Introduction to Macroeconomics Chapter 13 Savings, Investment, and Financial Markets

Savers and Borrowers Financial system is designed to bring together borrowers and savers Borrowers: (demand funds) require funds for investment Require loans to purchase new capital, new home, ect. Savers: (supply funds) have excess funds after satisfying needs/wants Can hold on to excess funds and gain no interest Put excess funds into the financial system and gain interest income

The Financial System Financial System is made up of: Financial Markets: Savers directly interact with borrowers Stock market Bond market Financial Intermediaries: Savers interact indirectly with borrowers through a “middle-man” Banks Mutual Funds

Financial Crisis 2008 - 2009 Starting in 2006 – housing prices in the US began to drop The housing “bubble” began to burst Due to bad subprime loans – many homeowners had to foreclose on their homes

Financial Crisis 2008 – 2009 Banks and other financial institutions began to fail The failure of Lehman Brothers, an investment bank, triggered the onset of the financial crisis With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron.

Financial Crisis 2008 – 2009 The financial crash lead to a credit crunch and economic downturn Borrowers unable to get loans because troubled lenders not confident in borrowers’ credit-worthiness. Failing financial institutions and a fall in investment caused GDP to fall and unemployment to rise. The effects spread to the global economy

Financial Crisis 2008 – 2009

Financial Crisis 2008 – 2009

Savings & Investment on Aggregate Level Private saving = The portion of households’ income that is not used for consumption or paying taxes = Y – T – C Public saving = Tax revenue less government spending = T – G National saving = private saving + public saving = (Y – T – C) + (T – G) = Y – C – G = the portion of national income that is not used for consumption or government purchases

Saving = investment in a closed economy Saving and Investment Recall the output equation: Y = C + I + G + NX For the rest of this chapter, focus on the closed economy case (NX = 0): Y = C + I + G Solve for I: In defense of the closed economy assumption: It’s true that most economies are open. However, the closed economy case is easier to learn, and we can still learn a lot about how the world works by studying the closed economy case. A later chapter will add international trade and capital flows to this model. national saving I = Y – C – G = (Y – T – C) + (T – G) Saving = investment in a closed economy 10

Budget Deficits and Surpluses Budget surplus = an excess of tax revenue over govt spending = T – G = public saving Budget deficit = a shortfall of tax revenue from govt spending = G – T = – (public saving) 11

The Market for Loanable Funds Supply and demand model that explains How to determine interest rates The allocation of loans to borrowers Assume: only one financial market All savers deposit their saving in this market. All borrowers take out loans from this market. There is one interest rate, which is both the return to saving and the cost of borrowing 12

Supply of Loanable Funds Interest Rate Loanable Funds ($billions) Supply comes from: Households with extra income Positive public saving Supply 80 6% 60 3% An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. 13

Demand for Loanable Funds Interest Rate Loanable Funds ($billions) Demand comes from: Firms borrow the funds for new capital Households borrow to purchase new houses Demand 50 7% 4% 80 A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded. 14

Equilibrium The interest rate adjusts to equate supply and demand. Loanable Funds ($billions) The interest rate adjusts to equate supply and demand. Supply Demand 5% 60 The eq. quantity of L.F. equals eq. investment and eq. saving. Due to space constraints, this slide uses “L.F.” to stand for loanable funds, and “eq’m” to stand for equilibrium. If the interest rate were lower than the equilibrium level, demand for funds would exceed supply, causing the interest rate to rise. The rise in the rate would make borrowing more costly, and thus would reduce the demand for funds. The rise in the interest rate would also encourage households to save more, which would increase the supply of funds. This process would occur until equilibrium was achieved. If the interest rate were higher than equilibrium, there would be a surplus of funds. The interest rate would fall to restore equilibrium. In the real world, the adjustment to equilibrium in financial markets is extremely rapid. 15

Application 1 Consider the impact of two government policies on the loanable funds market: Suppose the government decreases taxes on interest income Suppose the government provides a tax credit for firms investing in green technology What is the impact on the loanable funds market? Decide which curve shifts and why. Draw out the impact of each policy and analyze the new equilibrium.

Application 2 Suppose the government is running a budget deficit and needs to finance the shortfall in tax revenue by issuing government bonds. What is the impact on the loanable funds market? Decide which curve shifts and why. Draw out the impact of each policy and analyze the new equilibrium

Key Takeaways The loanable funds market is determined by the interaction between suppliers of loans (savers) and demand for loans (borrowers) Price of a loan = interest rates which is determined by: How much people want to save at a given rate How many loans will be taken out at that rate Gov’t policies can influence S/D of loans Gov’t deficits cause crowding out and lower investment