Saving, Investment, and the Financial System Chapter 8

Learning Objectives u Learn about some of the important financial institutions in the U.S. economy u Consider how the financial system is related to key macroeconomic variables u Develop a model of the supply and demand for loanable funds in financial markets

Learning Objectives (cont.) u Use the loanable-funds model to analyze various government policies u Consider how government budget deficits affect the U.S. economy

The Financial System u The financial system consists of institutions that help to match one person’s saving with another person’s investment. u It moves the economy’s scarce resources from savers to borrowers.

Financial Institutions in the U.S. Economy u The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. u Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

Financial Institutions in the U.S. Economy u Financial Markets u Stock Market u Bond Market u Financial Intermediaries u Banks u Mutual Funds

Financial Institutions in the U.S. Economy u Financial markets are the institutions through which savers can directly provide funds to borrowers. u Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. IOU

Characteristics of a Bond u Term: The length of time until the bond matures. u Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. u Tax Treatment: The way in which the tax laws treat the interest on the bond. u Municipal bonds are federal tax exempt.

u Stock represents ownership in a firm and is therefore, a claim to the profits that the firm makes. u The sale of stock to raise money is called equity financing. u Compared to bonds, stocks offer both higher risk and potentially higher returns. The Stock Market

The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.

The Stock Market Most newspaper stock tables provide the following information: u Price (of a share) u Volume (number of shares sold) u Dividend (profits paid to stockholders) u Price-earnings ratio

Financial Intermediaries: Banks u Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. u Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.

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

Financial Intermediaries: Mutual Funds u A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. u They allow people with small amounts of money to easily diversify.

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

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

Some Important Identities Assume a closed economy – one that does not engage in international trade: Y = C + I + G

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

Private Saving u 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)

Public Saving u Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

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.

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

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 Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

u The supply of loanable funds comes from people who have extra income they want to save and lend out. u The demand for loanable funds comes from households and firms that wish to borrow to make investments. Supply and Demand for Loanable Funds

u The interest rate is the price of the loan. u It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. u The interest rate in the market for loanable funds is the real interest rate. Supply and Demand for Loanable Funds

u Financial markets work much like other markets in the economy. u The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Loanable Funds (in billions of dollars) 0 Interest Rate Demand Supply 5% $1,200 Market for Loanable Funds...

Government Policies That Affect Saving and Investment u Taxes and saving u Taxes and investment u Government budget deficits

Taxes and Saving Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Taxes and Saving u A tax decrease increases the incentive for households to save at any given interest rate. u The supply of loanable funds curve shifts to the right. u The equilibrium interest rate decreases. u The quantity demanded for loanable funds increases.

S2S2 1. Tax incentives for saving increase the supply of loanable funds... An Increase in the Supply of Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% Supply, S 1 $1,200 Demand $1, and raises the equilibrium quantity of loanable funds. 4% 2....which reduces the equilibrium interest rate... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Taxes and Saving If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Saving Decisions u The main factors affecting household saving are: äThe real interest rate äDisposable income äPurchasing power of net assets äExpected future income

Saving Decisions u The Real Interest Rate äThe lower the real interest rate, the smaller is the amount of saving and the greater is the amount of consumption. u Disposable Income äThe greater a household's disposable income the greater is its saving.

Saving Decisions u Purchasing Power of Net Assets äNet assets are assets minus debts äThe greater the purchasing power of a household’s net assets the less is its saving.

Saving Decisions u Expected Future Income äThe lower a household’s expected future income the greater is its saving.

Saving Decisions u Saving Supply äIllustrates the relationship between saving and the real interest rate

Saving Supply a40.9 b61.0 c81.1 Real interest rateSaving (percent per year)(trillions of 1992 dollars

Saving Supply Saving (trillions of 1992 dollars) Real interest rate (percent per year)

Saving Supply Saving (trillions of 1992 dollars) Real interest rate (percent per year) a b c 2 SS

Saving Supply Saving (trillions of 1992 dollars) Real interest rate (percent per year) a b c A fall in the real interest rate decreases saving A rise in the real interest rate increases saving 2 SS

Saving Supply Saving (trillions of 1992 dollars) SS 0 Real interest rate (percent per year) A increase in saving supply 2 SS 1

Saving Supply Saving (trillions of 1992 dollars) SS 0 Real interest rate (percent per year) A increase in saving supply A decrease in saving supply 2 SS 1 SS 2

Saving Supply in the United States: 1970–1996

Taxes and Investment u An investment tax credit increases the incentive to borrow. u Increases the demand for loanable funds. u Shifts the demand curve to the right. u Results in a higher interest rate and a greater quantity saved.

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

An Increase in the Demand for Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% $1,200 Supply Demand, D 1 1. An investment tax credit increases the demand for loanable funds... D2D2 6% 2....which raises the equilibrium interest rate... $1, and raises the equilibrium quantity of loanable funds. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Investment Decisions u Business investment decisions are influenced by: 1) The expected profit rate 2) The real interest rate

Investment Decisions u The Expected Profit Rate äThe greater the expected profit rate from new capital, the greater is the amount of investment.

Investment Decisions u The Expected Profit Rate äThe net revenue from an investment in a plant is equal to the total revenue from sales minus the cost of labor and materials. äExpected profit is the net revenue minus the cost of the plant. äThe expected profit rate is the expected profit divided by the cost of the plant.

Investment Decisions u The Expected Profit Rate äThree Major Factors Affecting the Expected Profit Rate 1) The phase of the business cycle 2) Advances in technology 3) Taxes

Investment Decisions u The Real Interest Rate äThe lower the real interest rate, the greater is the amount of investment. äThe opportunity cost of funds is the real interest rate.

Investment Decisions u The Real Interest Rate äIf the real interest rate exceeds the expected profit rate, firms should not invest in new capital since they could earn more by loaning the funds to other firms. äMore investments are profitable at low interest rates, and less are profitable at high interest rates.

Investment Decisions u Investment Demand äIllustrates the relationship between investment and the real interest rate.

Investment Demand a b c Real interest rate (percent per year) LowAverageHigh Investment (trillions of 1992 dollars) Expected profit rate

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year)

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year) c b a ID

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year) c b a A rise in the real interest rate decreases investment A fall in the real interest rate increases investment ID 0.8

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year) ID 0

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year) ID 0 ID 1 An increase in the expected profit rate increases investment demand

Investment Demand Investment (trillions of 1992 dollars) Real interest rate (percent per year) ID 0 ID 1 ID 2 An increase in the expected profit rate increases investment demand A decrease in the expected profit rate decreases investment demand

Government Budget Deficits and Surpluses u When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. u The accumulation of past budget deficits is called the government debt.

Government Budget Deficits and Surpluses u Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. u This fall in investment is referred to as crowding out. u The deficit borrowing crowds out private borrowers who are trying to finance investments.

Government Budget Deficits and Surpluses u A budget deficit decreases the supply of loanable funds. u Shifts the supply curve to the left. u Increases the equilibrium interest rate. u Reduces the equilibrium quantity of loanable funds.

S2S2 1. A budget deficit decreases the supply of loanable funds... The Effect of a Government Budget Deficit... Loanable Funds (in billions of dollars) 0 Interest Rate $1,200 Supply, S 1 Demand 5% $ and reduces the equilibrium quantity of loanable funds which raises the equilibrium interest rate... 6% Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls.

Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

The U.S. Government Debt U.S. government debt

Summary u The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. u 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.

Summary u National income accounting identities reveal some important relationships among macroeconomic variables. u In particular, in a closed economy, national saving must equal investment. u Financial institutions attempt to match one person’s saving with another person’s investment.

Summary u The interest rate is determined by the supply and demand for loanable funds. u The supply of loanable funds comes from households who want to save some of their income. u The demand for loanable funds comes from households and firms who want to borrow for investment.

Summary u National saving equals private saving plus public saving. u A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. u When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

Graphical Review

Loanable Funds (in billions of dollars) 0 Interest Rate Demand Supply 5% $1,200 Market for Loanable Funds...

An Increase in the Supply of Loanable Funds... S2S2 1. Tax incentives for saving increase the supply of loanable funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% Supply, S 1 $1,200 Demand $1, and raises the equilibrium quantity of loanable funds. 4% 2....which reduces the equilibrium interest rate... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

An Increase in the Demand for Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% $1,200 Supply Demand, D 1 1. An investment tax credit increases the demand for loanable funds... D2D2 6% 2....which raises the equilibrium interest rate... $1, and raises the equilibrium quantity of loanable funds. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Effect of a Government Budget Deficit... S2S2 1. A budget deficit decreases the supply of loanable funds... Loanable Funds (in billions of dollars) 0 Interest Rate $1,200 Supply, S 1 Demand 5% $ and reduces the equilibrium quantity of loanable funds which raises the equilibrium interest rate... 6% Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The U.S. Government Debt U.S. government debt