Savings Investment and the Financial System Types of

Savings, Investment and the Financial System

Types of Savings Private saving q The portion of households’ disposable income that is not used for consumption q Y – TX + TR – C q Simplified as Y – T – C Public saving q Net tax revenue less government spending q TX – TR – G q Simplified as T – G

National Savings Private saving + Public savings q (Y – T – C) + (T – G) = q. Y–C–G q the portion of national income that is not used for consumption or government purchases +

Savings–Investment Identity National Income Accounting equation q. Y=C+I+G+N Assume a closed economy, so: q. Y=C+I+G Now, solve for I: q I = Y – C – G = (Y – T – C) + (T – G) national saving

Budget Balance Budget Surplus q Excess of tax revenue over government spending q T>G q Public saving Budget Deficit q Shortfall of tax revenue government spending q T<G q Public dis-saving from

US Budget Balance

International Capital Flows q In the real world, no economy is closed… q If national savings exceeds domestic investment, excess savings will “flow” out. q If domestic investment exceeds national savings, foreign savings will “flow” in.

China Savings-Investment Balance

Quick Problem Suppose the following: q q GDP = $10 trillion Consumption = $6. 5 trillion Government spending = $2. 0 trillion Budget deficit = $300 billion Now solve for the following: q q q Public savings Private savings National savings Investment Taxes

Financial System

Three Key Tasks Reducing Transaction Costs q Information on borrowers and lenders q Costs of negotiations, legal process, etc. Managing / Reducing Risk q Adverse selection and moral hazard risks q Diversification Providing Liquidity q Flexibility to convert financial asset into cash on short notice

Financial System

Types of Financial Assets (Instruments) Bank Deposits q q Claim by depositor on a bank; often on “demand” but not always Key terms: demand deposits, time deposits, CDs Loans q q Lending agreement between individual borrower and lender Common types: corporate loans, mortgages, car consumer Customized and not easily tradable (relatively illiquid) Key terms: collateralized vs. uncollateralized; fixed vs. floating interest rates Bonds q q IOU issued by borrower to many lenders simultaneously Common types: corporate, government, municipal Standardized and often tradable (relatively liquid); usually given credit rating Key terms: face value, coupon, yield, maturity Stocks q q q Share ownership in a company Perpetual and usually not redeemable, but often tradable Key terms: equities, dividend, price/earning ratio