Financial Sector: Saving, Investment and the Financial System AP MACROECONOMICS MR. BORDELON

Savings-Investment Spending Identity  Savings-investment spending identity. Savings and investment spending are always equal for the economy as a whole.  Why? This is an algebraic identity, so bare with me.

Savings-Investment Spending Identity  Assume there is an economy with no government or foreign trade, meaning only consumer and investment spending exist.  Income would have to equal spending. People earn income by selling, and that selling of goods is done by spending.  Total Income = Total Spending

Savings-Investment Spending Identity Total Income = Total Spending With income, consumers can either spend or save money. ▫ Total Income = Consumer Spending (C) + Savings (S) With spending, in this economy, spending is either done by consumers or investors. ▫ Total Spending = C + Investment Spending (I) Total Income = Total Spending  C + S = C + I

Savings-Investment Spending Identity  C + S = C + I  S = I  In short, with a basic economy, we end up with savings equal to investment. This is an accounting principle.  This is a simplified economy, however. What happens when we add government spending and net exports?  Let’s add government spending first.

Savings-Investment Spending Identity Government spending implies that governments can have savings. ▫ Budget surplus. Difference between tax revenue and government spending when tax revenue exceeds government spending. Government can also exceed its budget. ▫ Budget deficit. Difference between tax revenue and government spending when government spending exceeds tax revenue. One term to be aware of for our equation: ▫ Budget balance (BB). Difference between tax revenue and government spending. National savings. Sum of private savings and BB. Total amount of savings in the economy.

Savings-Investment Spending Identity  Looking at government spending, government spends money on g/s and pays transfers. To pay for this, government collects tax revenue.  If there is a balanced budget, then tax revenue = G + gov’t transfer payments  We can rewrite this equation to find the BB: BB = tax revenue – G – transfers.

Savings-Investment Spending Identity  BB = tax revenue – G – transfers  If BB > 0, the government has a budget surplus (saving)  If BB < 0, the government has a budget deficit (dissaving)  If BB = 0, the government has a balanced budget.  S + BB. National savings—combination of public and private sector.  Awesome, so now what? Well, add it to the S = I identity.

Savings-Investment Spending Identity  S + BB = I  BB > 0 (surplus): I increases.  BB < 0 (deficit): I decreases.  Even with surpluses and deficits, the S = I identity holds true.  Excellent. BUT THAT’S NOT ALL! Remember we need to look at net exports.

Savings-Investment Spending Identity  Two Sides:  Americans save money in U.S. or elsewhere.  Foreigners can save money in home country or U.S.  In other words, for any country, there is a series of capital inflows (savings) and outflows (spending).  Capital inflow (CI). Net inflow of funds into a country. Mathematically: CI = total inflow of foreign funds – total outflow of domestic funds

Savings-Investment Spending Identity  CI = total inflow of foreign funds – total outflow of domestic funds  CI can be positive or negative, which means it can increase or decrease total funds available for investment.  CI > 0: more foreign funds coming in than U.S. funds going out  CI < 0: less foreign funds coming in than U.S. funds going out.

Savings-Investment Spending Identity  Adding this to our S = I identity: S + BB + CI = I  CI > 0: more foreign funds coming in than U.S. funds going out, I increases.  CI < 0: less foreign funds coming in than U.S. funds going out, I decreases.

Savings-Investment Spending Identity Summary: S = I S + BB = I S + BB + CI = I For the AP exam, if they ask a question on S-I identity, then it typically follows these equations. ▫ Example. In Miltonia, no foreign trade is conducted. Which of the following would be an accurate statement of the savings- investment spending identity?  C. S + BB = I

Financial System Tasks—Key Terms Interest rate. Price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year. Wealth. Value of accumulated savings. Financial asset. Paper claim that entitles the buyer to future income from the seller. Physical asset. Claim on a tangible asset that gives the owner the right to dispose of the object as he sees fit. Liability. Requirement to pay money in the future. Keep these terms in mind as you focus on what financial systems do.

Financial System Tasks  Reduce transaction costs.  Transaction costs. Expenses of negotiating and executing a deal.  Example. Bob wants to buy a loaf of bread, a pound of apples, and a dozen eggs. He could drive to the bakery, then the orchard, and then to the farm. However, it is more convenient, and less costly, to buy it all at Winn-Dixie.  Example. Kestory, LTD wants to borrow money to build a factory. Kestory could go individually to Bordelon, Roeshink, etc. for a loan. Or Kestory could just simply go to a bank, which specializes in providing these funds. Banks, and other financial services companies, are able to make it easier, and less costly, for firms to engage in financial transactions like borrowing to make investments.

Financial System Tasks  Provide liquidity. Liquidity is about the ease you can turn an asset into cash.  iPad is an asset, but not all that liquid.  Savings account is an asset, and very liquid.  Example. If Kestory, LTD needs money to build a factory, that investment in a physical asset will not provide a stream of cash revenue for a long time. Until the factory begins to produce goods that generate revenue, Kestory may need liquidity (cash) to purchase raw materials, hire some workers and pay the electric bill. The financial system can provide liquidity by issuing loans, bonds, or stocks.

Financial System Tasks  Reduce risk.  Financial risk. Uncertainty about future outcomes that involve financial losses and gains.  Example. Given an uncertain future in investing, building a factory may have a risk that it will not be profitable. Kestory, LTD may want to build the factory, but using his own money is risky because the factory might not be profitable. Kestory could raise the money by selling shares of stock in the company. When a person buys a share of stock in a company, it gives that person a small stake in the ownership of the company. Kestory can pay for the factory, but does not need to risk his own money if the factory should fail to generate profits.  Diversification. Investing in several different assets so that possible losses are minimized.

Financial Assets Loans. Lending agreement between an individual lender and individual borrower. Unsecured. Bonds. Securitized debt. Seller of a bond promises to pay fixed sum of interest each year and to repay principal to owner of the bond on a particular date. Securities. Asset created by pooling individual loans and shares in that pool. Stocks. Share in ownership of a company, entitling stockholder to a share of the profits.

Financial Intermediaries  Financial intermediary. Institution that transforms funds gathered from many individuals into financial assets.  Mutual funds. Creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.  Pension Funds and Life Insurance Companies. Pension funds are non-profit institutions that collect the savings of its members and invest those funds in a wide variety of assets, providing retirement income. Life insurance companies sell policies which guarantee a payment to the policyholder’s beneficiaries when policyholder dies.  Banks. Financial intermediary that provides liquid assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers.