© 2007 Thomson South-Western

Saving, Investment, and the Financial System The financial 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.

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 Financial intermediaries

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds

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.

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. Bonds can be from companies (private/public) or the government (local-municipal, regional, provincial or national) levels Municipal bonds are federal tax exempt.

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. What about the primary Korean markets?

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

Financial Markets Reading the stock page…

Financial Markets Columns 1&2 52-Week Hi-Lo Range Column 3  Company Name and Type of Stock:  If there are no special symbols or letters following the company name, it is common stock (shares without a fixed rate of return of investment.) Other types of stock are “pf“ or preferred, etc. Column 4  Ticker symbol: This alphabetic symbol is a unique stock identifier. Column 5  Dividend Payment: This indicates the annual dividend payment per share. Column 6  Percent Yield:  This figure represents the dividend return an investor can expect on each share of stock.  It is calculated by dividing the annual dividend each share pays by its current market value, and is expressed as a percentage. Column 7  Price-Earnings Ratio (PE):  This calculation is one way of evaluating a stock's relative performance and value.  It is computed by dividing the stock's price by the company's per-share earnings for the most recent four quarters.  Higher Price-Earnings multiples suggest the investors are more optimistic about a stock's prospects than comparable lower-PE stocks, but the reason for high and low PEs also include the company's growth outlook, the industry the company is engaged in, company accounting policies, and whether the firm is a startup or a more established business. Column 8  Trading Volume:  This figure shows a total number of shares traded for the day, listed in hundreds.  Column 9  Hi/Lo:  This indicates the trading price range of the security during the day's trading.  Column 10  Close and Net Change: 

Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Banks Mutual Funds Etc.

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.

Financial Intermediaries Banks… help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchange is an item that people can easily use to engage in transactions. facilitate the purchases of goods and services.

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. Mutual funds allow people with small amounts of money to easily diversify. There are many funds on the market today. Some are index funds and others are active funds. Each fund will have a special focus.

Financial Intermediaries Mutual Fund – Example Templeton BRIC Fund Main Investments: The fund seeks long-term capital appreciation by normally investing at least 80% of its net assets in securities of "BRIC companies"—those companies… in Brazil, Russia, India or China (including the People's Republic of China, Hong Kong and Taiwan). Net Assets (millions) $375.8

Financial Intermediaries Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks

Financial Vehicles Has anyone here invested through any of these investment vehicles? Which ones? Why those particular vehicles? What was your criteria?

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 + NX Y = GDP C = Consumption I = Investment G = Government Purchases NX = Net Exports

Some Important Identities Assume a closed economy – one that does not engage in international trade: Y = C + I + G What is different in this scenario than in an economy that trades?

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).

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

Some Important Identities National saving, or saving, is equal to: S = I S = Y – C – G S = (Y – T – C) + (T – G)

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)

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)

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.

The Meaning of Saving and Investment Surpluses and Deficits Are they good things? What do you think? Deficit Trivia: Alexander Hamilton, the Secretary of the US Treasury during the presidency of George Washington advocated, and arranged for, the first national debt of the newly formed United States. Why did he feel that this was important?

The Meaning of Saving and Investment For the economy as a whole, saving must be equal to investment. S = I

A C T I V E L E A R N I N G 1 A. Calculations Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget deficit of $300 billion. Find public saving, taxes, private saving, national saving, and investment. This exercise asks your students to apply the concepts from the preceding slides to the kind of problem they might see on an upcoming exam. 27

A C T I V E L E A R N I N G 1 Answers, part A Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3 Public saving = T – G = – 0.3 Taxes: T = G – 0.3 = 1.7 Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8 National saving = Y – C – G = 10 – 6.5 = 2 = 1.5 Investment = national saving = 1.5 All numbers are in trillions of dollars. 28

A C T I V E L E A R N I N G 1 B. How a tax cut affects saving Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by $200 billion. In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment. 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. This exercise is designed to teach an important lesson and prevent a common mistake among students. When students are asked (on an exam, for example) to determine the effects of a tax cut on national saving, investment, and the interest rate, many students mistakenly state that the tax change has no effects because taxes enter positively in the expression for public saving, negatively in the expression for private saving, and not at all in the expression for national saving (Y – C – G). This exercise gets students to see that the effects of a tax cut on national saving and investment depend on the behavior of consumers. Immediately following this exercise is a discussion question designed to help students realize that the tax cut will most likely cause consumption to rise and national saving to fall. Of course, if you intend to teach your students that Ricardian Equivalence is an accurate description of the world, then you’d want to argue that scenario 1 is the most realistic. The reason for this, according to Ricardian Equivalence, is that consumers are forward-looking and realize that a tax cut today must be matched by a future tax increase that is equal in present value to today’s tax cut. Please be aware, however, that Ricardian Equivalence is not covered in this chapter, so it is not supported with test-bank or study guide questions. 29

A C T I V E L E A R N I N G 1 Answers, part B In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion. 1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged. 2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion. 30

A C T I V E L E A R N I N G 1 C. Discussion questions The two scenarios from this exercise were: 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. Which of these two scenarios do you think is more realistic? Why is this question important? If students have trouble understanding the first question, you can rephrase it in terms they are likely to grasp: Suppose a tax cut causes your annual take-home pay to rise from $40,000 to $42,000. What would you do with that extra $2000? Would you save ALL of it? Or would you spend at least part of it? In this light, most students would agree that the most realistic scenario involves consumers spending at least part of the proceeds of the tax cut. The answer to the first question determines whether a tax cut reduces investment. This is important because a fall in investment would cause, in the long run, a fall in the standard of living, according to what we learned in the Production and Growth chapter. The bigger point is this: while tax cuts seem appealing (nobody likes paying taxes, after all), they are not without cost. Later in the chapter, we will see HOW a tax cut causes investment to fall in a closed economy. (Answer: by raising interest rates.) 31

THE 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 Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. 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 Interest rate the price of the loan the amount that borrowers pay for loans and the amount that lenders receive on their saving in the market for loanable funds, the real interest rate

Supply and Demand for Loanable Funds Interest rate What is the current prime rate in Korea? What does prime rate mean? What are the current interest rates in Korean banks? Why do some banks pay a higher rate than others? What is usury? A recent law was passed here in Korea that put a maximum on the total amount of interest allowed in a year. What was that %?

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.

Figure 1 The Market for Loanable Funds Interest Rate Supply Demand 5% $1,200 Loanable Funds (in billions of dollars)

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

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 right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable Funds Interest Supply, S1 S2 Rate Demand 1. Tax incentives for saving increase the supply of loanable fund s . . . 5% $1,200 2. . . . which reduces the equilibrium interest rat e . . . 4% $1,600 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars)

Policy 1: Saving Incentives 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.

Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Figure 3 Investment Incentives Increase the Demand for Loanable Funds Interest Rate Supply D2 1. An investment tax credit increases the demand for loanable fund s . . . Demand, D1 6% $1,400 2. . . . which raises the equilibrium interest rate . . . 5% $1,200 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars)

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.

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.

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.

Figure 4: The Effect of a Government Budget Deficit Interest S2 Supply, S1 Rate Demand 1. A budget deficit decreases the supply of loanable fund s . . . $800 6% 2. . . . which raises the equilibrium interest rat e . . . $1,200 5% Loanable Funds 3. . . . and reduces the equilibrium quantity of loanable funds. (in billions of dollars)

Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Figure 5 The U.S. Government Debt Percent of GDP 120 World War II 100 80 60 Revolutionary War Civil War World War I 40 20 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Korean Governmental Polices What is the current situation in Korea? Are there incentives to save? Invest? Are we running a surplus / deficit / balanced budget?

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.

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.

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.

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.