1. Copyright © 2004 South-Western 26 Saving, Investment, and the Financial System

2. Copyright © 2004 South-Western Objectives a.Identify important financial institutions in the United States b.Explain how the financial system is related to key macro variables (GDP, CPI, unemployment) c.Explain the market for loanable funds and its implications (determination of interest rate) d.Comprehend how budget deficits affect the U.S. economy

3. Copyright © 2004 South-Western The Financial System financial systemThe financial system consists of the group of institutions in the economy that help to match o savers with borrowers. The financial system consists of institutions that bring savers and borrowers together. Financial institutions : 1. Financial markets 2. Financial intermediaries *borrowers: (those who engage in capital investment (and consumption))

4. Copyright © 2004 South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Credit Unions Savings and Loan Mutual Funds

5. Copyright © 2004 South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

6. Copyright © 2004 South-Western Financial Markets The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal (aaa to junk status) Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt. Mk: (risk/return tradeoff), (term length/return tradeoff)

7. Copyright © 2004 South-Western Financial Markets The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing (bonds – debt financing). Compared to bonds, stocks offer both higher risk and potentially higher returns. Big stock exchanges in the US are the New York Stock Exchange, the American Stock Exchange, and NASDAQ (Secondary markets – provide liquidity)

8. Copyright © 2004 South-Western Financial Markets The Stock Market Most newspaper stock tables provide the following information (text chap 26 – p 565 in hard cover): Price (of a share) Volume (number of shares sold) Dividend (profits paid per share to stockholders) Profit not paid to stockholders is referred to as (retained earnings) and used for investment (dividend yield is dividend as a percentage of the stock price) Price-earnings ratio – (price of stock / earnings per share) Where earnings per share = (profit / number of shares) - typical of historical ratio is P/E = 15 P/E > 15 implies price of stock is high relative to earnings P/E ratio is a “fundamental”

9. Copyright © 2004 South-Western Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Banks: take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. This interest differential is how banks make money

10. Copyright © 2004 South-Western Financial Intermediaries Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchange is an item that people can easily use to engage in transactions (money (cash) is a medium of exchange)

11. Copyright © 2004 South-Western Financial Intermediaries 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, bonds, or both. They allow people with small amounts of money to easily diversify (buy a wide variety of stocks and bonds so as to limit risk… risk/reward tradeoff) Think: Suppose a group of ten stocks each with 25% probability of increasing in value by $15 per share and 25% probability of decreasing in value by the same amount: Compare owning $10,000 of one stock with owning $10,000 worth of all ten – exposure to risk is reduced via diversification

12. Copyright © 2004 South-Western Financial Intermediaries Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks

13. Copyright © 2004 South-Western 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

14. Copyright © 2004 South-Western Some Important Identities closed economyAssume a closed economy – one that does not engage in international trade (no NX): Y = C + I + G *All income is used for consumption, saved, or taxed away (assume a balanced budget, that tax revenue = G)

15. Copyright © 2004 South-Western 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).

16. Copyright © 2004 South-Western Some Important Identities Substituting S for Y - C - G, the equation can be written as: S = I

17. Copyright © 2004 South-Western Some Important Identities National saving, or saving, is equal to: S = I Where… S = Y – C – G Add and subtract tax revenue S = (Y – T – C) + (T – G) Where T = tax revenue

18. Copyright © 2004 South-Western The Meaning of Saving and Investment National Saving National saving is the total income in the (closed) economy that remains after paying for consumption and government purchases. S = (Y – T – C) + (T – G)

19. Copyright © 2004 South-Western The Meaning of Saving and Investment Private Saving 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 Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

20. Copyright © 2004 South-Western The Meaning of Saving and Investment 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. (public dissaving) … the accumulation of deficits is called debt

21. Copyright © 2004 South-Western The Meaning of Saving and Investment For the economy as a whole, saving must be equal to investment. S = I market for loanable funds. Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

22. Copyright © 2004 South-Western THE MARKET FOR LOANABLE FUNDS The market for loanable funds is the market in which savers supply funds and those who want to borrow, in order to invest, demand funds Some money is borrowed to finance consumption Loanable fundsLoanable funds refers to all income that people have saved – not used for their own consumption.

23. Copyright © 2004 South-Western Market (D and S) for Loanable Funds The supply of loanable funds comes from people who have extra or discretionary income they want to save and lend out. Why? To earn interest, provide for the future… The demand for loanable funds comes from households and firms that wish to borrow to make investments (plant, equipment, human capital).

24. Copyright © 2004 South-Western Supply and Demand for Loanable Funds The interest rate is the price of the funds. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. We take the interest rate as the real interest rate (Real interest rate = Nominal Rate – Inflation)

25. Copyright © 2004 South-Western Supply and Demand for Loanable Funds 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. Why is the demand for funds downward sloping? Why is the supply of funds upward sloping?

26. Copyright © 2004 South-Western Demand for funds Suppose a $100 piece of equipment will generate $115 in revenue in the coming year and then depreciate 100% Will you borrow money to acquire (invest) in this piece of equipment? Depends on what the interest rate is

27. Copyright © 2004 South-Western Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200 Copyright©2004 South-Western

28. Policy 1.Policy with impact on saving – supply of funds 2.Policy with impact on investment – demand for funds 3.(Fiscal) Policy with impact on interest rates

29. Copyright © 2004 South-Western Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. For example interest income not taxed… * Show graph on whiteboard – supply of loanable funds shifts to the right.

30. Copyright © 2004 South-Western Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow (in order to invest). Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.

31. Figure 3 An Increase in 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 Copyright©2004 South-Western

32. Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

33. Copyright © 2004 South-Western 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 households and firms. This fall in investment is referred to as crowding out. The borrowing to cover the deficit crowds out private borrowers who are trying to finance investments.

34. Copyright © 2004 South-Western Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

35. 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... Copyright©2004 South-Western

36. Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. Suppose Y=20, C=12, G=4, and I=3 Then (Y-C-T) + (T-G) = S = I * If transfers increase then (T-G) increases, so while G = government purchases, transfers can have impact on deficit.

37. Copyright © 2004 South-Western Policy 3: Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. * Excess revenue is returned to citizens who save some portion of the return or revenue is used to pay down (retire) debt which increases the amount of loanable funds

38. 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 Copyright©2004 South-Western

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

40. Copyright © 2004 South-Western Summary In a closed economy, national saving must equal investment. (Classical / Keynesian debate – what if funds are not borrowed for investment?) Financial institutions coordinate matching one person’s saving with another person’s investment.

41. Copyright © 2004 South-Western Summary The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income (interest rate is a measure of the opportunity cost of consumption) The demand for loanable funds comes from households and firms who want to borrow for investment.

42. Copyright © 2004 South-Western Summary National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

43. Copyright © 2004 South-Western Check Contractor borrows money to buy a piece of equipment – investment Someone buys a Treasury Bond – saving Bank buys Treasury Securities – crowding out GDP = Y = C + I + G + NX If interest rates fall, “I” increases, GDP increases, and unemployment falls… If interest rates rise…