lol nice Tolstoy

and semck again what the book is actually saying is that households' savings ARE the supply of capital to firms. this does in fact mean all.

or at least it means that's the only place it comes from at present.

here's the actual wording:

"A firm cannot invest unless it has the funds to do so. Although firms can invest in many ways, it is always the case that the funds that firms use to boy capital goods come, directly or indirectly, from households. When a household decides not to consume a portion of its income, it saves. Investment by firms is the demand for capital. Saving by households is the supply of capital. Various financial institutions facilitate the transfer of households' savings to firms that use them for capital investment."

Unless one of the indirect ways households fund buying capital goods is by purchasing goods the firm sells, I don't see how this statement can be true.

Oh I see. Then I think I misinerpreted your initial post. Sorry.

That is, I thought that you were implying (when you said "via their savings,") that the book was talking about the loan a household makes to the bank by placing its money there. Clearly, that's wrong. It's talking about that but, even more, about spending. And all capital DOES come from that. Where else would a company have its OWN capital from than profit it had made in the past, which came from households spending money?

"Yeah exactly I'm asking why does Apple do that - if your choice is pay $10 million from your pocket or borrow it and pay $11 million overall, why would you choose the latter?"

As I mentioned before it deals with the ROE of firms in their financial statements. Firms want a high ROE to drive up stock prices, which is the ultimate goal.

Okay, say a firm is starting up with $100 dollars in reserve (to keep things simple) and wants to start a project that costs $100 dollars and will pay back $120 (lets just say all at once. Getting into time value of money makes it more complicated). So you can either spend the $100 you have in pocket or you can borrow $50 and spend 50 of your own. Borrowing $50 will cost you $5.

To the financial statements now. If you choose option A and use all of your money, you have $120 from the $100 of equity you spent. Your ROE is 20%.

Option B, you have $65 (120-50-5) from the $50 in equity you spent. Your ROE is 30%. Hopefully this clarifies things?

Reading comprehension fail

"directly or *indirectly* "

Of course this means from buying products or via other investments

@ Thucy

Because what is an extra $1 Million when you get $10 for free and don't have to risk your own money.

When I saw directly or indirectly I interpreted either by the buying of bonds (direct) or loans from banks emanating from personal savings (indirect).

But if yall think it means from spending as well as savings, ok, I guess I'll take that.

And no worries semck thanks for the help.

Also thanks goldfinger that makes sense I guess even if it is a bit bizarre.

Am I mistaken in taking that to be an example of how accounting norms can influence economic behavior in what are sometimes otherwise irrational ways?

I had another example of this a few months ago but forgot it. But you know what I mean right?

Like just the way the numbers are crunched has an effect on how you might behave, even if it's actually not the smartest way all told. (i.e. why borrow money if you don't need to)

"Because what is an extra $1 Million when you get $10 for free and don't have to risk your own money."

Hm. Uh. My limited mathematical and economic mind is now failing me.

I don't think this checks out - what if the $10 million investment is a flop - you still have to pay back $11m. You've lost $11m, haven't you?

No, you're not mistaken. Laws, regulations, finance, and accounting all have huge impacts on economic behavior. The financial and legal structure of a system determines economic behavior (in my belief)

Yes, but you've lost it over a much longer period of time.

"Yes, but you've lost it over a much longer period of time."

Well let's say the loan period is like 6 months.

I dunno. It's kinda funky.

Well okay I think that's about all I can think about this, I should move on the next section.

Thanks all for the help.

I haven't read anything here beyond Thucy's first post so i appologize if I am repeating something.

@Thucy: How did that company start?

The first transaction in every business is where the owner/owners invest in the company.

On top of that the equity of the company is still financed by additional funds being invested by the owners.

The entirely corporation originally started and in most cases, can only expand when owners invest in the company.

Of course this is what I was taught in accounting, and much of what I was taught in accounting is different then what is taught in economics

(Net Income, Opportunity Cost have different definitions, for example)

From an economic perspective I guess the only other thing to say is that for corporations to have the cash needed for expansion they had to have earned that money, which either came from:
a) Shareholders investing, technically households but would be classified under the investment, not consumer spending of a company.
b) Profit, if they had cash in the buisness, its because a consumer purchased a good or service from them.

Hope that helps.

^^Also, another little note. Borrowing $10 million with 10% interest doesn't cost a firm $11 million. It costs them something like $10.5 million depending on how long the loan is. Heck, if the period is long enough, it costs them less than $10 million to borrow $10 million (this is due to the time value of money)

There is no way companies like Apple are taking out 6 month loans.

@goldfinger: true up to a point, and that point is the shady back alley to the black market.

Ignore everything else being said on this thread. You're in micro 101, you don't need to overcomplicate things. Just use the flow of capital chart. Read this page:

http://www.netplaces.com/economics/the-circular-flow-of-economic-activity/the-private-sector.htm

2WL got that textbook answer. He right.

I think you are trying to create a logic problem out of a simple statement. The line you quoted didn't seem to be an absolute. But, I guess I didn't get it in context.

Apple will take out any kind of loan. Any loan Apple takes out right now is simply a kickback or bribe of some kind to help the loan office, bank, country, etc. etc.
As far as why companies take out loans Tolstoy hit the nail on the head, most companies have low profit margins and don't have the cash reserves to do everything they want, but they do have the revenue stream to justify a loan.
What if you have to expand. What if a rival is expanding and if he expands and captures market share you could be overwhelmed?
You better be ready to take out loans the keep pace with the competition in your field.
A business is not a household.
Households don't compete with one another for market share.

I haven't read anything in this thread in order to keep my answer clear.

This is a basic reinterpretation of the macroeconomic identities for a two-sector economics which is all about money flows and the fact that for each part of the economy (households, firms), the sources are equal to expenditures. The money is always circulating. Do not pollute your mind by any real world institutional factors, this is a model, it abstracts from all those tax shields and whatever unless it specifically says so.

The thing that got you confused is that the book is apparently very basic. If it says exactly "Households (via their savings) *supply* capital to firms who *demand* it.", it apparently abstract from the financial sector as well, which is an unnecessary abstraction. The book says that firms do not save money themselves, therefore their outflows are equal to wages W and residual profit π, both going to households (owners are households as well); the inflows are investment I and consumption C. The balance of households is thus C+I=W+π and the balance of firms is W+π=C+I. All is nice and balanced but very crude.

Let's add the financial sector. The financial sector in an intermediary, which enables efficient allocation of savings to investment. Abstracting from it is therefore bad and you should sue your book's authors for fooling you.

Firms still have inflows equal to C+I and outflows to households equal to W+π but this time, π is much lower since the firms also have outflows to the financial sector. These outflows are Sf (savings of firms) and Df (depreciation funds). The households still have an outflow C towards firms but instead of I to firms, they send Sh (savings of households) to the financial sector. The inflows of the financial sector is therefore Sh+Sf+Df and the outflow is I, investment funds flowing to the firms.

Therefore, your book basically presents a limit case of the latter model. Actually, scrap that, it doesn't present even that. It assumes that households themselves are perfectly capable of allocating the investment to the firms and therefore the finacial sector is redundant. Now, about the limit case I thought for a while it represented: if in the latter model the savings of firms and depreciation funds were equal to 0, the whole model would work and your book would be right. However, that is not the most probable scenario. In a similar manner, we could say that the households do not save anything and that their whole outflow is C. The model would still work but it's explanatory power in regard to real world would be even weaker than the two-sector model already is.

In conclusion, whether your book proposes that there is no financial sector or that the firms only have outflows W+π, they are unnecessarily weakening the explanatory power their model could have. The additional labour the students would need to use to learn the broadened model is minimal. Plus, it confused you by its simplicity so I could probably say that simpler doesn't always mean simpler :)

"the sources are equal to expenditures"

Instead of "expenditures", it should rather be "their usage", it's not really an expenditure in the accounting sense. It means that you don't hide your money under you pillow but rather send it somewhere else, even if it still yours, like making a sight deposit at a bank.