Introduction to Finance

W H E R E W E A R E G O I N G . . .
Part 2 focuses on the area of fi nance called investments. In Chapter 8 you will be introduced 
to the structure of interest rates. You will learn about the supply and demand for loanable 

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C H A PT E R 7 Savings and Investment Process
funds and the determinants of nominal or market interest rates. Characteristics of U.S. Treas-
ury debt obligations, which are considered to be free of default risk, will be discussed. Our 
attention then turns to the term or maturity structure of interest rates. Next we cover infl ation 
premiums and price movements. The last section of the chapter examines default risk pre-
miums. The remainder of Part 2 includes Chapter 9 on the time value of money, Chapter 10 
on the characteristics and valuations of bonds and stocks, Chapter 11 on securities markets, 
and Chapter 12 on fi nancial return and risk concepts.
H O W T H I S C H A P T E R A P P L I E S TO M E . . .
Every day you are faced with deciding whether to “consume more” or to “save.” For example, 
after buying dinner at a restaurant you may still have a few dollars left in the form of extra 
income, possibly from a part-time job while you are in college. What will you do with the 
money? You might buy a new CD or take a friend to the movie theater. Alternatively, you 
might decide to place the money in a savings account at a bank. The process of intermedi-
ation then moves your discretionary money from savings into investment. Of course, saving 
is not costless. Each time you make a decision to save, you are foregoing current consump-
tion. This action on your part not to immediately consume all of your income helps the 
economy grow. 
Our parents and other “experts” have likely provided similar advice to each of us about 
the importance of saving for a “rainy day.” Of course, they were telling us not to con-
sume all of our current income but rather to put some aside for an unexpected fi nancial 
need—that is, a “rainy day.” Such an action of saving not only provides protection against 
unanticipated future expenditures for the individual, but also allows investment. You are 
probably not a saver at this stage in your life. We say this because most individuals are 
spenders of their parents’ earnings and savings during their formative years, from birth 
through college. At the time of college graduation, most individuals have little or no sav-
ings but possess “earning power.” As earnings exceed expenditures, individuals have the 
opportunity to save in a variety of ways, ranging from short-term money market invest-
ments (considered to be cash) to long-term real estate investments in the form of home 
ownership.
As you move through your life cycle, you likely will have the opportunity to invest in 
stocks and bonds. Likewise, having an understanding of the types of fi nancial assets that are 
used by businesses to fi nance and grow their businesses will be of value to those of you who 
pursue business careers.
7.1
Gross Domestic Product 
and Capital Formation
Recall from Chapter 5 our discussion of the national economic policy objectives of economic 
growth, high employment, and price stability. Economic growth and employment are refl ected 
in the output of goods and services by a nation, as well as the nation’s ability to build build-
ings, roads, inventories, and other infrastructure. 
All of a nation’s output of goods and services may be consumed, or a portion of them may 
be saved. Individuals consume by making expenditures on durable and nondurable goods and 
services. Governments consume by purchasing goods and services. If all output is not con-
sumed, savings can be invested to construct residential and commercial structures, manufac-
ture producers’ durable equipment, and increase business inventories. This process is termed