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Saving, Investment, and the Financial System
1.
Copyright © 2004
South-Western 2626Saving, Investment, and the Financial System
2.
Copyright © 2004
South-Western The Financial System • The financial systemfinancial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. • It moves the economy’s scarce resources from savers to borrowers.
3.
Copyright © 2004
South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY • The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. • Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.
4.
Copyright © 2004
South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY • Financial Markets • Stock Market • Bond Market • Financial Intermediaries • Banks • Mutual Funds
5.
Copyright © 2004
South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY • Financial markets are the institutions through which savers can directly provide funds to borrowers. • Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.
6.
Copyright © 2004
South-Western Financial Markets • The Bond Market • A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. • Characteristics of a Bond • Term: The length of time until the bond matures. • Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. • Tax Treatment: The way in which the tax laws treat the interest on the bond. • Municipal bonds are federal tax exempt. IOU
7.
Copyright © 2004
South-Western Financial Markets • The Stock Market • Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. • The sale of stock to raise money is called equity financing. • Compared to bonds, stocks offer both higher risk and potentially higher returns. • The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.
8.
Copyright © 2004
South-Western Financial Markets • The Stock Market • Most newspaper stock tables provide the following information: • Price (of a share) • Volume (number of shares sold) • Dividend (profits paid to stockholders) • Price-earnings ratio
9.
Copyright © 2004
South-Western Financial Intermediaries • Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.
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South-Western Financial Intermediaries • Banks • take deposits from people who want to save and use the deposits to make loans to people who want to borrow. • pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.
11.
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South-Western Financial Intermediaries • Banks • Banks help create a medium of exchange by allowing people to write checks against their deposits. • A medium of exchanges is an item that people can easily use to engage in transactions. • This facilitates the purchases of goods and services.
12.
Copyright © 2004
South-Western Financial Intermediaries • Mutual Funds • A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. • They allow people with small amounts of money to easily diversify.
13.
Copyright © 2004
South-Western Financial Intermediaries • Other Financial Institutions • Credit unions • Pension funds • Insurance companies • Loan sharks
14.
Copyright © 2004
South-Western 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 + NXY = C + I + G + NX
15.
Copyright © 2004
South-Western Some Important Identities • Assume a closed economyclosed economy – one that does not engage in international trade: Y = C + I + GY = C + I + G
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Copyright © 2004
South-Western Some Important Identities • Now, subtract C and G from both sides of the equation: Y – C – G =IY – C – G =I • 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).
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Copyright © 2004
South-Western Some Important Identities • Substituting S for Y - C - G, the equation can be written as: S = IS = I
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Copyright © 2004
South-Western Some Important Identities • National saving, or saving, is equal to: S = IS = I S = Y – C – GS = Y – C – G S = (Y – T – C) + (T – G)S = (Y – T – C) + (T – G)
19.
Copyright © 2004
South-Western The Meaning of Saving and Investment • National Saving • National saving is the total income in the economy that remains after paying for consumption and government purchases. • Private Saving • 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)Private saving = (Y – T – C)
20.
Copyright © 2004
South-Western The Meaning of Saving and Investment • Public Saving • Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)Public saving = (T – G)
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Copyright © 2004
South-Western The Meaning of Saving and Investment • Surplus and Deficit • If T > G, the government runs a budget surplus because it receives more money than it spends. • The surplus of T - G represents public saving. • If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.
22.
Copyright © 2004
South-Western The Meaning of Saving and Investment • For the economy as a whole, saving must be equal to investment. S = IS = I
23.
Copyright © 2004
South-Western THE MARKET FOR LOANABLE FUNDS • Financial markets coordinate the economy’s saving and investment in the market formarket for loanable funds.loanable funds.
24.
Copyright © 2004
South-Western THE MARKET FOR LOANABLE FUNDS • The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.
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South-Western THE MARKET FOR LOANABLE FUNDS • Loanable fundsLoanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.
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South-Western Supply and Demand for Loanable Funds • The supply of loanable funds comes from people who have extra income they want to save and lend out. • The demand for loanable funds comes from households and firms that wish to borrow to make investments.
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South-Western Supply and Demand for Loanable Funds • The interest rate is the price of the loan. • It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. • The interest rate in the market for loanable funds is the real interest rate.
28.
Copyright © 2004
South-Western Supply and Demand for Loanable Funds • Financial markets work much like other markets in the economy. • The equilibrium of the supply and demand for loanable funds determines the real interest rate.
29.
Figure 1 The
Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200 Copyright©2004 South-Western
30.
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South-Western Supply and Demand for Loanable Funds • Government Policies That Affect Saving and Investment • Taxes and saving • Taxes and investment • Government budget deficits
31.
Copyright © 2004
South-Western Policy 1: Saving Incentives • Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.
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Copyright © 2004
South-Western Policy 1: Saving Incentives • A tax decrease increases the incentive for households to save at any given interest rate. • The supply of loanable funds curve shifts to the right. • The equilibrium interest rate decreases. • The quantity demanded for loanable funds increases.
33.
Figure 2 An
Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1 S2 2.. . . which reduces the equilibrium interest rate . . . 3.. . . and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds . . . 5% $1,200 4% $1,600 Copyright©2004 South-Western
34.
Copyright © 2004
South-Western Policy 1: Saving Incentives • If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.
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Copyright © 2004
South-Western Policy 2: Investment Incentives • An investment tax credit increases the incentive to borrow. • Increases the demand for loanable funds. • Shifts the demand curve to the right. • Results in a higher interest rate and a greater quantity saved.
36.
Copyright © 2004
South-Western Policy 2: Investment Incentives • If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.
37.
Figure 3 An
Increase in the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds . . . 2. . . . which raises the equilibrium interest rate . . . 3. . . . and raises the equilibrium quantity of loanable funds. Supply Demand,D1 D2 5% $1,200 6% $1,400 Copyright©2004 South-Western
38.
Copyright © 2004
South-Western Policy 3: Government Budget Deficits and Surpluses • When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. • The accumulation of past budget deficits is called the government debt.
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South-Western Policy 3: Government Budget Deficits and Surpluses • Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. • This fall in investment is referred to as crowding out. • The deficit borrowing crowds out private borrowers who are trying to finance investments.
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South-Western Policy 3: Government Budget Deficits and Surpluses • A budget deficit decreases the supply of loanable funds. • Shifts the supply curve to the left. • Increases the equilibrium interest rate. • Reduces the equilibrium quantity of loanable funds.
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Figure 4: The
Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 3. . . . and reduces the equilibrium quantity of loanable funds. S2 2.. . . which raises the equilibrium interest rate . . . Supply,S1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds . . . Copyright©2004 South-Western
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South-Western Policy 3: Government Budget Deficits and Surpluses • When government reduces national saving by running a deficit, the interest rate rises and investment falls.
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South-Western Policy 3: Government Budget Deficits and Surpluses • A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.
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Figure 5 The
U.S. Government Debt Percent of GDP 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 Revolutionary War 2010 Civil War World War I World War II 0 20 40 60 80 100 120 Copyright©2004 South-Western
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South-Western Summary • The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. • 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.
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South-Western Summary • National income accounting identities reveal some important relationships among macroeconomic variables. • In particular, in a closed economy, national saving must equal investment. • Financial institutions attempt to match one person’s saving with another person’s investment.
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South-Western Summary • The interest rate is determined by the supply and demand for loanable funds. • The supply of loanable funds comes from households who want to save some of their income. • The demand for loanable funds comes from households and firms who want to borrow for investment.
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South-Western Summary • National saving equals private saving plus public saving. • A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. • When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.
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