Ch 25 Saving, Investment and the Financial System

*p review of financial terms learned in Micro stock market lessons

I. Saving and Investments in the National Income Accounts *assume a closed economy for now Y = C+I+G (Income = Expenditures) Subtract Consumption and Government from both sides Y-C-G = I Y-C-G : tells us our income (Y) after we paid for C and G….so this is National Savings (S) …..so Y-C-G = I ……= ……S = I *think back to AE model ….at Equilibrium, S = I …so National Savings = …. S = Y-C-G

If S = I : how is this coordinated in the economy????? THE FINANCIAL SYSTEM TAKES IN A NATION’S SAVINGS AND DIRECTS IT TO THE NATION’S INVESTMENTS (p.563)

National Savings is separated into Private and Public *must consider taxes Private Income (Y) must subtract private Taxes (T) and private Consumption ( C ) ….so Private Savings = Y-T-C Public Income consists of Tax revenue (T) and subtract Government spending (G) …so Public Savings = T-G National Savings = Private Savings + Public Savings S = ( Y-T-C) + (T-G)

II. Meaning of Saving and Investment ***specific use of terms***

III. Market For Loanable Funds Supply Curve: The Supply of What? ? ? Demand Curve: The Demand of What?

Supply =  Savings ….comes from …. People have extra income and lend it out Examples… Savings accounts, buy bonds

Demand= Investment….comes from.. Households and firms want to borrow to invest Examples… Home mortgages, firms buy new equipment, factories

Interest Rates = price of borrowing High int rates = Borrowing is…. more expensive = D falls = Downward sloping

High interest rates = Savings is…. More incentive = S increases = Upward sloping

Examine Govt. policies that affect SAVING (S) AND INVESTMENT (D) Three steps: 1. Shift S or D 2. Direction of shift 3. Evaluate new equilibrium

Remember: the G taxes all income earned on interest and can influence the incentive to save by changing the tax on “interest income” (or dividends, or capital gains) Ex: G decrease capital gains tax : or G remove tax on dividends : or G reduces tax on interest income: 1. shift? - because the incentive affects savings; we know that Savings = Supply 2. direction? – increase incentive to save = shift S right 3. evaluate – creates lower interest rate ( r ); move along D curve : and since a lower ( r ) makes it easier to borrow, and lead to greater investment (*remember I is part of GDP) = raise eq Q of Loanable Funds Consider opposite examples

Taxes and Investment Ex: what if govt. gave incentive (decrease taxes) for firms to build new factories 1. shift? - because the incentive is to increase I, we know that I = Demand 2. direction? – incentive to increase I = shift D right 3. evaluate – creates higher ( r ) ; move along S curve: and since higher ( r ) makes it better to save = greater savings. = raise eq. Q of Loanable Funds Consider opposite examples

Govt Budget Deficit (Deficit = more govt spending than taking in tax revenue) Govt. finance deficits by borrowing in the bond market. (*accumulation of past govt. borrowing is called govt. debt. ) 1. shift? Govt. deficit is a reduction of national savings (private + public savings = national savings) 2. direction? - public savings is negative so shift S left 3. evaluate- creates higher ( r ) ; move along D curve: and since higher ( r ) makes it harder to borrow to invest, leads to reduced I (= CROWDING OUT EFFECT) Consider opposite examples

*when G tries expansionary fiscal policy by increasing G spending ; but they increase the deficit to do so; results in higher ( r ) which reduces I spending which reduces the expansionary effect. = Crowding Out Effect *when G tries expansionary fiscal policy by increasing G spending ; but they increase the deficit to do so; results in higher ( r ) which makes dollar APPRECIATE, which reduces Nx, which reduces the expansionary effect…….= Nx Effect Consider opposite examples

Note on bonds: When a corporation or govt. issues a bond --- investor pays full price (ex. $1,000) Earns FIXED INTEREST RATE (every 3 mos. or 6 mos.) (ex. 10%) When the bond MATURES --- get full purchase price back But – bonds can be bought and sold on NYSE before maturity. Example: Buy bond for 10%, maturity = 10 yrs, interest paid every 6 mos. In one year, you earned $200.

But --- you notice interest rates have increased (ex. 15%) so you figure you can get better returns on a different bond. You decide to sell it,,,,,but who would buy a $1,000 bond w/ 10%, when they can get 15%. To sell it, it is discounted [BOND PRICE DECREASES] ex- to $800….. ….so as IR increase…….. Bond prices decrease

Why would I buy this bond? I buy bond for $800, but …. I am earning 10% on a $1000 bond *****Inverse relationships between Interest Rates and Bond Prices