Chapter 13

1. Chapter 13 Saving, Investment and the Financial System

2. Financial Markets. . . • . . . are the markets in the economy that help to match one person’s saving with another person’s investment. • . . . move the economy’s scarce resources from savers to borrowers. • . . . are opportunities for savers to channel unspent funds into the hands of borrowers.

3. Financial Institutions in the U.S. Economy • Institutions that allow savers and borrowers to interact are called financial intermediaries. • Types of Financial Intermediaries: • Banks - Bond Market • Stock Market - Mutual Funds • Other

4. Financial Intermediaries: Banks • Banks take in deposits from people who want to save and make loans to people who want to borrow. • Banks pay depositors interest and charge borrowers higher interest on their loans. • Banks help create a medium of exchange, by allowing people to write checks against their deposits.

5. Financial Intermediaries: The Bond Market • A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. • 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 principle. • Tax Treatment: municipal bonds on which taxes are deferred on the interest.

6. Understanding Bond Prices • Quoted as $100 bond • is an agreement to pay: • coupon rate each year until maturity • $100 at maturity

7. Example from Wall Street Journal • coupon rate=6% • Maturity=Oct. 1999 • Buyer of the bond gets: • 6%of $100=$6 coupon payment in Oct. 1999, would get it every year until maturity • $100 in Oct. 1999 • Price is 101:22 or 111 22/32

8. Price of a Bond • Price = present value of future income • For a $100 one year bond: • Price=coupon payment/(1+r) • +$100/(1+r)

9. Back to our example • Coupon rate and maturity are determined when the bond is issued • Price is determined in the market • Let’s find the yield, r

10. Use the formula • Price=coupon/(1+r)+$100/(1+r) • 101 22/32=$6/(1+r)+$100/(1+r) • Solving implies r=106/(101 22/32)-1 =.0424=4.24% • Differs from WSJ a bit because we assume exactly one year, but WSJ counts exact number of days

11. Financial Intermediaries: The Stock Market • Stock represents ownership in a firm, thus the owner has claim to the profits that the firm makes. • Sale of stock infers “equity finance” but offers both higher risk and potentially higher return. • Markets in which stock is traded: • New York Stock Exchange • American Stock Exchange • NASDAQ

12. Financial Intermediaries: Mutual Funds • Mutual Funds 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.

13. Financial Intermediaries: Other • Other financial intermediaries include: • Savings and Loans Associations • Credit Unions • Pension Funds • Insurance Companies • Loan Sharks

14. Quick Quiz! • What is stock? • What is a bond? • How are they different? • How are they similar?

15. 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: Y = C + I + G • National Saving or Saving is equal to: Y - C - G = I = S

16. 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)

17. 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.

18. Quick Quiz! • Define private saving, public saving, national saving, and investment. • How are they related?

19. The Market For Loanable Funds • Financial markets coordinate the economy’s saving and investment in The Loanable Funds Market • The Supply of Loanable Funds comes from people who have extra income that they want to loan out. • The Demand for Loanable Funds comes from those who wish to borrow to make investments.

20. The Market For Loanable Funds Interest Rate Loanable Funds

21. The Market For Loanable Funds Interest Rate Supply Loanable Funds

22. The Market For Loanable Funds Interest Rate Supply Demand Loanable Funds

23. The Market For Loanable Funds Interest Rate Supply 5% Demand Loanable Funds $1,200

24. The Market For Loanable Funds Interest Rate Supply Movement to equilibrium is consistent with principles of supply and demand. 5% Demand Loanable Funds $1,200

25. 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.

26. Government Policy That Affects The Economy’s Saving and Investment • Policies that influence the loanable funds market: • Taxes and Saving • Taxes and Investment • Government Budget Deficits • Observe how policy affects equilibrium, interest rates and funds.

27. Government Policy That Affects The Economy’s Saving and Investment • Taxes on savings reduce the incentive to save. A tax decrease would alter the incentive for households to save at any given interest rate and would affect the supply of loanable funds resulting in the: • Supply curve shifting to the right. • Equilibrium interest rate would drop. • Quantity demanded for funds would rise.

28. The Market For Loanable Funds Interest Rate Supply 5% Demand Loanable Funds $1,200

29. The Market For Loanable Funds Interest Rate Supply Taxes on savings reduce the incentive to save affecting the supply of loanable funds 5% Demand Loanable Funds $1,200

30. The Market For Loanable Funds Interest Rate Supply 5% 4% Demand Loanable Funds $1,300 $1,200

31. 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. • An investment tax credit would: • Alter the demand for loanable funds. • Cause the demand curve to shift to the right. • Result in higher interest rate and greater saving.

32. The Market For Loanable Funds Interest Rate Supply 5% Demand Loanable Funds $1,200

33. The Market For Loanable Funds Interest Rate Supply Tax Break on investment would increase the incentive to borrow altering the demand for loanable funds. 5% Demand Loanable Funds $1,200

34. The Market For Loanable Funds Interest Rate Supply 6% 5% Demand Loanable Funds $1,300 $1,200

35. 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. • The budget deficit: • Alters the supply curve, reducing supply. • Causes the supply to shift to the left. • Results in Crowding Out.

36. 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.

37. The Market For Loanable Funds Interest Rate Supply 5% Demand Loanable Funds $1,200

38. The Market For Loanable Funds Interest Rate Supply Government borrowing to finance its budget deficit, reduces the supply of loanable funds. 5% Demand Loanable Funds $1,200

39. The Market For Loanable Funds Interest Rate Supply 6% 5% Demand Loanable Funds $1,000 $1,200

40. 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.