1. CHAPTER 4: SAVING, INVESTMENT AND THE FINANCIAL SYSTEM

2. Function of the Financial System The financial system consists of the group of institutions in the economy that perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds. The financial system consists of the group of institutions in the economy that perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds. Promotes economic efficiency by producing an efficient allocation of capital, which increases production. Promotes economic efficiency by producing an efficient allocation of capital, which increases production. Improve the well-being of consumers by allowing them to time purchases better. Improve the well-being of consumers by allowing them to time purchases better.

3. FINANCIAL INSTITUTIONS The financial system is made up of financial institutions that matches savers and borrowers. The financial system is made up of financial institutions that matches savers and borrowers. Financial institutions can be grouped into two different categories: Financial institutions can be grouped into two different categories: Financial markets Financial markets Financial intermediaries Financial intermediaries

4. FINANCIAL INSTITUTIONS Financial markets are arrangements (location or medium) where savers can directly provide funds to borrowers. Financial markets are arrangements (location or medium) where savers can directly provide funds to borrowers. Financial intermediaries are financial institutions which collect funds from savers and lend to borrowers. They “intermediate” between savers and borrowers. Financial intermediaries are financial institutions which collect funds from savers and lend to borrowers. They “intermediate” between savers and borrowers.

6. FINANCIAL INSTITUTIONS Financial Markets Financial Markets Stock Market: Share of ownership in a firm. Firms borrow money from savers who buy their shares. Stock Market: Share of ownership in a firm. Firms borrow money from savers who buy their shares. Bond Market: Debt instrument. Government and firms issue bonds to borrow money from savers who buy these bonds. Bond Market: Debt instrument. Government and firms issue bonds to borrow money from savers who buy these bonds.

7. FINANCIAL INSTITUTIONS Financial Intermediaries Financial Intermediaries Institutions that accept deposits : Banks Institutions that accept deposits : Banks Investment Intermediaries: Investment Funds (collects savings and manages a portfolio of securities on owners’ behalf). Careful with the “investment” word! Investment Intermediaries: Investment Funds (collects savings and manages a portfolio of securities on owners’ behalf). Careful with the “investment” word! Contractual Savings Institutions: Life Insurance, Fire & Casualty Insurance, Pension Funds, Government Retirement Funds. Contractual Savings Institutions: Life Insurance, Fire & Casualty Insurance, Pension Funds, Government Retirement Funds.

8. Financial Markets The Bond Market The Bond Market A bond is a debt instrument that specifies obligations of the borrower (issuer) to the holder (owner) of the bond. A bond is a debt instrument that specifies obligations of the borrower (issuer) to the holder (owner) of the bond. Characteristics of a Bond Characteristics of a Bond Face Value: Nominal YTL value to be repaid at the date of maturity. Face Value: Nominal YTL value to be repaid at the date of maturity. Date of Maturity: The time at which the face value will be repaid. Date of Maturity: The time at which the face value will be repaid.

9. Financial Markets Types of Bonds: Types of Bonds: Discount Bond: Current price is smaller than face value, sold at a discount. Ex: Treasury discount bond with 1000 YTL face value and one year maturity is sold for 900 YTL. then the interest rate will be Discount Bond: Current price is smaller than face value, sold at a discount. Ex: Treasury discount bond with 1000 YTL face value and one year maturity is sold for 900 YTL. then the interest rate will be (1000-900) / 900 = 11.1 % (1000-900) / 900 = 11.1 %

10. Financial Markets Types of Bonds (continued): Types of Bonds (continued): Coupon Bond: Issuer of this bond makes fixed interest payments to the holder every year until the maturity date. Ex: A coupon bond with 1000 YTL face value, 50% coupon rate, annual coupon payments and 5 years maturity issued by the Treasury. The treasury will pay you 500 YTL every year and will pay you 1500 YTL five years later. Coupon Bond: Issuer of this bond makes fixed interest payments to the holder every year until the maturity date. Ex: A coupon bond with 1000 YTL face value, 50% coupon rate, annual coupon payments and 5 years maturity issued by the Treasury. The treasury will pay you 500 YTL every year and will pay you 1500 YTL five years later.

11. Financial Markets The Stock Market The Stock Market Stock represents a share of ownership in a firm. A share of stock is a claim on the earnings and assets of the corporation. Ex: If Turkcell has 1,000,000 total shares and you own 1 share, then you own 1/1,000,000 of Turkcell’s assets. Stock represents a share of ownership in a firm. A share of stock is a claim on the earnings and assets of the corporation. Ex: If Turkcell has 1,000,000 total shares and you own 1 share, then you own 1/1,000,000 of Turkcell’s assets. Stocks pay “dividends” to the shareholders regularly. Ex: every 6 months. Stocks pay “dividends” to the shareholders regularly. Ex: every 6 months. Compared to bonds, stocks offer both higher risk and potentially higher returns. Tradeoff: risk-return. Compared to bonds, stocks offer both higher risk and potentially higher returns. Tradeoff: risk-return.

12. Financial Markets The Stock Market The Stock Market Both stocks and bonds are first issued in the primary market. This is when the issuer firm does initial public offering (IPO). After that, stocks are traded in the secondary market. Stock exchanges are the secondary markets. Both stocks and bonds are first issued in the primary market. This is when the issuer firm does initial public offering (IPO). After that, stocks are traded in the secondary market. Stock exchanges are the secondary markets. The stock exchange in Turkey: Istanbul Stock Exchange (ISE). In the United States: New York Stock Exchange, the American Stock Exchange, and NASDAQ. London, Frankfurt and Tokyo have large stock exchanges. The stock exchange in Turkey: Istanbul Stock Exchange (ISE). In the United States: New York Stock Exchange, the American Stock Exchange, and NASDAQ. London, Frankfurt and Tokyo have large stock exchanges.

13. Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Why do we need intermediaries? Why do we need intermediaries? Small savers cannot buy stocks or bonds, or cannot diversify easily because of transaction costs. Small savers cannot buy stocks or bonds, or cannot diversify easily because of transaction costs. Small borrowers (firms) cannot issue stocks or bonds, so they borrow from banks. Small borrowers (firms) cannot issue stocks or bonds, so they borrow from banks. Intermediaries solve these problems. Economies of scale reduces transaction costs. Intermediaries solve these problems. Economies of scale reduces transaction costs.

14. Financial Intermediaries Banks… Banks… take deposits from people who want to save and use the deposits to make loans to people who want to borrow. take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors no interest (checking accounts) or some interest (savings accounts) on their deposits. pay depositors no interest (checking accounts) or some interest (savings accounts) on their deposits. charge borrowers higher interest on their loans. charge borrowers higher interest on their loans. profit from the interest rate difference and fees for liquidity services. profit from the interest rate difference and fees for liquidity services.

15. Financial Intermediaries Banks provide liquidity services by… Banks provide liquidity services by… allowing people to purchase goods and services using debit and credit cards. No need to carry cash. allowing people to purchase goods and services using debit and credit cards. No need to carry cash. write checks against their checking account deposits. More common in the US. write checks against their checking account deposits. More common in the US. use internet to make purchases, money transfers, automatic bill payments, etc. use internet to make purchases, money transfers, automatic bill payments, etc.

16. Financial Intermediaries Investment (Mutual) Funds Investment (Mutual) Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio of various types of stocks and bonds. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio of various types of stocks and bonds. Mutual funds allow people with small amounts of money to easily diversify. They pool savings so that they can avoid transaction costs: economies of scale. Mutual funds allow people with small amounts of money to easily diversify. They pool savings so that they can avoid transaction costs: economies of scale.

17. 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: 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

18. Some Important Identities Assume a closed economy (as opposed to an open economy). A closed economy does not engage in international trade: NX = 0 Assume a closed economy (as opposed to an open economy). A closed economy does not engage in international trade: NX = 0 Y = C + I + G

19. Some Important Identities We define national saving of an economy as the total income in the economy that is left after paying for consumption and government purchases. We define national saving of an economy as the total income in the economy that is left after paying for consumption and government purchases. If we subtract C and G from total income in the equation: If we subtract C and G from total income in the equation: Y – C – G = I We get national saving (S) on the left hand side. We get national saving (S) on the left hand side.

20. Some Important Identities Denoting saving by S, we get: Denoting saving by S, we get: S = I For a closed economy, saving equals investment. For a closed economy, saving equals investment.

21. Some Important Identities We can divide national saving into two parts: private saving and public saving. Suppose T is the amount of tax revenues collected by the government. We can divide national saving into two parts: private saving and public saving. Suppose T is the amount of tax revenues collected by the government. S = Y – C – G We can also write: We can also write: S = (Y – T – C) + (T – G) National S. = Private S. + Public S.

22. Some Important Identities Private Saving Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. 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) Private saving = (Y – T – C)

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

24. Surplus and Deficit Surplus and Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. 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. 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. In this case public saving is negative. This has been the case in Turkey in most of its history. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue. In this case public saving is negative. This has been the case in Turkey in most of its history. Some Important Identities

25. The Meaning of Saving and Investment For the (closed) economy as a whole, saving must be equal to investment. For the (closed) economy as a whole, saving must be equal to investment. S = I For economists, investment refers to purchase of machinery, equipment and buildings. In everyday language, “investment” is used to describe purchases of stocks and bonds. For us, those are acts of saving. For economists, investment refers to purchase of machinery, equipment and buildings. In everyday language, “investment” is used to describe purchases of stocks and bonds. For us, those are acts of saving.

26. THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in 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 is the market in which those who save supply funds and those who borrow demand funds. The market for loanable funds is the market in which those who save supply funds and those who borrow demand funds.

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

28. Supply and Demand 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. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from people who have extra income they want to save and lend out. The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from firms and households that wish to borrow to make investments. The demand for loanable funds comes from firms and households that wish to borrow to make investments.

29. Supply and Demand for Loanable Funds Interest rate Interest rate Is the price of the loan (credit) Is the price of the loan (credit) Is the amount that borrowers pay for loans and the amount that lenders earn on their saving Is the amount that borrowers pay for loans and the amount that lenders earn on their saving in the market for loanable funds, we use the real interest rate. Ignore inflation. in the market for loanable funds, we use the real interest rate. Ignore inflation.

30. Supply and Demand for Loanable Funds Financial markets work much like other markets in the economy. Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

31. Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment Government Policies That Affect Saving and Investment Taxes on saving (interest earnings). Taxes on saving (interest earnings). Taxes on investment expenditures. Taxes on investment expenditures. Government budget deficits and surpluses. Government budget deficits and surpluses.

32. Policy 1: Saving Incentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. A tax cut on interest earnings increases the incentive for households to save at any given interest rate. A tax cut on interest earnings increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts right. The supply of loanable funds curve shifts right. The equilibrium interest rate decreases. The equilibrium interest rate decreases. Amount of investment increases. Amount of investment increases.

33. Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S2 2.... which reduces the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600

34. Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater saving and investment. If a change in tax law encourages greater saving, the result will be lower interest rates and greater saving and investment.

35. Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Increases the demand for loanable funds. Shifts the demand curve to the right. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved and invested. Results in a higher interest rate and a greater quantity saved and invested.

36. Figure 3 Investment Incentives Increase the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 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. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400

37. Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving and investment. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving and investment.

38. Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall (G - T) is called the budget deficit (flow concept). When the government spends more than it receives in tax revenues, the short fall (G - T) is called the budget deficit (flow concept). Government borrows to finance its deficit. Issues and sells bonds in the bond market. Government borrows to finance its deficit. Issues and sells bonds in the bond market. The accumulation of past budget deficits is called the government debt (stock concept). The accumulation of past budget deficits is called the government debt (stock concept).

39. Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by firms. Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by firms. This fall in investment is referred to as crowding out. This has been especially big problem for Turkey. This fall in investment is referred to as crowding out. This has been especially big problem for Turkey. The deficit borrowing crowds out private borrowers who are trying to finance investments. Also keeps int. rate very high. The deficit borrowing crowds out private borrowers who are trying to finance investments. Also keeps int. rate very high.

40. Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Shifts the supply curve to the left. Increases the equilibrium interest rate. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds. Reduces the equilibrium quantity of loanable funds.

41. Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 3.... and reduces the equilibrium quantity of loanable funds. S2S2 2.... which raises the equilibrium interest rate... Supply,S1S1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds...

42. Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

43. Figure 5 The U.S. Government Debt Percent of GDP 17901810183018501870189019101930195019701990 Revolutionary War 2010 Civil War World War I World War II 0 20 40 60 80 100 120