financing: Households & business firms use current income and accumulated savings to purchase financial securities.
External Financing: Any economic unit like business firms and the government raise funds by issuing financial liabilities, by issuing bonds and by issuing stocks.
The act of borrowing simultaneously creates an equal volume of financial assets. For example, lending of $10,000 by a household will create exactly $10,000 liability of the firm or the government that borrowed the money. So, volume of financial assets created by lenders equals to volume of liabilities issued by borrowers.
Total Assets = Liabilities + Owner's Equity
=> Real Assets + Financial Assets = Liabilities + Net Worth
In the financial system, financial asset is equal to liabilities. Real asset is equal to net worth. So the society increases its wealth by saving and increasing the quantity of its real asset.
Business firm, household or unit of government in the financial system must conform to this equation.
R - E = "FA - "D
R = Current income, E = Current expenditure, "FA = Change in holdings of financial assets, "D = Change in liabilities & debts
This equation was developed by John Gurley & Edward Shaw in 1960.
If E>R, i) It will reduce the holdings of financial assets by withdrawing money from the savings account.
ii) It can issue debt security or equity security
iii) It can use some combination of both
If R>E, i) It increases the holdings of financial assets by placing money in the savings account and/or buying stocks of shares.
ii) It can pay out some outstanding debt
iii) A firm can retire previously issued stock
iv) It can use some combination of all three
If any economic system for a given period of time and economic unit falls into one of three groups-
i) Deficit Budget Unit (DBU) when E>R. They are net borrowers of fund.
ii) Surplus Budget Unit (SBU) when R>E. They are net lenders of fund.
iii) Balanced Budget Unit (BBU) when R = E. They are neither net lenders nor net borrowers.
What is Money?
Money is anything that is generally excepted as payment for goods & services and repayment of debts. Money is called a true financial assets because all financial assets are valued in terms of money.
Functions of Money
1. Money serve as the standard of value for all goods & services. All goods & services are expressed in terms of money.
2. Money serves as a medium of exchange. It is only the financial assets which is accepted by households business firms and the government in payment for goods & services.
3. Money serves as a reserve for future purchasing power.
4. Money functions as the only perfectly liquid asset in the financial system because money need not be converted in any other form for spending.
3 Characteristics for Perfectly Liquid Asset
1. Price Stability: An asset is considered liquid if its price is relatively stable over time.
2. ready Marketability: If the asset has active resell market.
3. Reversibility: If the asset can be reversible without substantial loss.
Degree of Liquidity:
All assets differ in their degree of liquidity. For example, i) Financial assets (stocks, bonds) are considered highly liquid assets. ii) Real assets like home, automobile are difficult to sell in a hurry without making a substantial loss.
Disadvantages of Money:
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Components of Money
There are three components of money. Money = M1 + M2 + M3
M1 => Most liquid form like currency, checking account
M2 => Household savings (savings deposits, money market funds)
M3 => Institutional funds like time deposits, euro dollars/currencies (collection of different major currencies)
