Market for Loanable Funds.ppt

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Market for Loanable Funds.ppt

  1. 1. The Financial System
  2. 2. 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 different categories: financial markets and financial intermediaries. </li></ul>
  3. 3. 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><ul><ul><li>Others </li></ul></ul>
  4. 4. Bond Market <ul><li>A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. </li></ul><ul><li>Characteristics of a Bond </li></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>IOU
  5. 5. The Stock Market <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><li>The sale of stock to raise money is called equity financing. </li></ul><ul><ul><li>Compared to bonds, stocks offer both higher risk and potentially higher returns. </li></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>
  6. 6. Financial Markets <ul><li>Most newspaper stock tables provide the following information: </li></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>
  7. 7. Bonds vs. Stocks <ul><li>Importance difference is that bonds are debt and stocks are the owners claims on the residuals of the company. </li></ul><ul><li>If bankruptcy occurs, bondholders are paid of before stockholders. </li></ul>
  8. 8. Financial Intermediaries <ul><li>Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. </li></ul><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><ul><ul><li>Banks help create a medium of exchange by allowing people to write checks against their deposits. </li></ul></ul><ul><ul><ul><li>A medium of exchanges is an item that people can easily use to engage in transactions. </li></ul></ul></ul><ul><ul><li>A medium of exchange facilitates the purchases of goods and services by removing the coincidence of wants and lowering transaction costs </li></ul></ul>
  9. 9. <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>They allow people with small amounts of money to easily diversify. </li></ul></ul></ul><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>
  10. 10. 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><ul><li>Assume a closed economy – one that does not engage in international trade: </li></ul><ul><li>Y = C + I + G </li></ul>
  11. 11. <ul><li>Now, subtract C and G from both sides of the equation: </li></ul><ul><li>Y – C – G =I </li></ul><ul><li>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). </li></ul><ul><li>Substituting S for Y - C - G , the equation can be written as: </li></ul><ul><li>S = I </li></ul><ul><li>National saving, or saving, is equal to: </li></ul><ul><li>S = I </li></ul><ul><li>S = Y – C – G </li></ul><ul><li>S = (Y – T – C) + (T – G) </li></ul><ul><li>Note that we have subtracted T from Y to get private saving = (Y – T – C) and added taxes to get government saving = (T – G) </li></ul>
  12. 12. National Saving <ul><li>Total income in the economy that remains after paying for consumption and government purchases. </li></ul><ul><li>Private Saving </li></ul><ul><ul><li>Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. </li></ul></ul><ul><ul><li>Private saving = (Y – T – C) </li></ul></ul><ul><li>Public Saving </li></ul><ul><ul><li>Public saving is the amount of tax revenue that the government has left after paying for its spending. </li></ul></ul><ul><ul><li>Public saving = (T – G) </li></ul></ul>
  13. 13. 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><ul><li>Remember from above that for the economy as a whole, saving must be equal to investment. </li></ul><ul><li>S = I </li></ul>
  14. 14. THE MARKET FOR LOANABLE FUNDS <ul><li>Financial markets coordinate the economy’s saving and investment in the market for loanable funds. </li></ul><ul><li>The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. </li></ul><ul><li>Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. </li></ul>
  15. 15. Supply and Demand for Loanable Funds <ul><li>The supply of loanable funds comes from people who have extra income they want to save and lend out. </li></ul><ul><li>The demand for loanable funds comes from households and firms that wish to borrow to make investments. </li></ul><ul><li>The interest rate is the price of the loan. </li></ul><ul><li>It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. </li></ul><ul><li>The interest rate in the market for loanable funds is the real interest rate. </li></ul><ul><li>Financial markets work much like other markets in the economy. </li></ul><ul><ul><li>The equilibrium of the supply and demand for loanable funds determines the real interest rate . </li></ul></ul>
  16. 16. Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Real Interest Rate Copyright©2004 South-Western Supply Demand 5% $1,200
  17. 17. Government Policies That Affect Saving and Investment <ul><li>Taxes and saving </li></ul><ul><li>Taxes and investment </li></ul><ul><li>Government budget deficits </li></ul>
  18. 18. Supply of Loanable Funds: 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><ul><li>A tax decrease increases the incentive for households to save at any given interest rate. </li></ul><ul><ul><li>The supply of loanable funds curve shifts to the right. </li></ul></ul><ul><ul><li>The equilibrium interest rate decreases. </li></ul></ul><ul><ul><li>The quantity demanded for loanable funds increases. </li></ul></ul><ul><li>If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. </li></ul>
  19. 19. Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Copyright©2004 South-Western 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
  20. 20. Demand for Loanable Funds: Investment Incentives <ul><li>An investment tax credit increases the incentive to borrow. </li></ul><ul><ul><li>Increases the demand for loanable funds. </li></ul></ul><ul><ul><li>Shifts the demand curve to the right. </li></ul></ul><ul><ul><li>Results in a higher interest rate and a greater quantity saved. </li></ul></ul><ul><li>If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. </li></ul>
  21. 21. Figure 3 An Increase in the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Copyright©2004 South-Western 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
  22. 22. Government Budget Deficits and Surpluses <ul><li>When the government spends more than it receives in tax revenues, the short fall is called the budget deficit . </li></ul><ul><li>The accumulation of past budget deficits is called the government debt. </li></ul><ul><li>Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. </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>
  23. 23. Policy 3: Government Budget Deficits and Surpluses <ul><li>A budget deficit decreases the supply of loanable funds. </li></ul><ul><ul><li>Shifts the supply curve to the left. </li></ul></ul><ul><ul><li>Increases the equilibrium interest rate. </li></ul></ul><ul><ul><li>Reduces the equilibrium quantity of loanable funds. </li></ul></ul><ul><li>When government reduces national saving by running a deficit, the interest rate rises and investment falls . </li></ul><ul><li>A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. </li></ul>
  24. 24. Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate Copyright©2004 South-Western 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 . . .
  25. 25. 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 Copyright©2004 South-Western Revolutionary War Civil War World War I World War II
  26. 26. 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>
  27. 27. 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>
  28. 28. 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>
  29. 29. 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>
  30. 30. 19.927   17.07   13.724   11   7.82   4.69   Totals 15.58 13.33 10.77 8.47 5.38 2.86   Inaccuracies of CBO Projections 4.35 3.74 2.95 2.62 2.44 1.83   Economic and Technical Factors Year + 4 Year + 3 Year + 2 Year + 1 Year Year Budget Budget Budget Budget Budget Current Date the Projection Was Published Inaccuracies in CBO's Baseline Projections of the Primary Surplus or Deficit (As a percentage of actual revenues) Table 4.

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