CHAPTER 26 Savings Investment Spending and the Financial

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CHAPTER 26 Savings, Investment Spending, and the Financial System Power. Point® Slides by Can

CHAPTER 26 Savings, Investment Spending, and the Financial System Power. Point® Slides by Can Erbil © 2005 Worth Publishers, all rights reserved

What you will learn in this chapter: The relationship between savings and investment spending

What you will learn in this chapter: The relationship between savings and investment spending About the loanable funds market, which shows how savers are matched with borrowers The purpose of the four principal types of assets: stocks, bonds, loans, and bank deposits How financial intermediaries help investors achieve diversification Some competing views of what determines stock prices and why stock market fluctuations can be a source of macroeconomic instability 2

The Savings–Investment Spending Identity in a Closed Economy In a closed economy: GDP =

The Savings–Investment Spending Identity in a Closed Economy In a closed economy: GDP = C + I + G SPrivate = GDP + TR − T − C SGovernment = T − TR − G NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G) = GDP − C − G Hence, I = NS Investment spending = National savings in a closed economy 3

Budget Surplus and Budget Deficit 4

Budget Surplus and Budget Deficit 4

The Savings–Investment Spending Identity in an Open Economy I = SPrivate + SGovernment +

The Savings–Investment Spending Identity in an Open Economy I = SPrivate + SGovernment + (IM – X) = NS + KI (10) Investment spending = National savings + Capital inflow in an open economy 5

The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003 6

The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003 6

The Meaning of Saving and Investment n n Private saving is the income remaining

The Meaning of Saving and Investment n n Private saving is the income remaining after households pay their taxes and pay for consumption. Examples of what households do with saving: n buy corporate bonds or equities n purchase a certificate of deposit at the bank n buy shares of a mutual fund n let accumulate in saving or checking accounts 7

The Meaning of Saving and Investment n Investment is the purchase of new capital.

The Meaning of Saving and Investment n Investment is the purchase of new capital. n Examples of investment: n General Motors spends $250 million to build a new factory in Flint, Michigan. n You buy $5000 worth of computer equipment for your business. n Your parents spend $300, 000 to have a new house built. Remember: In economics, investment is NOT the purchase of stocks and bonds! 8

The Market for Loanable Funds n n A supply-demand model of the financial system.

The Market for Loanable Funds n n A supply-demand model of the financial system. Helps us understand n n how the financial system coordinates saving & investment how government policies and other factors affect saving, investment, the interest rate 9

The Market for Loanable Funds Assume: only one financial market. n All savers deposit

The Market for Loanable Funds Assume: only one financial market. n All savers deposit their saving in this market. n All borrowers take out loans from this market. n There is one interest rate, which is both the return to saving and the cost of borrowing. 10

The Market for Loanable Funds The supply of loanable funds comes from saving: n

The Market for Loanable Funds The supply of loanable funds comes from saving: n Households with extra income can loan it out and earn interest. n SHIFTS in the Supply Curve: n Changes in private savings behavior n Changes in capital flows 11

The Slope of the Supply Curve Interest Rate Supply 6% 3% 60 80 An

The Slope of the Supply Curve Interest Rate Supply 6% 3% 60 80 An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. Loanable Funds ($billions) 12

The Market for Loanable Funds The demand for loanable funds comes from investment: •

The Market for Loanable Funds The demand for loanable funds comes from investment: • Firms borrow the funds they need to pay for new equipment, factories, etc. • Households borrow the funds they need to purchase new houses. • SHIFTS in the Demand Curve • Changes in perceived business opportunities • Changes in government’s borrowing 13

The Slope of the Demand Curve A fall in the interest rate reduces the

The Slope of the Demand Curve A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded. Interest Rate 7% 4% Demand 50 80 Loanable Funds ($billions) 14

Equilibrium Interest Rate Supply The interest rate adjusts to equate supply and demand. The

Equilibrium Interest Rate Supply The interest rate adjusts to equate supply and demand. The eq’m quantity of L. F. equals eq’m investment and eq’m saving. 5% Demand 60 Loanable Funds ($billions) 15

Policy 1: Saving Incentives Interest Rate S 1 S 2 5% 4% D 1

Policy 1: Saving Incentives Interest Rate S 1 S 2 5% 4% D 1 60 70 Tax incentives for saving increase the supply of L. F. …which reduces the eq’m interest rate and increases the eq’m quantity of L. F. Loanable Funds ($billions) 16

Policy 2: Investment Incentives Interest Rate An investment tax credit increases the demand for

Policy 2: Investment Incentives Interest Rate An investment tax credit increases the demand for L. F. S 1 6% 5% D 2 …which raises the eq’m interest rate and increases the eq’m quantity of L. F. D 1 60 70 Loanable Funds ($billions) 17

A C T I V E L E A R N I N G

A C T I V E L E A R N I N G 2: Exercise A. Use the loanable funds model to analyze the effects of a government budget deficit: n Draw the diagram showing the initial equilibrium. n Determine which curve shifts when the government runs a budget deficit. n Draw the new curve on your diagram. n What happens to the equilibrium values of the interest rate and investment? 1818

A C T I V E L E A R N I N G

A C T I V E L E A R N I N G 2: Exercise B. Use the loanable funds model to analyze the effects of tax decrease on the interest earned on savings. How does the tax decrease on interest on savings affect the market? n Draw the diagram showing the initial equilibrium. n Determine which curve shifts when the government runs a budget deficit. n Draw the new curve on your diagram. n What happens to the equilibrium values of the interest rate and investment? 1919

Policy 3. Government Budgets 20

Policy 3. Government Budgets 20

Budget Deficits, Crowding Out, and Long-Run Growth n Our analysis: increase in budget deficit

Budget Deficits, Crowding Out, and Long-Run Growth n Our analysis: increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available for investment. n This is called crowding out. n Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy’s growth rate and future standard of living. 21

The U. S. Government Debt n The government finances deficits by borrowing (selling government

The U. S. Government Debt n The government finances deficits by borrowing (selling government bonds). n Persistent deficits lead to a rising govt debt. n The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue. n Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime – until the early 1980 s. 22

U. S. Government Debt as a Percentage of GDP, 1970 -2007 WW 2 Revolutionary

U. S. Government Debt as a Percentage of GDP, 1970 -2007 WW 2 Revolutionary War Civil War WW 1 23

The Financial System - Definitions Ø Wealth Ø Financial asset Ø Physical asset Ø

The Financial System - Definitions Ø Wealth Ø Financial asset Ø Physical asset Ø Liability Ø Transaction costs Ø Financial risk 24

Risk-Averse Attitudes Toward Gain and Loss 25

Risk-Averse Attitudes Toward Gain and Loss 25

Three Tasks of a Financial System ØReducing transaction costs ØReducing financial risk ØProviding liquid

Three Tasks of a Financial System ØReducing transaction costs ØReducing financial risk ØProviding liquid assets 26

Financial Intermediaries Ø Mutual funds Ø Pension funds Ø Life insurance companies Ø Banks

Financial Intermediaries Ø Mutual funds Ø Pension funds Ø Life insurance companies Ø Banks 27

Financial Fluctuations ØFinancial market fluctuations can be a source of macroeconomic instability. ØAre markets

Financial Fluctuations ØFinancial market fluctuations can be a source of macroeconomic instability. ØAre markets irrational? ØPolicy makers assume neither that markets always behave rationally nor that they can outsmart them. 28

The End of Chapter 26 coming attraction: Chapter 27: Aggregate Supply and Aggregate Demand

The End of Chapter 26 coming attraction: Chapter 27: Aggregate Supply and Aggregate Demand 29