1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Saving, Investment, and the Financial System 1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Financial Institutions Financial System –Group of institutions in the economy that help match one person’s saving with another person’s investment –Coordinates the economy’s scarce resources from savers to borrowers Financial Institutions –Financial markets –Financial intermediaries 2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Financial Markets –Institutions through which savers can directly provide funds to borrowers. The two most important: The bond market The stock market 3 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. The Bond Market The bond market –Bond: A certificate of indebtedness Time of maturity - the loan will be repaid Rate of interest Principal - amount borrowed 4 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. The Bond Market The bond market –Three Characteristics of Bonds Term: The length of time until maturity –Long-term bonds are riskier than short-term bonds Credit Risk: The probability of default –Higher risk pays a higher interest rate. U.S. Govt tends to pay lowest interest rate. Tax Treatment –Corporate bonds are taxable –Municipal bonds, bonds issued by state and local governments are tax-free 5 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. The Stock Market Stock: A claim to partial ownership in a firm –Equity finance Sale of stock to raise money –Organized stock exchanges NYSE (Large Caps), Nasdaq (Small Caps) Stock prices: Respond to demand and supply based upon expectations of future profitability –Stock index Average of a group of stock prices DJIA, S&P 500, Russell 2000 6 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Financial Intermediaries Financial intermediaries –Financial institutions through which savers can indirectly provide funds to borrowers. Two of the most common: Banks Mutual funds 7 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Banks –Take in deposits from savers Banks pay interest to savers (investors) –Make loans to borrowers Banks charge interest (borrowers) –Banks pay lower interest rate to investors than they charge to borrowers. Banks make $’s! (Savings rate vs Mortgage rate) –Facilitate a medium of exchange for purchasing of goods and services through debit cards and checks 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Mutual Funds Institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds –Advantages of purchasing mutual funds vs buying stocks in an individual company Diversification Access to professional money managers –Questionable about the value of “professional money managers” since index funds outperform most professionally managed funds. 9 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. National Income Accounts Rules of national income accounting include important identities Identity –An equation that must be true because of the way the variables in the equation are defined –Clarify how different variables are related to one another –GDP Example: Y = C + I + G + NX 10 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Accounting Identities Gross Domestic Product (GDP) –Measures both Total Income and Total Expenditure Y = C + I + G + NX Y= gross domestic product GDP C = consumption G = government purchases NX = net exports 11 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Accounting Identities A closed economy doesn’t interact with other economies –NX = 0 An open economy interacts with other economies –NX ≠ 0 12 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Accounting Identities Assumption for closed economy: NX = 0 Y = C + I + G National saving (saving), S Total income in the economy that remains after paying for consumption (C) and government purchases (G) Y – C – G = I Y – C – G = S (National Saving) Therefore: S = I 13 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Accounting Identities If T = Taxes collected from households minus transfer payments (SS, Welfare), we can write S in two ways: 1)S = Y – C – G 2)S = (Y – T – C) + (T – G) Equations 2: S = Private Saving + Public Saving Private saving, Y – T – C is income that households have left after paying for taxes and consumption Public saving, T – G is tax revenue that the government has left after paying for its spending 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Accounting Identities Budget surplus: T – G > 0 –Excess of tax revenue over government spending Budget deficit: T – G < 0 –Shortfall of tax revenue from government spending 15 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Saving and Investing Accounting identity: S = I reveals an important fact: For the economy as a whole, Savings must equal Investment Saving = Investment –Financial markets (bond/stock) and intermediaries (banks/mutual funds) stand between S and I and take in the nation’s saving and direct it to the nation’s investment –For the economy as a whole one person’s savings can finance another person’s investment through the financial system. 16 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Saving and Investing Saving –When a person takes disposable income and puts it in the bank or purchases bonds, stocks or mutual funds, this is commonly misunderstood to be investment. Economists count this as saving Investment –Investment is defined by economists as the purchase of new capital such as buildings or equipment. When a person purchases a new house, this adds to the nation’s investment. When a company sells stock or bonds to fund a new factory, this is counted as investment as well. 17 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. The Market for Loanable Funds Market for loanable funds –Market consists of: Those who want to save supply funds Those who want to borrow to invest demand funds –One interest rate which is the return to saving and cost of borrowing –We will ignore the diversity of financial institutions and assume the economy has a single financial market 18 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. The Market for Loanable Funds Supply and demand of loanable funds –The source of the supply of loanable funds is saving –The source of the demand for loanable funds is investment –The price of a loan = real interest rate Amount borrowers pay for a loan adjusted for inflation Amount lenders receive on their saving adjusted for inflation 19 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. The Market for Loanable Funds Supply and demand of loanable funds –As the interest rate rises Quantity of funds demanded declines (less investment) Quantity of funds supplied increases (more savings) –Demand curve (Investors) Slopes downward: as funds become more expensive, less investment –Supply curve (Savers) Slopes upward: as interest increases, more people willing to save. 20 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Figure 1 21 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Interest Rate Loanable Funds (in billions of dollars) 0 Supply Demand 5% $1,200 The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national saving, including both private saving and public saving. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied and demanded.

22. The Market for Loanable Funds Government policies –Can affect the economy’s saving and investment –3 Types of government policies 1. Saving incentives 2. Investment incentives 3. Government budget deficits and surpluses 22 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Policy 1: Saving Incentives Shelter some saving from taxation –Affects supply of loanable funds –Results in an increase in supply of loanable funds because the supply curve shifts right –New equilibrium results in lower interest rate and higher quantity of loanable funds that leads to greater investment 23 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Figure 2 24 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Saving Incentives Increase the Supply of Loanable Funds Interest Rate Loanable Funds (in billions of dollars) 0 Supply, S 1 Demand 5% $1,200 A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S 1 to S 2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion. S2S2 4% $1,600 1. Tax incentives for saving increase the supply of loanable funds... 3.... and raises the equilibrium quantity of loanable funds. 2.... which reduces the equilibrium interest rate...

25. Policy 2: Investment Incentives Investment tax credit: Gives a tax advantage to any firm building a new building or purchasing new equipment –Affects demand for loanable funds –Increase in demand that shifts demand curve right –New equilibrium results in higher interest rate which induces greater saving which results in a higher quantity of loanable funds 25 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Figure 3 26 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment Incentives Increase the Demand for Loanable Funds Interest Rate Loanable Funds (in billions of dollars) 0 Supply Demand, D 1 5% $1,200 If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D 1 to D 2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion. D2D2 6% $1,400 1. An investment tax credit increases the demand for loanable funds... 2.... which raises the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds.

27. Policy 3: Budget Deficit/Surplus If Government starts with balanced budget then runs a budget deficit –Changes the supply of loanable funds because loanable funds are comprised of public and private saving Deficits reduce public saving so funds are less available Decrease in supply of loanable funds as supply curve shifts left resulting in a new equilibrium with higher interest rate and smaller quantity of available loanable funds 27 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Figure 4 28 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Effect of a Government Budget Deficit Interest Rate Loanable Funds (in billions of dollars) 0 Supply, S 1 Demand 5% $1,200 When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S 1 to S 2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion. S2S2 6% $800 1. A budget deficit decreases the supply of loanable funds... 3.... and reduces the equilibrium quantity of loanable funds. 2.... which raises the equilibrium interest rate...

29. Policy 3: Budget Deficit/Surplus Crowding out –Decrease in investment as a result of government borrowing loanable funds to cover for deficit When Government incurs a budget deficit –As national saving decreases, interest rate rises and investment falls as funds become more expensive to firms 29 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Policy 3: Budget Deficit/Surplus When Government incurs a budget surplus –National saving increases resulting in an increase in supply of loanable funds which reduce interest rates and stimulates investment as funds become cheaper 30 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. The history of U.S. government debt Debt of U.S. federal government –As a percentage of U.S. GDP has fluctuated throughout history 0% of GDP in 1836 107% of GDP in 1945 When Debt-GDP ratio declines –Government indebtedness is shrinking relative to its ability to raise tax revenue suggesting that the Government is living within its means 31 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. The history of U.S. government debt When Debt-GDP ratio rises –Government indebtedness is increasing relative to its ability to raise tax revenue suggesting fiscal policy cannot be sustained forever at current levels War is a primary cause of fluctuations in government debt: –Debt financing of war is considered an appropriate policy Keeps tax rates smooth over time; alternative is to raise taxes sharply during wartime to pay Debt financing of war shifts part of the cost to future generations 32 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Figure 5 33 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The U.S. Government Debt The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied throughout history. Wartime spending is typically associated with substantial increases in government debt.

34. The history of U.S. government debt President Ronald Reagan, 1981 –Large increase in government debt not caused by war –Committed to smaller government and lower taxes –Cutting government spending is more difficult politically than cutting taxes –Result was a period of large budget deficits –Government debt: 26% of GDP in 1980 to 50% of GDP in 1993 34 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. The history of U.S. government debt President Bill Clinton, 1993 –1 st Major goal - deficit reduction –When Republicans took control of Congress in1995 deficit reduction was high on their agenda –Both of these efforts substantially reduced the size of the government budget deficit and eventually turned to a surplus –By the late 1990s: debt-GDP ratio - declining 35 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. The history of U.S. government debt President George W. Bush –Debt-GDP ratio - started rising again –Budget deficit Signed into law several major tax cuts 2001 recession which decreased tax revenue and increased government spending September 11, 2001 attacks (resulted in Homeland Security), subsequent wars in Iraq and Afghanistan lead to increases in government spending 36 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. The history of U.S. government debt 2008, financial crisis and deep recession –Dramatic increase in the debt-GDP ratio –Increased budget deficit –Several policy measures passed by the Bush and Obama administrations aimed at combating the recession Reduced tax revenue Increased government spending 37 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. The history of U.S. government debt 2009 and 2010 –Federal government’s budget deficit = 10% of GDP, the largest since WWII –The borrowing to finance budget deficit lead to substantial increase in the debt- GDP ratio Policy challenges for future generations –Putting the federal budget back on a sustainable path with a stable or declining debt-GDP ratio is one of the great policy challenges for future policymakers. 38 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.