PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM Chapter 8 Copyright © 2014 by Nelson Education Ltd.8-2

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM  Financial system : the group of institutions in the economy that help to match one person’s savings with another person’s investment  This chapter examines how the financial system works. Copyright © 2014 by Nelson Education Ltd.8-3

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY  Financial institutions can be grouped into two categories:  Financial markets  Financial intermediaries Copyright © 2014 by Nelson Education Ltd.8-4

Financial Markets  Financial markets : financial institutions through which savers can directly provide funds to borrowers Copyright © 2014 by Nelson Education Ltd.8-5

Financial Markets: The Bond Market  Bond : a certificate of indebtedness that specifies the obligation of the borrower to the holder of the bond  Debt finance: the sale of a bond to raise money  Characteristics:  the bond’s term  the bond’s credit risk Copyright © 2014 by Nelson Education Ltd.8-6

Financial Markets: The Stock Market  Stock : represents ownership in a firm and is, therefore, a claim to its profits  Equity finance: the sale of a stock to raise money  The prices at which shares trade on stock exchanges are determined by the supply and demand for the stock. Copyright © 2014 by Nelson Education Ltd. moodboard/Thinkstock 8-7

 Stock index : is an average of a group of stock prices  Dow Jones Industrial Average  S&P/TSX Composite Index  Because stock prices reflect expected profitability, stock indexes are watched closely as possible indicators of future economic conditions. Copyright © 2014 by Nelson Education Ltd.8-8 Financial Markets: The Stock Market

Financial Intermediaries  Financial intermediaries : financial institutions through which savers can indirectly provide funds to borrowers Copyright © 2014 by Nelson Education Ltd.8-9

Financial Intermediaries  Bank : The primary function of a bank is to take deposits from savers and use these deposits to make loans to people who want to borrow. Copyright © 2014 by Nelson Education Ltd. Thinkstock 8-10

 Mutual funds : an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds  Allow diversification  Access to the skills of professional money managers Copyright © 2014 by Nelson Education Ltd. Financial Intermediaries 8-11

QuickQuiz What is a stock? What is a bond? How are they different? How are they similar? Copyright © 2014 by Nelson Education Ltd.8-12

SAVING AND INVESTMENT IN THE NATIONAL ACCOUNTS  Accounting : refers to how various numbers are defined and added up  The national income accounts include, in particular, GDP and many related statistics. Copyright © 2014 by Nelson Education Ltd.8-13

Some Important Identities Copyright © 2014 by Nelson Education Ltd. In a closed economy: 8-14

Copyright © 2014 by Nelson Education Ltd. National saving (S): the total income in the economy that remains after paying for consumption and government purchases Some Important Identities 8-15

Copyright © 2014 by Nelson Education Ltd. Let T denote the taxes collected by government minus transfer payments. National saving can then be expressed in either of two ways: or Some Important Identities 8-16

Copyright © 2014 by Nelson Education Ltd. Private saving : the income that households have left after paying for taxes and consumption Public saving : the tax revenue that the government has left after paying for its spending Some Important Identities 8-17

Copyright © 2014 by Nelson Education Ltd. Budget surplus : Budget deficit : Some Important Identities 8-18

The Meaning of Saving and Investment  The terms saving and investment can sometimes be confusing.  Although the accounting identity S = I shows that saving and investment are equal for the economy as a whole, this does not have to be true for every individual household or firm. Copyright © 2014 by Nelson Education Ltd.8-19

QuickQuiz Define the following: Private saving Public saving National saving National investment How are they related? Copyright © 2014 by Nelson Education Ltd.8-20

Copyright © 2014 by Nelson Education Ltd.  Suppose GDP equals $10 million, consumption equals $6.5 million, the government spends $2 million and has a budget deficit of $300 million.  Find public saving, taxes, private saving, national saving, and investment Active Learning A. Calculations

Copyright © 2014 by Nelson Education Ltd. 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 = Active Learning Answers: Part A

Copyright © 2014 by Nelson Education Ltd.  Use the numbers from the preceding exercise but suppose now that the government cuts taxes by $200 million.  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/ Active Learning B. Calculations

Copyright © 2014 by Nelson Education Ltd. In both scenarios, public saving falls by $200 million, and the budget deficit rises from $300 million to $500 million. 1. If consumers save the full $200 million, national saving is unchanged, so investment is unchanged. 2. If consumers save $50 million and spend $150 million, then national saving and investment each fall by $150 million Active Learning Answers: Part B

Copyright © 2014 by Nelson Education Ltd. 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? 8-25 Active Learning C. Discussion Questions

THE MARKET FOR LOANABLE FUNDS  Market for loanable funds : the market in which those who want to save supply funds and those who want to borrow to invest demand funds Copyright © 2014 by Nelson Education Ltd.8-26

Supply and Demand for Loanable Funds  Saving is the source of supply for loanable funds.  Investment is the source of demand for loanable funds.  The interest rate is the price of a loan. Copyright © 2014 by Nelson Education Ltd.8-27

FIGURE 8.1: The Market for Loanable Funds Copyright © 2014 by Nelson Education Ltd.8-28

Policy I: Saving Incentives  A higher saving rate could lead to a higher rate of growth of GDP.  People respond to incentives:  Consumption taxes like the GST  RRSPs  TFSA  RESP Copyright © 2014 by Nelson Education Ltd.8-29

FIGURE 8.2: An Increase in the Supply of Loanable Funds Copyright © 2014 by Nelson Education Ltd.8-30

Policy 2: Investment Incentives  An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment. Copyright © 2014 by Nelson Education Ltd.8-31

FIGURE 8.3: An Increase in the Demand for Loanable Funds Copyright © 2014 by Nelson Education Ltd.8-32

Policy 3: Government Budget Deficits and Surpluses  Government debt : the sum of past budget deficits and surpluses Copyright © 2014 by Nelson Education Ltd.8-33

FIGURE 8.4: The Effect of a Government Budget Deficit Copyright © 2014 by Nelson Education Ltd.8-34

 Crowding out : a decrease in investment that results from government borrowing Copyright © 2014 by Nelson Education Ltd.8-35 Policy 3: Government Budget Deficits and Surpluses

FIGURE 8.5: Federal and Provincial/Territorial Net Debt in Canada Copyright © 2014 by Nelson Education Ltd.8-36

QuickQuiz If more Canadians adopted a “live for today” approach to life, how would this affect saving, investment, and the interest rate? Copyright © 2014 by Nelson Education Ltd.8-37

Copyright © 2014 by Nelson Education Ltd. Create a Portfolio Assume you have $ in savings. Create a portfolio of securities worth $ Decide what financial instruments you would like to use, then find their current prices in the newspaper. 1.Calculate your holdings of each security, based on current prices. 2.What objectives do you have for this portfolio? Was it chosen to maximize short-term gains, long-term stability, or some other objective? 8-38 Classroom Activity

Copyright © 2014 by Nelson Education Ltd. Create a Portfolio 3.Explain how each of the following economic events would affect the value of your portfolio. A.an increase or decrease in interest rates B.a recession C.rapid inflation D.a depreciation of the Canadian dollar 8-39 Classroom Activity

THE END Chapter 8 Copyright © 2014 by Nelson Education Ltd.8-40