Harcourt Brace & Company Chapter 25 Saving, Investment and the Financial System

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Chapter 25

Saving, Investment and the

Financial System

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Financial Markets. . . . . . matching one person’s saving with

another person’s investment (directly) . . . move the economy’s scarce

resources from savers to borrowers. . . . are opportunities for savers to

channel unspent funds into the hands of borrowers.

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The Bond Market

• A bond is a debt instrument.• Characteristics of a bond:

– Term: the length of time until maturity.

– Credit Risk: the probability that the borrower will fail to pay some of the interest or principal.

– Tax Treatment: municipal bonds interest is tax exempt.

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Types of Bonds (debt securities)

• Corporate Bonds• Municipal Bonds• U.S.Treasury Bonds and Notes• U.S. Treasury Bills• Commercial Paper

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• Stock represents ownership in a firm (equity finance)

• Risk vs. Return• Primary vs. Secondary Market• Major U.S. Markets:

– New York Stock Exchange

– NASDAQ

The Stock Market

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Financial Institutions in the U.S. Economy

• Institutions that indirectly allow savers to provide funds to borrowers are called financial intermediaries.

• Types of Financial Intermediaries:– Banks - Credit Unions

– Savings Banks - Mutual Funds

– Other

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Financial Intermediaries: Banks

• Banks take in deposits and make loans.

• Banks pay depositors interest and charge borrowers higher interest on their loans.

• Other functions: checkable deposits, supply currency, safe deposit boxes

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Financial Intermediaries: Mutual Funds

• A Mutual Fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both.

• Allows people with small amounts of money to diversify and to reduce risk.

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Financial Intermediaries: Other

Other financial intermediaries include:– Savings Banks (S&L’s)

– Credit Unions

– Pension Funds

– Insurance Companies

– Finance Companies

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Saving and Investment in the National Income Accounts

• Recall: GDP is both total income in an economy and the total expenditure on the economy’s output of goods and services:

Y = C + I + G + NX• Assume a closed economy (NX=0):

Y = C + I + G• National Saving or Saving is equal to:

Y - C - G = I = S

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Saving and Investment in the National Income Accounts

• National Saving or Saving is equal to:

Y - C - G = I = S or

S = (Y - T - C) + (T - G)where “T” = taxes net of transfers

• Two components of national saving:

Private Saving = (Y - T - C)

Public Saving = (T - G)

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For Example

• IF Y=$6,000, T=$1,000, C=$4,000 and G=$1,200, then

• I=S=$800 (Y-C-G)• Private Savings=$1000 (Y-T-C)• Public Savings=-$200 (T-G)

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Saving and Investment

• Private Saving is the amount of income that households have left after paying their taxes and paying for their consumption.

• Public Saving is the amount of tax revenue that the government has left after paying for its spending.

• For the economy as a whole, saving must be equal to investment.

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• Financial markets coordinate the economy’s saving and investment in

The Loanable Funds Market• The Supply of Loanable Funds comes

from private and public savings.• The Demand for Loanable Funds

comes from households and firms who wish to borrow.

The Market For Loanable Funds

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The Market For Loanable FundsInterest

Rate

Loanable Funds

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The Market For Loanable Funds

SupplyInterest

Rate

Loanable Funds

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

5%

$1,200

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

5%

$1,200

Movement to equilibrium is

consistent with principles of supply

and demand.

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The Market For Loanable Funds

• The supply and demand for loanable funds depends on the real interest rate. Movement to equilibrium is the process of determining the real interest rate in the economy.

• Saving represents the supply of loanable funds, while investment represents demand.

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Government Policy That Affects The Economy’s Saving and Investment

• Policies that influence the loanable funds market:

–Taxes and Saving (Fig. 25-2)

–Taxes and Investment (Fig. 25-3)

–Gov. Budget Deficits (Fig. 25-4)

• Observe how policy affects equilibrium, interest rates and funds.

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Government Policy That Affects The Economy’s Saving and Investment

• Taxes on savings impact the incentive to save, e.g. A tax decrease would alter the incentive for households to save at any given interest rate and would affect the supply of loanable funds.

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The Market For Loanable Funds

Supply

Demand

InterestRate

5%

$1,200 Loanable Funds

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

5%

$1,200

Lower taxes on savings will likely

increase the supply of loanable funds

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$1,200

The Market For Loanable Funds

Supply

Demand

InterestRate

5%

4%

$1,300 Loanable Funds

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Government Policy That Affects The Economy’s Saving and Investment

• A Tax Break on investment would increase the incentive to borrow if an investment tax credit were given.

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The Market For Loanable Funds

Supply

Demand

InterestRate

5%

$1,200 Loanable Funds

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The Market For Loanable Funds

Supply

Demand

InterestRate

5%

$1,200 Loanable Funds

Tax Break on investment would

increase the incentive to borrow altering the demand for loanable funds.

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

5%

$1,200

6%

$1,300

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Government Policy That Affects The Economy’s Saving and Investment

• Government Budget Deficit:– When the government spends more than

it receives in tax revenues

– the accumulation of past budget deficits is called the government debt.

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Government Policy That Affects The Economy’s Saving and Investment

• When the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms.

• This deficit borrowing “crowds out” the private borrowers who are trying to finance investments.

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Crowding Out

Defined as the “fall in investment as a result of increased government

borrowing”

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The Market For Loanable Funds

Supply

Demand

InterestRate

5%

$1,200 Loanable Funds

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The Market For Loanable Funds

Supply

Demand

InterestRate

5%

$1,200 Loanable Funds

Government borrowing to finance

its budget deficit, reduces the supply of

loanable funds.

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The Market For Loanable Funds

Supply

Demand

InterestRate

Loanable Funds

6%

$1,000

5%

$1,200

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Debt vs. Deficit/Surplus

• Federal Debt (2002)---$6.1 Trillion (but declining as a % of GDP, Fig. 25-5).

• Federal Deficit of $292 Billion in 1992• Surplus of $127 Billion FY2001• Deficit of $159 Billion in FY2002

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Conclusion

• Financial markets coordinate borrowing and lending and thereby help allocate the economy’s scarce resources efficiently.

• Financial markets are like other markets in the economy. The price in the loanable funds market - interest rate - is governed by the forces of supply and demand.