Saving Investment and the Financial System Chapter 26

Saving, Investment, and the Financial System Chapter 26 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887 -6777.

The Financial System u The financial system consists of institutions that help to match one person’s saving with another person’s investment. u It moves the economy’s scarce resources from savers to borrowers. u The financial system is made up of institutions(Markets and Intermediaries) Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Financial Institutions in the U. S. Economy u Financial Markets u Stock Market u Bond Market u Financial Intermediaries u Banks u Mutual Funds Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Other Financial Institutions u Credit unions u Pension funds u Insurance companies u Loan sharks Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. IOU Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Characteristics of a Bond u Term: The length of time until the bond matures. u Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. u Tax Treatment: The way in which the tax laws treat the interest on the bond. u Municipal bonds are federal tax exempt. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Stock Market Basics u What is Stock? äA stock is a tradable security that a firm issues to certify that the stockholder owns a share of the firm. äFigure 19. 1 shows an example of a stock certificate. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Stock Market u Stock represents ownership in a firm and is therefore, a claim to the profits that the firm makes. u The sale of stock to raise money is called equity financing. u Compared to bonds, stocks offer both higher risk and potentially higher returns. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Stock Market The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Stock Market Most newspaper stock tables provide the following information: u Price (of a share) u Volume (number of shares sold) u Dividend (profits paid to stockholders) u Price-earnings ratio Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Stock Market Basics u Reading the Stock Market Report ä Figure 19. 2 in the textbook shows a part of a page from of the Wall Street Journal. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Market for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Market for Loanable Funds. . . Interest Rate Supply 5% Demand 0 $1, 200 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Loanable Funds (in billions of dollars)

Government Policies That Affect Saving and Investment u Taxes and saving u Taxes and investment u Government budget deficits Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds. . . Interest Rate Supply, S 1 S 2 1. Tax incentives for saving increase the supply of loanable funds. . . 5% 4% Demand 2. . which reduces the equilibrium interest rate. . . 0 $1, 200 Loanable Funds $1, 600 (in billions of dollars) 3. . and raises the equilibrium quantity of loanable funds.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Demand for Loanable Funds. . . Interest Rate 6% 5% 2. . which raises the equilibrium interest rate. . . 0 Supply 1. An investment tax credit increases the demand for loanable funds. . . D 2 Demand, D 1 $1, 400 $1, 200 Loanable Funds (in billions of dollars) 3. . and raises the equilibrium quantity of loanable funds.

Government Budget Deficits and Surpluses u When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. ä u For 2003, the budget deficit is $307 billion The accumulation of past budget deficits is called the government debt. ä For 2003, the total debt is 6. 7 trillion. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Government Budget Deficits and Surpluses u Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. u This fall in investment is referred to as crowding out. u The deficit borrowing crowds out private borrowers who are trying to finance investments. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effect of a Government Budget Deficit. . . Interest Rate S 2 6% 5% 2. . which raises the equilibrium interest rate. . . $1, 200 $800 0 3. . and reduces the equilibrium quantity of loanable funds. Supply, S 1 1. A budget deficit decreases the supply of loanable funds. . . Demand Loanable Funds (in billions of dollars)