Chap18 Investments Savings

8/10/2019 Chap18 Investments Savings

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18Saving, Investment,

and the FinancialSystem


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Context

Continue with a sequence of topics which deal with the

production of output in the long run. In the previous lecture, we found that capital and labor are

among the primary determinants of output.

The purpose of the present lecture is to show how saving

and investment are coordinated by the loanable fundsmarket.

Within the framework of the loanable funds market, we willstudy the effects of taxes and government deficits on saving,

investment,

the accumulation of capital,

the growth rate of output.


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The Financial System

The financial system consists of the group of

institutions in the economy that help to match one

persons saving with another persons investment.

It moves the economys scarce resources from savers to

borrowers.


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FINANCIAL INSTITUTIONS IN THE U.S.ECONOMY

Thefinancial system is made up of financial

institutions that coordinate the actions of

savers and borrowers.

Financial institutions can be grouped into twodifferent categories:

financial markets and

financial intermediaries.


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FINANCIAL INSTITUTIONS IN THE U.S.ECONOMY

Financial markets are the institutions through which

savers can directlyprovide funds to investors.

Stock Market

Bond Market

Financial intermediaries are financial institutions

through which savers can indirectlyprovide funds to

investors.

Banks

Mutual Funds


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Financial Markets

The Bond Market A bond is a certificate of indebtedness that

specifies obligations of the borrower tothe holder of the bond.

Characteristics of a Bond Rate of interestthat will be paid periodically until the loan

matures.

Term: The length of time until the bond matures. All else equal, long-term bonds pay higher rates of interest than short-term bonds.

Credit Risk: The probability that the borrower will fail to paysome of the interest or principal. All else equal, the more risky a bond is, the higher its interest rate.

Tax Treatment: The way in which the tax laws treat the intereston the bond. Municipal bonds are federal tax exempt.

IOU


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Financial Markets

The Stock Market

Most newspaper stock tables provide the following

information:

Price (of a share)

The price of a stock generally reflects the perception of a companys futureprofitability.

Volume (number of shares sold)

Dividend (profits paid to stockholders)

A corporation's earnings, or accounting profit, is the amount of

revenue it receives for the sale of its products minus its costs of

production as measured by its accountants.


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The Stock Market(cont)

Earnings per share is the company's total earnings divided

by the number of shares of stock outstanding.

Theprice-earnings ratio(P/E), is the price of a

corporation's stock divided by the amount the corporation

earned per share over the past year. Historically, the typical price-earnings ratio is about 15.

High P/E indicates that a corporation's stock is expensive relative

to its recent earnings;

this might indicate either that people expect earnings to rise in the future orthat the stock is overvalued.

Low P/E indicates that a corporation's stock is cheap relative to its

recent earnings;

this might indicate either that people expect earnings to fall or that the stock

is undervalued.


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Financial Intermediaries: Role of Banks

Their primary role is to take deposits from people who want

to save and use the deposits to make loans to people whowant to borrow.

Pay depositors interest on their deposits and charge

borrowers a higher rate of interest to cover the costs ofrunning the bank and provide the bank owners with some

amount of profit

Create a medium of exchangeby providing checking

accounts and allowing people to write checks against theirdeposits.

A medium of exchanges is an item that people can easily use to

engage in transactions.

This facilitates the purchases of goods and services.


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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 portfolio,

of various types of stocks, bonds, or both.

They allow people with small amounts of money to

easily diversify.

Index fundsare mutual funds that buy all of the

stocks of a given stock index.

Generally perform better than funds with active fundmanagement.

they trade stocks less frequently and they do not have to pay the

salaries of fund managers.


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Assignment

1. Assume you have $100,000 in savings.

2. Create a portfolio of securities worth $100,000.

3. Decide what financial instruments you would like to use, then

find their current prices in the newspaper.

4. Calculate your holdings of each security, based on current prices.

What objectives do you have for this portfolio? Was it chosen to

maximize short-term gains, long-term stability, or some other

objective?

Explain how each of the following economic events would affect

the value of your portfolio.

an increase or decrease in interest rates

a recession

rapid inflation

a depreciation of the U.S. dollar


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Financial Intermediaries

Other Financial Institutions

Credit unions

Pension funds

Insurance companies

Loan sharks

S G S


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SAVING AND INVESTMENT IN THENATIONAL INCOME ACCOUNTS

Recall:

GDP is both total income in an economy and total

expenditure on the economys output of goods

and services

GDP can be divided up into four components:

consumption, investment, government purchases, and

net exports.

Y = C + I + G + NX


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Some Important Identities

Assume a closed economy

i.e., one that does not engage in international trade

This implies that GDP can now be divided into

only three components:

Y = C + I + G


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Some Important Identities

National saving, or saving, is equal to:

S = I

S = YCG

We can add and subtract taxes:S = YCG + TT

After rearrangement:

S = (Y

T

C) + (T

G)

S = Sprivate

+ Spublic

Two types of saving.


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The Meaning of Saving and Investment

National Saving

National savingis the total income in the economy that

remains after paying for consumption and government

purchases.

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 TC)


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Surplus and Deficit

If T > G, the government runs a budget surplusbecauseit receives more money than it spends.

Budget surplus:an excess of tax revenue over governmentspending.

The surplus of T - Grepresentspublic saving.

If G > T, the government runs a budget deficitbecause itspends more money than it receives in tax revenue.

Budget deficit:a shortfall of tax revenue from government

spending. To make up for this shortfall, the government must go to the

loanable funds market and borrow the money.

This will reduce the supply of loanable funds available for

investment.


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Public Saving

Public saving is the amount of tax revenue that the

government has left after paying for its spending.

Public saving = (TG)


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An illustration

Suppose that GDP is $8 trillion, taxes are $1.5 trillion, private saving

is $0.5 trillion, and public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption, government

purchases, national saving, and investment.

Given that Y = 8 and T = 1.5,

Sprivate = 0.5 = YTC,Spublic= 0.2 = TG.

Since Sprivate= YTC, then a rearrangement gives

C = YTSprivate= 81.50.5 = 6.

Since Spublic = T - G, then rearranging gives

G = TSpublic= 1.50.2 = 1.3.

Since S = national saving = Sprivate+ Spublic= 0.5 + 0.2 = 0.7.

Finally, since I = investment = S, I = 0.7.


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THE MARKET FOR LOANABLE FUNDS

Coordination of the economys saving and investment

occurs in the market for loanable funds. The market for loanable funds (LF) is the market in which those

who want to savesupply funds and those who want to borrow

(and invest) demand funds.

LF is all income that people have chosen to save and lendout, rather than use for their own consumption.

The supply of LFcomes from people who have extra income they

want to save and lend out.

They buy stocks and bonds

The demand for LFcomes from households and firms that wish to

borrow to make investments.

Families borrow to invest in new homes while firms may borrow to purchase

new equipment or to build factories.


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Outside of the economics profession, most people use

the terms saving and investing interchangeably.

In macroeconomics, investment refers to the purchase of

new capital, such as equipment or buildings.

What is the meaning of the identity: S = I ? For the economy as a whole, saving must be equal to

investment.

The bond market, the stock market, banks, mutual funds, and

other financial markets and institutions stand between the two

sides of the S=Iequation.

These markets and institutions take in the nation's saving and

direct it to the nation's investment.


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Supply and Demand for Loanable Funds

Markets for loanable funds work much like other

markets in the economy.

The equilibrium of the supply and demand for loanable

funds determines the price of a loan

The real interest rate is the price of the loan.

It represents the amount that borrowers pay for loans and

the amount that lenders receive on their saving.

f


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Figure 1 The Market for Loanable Funds

Loanable Funds

(in billions of dollars)0

Interest

RateSupply/Saving

Demand/Investing

All else equal, as the interest rate rises, the quantity of loanable funds supplied will

increase.

All else equal, as the interest rate rises, the quantity of loanable funds demandedwill fall.

Fi 1 Th M k f L bl F d


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Figure 1 The Market for Loanable Funds

Loanable Funds

(in billions of dollars)0

Interest

Rate

Supply/Saving

Demand/Investing

5%

$1,200

If the quantity of funds demanded is smaller than the quantity

of funds supplied, lenders would compete for borrowers,

driving the interest rate down.

If the quantity of funds demanded is greater than the

quantity of funds supplied, the shortage of loanablefunds would encourage lenders to raise the interest rate.


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Supply and Demand for Loanable Funds

Government Policies That Affect Saving and

Investment Saving incentives

Investment Incentives

Government budget deficits


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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.

A tax reduction increases the incentive for

households to save at any given interest rate. The loanable funds supply curve shifts to the right.

The equilibrium interest rate decreases.

The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable


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Figure 2 An Increase in the Supply of LoanableFunds

Loanable Funds

(in billions of dollars)

0

Interest

Rate

Supply, S1 S2

2. . . . whichreduces theequilibrium

interest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

1. Tax incentives for

saving increase the

supply of loanablefunds . . .

5%

$1,200

4%

$1,600


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Policy 1: Saving Incentives

Conclusion?

If a change in tax law encourages greater saving,

the result will be lowerinterest rates andgreater

investment.


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Policy 2: Investment Incentives

An investment tax credit increases the incentive to

borrow.

Reduces taxes for any firm building a new factory or

buying a new piece of equipment

=>Increases the demand for loanable funds. =>Shifts the demand curve to the right.

=>Results in a higher interest rate and a greater quantity

saved. If a change in tax laws encourages greater

investment, the result will be higherinterest rates

andgreatersaving.

A I i th D d f L bl F d


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An Increase in the Demand for Loanable Funds

Loanable Funds


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, D1

D2

5%

$1,200

6%

$1,400

Policy 3: Government Budget Deficits and


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Policy 3: Government Budget Deficits andSurpluses

When the government spends more than it receives

in tax revenues, the shortfall is called the budgetdeficit.

The accumulation of past budget deficits is called

the government debt.

Government borrowing to finance its budget deficit

reduces the supply of loanable funds available to

finance investment by households and firms:SPublic=> S

Which curve does this affect?



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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.

Figure 4: The Effect of a Government Budget


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Figure 4: The Effect of a Government BudgetDeficit

Loanable Funds


0

Interest

Rate

3. . . . and reduces the equilibrium

quantity of loanable funds.

S2

2. . . . which

raises the

equilibrium

interest rate . . .

Supply, S1

Demand

$1,200

5%

$800

6%1. A budget deficit

decreases the

supply of loanable

funds . . .

Copyright2004 South-Western



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When government reduces national saving by

running a deficit, the interest rate risesandinvestmentfalls.

This fall in investment is referred to as crowding

out. The deficit borrowing crowds out private borrowers who

are trying to finance investments.

SPrivate+ SPublic= S= I. A budget surplus increasesthe supply of loanable

funds, reducesthe interest rate, andstimulates

investment.

The U S Government Debt


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The U.S. Government Debt

Percent

of GDP

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

RevolutionaryWar

2010

CivilWar World War I

World War II

0

20

40

60

80

100

120

Copyright2004 South-Western

Th U S G t D bt


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The U.S. Government Debt

In recent years, government debt has been about 50

percent of GDP. Throughout history, the primary cause of

fluctuations in government debt has been wars.

However, the U.S. debt also increased substantiallyduring the 1980s when taxes were cut butgovernment spending was not.

By the late 1990s, the debt to GDP ratio begandeclining due to budget surpluses.

As of 2002, the Congressional Budget Office wasprojecting that the debt-GDP ratio would decline

over the next decade to reach 15 percent in 2012.


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The Financial Crisis of 20082009

A financial crisis led to a deep recession in the U.S.

and around the world. A few unemployment rates:

3

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6

7

8

9

10

11

12

-2007

01

-2008

02

-2008

03

-2008

04

-2008

05

-2008

06

-2008

07

-2008

07

-2008

08

-2008

09

-2008

10

-2008

11

-2008

12

-2008

01

-2009

02

-2009

03

-2009

04

-2009

05

-2009

06

-2009

07

-2009

08

-2009

09

-2009

10

-2009

11

-2009

12

-2009

%

oflaborforce

USAFranceU.K.CanadaSweden

El t f Fi i l C i


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FYI: Elements of Financial Crises

Large decline in some asset prices 20082009: Housing prices fell 30%.

Insolvencies at financial institutions

2008

2009:Banks and other institutions failed when many

homeowners stopped paying their mortgages.

Decline in confidence in financialinstitutions

20082009:Customers with uninsured deposits began

pulling their funds out of financial institutions.

El t f Fi i l C i


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FYI: Elements of Financial Crises

Credit crunch 20082009: Borrowers unable to get loans

because troubled lenders not confident inborrowers credit-worthiness.

Economic downturn

20082009: Failing financial institutions anda fall in investment caused GDP to fall and

unemployment to rise.

Vicious circle

20082009: The downturn reduced profits

and asset values, which worsened the crisis.

CNN Vid A M tt f P i iti


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CNN Video: A Matter of Priorities

There are many, including President Bush, who

argue for a tax cut. What are their arguments?

The arguments for the tax cuts are twofold.

because of the economic slowdown, a tax cut is needed to

stimulate the economy. the surplus arises because taxpayers have overpaid, i.e.,

provided more money than was needed to finance the activities

of the government.

Do taxpayers benefit if the debt is repaid? Who decides how the surplus is going to be used?

S


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Summary

The U.S. financial system is made up of financial

institutions such as the bond market, the stockmarket, banks, and mutual funds.

All these institutions act to direct the resources of

households who want to save some of their incomeinto the hands of households and firms who want to

borrow.

S


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Summary

National income accounting identities reveal some

important relationships among macroeconomicvariables.

In particular, in a closed economy, national saving

must equal investment. Financial institutions attempt to match one persons

saving with another persons investment.

S


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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.

The demand for loanable funds comes fromhouseholds and firms who want to borrow for

investment.

S


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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.

Documents

Chap18 Investments Savings