Principles of Macroeconomics Saving, Investment, and the Financial System

Saving, Investment, and the Financial System Learning Objectives What is Money? The Market for Loanable Funds The Financial System

Saving, Investment, and the Financial System What is Money? Money is anything that can be used for the purchase of goods and services and the repayment of debt. Money can be a commodity (for example, cigarettes serve as money in a prison). Modern money is Fiat money (the term Fiat is Italian, meaning something like “per decree”) The use of Fiat money is more efficient than a barter economy.

Saving, Investment, and the Financial System Functions of Money Medium of exchange Unit of account Store value Standard of deferred payment  Money is the most liquid asset an individual can have.

Saving, Investment, and the Financial System Measuring Money M1 = Cash and checking account deposits M2 = M1 + funds that can be accessed within a short-term (3 months).

Saving, Investment, and the Financial System The Market for Loanable Funds … is just a regular market with an interest rate as the price for funds. Examples of Determinants of Supply Demand Economic outlook Business expectations Demography (Aging society) Regulations

Saving, Investment, and the Financial System Purpose: To channel funds from savers to investors Players: Financial system consists of Federal Reserve, banks, credit unions, and other institutions that borrow and/or carry out investments. Functions: (1) Reduce information and matching costs (2) Spread risk (if financial markets are competitive).

Saving, Investment, and the Financial System Bonds Government and companies issue bonds to attract money from savers for investment purposes. How does a bond work? Example: Government essentially issues a sheet of paper that says: If you give me $100 today (face value), I pay you for ten years every year an interest of $5 (coupon rate) and when the bond matures you get back the $100. Will the bond also sell for $100? No. What matters is not the face value of the bond but the general interest rate (yield), which is determined by demand and supply in the market for loanable funds and depends on many factors.

Saving, Investment, and the Financial System Bonds (Contd). How does a bond work? (Contd.) Assume investors demand a yield on a bond of 7%. Then, the government bond with a face value of $100 and a coupon rate of 5% is underpriced and the bond will not sell at the face value, but at a price below. The question then simply becomes: How much would someone have to pay for a bond that pays an annual interest of $5 when the expected yield is 7%?

Saving, Investment, and the Financial System Bonds (Contd). How does a bond work? (Contd.) Answer: where C = Coupon rate (could be zero) r = expected interest rate M = Value at Maturity Example: Calculate the price for a two-year bond with C=5, M=100, and r=7%.

Saving, Investment, and the Financial System Bonds vs. Stocks Bonds pay an interest, stocks a dividend. Bonds are less risky than stocks. Again, there is a trade-off between risk and return. The greater the risk, the greater the possible return.

Saving, Investment, and the Financial System Summary What are the functions of money? What is the role of the financial system? How to determine bond prices Difference between stocks and bonds.