13 Saving, Investment, and the Financial System
What’s in This Chapter? <ul><li>Why should we care  about a country’s levels of saving and investment? </li></ul><ul><li>W...
Importance of Saving and Investment <ul><li>Our standard of living depends on our productivity </li></ul><ul><li>Our produ...
The Financial System   <ul><li>The  financial system  consists of the group of institutions in the economy that help to ma...
Financial Institutions In The U.S. Economy <ul><li>The  financial system  is made up of financial institutions that coordi...
Financial Institutions In The U.S. Economy <ul><li>Financial markets  are the institutions through which savers can  direc...
Financial Institutions In The U.S. Economy <ul><li>Financial Markets </li></ul><ul><ul><li>Stock Market </li></ul></ul><ul...
Financial Markets <ul><li>The Bond Market </li></ul><ul><ul><li>A  bond  is a certificate of indebtedness that specifies o...
Financial Markets  <ul><li>The Stock Market </li></ul><ul><ul><li>Stock  represents a claim to partial ownership in a firm...
Financial Markets  <ul><li>The Stock Market </li></ul><ul><ul><li>Most newspaper stock tables provide the following inform...
Financial Intermediaries <ul><li>Financial intermediaries  are financial institutions through which savers can  indirectly...
Financial Intermediaries <ul><li>Banks </li></ul><ul><ul><li>take deposits from people who want to save and use the deposi...
Financial Intermediaries <ul><li>Banks </li></ul><ul><ul><li>Banks help create a  money  by allowing people to write check...
Financial Intermediaries <ul><li>Mutual Funds </li></ul><ul><ul><li>A  mutual fund  is an institution that sells shares to...
Financial Intermediaries <ul><li>Other Financial Institutions  </li></ul><ul><ul><li>Credit unions </li></ul></ul><ul><ul>...
Saving And Investment In The National Income Accounts <ul><li>Recall that GDP is both total income in an economy and total...
Some Important Identities <ul><li>Assume a  closed economy   – one that does not engage in international trade.  </li></ul...
Some Important Identities <ul><li>The left side of the equation  Y – C – G = I  is the total income in the economy after p...
<ul><li>National Saving, or Saving, is equal to: S = Y – C – G </li></ul><ul><li>The government’s net tax revenues are den...
The Meaning of Saving and Investment <ul><li>Surplus and Deficit </li></ul><ul><ul><li>If  T > G , the government runs a  ...
THE MARKET FOR LOANABLE FUNDS
The Market For Loanable Funds <ul><li>For the economy as a whole, saving must be equal to investment: </li></ul><ul><li>S ...
The Market For Loanable Funds <ul><li>The  market for loanable funds  is the market in which  </li></ul><ul><ul><li>The  s...
Supply and Demand for Loanable Funds <ul><li>Financial markets work much like other markets in the economy. </li></ul><ul>...
Supply and Demand for Loanable Funds <ul><li>The interest rate is the price of a loan. </li></ul><ul><ul><li>It represents...
Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200
Supply and Demand for Loanable Funds <ul><li>Government Policies That Affect Saving and Investment </li></ul><ul><ul><li>T...
Policy 1: Saving Incentives <ul><li>Taxes on interest income substantially reduce the future payoff from current saving an...
Policy 1: Saving Incentives <ul><li>An income tax cut  increases the incentive for households to save, at any given intere...
Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,  S 1 ...
Policy 2: Investment Incentives <ul><li>An investment tax credit  increases the incentive to borrow. </li></ul><ul><ul><li...
Figure 3 An Increase in the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An invest...
Policy 3: Government Budget Deficits and Surpluses <ul><li>When the government spends more than it receives in tax revenue...
Policy 3: Government Budget Deficits and Surpluses <ul><li>Government borrowing to finance its budget deficit reduces the ...
Policy 3: Government Budget Deficits and Surpluses <ul><li>A budget deficit  decreases the supply of loanable funds.  </li...
Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 3.  . . . and ...
Policy 3: Government Budget Deficits and Surpluses <ul><li>A budget surplus  increases  the supply of loanable funds,  red...
Should a Nation’s Government Try to Change Its Levels of Saving and Investment? <ul><li>There’s no clear answer </li></ul>...
Should a Nation’s Government Try to Change Its Levels of Saving and Investment? <ul><li>The level of saving and investment...
US Federal Government Budget Deficit FY 2009 Budget Deficit = $1.4 trillion
Figure 5 The U.S. Government Debt Percent of GDP 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 0 20 40 60 80...
Summary <ul><li>The U.S. financial system is made up of financial institutions such as the bond market, the stock market, ...
Summary <ul><li>National income accounting identities reveal some important relationships among macroeconomic variables. <...
Summary <ul><li>The interest rate is determined by the supply and demand for loanable funds. </li></ul><ul><li>The supply ...
Summary <ul><li>National saving equals private saving plus public saving. </li></ul><ul><li>A government budget deficit re...
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  • It may be a good idea to mention that the income effect counteracts and may even exceed the substitution effect.
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    1. 1. 13 Saving, Investment, and the Financial System
    2. 2. What’s in This Chapter? <ul><li>Why should we care about a country’s levels of saving and investment? </li></ul><ul><li>What is a nation’s financial system ? What does it do and why does it matter? </li></ul><ul><li>Why are the levels of saving and investment high at some times (or, for some countries) and low at other times (or, for other countries)? </li></ul><ul><li>What can the government do to change a nation’s saving and investment levels? </li></ul><ul><li>What should the government do in this regard? </li></ul>
    3. 3. Importance of Saving and Investment <ul><li>Our standard of living depends on our productivity </li></ul><ul><li>Our productivity depends on the availability of physical capital, human capital, natural resources and technology </li></ul><ul><li>Improvements in our standard of living (or, simply, economic growth) requires increases in the availability of the above resources </li></ul><ul><li>And that in turn requires saving and investment </li></ul>
    4. 4. The Financial System <ul><li>The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. </li></ul><ul><li>It moves the economy’s scarce resources from savers to investors (or, from lenders to borrowers). </li></ul>
    5. 5. Financial Institutions In The U.S. Economy <ul><li>The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. </li></ul><ul><li>Financial institutions can be grouped into two categories: </li></ul><ul><ul><li>financial markets and </li></ul></ul><ul><ul><li>financial intermediaries. </li></ul></ul>
    6. 6. Financial Institutions In The U.S. Economy <ul><li>Financial markets are the institutions through which savers can directly provide funds to borrowers. </li></ul><ul><li>Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. </li></ul>
    7. 7. Financial Institutions In The U.S. Economy <ul><li>Financial Markets </li></ul><ul><ul><li>Stock Market </li></ul></ul><ul><ul><li>Bond Market </li></ul></ul><ul><li>Financial Intermediaries </li></ul><ul><ul><li>Banks </li></ul></ul><ul><ul><li>Mutual Funds </li></ul></ul>
    8. 8. Financial Markets <ul><li>The Bond Market </li></ul><ul><ul><li>A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. </li></ul></ul><ul><ul><li>Characteristics of a Bond </li></ul></ul><ul><ul><ul><li>Term : The length of time until the bond matures. </li></ul></ul></ul><ul><ul><ul><li>Credit Risk : The probability that the borrower will fail to pay some of the interest or principal. </li></ul></ul></ul><ul><ul><ul><li>Tax Treatment : The way in which the tax laws treat the interest on the bond. </li></ul></ul></ul><ul><ul><ul><ul><li>Municipal bonds are federal tax exempt. </li></ul></ul></ul></ul>
    9. 9. Financial Markets <ul><li>The Stock Market </li></ul><ul><ul><li>Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. </li></ul></ul><ul><ul><li>The sale of stock to raise money is called equity financing. </li></ul></ul><ul><ul><ul><li>Compared to bonds, stocks offer both higher risk and potentially higher returns. </li></ul></ul></ul><ul><ul><li>The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. </li></ul></ul>
    10. 10. Financial Markets <ul><li>The Stock Market </li></ul><ul><ul><li>Most newspaper stock tables provide the following information: </li></ul></ul><ul><ul><ul><li>Price (of a share) </li></ul></ul></ul><ul><ul><ul><li>Volume (number of shares sold) </li></ul></ul></ul><ul><ul><ul><li>Dividend (profits paid to stockholders) </li></ul></ul></ul><ul><ul><ul><li>Price-earnings ratio </li></ul></ul></ul>
    11. 11. Financial Intermediaries <ul><li>Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. </li></ul><ul><li>Examples: </li></ul><ul><ul><li>Banks </li></ul></ul><ul><ul><li>Mutual funds </li></ul></ul><ul><ul><li>Other </li></ul></ul>
    12. 12. Financial Intermediaries <ul><li>Banks </li></ul><ul><ul><li>take deposits from people who want to save and use the deposits to make loans to people who want to borrow. </li></ul></ul><ul><ul><li>pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. </li></ul></ul>
    13. 13. Financial Intermediaries <ul><li>Banks </li></ul><ul><ul><li>Banks help create a money by allowing people to write checks against their deposits. </li></ul></ul><ul><ul><ul><li>Money is anything that people can easily use to engage in transactions. </li></ul></ul></ul><ul><ul><li>This facilitates the purchases of goods and services. </li></ul></ul>
    14. 14. Financial Intermediaries <ul><li>Mutual Funds </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><ul><li>Mutual funds allow people with small amounts of money to easily diversify. </li></ul></ul></ul>
    15. 15. Financial Intermediaries <ul><li>Other Financial Institutions </li></ul><ul><ul><li>Credit unions </li></ul></ul><ul><ul><li>Pension funds </li></ul></ul><ul><ul><li>Insurance companies </li></ul></ul><ul><ul><li>Loan sharks </li></ul></ul>
    16. 16. Saving And Investment In The National Income Accounts <ul><li>Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: </li></ul><ul><li>Y = C + I + G + NX </li></ul>
    17. 17. Some Important Identities <ul><li>Assume a closed economy – one that does not engage in international trade. </li></ul><ul><li>In such an economy, NX = 0. Therefore, Y = C + I + G + NX becomes </li></ul><ul><li>Y = C + I + G </li></ul><ul><li>Now, subtract C and G from both sides of the equation: Y – C – G = I </li></ul>
    18. 18. Some Important Identities <ul><li>The left side of the equation Y – C – G = I is the total income in the economy after paying for consumption and government purchases </li></ul><ul><ul><li>This is called national saving, or just saving (S) . </li></ul></ul><ul><li>The equation becomes: </li></ul><ul><li>S = I </li></ul><ul><li>Saving equals investment </li></ul><ul><li>The saving of households ends up loaned to businesses, who spend the borrowed money </li></ul>
    19. 19. <ul><li>National Saving, or Saving, is equal to: S = Y – C – G </li></ul><ul><li>The government’s net tax revenues are denoted T </li></ul><ul><li>T = tax revenues – transfer payments </li></ul><ul><li>S = Y – C – G can be re-written as S = (Y – T – C) + (T – G) </li></ul><ul><li>Y – T is total after-tax income or disposable income </li></ul><ul><li>Y – T – C is the private sector’s saving or Private Saving </li></ul><ul><li>T – G is the government’s saving or Public Saving </li></ul><ul><li>National Saving = Private Saving + Public Saving </li></ul>Some Important Identities
    20. 20. The Meaning of Saving and Investment <ul><li>Surplus and Deficit </li></ul><ul><ul><li>If T > G , the government runs a budget surplus because it receives more money than it spends. </li></ul></ul><ul><ul><li>The surplus of T - G represents public saving. </li></ul></ul><ul><ul><li>If G > T , the government runs a budget deficit because it spends more money than it receives in tax revenue. </li></ul></ul>
    21. 21. THE MARKET FOR LOANABLE FUNDS
    22. 22. The Market For Loanable Funds <ul><li>For the economy as a whole, saving must be equal to investment: </li></ul><ul><li>S = I </li></ul><ul><li>Financial markets coordinate the economy’s saving and investment in the market for loanable funds. </li></ul>
    23. 23. The Market For Loanable Funds <ul><li>The market for loanable funds is the market in which </li></ul><ul><ul><li>The supply of loans come from households with savings </li></ul></ul><ul><ul><li>The demand for loans come from businesses (and households) that wish to spend for investment </li></ul></ul>
    24. 24. Supply and Demand for Loanable Funds <ul><li>Financial markets work much like other markets in the economy. </li></ul><ul><li>The equilibrium of the supply and demand for loanable funds determines the real interest rate. </li></ul>
    25. 25. Supply and Demand for Loanable Funds <ul><li>The interest rate is the price of a loan. </li></ul><ul><ul><li>It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. </li></ul></ul><ul><li>More precisely, the price of a loan is the real interest rate . </li></ul><ul><ul><li>The real interest rate is the inflation-adjusted interest rate </li></ul></ul><ul><ul><li>real interest rate = nominal interest rate – inflation rate </li></ul></ul><ul><ul><li>See chapter 11 for further discussion </li></ul></ul>
    26. 26. Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200
    27. 27. Supply and Demand for Loanable Funds <ul><li>Government Policies That Affect Saving and Investment </li></ul><ul><ul><li>Taxes can affect saving </li></ul></ul><ul><ul><li>Taxes can affect investment </li></ul></ul><ul><ul><li>Government budget deficits can affect saving </li></ul></ul>
    28. 28. Policy 1: Saving Incentives <ul><li>Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. </li></ul>
    29. 29. Policy 1: Saving Incentives <ul><li>An income tax cut increases the incentive for households to save, at any given interest rate. </li></ul><ul><ul><li>The supply curve of loanable funds shifts to the right. </li></ul></ul><ul><ul><li>The equilibrium interest rate decreases . </li></ul></ul><ul><ul><li>The quantity of saving and investment increases . </li></ul></ul>
    30. 30. Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply, S 1 S 2 2. . . . which reduces the equilibrium interest rat e . . . 3. . . . and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable fund s . . . 5% $1,200 4% $1,600
    31. 31. Policy 2: Investment Incentives <ul><li>An investment tax credit increases the incentive to borrow. </li></ul><ul><ul><li>Shifts the demand curve for loanable funds to the right. </li></ul></ul><ul><ul><li>The interest rate increases and saving and investment increase as well. </li></ul></ul>
    32. 32. 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 fund s . . . 2. . . . which raises the equilibrium interest rate . . . 3. . . . and raises the equilibrium quantity of loanable funds. Supply Demand, D 1 D 2 5% $1,200 6% $1,400
    33. 33. Policy 3: Government Budget Deficits and Surpluses <ul><li>When the government spends more than it receives in tax revenues, T – G < 0. </li></ul><ul><ul><li>the gap is called the budget deficit . </li></ul></ul><ul><ul><li>The government must borrow money in the market for loanable funds to fill the gap </li></ul></ul><ul><li>The accumulation of past budget deficits is called the government debt. </li></ul>
    34. 34. Policy 3: Government Budget Deficits and Surpluses <ul><li>Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms (the private sector). </li></ul><ul><li>This fall in investment is referred to as crowding out . </li></ul><ul><ul><li>The deficit borrowing crowds out private borrowers who are trying to finance investments. </li></ul></ul>
    35. 35. Policy 3: Government Budget Deficits and Surpluses <ul><li>A budget deficit decreases the supply of loanable funds. </li></ul><ul><ul><li>The supply curve of loanable funds shifts to the left. </li></ul></ul><ul><ul><li>The interest rate increases. </li></ul></ul><ul><ul><li>Saving and investment decrease. </li></ul></ul>
    36. 36. 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. S 2 2. . . . which raises the equilibrium interest rat e . . . Supply, S 1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable fund s . . .
    37. 37. Policy 3: Government Budget Deficits and Surpluses <ul><li>A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. </li></ul>
    38. 38. Should a Nation’s Government Try to Change Its Levels of Saving and Investment? <ul><li>There’s no clear answer </li></ul><ul><li>More saving and investment is not always good for us. </li></ul><ul><ul><li>While the future is important, so is the present. While saving and investment improve our future standard of living, they reduce our current standard of living </li></ul></ul>
    39. 39. Should a Nation’s Government Try to Change Its Levels of Saving and Investment? <ul><li>The level of saving and investment that comes out of the interactions of savers and investors in the market for loanable funds is usually—though not always—just right </li></ul><ul><li>The government should intervene only when </li></ul><ul><ul><li>It is clear that the market is likely to malfunction, and </li></ul></ul><ul><ul><li>The government is reasonably sure that it would be able to do a better job than the market </li></ul></ul>
    40. 40. US Federal Government Budget Deficit FY 2009 Budget Deficit = $1.4 trillion
    41. 41. Figure 5 The U.S. Government Debt Percent of GDP 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 0 20 40 60 80 100 120 Revolutionary War Civil War World War I World War II
    42. 42. Summary <ul><li>The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. </li></ul><ul><li>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. </li></ul>
    43. 43. Summary <ul><li>National income accounting identities reveal some important relationships among macroeconomic variables. </li></ul><ul><li>In particular, in a closed economy, national saving must equal investment. </li></ul><ul><li>Financial institutions attempt to match one person’s saving with another person’s investment. </li></ul>
    44. 44. Summary <ul><li>The interest rate is determined by the supply and demand for loanable funds. </li></ul><ul><li>The supply of loanable funds comes from households who want to save some of their income. </li></ul><ul><li>The demand for loanable funds comes from households and firms who want to borrow for investment. </li></ul>
    45. 45. Summary <ul><li>National saving equals private saving plus public saving. </li></ul><ul><li>A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. </li></ul><ul><li>When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP. </li></ul>

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