Financial Intermediaries

Financial Intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.  There are many financial intermediaries, but banks and mutual funds are the most important ones.


Banks help the savers and borrowers by loaning out and saving money. Savers benefit by depositing their money into the bank where they are able to earn an interest on the money they have deposited. Borrowers benefit from the banks because they are able to take out loans from the bank, so they can purchase what they need.

Mutual Funds 

Mutual funds is an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. The positives for mutual funds is your able to diversify your money. Mutual funds are where you only have to invest a small amount of your money and it lowers your risk when you diversify your investments.


Author: Gregory Mankiw

How does the Government deal with a Financial Crisis?

A financial crisis usually comes about when there is a “boom” and then a bust or crash in the economy.  An example of a financial crisis in America is when a housing boom was followed by a bust which led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.

The government can prevent a crisis like this by keeping interest rates on track instead of being too low or too high.  This will keep investment and consumption fairly constant and keep the economy stable.  Also, the government should keep expectations high so that people keep putting money into the economy, which will prevent a recession.

If the economy does crash and there is a crisis, the government could do a few things to try to put it back on track.  First, the Fed could increase the Money Supply, increasing interest rates and encouraging investment and hopefully shifting demand to the right.  The government could also help the economy by buying bonds which puts more money into the market and ideally having the same effect as simply increasing money supply.

Chapter 26 Vocabulary

Financial System– help match the savings of one person with the investment of another

Financial Markets– institutions through which savers can directly provide funds to borrowers

  • Bond Market

– A bond is a certificate of indebtness

  • Stock Market

–  a stock is a claim to partial ownership in a firm

Financial Intermediaries-instistutions through which saves can indirectly provide funds to borrowers

  • Banks
  • Mutual Funds


Chapter 26: Finance/Stocks and Bonds simple

In a financial system, there are two kinds of people: savers and borrowers. To put it simply, savers spend less than than they have and borrowers spend more than they have.  Financial markets are institutions through which savers can directly provide funds to borrowers.  There are two important markets in our economy today: the bond market and the stock market.

A bond is a certificate of indebtedness. In other words, it is an official certificate saying that you’ve loaned money to a company and they now owe you money (an IOU, if you will).  Bonds have terms and also gain interest.  So, a long-term bond is riskier than a short-term bond because the holders have to wait longer to get their money back, so long-term bonds generally have higher interest rates.  Bonds are referred to as “debt finance”.

Stock is a claim to partial ownership in a firm.  If you buy stock in Apple, it means that you own a part of Apple and you get a percentage of the profit.  Stock holders will be affected more by the success or failure of a company because they only receive profit, whereas bond holders get the more stable interest.   So, bonds are more stable, but stocks have the possibility of gaining more profit.


The Crowding-Out Effect

Crowding out effect– The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

Crowding out because of fiscal policy: when the government increases its discretionary spending or lowers taxes, these policies must be funded by government borrowing.  When governments borrow, increases in savings must occur to satisfy the borrowing going on by the government.  In order to get this increase in savings, the interest rate has to go up.  When interest rates rise, consumers spend less on durable goods (cars, or other financeable items) and houses.  Firms also invest less because the opportunity cost of money has risen.
The process of crowding out:
  1. Government spending becomes larger than tax revenues.
  2. Government deficit becomes positive.
  3. Government needs to borrow money to finance the deficit which requires an increase in economy wide saving.
  4. In order to save more, the economy wide interest rate must rise.
  5. Higher interest rates increase the opportunity cost of spending/borrowing money so consumption and investment decline.

Author: Gregory Mankiw

Crowding Out Effect


Definition of ‘Crowding Out Effect’

An economic concept where increased public sector spending replaces, or drives down, private sector spending. Crowding out refers to when government must finance its spending with taxes and/or with deficit spending, leaving businesses with less money and effectively “crowding them out.” One explanation of why crowding out occurs is government financing of projects with deficit spending through the use of borrowed money. Because the government borrows such large amounts of capital, its activities can increase interest rates. Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investment activities.

Investopedia explains ‘Crowding Out Effect’

For example, the higher taxes required for government to fund social welfare programs leaves less discretionary income for individuals and businesses to make charitable donations. Further, when government funds certain activities there is little incentive for businesses and individuals to spend on those same things. Another example is increased government spending on Medicaid, which has been linked to decreased availability of private health insurance.

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Loanable Funds Market

Market for Loanable Funds:The market in which those who want to save supply funds and those who want to borrow to invest demand funds.

Loanable Funds: Amount of money that banks have available to loan to businesses or households (income that people have chosen to save and lend out, rather than use for their own consumption.)




The supply of loanable funds comes from people who have extra income they want to save and lend out.
The demand for loanable funds comes from households and firms that wish to borrow to make investments.


The equilibrium of the supply and demand for loanable funds determines the real interest rate.
Government Policies That Affect Saving and Investment:
•Taxes and saving
•Taxes and investment
•Government budget deficits