What created the global financial crisis?

© 2013 Pearson

© 2013 Pearson

What created the global

financial crisis?

© 2013 Pearson

10When you have completed your study of this chapter, you will be able to

1 Describe the financial markets and the key financial institutions.

2 Explain how borrowing and lending decisions are made and how these decisions interact in the loanable funds market.

3 Explain how a government budget surplus or deficit influences the real interest rate, investment, and saving.

CHAPTER CHECKLIST

Finance, Saving, and Investment

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Some Financial Definitions

Physical capital is the tools, instruments, machines, buildings, and other constructions that have been produced in the past and that are used to produce goods and services.

Financial capital is the funds that firms use to buy and operate physical capital.

10.1 FINANCIAL INSTITUTIONS AND MARKETS

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Investment, Capital, Wealth, and Saving

Gross investment is the total amount spent on new capital goods.

Net investment is the change in the quantity of capital—equals gross investment minus depreciation.


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Figure 10.1 illustrates the relationship between capital and investment.

On January 1, 2012,Tom’s DVDBurning, Inc. had DVD recordingmachines valued at $30,000.


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During 2012, the value of Tom’s machines fell by $20,000, depreciation.

During 2012, Tom’s spent $30,000 on new machines—grossinvestment.

Tom’s net investment was $10,000, so at the end of 2012,Tom had capital valued at $40,000.


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Wealth is the value of all the things that a person owns.

Saving is the amount of income that is not paid in taxes or spent on consumption goods and services; saving adds to wealth.


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Markets for Financial Capital

Saving is the source of funds that are used to finance investment, and these funds are supplied and demanded by three types of markets:

• Loans markets• Bond markets• Stock markets


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Loan Markets

Businesses often want short-term loans to buy inventories or to extend credit to their customers.

Sometimes they get these funds in the form of a loan from a bank.

Households often want funds to purchase big-ticket items, such as automobiles or household furnishings and appliances.

They get these funds as bank loans, often in the form of outstanding credit card balances.


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Bond Markets

Bond is a promise to pay specified sums of money on specified dates; it is a debt for the issuer.

The bond market is a financial market in which bonds issued by firms and governments are traded.

The term of a bond might be long (decades) or short (just a month or two).

Firms often issue very short-term bonds as a way of getting paid for their sales before the buyer is able to pay.


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Another type of bond is a mortgage-backed security, which entitles the holder to the income from a package of mortgages.

Mortgage-backed securities were at the center of the storm in the financial markets of 2007–2008.

Stock Markets

Stock is a certificate of ownership and claim to the profits that a firm makes.

The stock market is a financial market in which shares of companies’ stocks are traded.


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Financial Institutions

A financial institution is a firm that operates on both sides of the markets for financial capital: It borrows in one market and lends in another.

The key financial institutions are :

• Investment banks• Commercial banks• Government-sponsored mortgage lenders• Pension funds• Insurance companies


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Insolvency and Illiquidity

Net worth is the total market value of what it has lent minus the market value of what it has borrowed.

If net worth is positive, the institution is solvent and can remain in business.

But if net worth is negative, the institution is insolvent and must stop trading.

The owners of an insolvent financial institution—usually its stockholders—bear the loss when the assets are sold and debts paid.


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A firm is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay more of what it has borrowed than its available cash.

In normal times, a financial institution that is illiquid can borrow from another institution.

But if all financial institutions are short of cash, the market for loans among financial institutions dries up.

Insolvency and illiquidity were at the core of the financial meltdown of 2007–2008.


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Interest Rates and Asset Prices

Stocks, bonds, and loans are collectively called financial assets.

The interest rate on a financial asset is a percentage of the price of the asset.

So if the asset price rises, other things remaining the same, the interest rate falls.

And conversely, if the asset price falls, other things remaining the same, the interest rate rises.


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The loanable funds market is the aggregate of the markets for loans, bonds, and stocks.

In the market for loanable funds there is just one average interest rate which we refer to as the interest rate.

10.2 THE LOANABLE FUNDS MARKET

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Flows in the Loanable Funds Market

Loanable funds are used for

1. Business investment2. Government budget deficit3. International investment or lending

Loanable funds come from

1. Private saving2. Government budget surplus3. International borrowing


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The Demand for Loanable Funds

The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period.

Investment is the major item that influences the demand side of the market for loanable funds.

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Investment depends on

1. The real interest rate

2. Expected profit

The real interest rate is the opportunity cost of the funds used to finance the purchase of capital.

So firms compare the real interest rate with the rate of profit that they expect to earn on their new capital.

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Firms invest only when they expect to earn a rate of profit that exceeds the real interest rate.

The higher the real interest rate, the fewer projects that are profitable, so the smaller is the quantity of loanable funds demanded.

The lower the real interest rate, the more projects that are profitable, so the larger is the quantity of loanable funds demanded.

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Demand for Loanable Funds Curve

The demand for loanable funds is the relationship between the quantity of investment demanded and the real interest rate, other things remaining the same.

The demand for loanable funds is shown by a demand for loanable funds schedule or curve.

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Figure 10.2 shows the demand for loanable funds.

Points A through E on the curve DLF correspond to the rows in the table.

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1. A rise in the real interest rate decreases the quantity of loanable funds demanded.

2. A fall in the real interest rate increases the quantity of loanable funds demanded.

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Changes in the Demand for Loanable Funds

When the expected profit changes, the demand for loanable funds changes.

Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment and the greater is the demand of loanable funds.

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The many influences on expected profit can be placed in three groups:

• Objective influences such as the phase of the business cycle, technological change, and population growth

• Subjective influences summarized in the phrase “animal spirits”

• Contagion effects summarized in the phrase “irrational exuberance”

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Figure 10.3 shows:

1. An increase in expected profit increases investment and shifts the demand for loanable funds curve rightward to DLF1.

2. A decrease in expected profit decreases investment and shifts the demand for loanable funds curve leftward to DLF2.

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The Supply of Loanable Funds

The quantity of loanable funds supplied is the total funds available from private saving, the government budget surplus, and international borrowing during a given period.

Saving is the main item and it depends on

1. The real interest rate2. Disposable income3. Wealth4. Expected future income5. Default risk

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Other things remaining the same,• The higher the real interest rate, the greater is the

quantity of saving and the greater is the quantity of loanable funds supplied.

• The lower the real interest rate, the smaller is the quantity of saving and the smaller is the quantity of loanable funds supplied.

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The Supply of Loanable Funds Curve

The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.

The real interest rate is the opportunity cost of consumption expenditure.

A dollar spent is a dollar not saved, so the interest that could have been earned on that saving is forgone.

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Points A through E on the curve correspond to the rows in the table.

Figure 10.4 shows supply of loanable funds.

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2. A fall in the real interest rate decreases the quantity of loanable funds supplied.

1. A rise in the real interest rate increases the quantity of loanable funds supplied.

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Changes in the Supply of Loanable Funds

The four main factors that influence saving and change the supply of loanable funds are

1. Disposable income

2. Wealth

3. Expected future income

4. Default risk

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Disposable income is the income earned minus net taxes.

Other things remaining the same,• The greater a household’s disposable income, the

greater is its saving.• The greater a household’s wealth (what it owns),

the less it will save. • The higher a household’s expected future income,

the smaller is its saving today.

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Shifts of the Supply of Loanable Funds Curve• Along the supply of loanable funds curve, all the

influences on saving other than the real interest rate remain the same.

• A change in any of these influences on saving changes saving and shifts the supply of loanable funds curve.

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Figure 10.5 shows a change in the supply of loanable funds.

1. The supply of loanable funds curve shifts rightward from SLF0 to SLF1 if

• Disposable income increases.

• Wealth, expected future income, or default risk decreases.

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2. The supply of loanable funds curve shifts leftward from SLF0 to SLF2 if

• Disposable income decreases.

• Wealth, expected future income, or default risk increases.

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Equilibrium in the Loanable Funds Market

Figure 10.6 shows how the real interest rate is determined.

• DLF is the demand for loanable funds curve

• SLF is the supply of loanable funds curve

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1. If the real interest rate is 8 percent a year, the quantity demanded is less than the quantity supplied. There is a surplus of funds. The real interest rate falls.

2. If the real interest rate is 4 percent a year, the quantity demanded exceeds the quantity supplied. There is a shortage of funds. The real interest rate rises.

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3. When the real interest rate is 6 percent a year, the quantity of loanable funds demanded equals the quantity supplied.

There is neither a shortage nor a surplus of funds, and the real interest rate is at its equilibrium level.

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Changes in Demand and Supply

1. If the demand for loanable funds increases, the real interest rate rises.

2. If the supply of loanable funds increases, the real interest rate falls.

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A Government Budget Surplus

A government budget surplus increases the supply of loanable funds.

To find the supply of loanable funds, we must add the government budget surplus to private saving supply.

An increase in the supply of loanable funds brings a lower real interest rate, which decreases the quantity of private funds supplied and increases the quantity of investment and the quantity of loanable funds demanded.

10.3 GOVERNMENT IN LOANABLE FUNDS MARKET

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Figure 10.8 shows the effects of government budget surplus.

With balanced government budgets, the real interest rate is 6 percent a year and the quantity of loanable funds is $2 trillion a year.

1. A government budget surplus of $1 trillion is added to private saving to determine the supply of loanable funds curve SLF.


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2. The real interest rate falls to 4 percent a year.

3. The private supply of funds decreases to $1.5 trillion.

4. The quantity of loanable funds demanded and investment increase to $2.5 trillion.


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A Government Budget Deficit

A government budget deficit increases the demand for loanable funds.

The increase in the demand of loanable funds raises the real interest rate, which increases the quantity of private funds supplied.

But the higher interest rate decreases investment and the quantity of loanable funds demanded by firms to finance investment.


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Figure 10.9 shows the effects of government budget surplus.

With balanced government budgets, the real interest rate is 6 percent a year and the quantity of loanable funds is $2 trillion a year.

1. A government budget deficit of $1 trillion is added to the private demand to determine the demand for loanable funds curve DLF.


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2. The real interest rate rises to 8 percent a year.

3. The supply of loanable funds increases to $2.5 trillion.

4. The quantity of loanable funds demanded and investment decrease to $1.5 trillion.

Investment is crowded out.


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The tendency for a government budget deficit to raise the real interest rate and decrease investment is called the crowding-out effect.


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The Ricardo-Barro Effect

The proposition that a government budget deficit has no effect on the real interest rate or investment.

The Ricardo-Barro effect operates if private saving and the private supply of loanable funds increase to offset any government budget deficit.

That is, the supply of loanable funds increases by an amount equal to the government budget deficit and the interest rate does not change.

Most economists regard this outcome unlikely.


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Events in the market for loanable funds, on both the supply side and demand side, created the global financial crisis.

An increase in default risk decreased the supply of loanable funds.

The disappearance of some major Wall Street institutions and lowered profit expectations decreased the demand for loanable funds.

These institutions include Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac, Merrill Lynch, and AIG.

What Created the Global Financial Crisis?

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But what caused the increase in default risk and the failure of so many financial institutions?

Between 2002 and 2005, interest rates were low. There were plenty of willing borrowers and plenty of willing lenders.

Fuelled by easy loans, home prices rose rapidly.

Lenders bundled their loans into mortgage-backed securities and sold them to eager buyers around the world.


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Then, in 2006, interest rates began to rise and home prices began to fall.

People defaulted on mortgages and banks took losses.

Some banks became insolvent.

A downward spiral of lending was under way.


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What created the global financial crisis?