1. Ch. 8: Saving and Investment, and the Financial System
Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)
Ch. 8: Saving and Investment, and the Financial System

2. Financial Markets Entrepreneurs are people with ideas.
They need funds to put their ideas into fruition.
People who have funds would like to get a high return for them.
Financial markets bring the savers with funds (lenders) together with borrowers.
Savers supply loanable funds and borrowers demand loanable funds.
Econ Dr. Ugur Aker

3. Financial Markets Bond Market Stock Market Foreign Exchange Market
Econ Dr. Ugur Aker

4. Bonds A bond is an IOU. Lender gives a sum of money to borrower.
Borrower gives a piece of paper that indicates
The amount of interest payment per year to be paid to the bondholder.
The amount of principal (face value) to be paid to the bondholder at the maturity date.
The date the principal will be paid.
Econ Dr. Ugur Aker

5. Primary and Secondary Markets
When the bond is first issued it goes to the primary market.
The borrower (the issuing firm) gets the funds and the lender gets the bond.
The bonds can be resold in the secondary market.
The ownership of the bond changes.
The issuer gets nothing.
The price of the bond depends on the supply and demand for similar bonds.
Econ Dr. Ugur Aker

6. Bond Prices and Interest Rates
A bond that pays $100 per year for 30 years and sold for $1000 yields an interest return of how much?
Roughly 10%.
The same bond is sold for $ What is the interest return?
Roughly 8%.
The same bond is sold for $500. What is the interest rate?
Roughly 20%.
Econ Dr. Ugur Aker

7. Bond Prices and Interest Rates
Bond prices and interest rates are always inversely related.
The higher the interest rate, the lower is the bond price.
The higher the bond price, the lower is the interest rate.
Econ Dr. Ugur Aker

8. Different Bonds
Would you be willing to pay the same price for the following bonds?
US Federal Government bond.
ATT bond.
Cleveland City bond.
LTV Steel bond.
Econ Dr. Ugur Aker

9. Why Do Bonds Have Different Prices?
Risk
The higher the risk of default (inability of the issuer to pay interest or principal), the lower is the price (the higher is the interest rate).
Liquidity
The easier it is to convert the bond into cash in the future, the higher is the price (the lower is the interest rate).
Tax considerations
If the interest payments are tax-free, there will be more demand for it. Higher price and lower interest rate.
Maturity
The farther the maturity date, the lower will be the price (the higher the interest rate).
Econ Dr. Ugur Aker

10. Stocks A firm may choose to raise funds by issuing stock.
The stock holder becomes part owner, sharing the future profits and losses.
The firm gets the funds from the primary market.
The stock exchanges hands in the secondary market, transferring ownership.
Econ Dr. Ugur Aker

11. Financial Intermediaries
Financial intermediaries are institutions that channel the savers’ funds to the borrowers.
Banks
Take deposits from savers.
Lend funds to borrowers.
Mutual Funds
Buy stock.
Econ Dr. Ugur Aker

12. Econ Dr. Ugur Aker

13. National Investments Match Savings
Y = C + I + G + NX
Y = C + S + T
C + S + T = C + I + G + NX
S + (T – G) – NX = I
Investments will have to be matched by private savings (S), government savings (T-G), and foreign savings (-NX).
NX = Exports – Imports
-NX = Imports - Exports
Econ Dr. Ugur Aker

14. Financing US Investments
In the eighties and well into the nineties the budget of the government was in deficit.
How did US keep its investments high?
Foreign indebtedness.
The twin deficits were, therefore, related.
Econ Dr. Ugur Aker

15. Loanable Funds Real The supply of loanable funds Interest rate
are provided by savers, i.e.,
lenders. The demand for
loanable funds comes from
borrowers. The market
equilibrium is reached at
a specific real interest rate. S D
Loanable Funds
Econ Dr. Ugur Aker

16. What Happens When
Tax laws are changed to eliminate taxes from savings.
Tax laws are changed to give tax breaks for investments.
Government budget deficit increases.
Government budget surplus increases.
Econ Dr. Ugur Aker

17. Repealing Taxes on Savings
Suppose taxes on interest
earnings were eliminated.
Or income taxes were
replaced by sales taxes. Or
savings to be used for
retirement purposes were
tax free. What would
happen To the real interest
rate and amount of savings
available? S S i1 i2 D
1200
1000
Econ Dr. Ugur Aker

18. Why Don’t We Do It? Who benefits from the tax cut?
How do sales taxes affect the poor and the rich?
Who puts more value to present consumption over future consumption?
Econ Dr. Ugur Aker

19. Investment Tax Credit When government allows investment
expenditures to be deducted from
earnings (instead of just depreciation),
firms will have more incentive to
expand. Demand to borrow funds
will increase, raising the real interest
rate and the amount borrowed. S 6% 5% D D
Loanable Funds
Econ Dr. Ugur Aker

20. Government Budget Surplus
Interest
rate
When the government budget
shows a surplus, the amount of
savings in the economy rises;
public saving is positive. The
additional funds available will
shift the supply curve to the
right, reducing the interest rate
and increasing the funds used
for investment purposes. S S D
Loanable funds
Econ Dr. Ugur Aker

21. Crowding Out
When government runs a deficit, national savings drop because public saving becomes negative.
The supply curve in the loanable funds market shifts left.
Interest rates rise.
Private entities find it more expensive to borrow, so they borrow less and undertake lower levels of investments.
Private investment is crowded out by the government’s borrowing.
Econ Dr. Ugur Aker

22. Source: http://www.stls.frb.org/images/publications/net/page17.gif
Econ Dr. Ugur Aker