Lectures 7-8 (Chap. 26) Saving, Investment, and the Financial System

Objectives We discussed how GDP is calculated and what determines the growth of GDP. One of the determinants of GDP growth is savings and investment. In these lectures, we discuss how saving and investment are determined. the financial, in particular, loan market where saving and investment are determined. the role of interest rates. how government policies affect saving, investment and interest rates.

Financial Markets ■They help to match one person’s saving with another person’s investment. ■Stock market and bond market are important financial markets. ■Financial resources are scarce so equilibrium is achieved by supply and demand in efficient financial markets. ■Interest rates make supply equal to demand in such markets.

Stock ▶ Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. ▶ Companies pay dividends to shareholders. ▶ Shareholders have a right to attend general meetings and can exercise votes according to the number of shares they hold. ▶ 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 Korea are the Korean Stock Exchange, and KOSDAQ.

Bond 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. Bonds as well as stocks are traded in markets.

Exchange of stock and bond  The price of stock or bond and its volume of transaction are determined by supply and demand.  Sellers and buyers of a stock behave according to their expectation of dividends and capital gain based on fluctuations of the stock price.  Sellers and buyers of a bond behave according to expected price of the bond and interests. Present value of a bond: Suppose interest rate is r, the present value of bond X that is paid at the end of N is X/(1+r) N  An decrease in interest rates leads to an increase in the present value of the bond.  Hence one should buy a bond when he/she expects that interest rates will decrease.

Interest rates and bond prices 1 year2 year3 year4 year5 year Interest rates 5% Interest rates 10% Interest rates 3%

Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. They include: Banks, Mutual funds, Insurance companies Why do financial intermediaries exist? By pooling resources, they help to diversify risks and satisfy borrowers and savers by changing maturity. They might have better investment skill due to the economies of scale and division of labour. 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.

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS ■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 closed economy ■Assume a closed economy – one that does not engage in international trade or net exports (NX) are zero: Y = C + I + G ■Now, subtract C and G from both sides of the equation: Y – 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).

Some Important Identities in the National Income Accounts ■Substituting S for Y - C - G, the equation can be written as: S = I ■National saving, or saving, is equal to: S = I S = Y – C – G S = (Y – T – C) + (T – G) ■That is, national saving is the sum of private saving (Y – T – C) and public saving (T – G). (Y – T – C) and public saving (T – G).

The Meaning of Saving and Investment ■National saving is the total income in the economy that remains after paying for consumption and government purchases. ■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) ■Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) ■For the economy as a whole, saving must be equal to investment (we assume a closed economy). S = I S = I

Budget Surplus and Budget 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.

THE MARKET FOR LOANABLE FUNDS market for loanable funds. ■Financial markets coordinate the economy’s saving and investment in 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.

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.

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. ■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.

The market for loanable funds Interest rates loanable funds

The market for loanable funds S Interest rates loanable funds

The market for loanable funds S D Interest rates loanable funds

The market for loanable funds S D 5% $1,200 Interest rates loanable funds

The market for loanable funds S D 5% $1,200 Market equilibrium is achieved according to supply and demand. Interest rates loanable funds

Demand and supply for loanable funds are determined by real interest rates. Supply for loanable funds is savings while demand for loanable funds is investment. Other factors, except interest rates, that affect demand and supply for loanable funds shift demand or supply curve of loanable funds (eg: increase in income; pessimistic attitude toward the future of the economy) The market for loanable funds

Supply and Demand for Loanable Funds ■Government Policies That Affect Saving and Investment ▶ Taxes and saving ▶ Taxes and investment ▶ Government budget deficits

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. ■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.

The market for loanable funds S D 5% $1,200 Interest rates loanable funds

The market for loanable funds S D 5% $1,200 Interest rates loanable funds

$1,200 The market for loanable funds S D 5% 4% $1,300 Interest rates loanable funds If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

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

The market for loanable funds S D Interest rates 5% $1,200 loanable funds

The market for loanable funds S D 5% $1,200 A tax incentive for investment increases the demand for loanable funds. Interest rates loanable funds

The market for loanable funds S D 5% $1,200 6% $1,300 Interest rates loanable funds If a change in tax law encourages greater investment, the result will be ( ) interest rates and ( ) investment.

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. ■Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms.

Policy 3: Government Budget Deficits and Surpluses ■This fall in investment is referred to as crowding out. ▶ The deficit borrowing crowds out private borrowers who are trying to finance investments. ■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.

The market for loanable funds S D 5% $1,200 Interest rates loanable funds

The market for loanable funds S D 5% $1,200 A budget deficit decreases the supply of loanable funds. Interest rates loanable funds

The market for loanable funds S D 6% $1,000 5% $1,200 Interest rates loanable funds When government reduces national saving by running a deficit, the interest rate rises and investment falls.

Russian Financial Crisis ■The Russian Government announced moratorium on some government debts in August ■Some economists viewed this as a further blow to the already suffering Russian economy. ■However, Russia recorded a positive growth in 1999, ending a series of negative growth during  One of the reasons for this is that saving was used to finance mainly the budget deficit before the crisis but began to be used for private investment after it (other reasons: devaluation of ruble, oil price increase).

Quiz 1  A presidential candidate, Mr A announced his election promises that included the achievement of annual economic growth rate by 7%. As policies to fulfil this promise, he suggested lower taxes on interest income and an investment tax credit. He also promised that he would reduce a budget deficit during his presidency. Do you think these promises can be achieved?

Quiz 2  Suppose that the Ministry of Economy and Finance wants to adopt a policy of either lower tax on interest income or an investment tax credit. What information is needed to understand which policy is more effective?

Elasticity of supply and demand curves Interest rates Loanable funds A shift of supply curve increases loanable funds to a larger extent when it is less elastic. That is, decreasing tax on interest income is more effective when the supply curve is less elastic. D S1 S2 S’1S’1 S’2S’2

Elasticity of supply and demand curves Interest rates Loanable funds D’D’ D S1 S2 If demand curve is less elastic, decreasing tax on interest income raises loanable funds to a smaller extent

Ricardian Equivalence  The government wants to spend a large sum of money, beyond its original plan, on helping out people suffering from a severe earthquake. It considers an option between issuing government bonds and tax increases. A majority of people support issuing government bonds, believing it does not affect the current economy negatively. Do you think this view is correct?  Government debts that will increase by issuing government bonds are that the people of the country has to pay in the future. Households who expect tax increases to pay for the debts will increase savings now. If government borrowing is financed solely by private savings, national savings do not change and thus interest rates and investment remain the same as before.  In the case of tax increases, private savings decrease while public savings increase. Therefore, interest rates and investment do not change. In other words, These two policies affect only the composition of savings (private or public).  As this example shows, real variables in the economy (interest rates and investment) are not affected by a way of government financing and this is called Ricardian equivalence.