Saving Investment and the Financial System Chapter 4

Saving, Investment, and the Financial System Chapter 4

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. @eddiestp

Financial Institutions in the U. S. Economy u The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. u Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. @eddiestp

Financial Institutions in the U. S. Economy u Financial Markets u Stock Market u Bond Market u Financial Intermediaries u Banks u Mutual Funds @eddiestp

Financial Institutions in the U. S. Economy u Financial markets are the institutions through which savers can directly provide funds to borrowers. u Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. @eddiestp

The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Obligasi adalah surat hutang yang menentukan kewajiban peminjam kepada pemegang obligasi. @eddiestp

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. @eddiestp

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. @eddiestp

The Stock Market The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. @eddiestp

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 @eddiestp

Financial Intermediaries: Banks u Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. u Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. @eddiestp

Banks u Banks help create a medium of exchange by allowing people to write checks against their deposits. u A medium of exchanges is an item that people can easily use to engage in transactions. u This facilitates the purchases of goods and services. @eddiestp

Financial Intermediaries: Mutual Funds u. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. u They allow people with small amounts of money to easily diversify. @eddiestp

Other Financial Institutions u Credit unions u Pension funds u Insurance companies u Loan sharks @eddiestp

Saving and Investment in the National Income Accounts Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX @eddiestp

Some Important Identities Assume a closed economy – one that does not engage in international trade: Y=C+I+G @eddiestp

Some Important Identities u Now, subtract C and G from both sides of the equation: Y – C – G =I u The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S). @eddiestp

Some Important Identities S for Y-C-G, the equation can be written as: u Substituting S=I @eddiestp

Some Important Identities u National saving, or saving, is equal to: S=I S=Y–C–G S = (Y – T – C) + (T – G) @eddiestp

Private Saving u Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) @eddiestp

Public Saving u Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) @eddiestp

Surplus and Deficit u If T>G, the government runs a budget surplus because it receives more money than it spends. u The surplus of T-G represents public saving. u If G>T, the government runs a budget deficit because it spends more money than it receives in tax revenue. @eddiestp

Saving and Investment u. For the economy as a whole, saving must be equal to investment. S=I @eddiestp

The Market for Loanable Funds Financial markets coordinate the economy’s saving and investment in the market for loanable funds. @eddiestp

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. @eddiestp

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

Supply and Demand for Loanable Funds u The interest rate is the price of the loan. u It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. u The interest rate in the market for loanable funds is the real interest rate. @eddiestp

Supply and Demand for Loanable Funds u. Financial markets work much like other markets in the economy. u The equilibrium of the supply and demand for loanable funds determines the real interest rate. @eddiestp

Market for Loanable Funds. . . Interest Rate Supply 5% Demand 0 $1, 200 Loanable Funds (in @eddiestp billions of dollars)

Government Policies That Affect Saving and Investment u Taxes and saving u Taxes and investment u Government budget deficits @eddiestp

Taxes and Saving Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. @eddiestp

Taxes and Saving u. A tax decrease increases the incentive for households to save at any given interest rate. u The supply of loanable funds curve shifts to the right. u The equilibrium interest rate decreases. u The quantity demanded for loanable funds increases. @eddiestp

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.

Taxes and Saving If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. @eddiestp

Taxes and Investment u An investment tax credit increases the incentive to borrow. u Increases the demand for loanable funds. u Shifts the demand curve to the right. u Results in a higher interest rate and a greater quantity saved. @eddiestp

Taxes and Investment If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. @eddiestp

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. u The accumulation of past budget deficits is called the government debt. @eddiestp

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. @eddiestp

Government Budget Deficits and Surpluses u. A budget deficit decreases the supply of loanable funds. u Shifts the supply curve to the left. u Increases the equilibrium interest rate. u Reduces the equilibrium quantity of loanable funds. @eddiestp

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)

Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. @eddiestp

Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. @eddiestp

The U. S. Government Debt 100 80 60 U. S. government debt 40 20 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 @eddiestp

Summary u The U. S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. u All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow. @eddiestp

Summary u National income accounting identities reveal some important relationships among macroeconomic variables. u In particular, in a closed economy, national saving must equal investment. u Financial institutions attempt to match one person’s saving with another person’s investment. @eddiestp

Summary u The interest rate is determined by the supply and demand for loanable funds. u The supply of loanable funds comes from households who want to save some of their income. u The demand for loanable funds comes from households and firms who want to borrow for investment. @eddiestp

Summary u National saving equals private saving plus public saving. u A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. u When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP. @eddiestp

Graphical Review @eddiestp

Market for Loanable Funds. . . Interest Rate Supply 5% Demand 0 $1, 200 Loanable Funds (in billions of dollars) @eddiestp

All these items and derived items copyright © 2001 by eddiestp/Polmed. 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.

All these items and derived items copyright © 2001 by eddiestp/Polmed. 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.

All these items and derived items copyright © 2001 by eddiestp/Polmed The Effect of a Government Budget Deficit. . . Interest Rate S 2 6% 5% 2. . which raises the equilibrium interest rate. . . $800 $1, 200 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)

The U. S. Government Debt 100 80 60 U. S. government debt 40 20 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 @eddiestp