PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Saving, Investment, and the Financial System 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Saving and Investment Investment refers to the purchase of new capital, such as equipment or buildings.Investment refers to the purchase of new capital, such as equipment or buildings. An individual’s purchase of stock or other financial commodities is called saving. ( 雖然在日常用語上常將 購買股票等金融資產稱為「投資」，但在總體經濟 學的定義應稱為儲蓄 )An individual’s purchase of stock or other financial commodities is called saving. ( 雖然在日常用語上常將 購買股票等金融資產稱為「投資」，但在總體經濟 學的定義應稱為儲蓄 )

Financial Institutions Financial system –Group of institutions in the economy That help match one person’s saving with another person’s investment –Moves the economy’s scarce resources from savers to borrowers Financial institutions –Financial markets –Financial intermediaries 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Markets Financial markets –Savers can directly provide funds to borrowers –The bond market –The stock market 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Markets The bond market –Bond - certificate of indebtedness Time of maturity - the loan will be repaid Rate of interest Principal - amount borrowed –Term - length of time until maturity –Credit risk – probability of default –Tax treatment 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Markets The stock market –Stock - claim to partial ownership in a firm –Organized stock exchanges Stock prices: demand and supply –Equity finance Sale of stock to raise money –Stock index Average of a group of stock prices 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Intermediaries Financial intermediaries –Savers can indirectly provide funds to borrowers –Banks –Mutual funds 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Intermediaries Banks –Take in deposits from savers Banks pay interest –Make loans to borrowers Banks charge interest –Facilitate purchasing of goods and services Checks – medium of exchange 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Intermediaries Mutual funds –Institution that sells shares to the public –Uses the proceeds to buy a portfolio of stocks and bonds –Advantages Diversification Access to professional money managers 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

THE MARKET FOR LOANABLE FUNDS 為了簡化分析，假設所有的金融都在一個可貸 資金市場上進行。 The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders. The interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender to a borrower for the use of their savings for a certain period (e.g. one year).

The Market for Loanable Funds The rate of return on a project is the profit earned on the project expressed as a percentage of its cost. A business will want a loan when the rate of return on its project is greater than or equal to the interest rate.

The Demand for Loanable Funds Interest rate 12% 4 0 $ Quantity of loanable funds (billions of dollars) Demand for loanable funds, D

The Supply for Loanable Funds Interest rate 12% 4 0 $ Quantity of loanable funds (billions of dollars) Supply of loanable funds, S

Equilibrium in the Loanable Funds Market Interest rate 12% $300 Quantity of loanable funds (billions of dollars) Offers not accepted from lenders who demand interest rate of more than 8%. Projects with rate of return less than 8% are not funded. Projects with rate of return 8% or greater are funded. Offers accepted from lenders willing to lend at interest rate of 8% or less. r* Q*

The Market for Loanable Funds Market for loanable funds –Market Those who want to save supply funds Those who want to borrow to invest demand funds –One interest rate Return to saving Cost of borrowing –Assumption Single financial market 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Market for Loanable Funds Supply and demand of loanable funds –Source of the supply of loanable funds Saving –Source of the demand for loanable funds Investment –Price of a loan = real interest rate Borrowers pay for a loan Lenders receive on their saving 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Market for Loanable Funds Government policies –Can affect the economy’s saving and investment Saving incentives Investment incentives Government budget deficits and surpluses 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Policy 1: Saving Incentives Shelter some saving from taxation –Affect supply of loanable funds –Increase in supply Supply curve shifts right –New equilibrium Lower interest rate Higher quantity of loanable funds –Greater investment 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving Incentives Increase the Supply of Loanable Funds Interest Rate Loanable Funds (in billions of dollars) 0 Supply, S 1 Demand 5% $1,200 A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S 1 to S 2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion. S2S2 4% $1, Tax incentives for saving increase the supply of loanable funds and raises the equilibrium quantity of loanable funds which reduces the equilibrium interest rate...

Policy 2: Investment Incentives Investment tax credit –Affect demand for loanable funds –Increase in demand Demand curve shifts right –New equilibrium Higher interest rate Higher quantity of loanable funds –Greater saving 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment Incentives Increase the Demand for Loanable Funds Interest Rate Loanable Funds (in billions of dollars) 0 Supply Demand, D 1 5% $1,200 If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D 1 to D 2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion. D2D2 6% $1, An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds.

Policy 3: Budget Deficit/Surplus Government - starts with balanced budget –Then starts running a budget deficit Change in supply of loanable funds Decrease in supply –Supply curve shifts left New equilibrium –Higher interest rate –Smaller quantity of loanable funds 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 4 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effect of a Government Budget Deficit Interest Rate Loanable Funds (in billions of dollars) 0 Supply, S 1 Demand 5% $1,200 When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S 1 to S 2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion. S2S2 6% $ A budget deficit decreases the supply of loanable funds and reduces the equilibrium quantity of loanable funds which raises the equilibrium interest rate...

Policy 3: Budget Deficit/Surplus Crowding out –Decrease in investment –Results from government borrowing Government - budget deficit –Interest rate rises –Investment falls 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Policy 3: Budget Deficit/Surplus Government – budget surplus –Increase supply of loanable funds –Reduce interest rate –Stimulates investment 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt Debt of U.S. federal government –As a percentage of U.S. GDP –Fluctuated 0% of GDP in % of GDP in 1945 Declining debt-GDP ratio –Government indebtedness is shrinking relative to its ability to raise tax revenue –Government - living within its means 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt Rising debt-GDP –Government indebtedness is increasing relative to its ability to raise tax revenue Fiscal policy cannot be sustained forever at current levels War – primary cause of fluctuations in government debt: –Debt financing of war – appropriate policy Tax rates – smooth over time Shifts part of the cost to future generations 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 5 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The U.S. Government Debt The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied throughout history. Wartime spending is typically associated with substantial increases in government debt.

The history of U.S. government debt President Ronald Reagan, 1981 –Large increase in government debt – not explained by war –Committed to smaller government and lower taxes –Cutting government spending - more difficult politically than cutting taxes –Period of large budget deficits –Government debt: 26% of GDP in 1980 to 50% of GDP in © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt President Bill Clinton, 1993 –Major goal - deficit reduction –And Republicans took control of Congress, 1995 Deficit reduction –Substantially reduced the size of the government budget deficit –Eventually: surplus –By the late 1990s: debt-GDP ratio - declining 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt President George W. Bush –Debt-GDP ratio - started rising again –Budget deficit Several major tax cuts 2001 recession - decreased tax revenue and increased government spending Spending on homeland security –Following the September 11, 2001 attacks –Subsequent wars in Iraq and Afghanistan –Increases in government spending 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt 2008, financial crisis and deep recession –Dramatic increase in the debt-GDP ratio –Increased budget deficit –Several policy measures passed by the Bush and Obama administrations Aimed at combating the recession Reduced tax revenue Increased government spending 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The history of U.S. government debt 2009 and 2010 –Federal government’s budget deficit = 10% of GDP –Borrowing to finance budget deficit –Substantial increase in the debt-GDP ratio Policy challenges for future generations –Putting the federal budget back on a sustainable path Stable or declining debt-GDP ratio 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

 100 年度中央政府總預算案歲出編列 1 兆 7,896 億元， 歲入編列 1 兆 6,306 億元，整體歲出歲入相抵差短 1,590 億元。 中央政府債務餘額佔 GDP 比例 億 30%

National Income Accounts Rules of national income accounting –Important identities Identity –An equation that must be true because of the way the variables in the equation are defined –Clarify how different variables are related to one another 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

NATIONAL INCOME ACCOUNTS Recall that GDP is : Y = C + I + G + (X － M) closed economyAssume a closed economy – one that does not engage in international trade: Y = C + I + G Recall that in this identity, investment (I) includes changes in inventory.Recall that in this identity, investment (I) includes changes in inventory.

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

Some Important Identities 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)

Some Important Identities National saving is the total income in the economy that remains after paying for consumption and government purchases: S = (Y – T – C) + (T – G) S = Y – C – G This definition implies S = I

Some Important Identities 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.

In an open economy NOTE: For an open economy, the identity S=I is modified as S ＝ I ＋ (X － M). Saving Identity is true by definition. It is true because the “Investment” in the identity includes planned (desired) investment and unplanned changes in inventory. Equilibrium in the loanable funds market is reached only when the desired investment equals saving.