Macro Chapter 13 Saving, Investment, and the Financial System PDF

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Notes for Macro with Rafia Zafar...

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Saving, Investment, and the Financial System The Financial System ● Financial system is the group of institutions in the economy that help match one person’s saving with another person’s investment. ● At any time some people want to save some of their income for the future and others want to borrow to finance current investment. ● The financial system moves the economy’s scarce resources from savers to borrowers. ● The financial system is made up of various financial institutions. Financial institutions can be grouped into two categories: Financial Markets and Financial Intermediaries.

Financial Markets ● Financial markets are the financial institutions where savers can directly provide funds to borrowers ● The two most important financial markets are Bonds and Stock markets.

The Bond Market ● Definition: A certificate of indebtedness. ● The sale of bond to raise money is called debt finance. ● A bond identifies the date the loan will be repaid (maturity date) and the rate of interest that will be paid every period until the loan matures. ○ Example of three most important things: ○ Face Value: $500 ○ Maturity Date: 5 years (term) ○ Interest Rate: 2% ● If intel and US Gov both issue a bond, the US Gov bond is less risky because a company can crash and you may not get payment. ● Bonds differ in value according to three characteristics: ○ Term- length of time until maturity. All else being equal, long-term bonds pay higher rates of interest than short-term bonds. ○ Credit risk- probability of default. All else being equal, the more risky a bond is, the higher its interest rate. ○ Tax treatment- For example, when state and local governments issue bonds (called municipal bonds), these bonds are not taxed. This makes the bonds more attractive, lowering the interest rate needed to entice people to buy them.

The Stock Market ● Definition: A claim to partial ownership in a firm. ● More risky because their value changes (can go down if company is doing poorly)

● The sale of stock to raise money is called equity finance. ● The price of a stock generally reflects the perception of a company’s future profitability. ● The prices at which shares trade on stock exchange are determined by the supply and demand for stock in theses companies. ● A stock index is computed as an average of a group of stock prices. ○ Dow Jones

Financial Intermediaries ● Definition: Financial institutions through which savers can indirectly provide funds to borrowers. Two of the most important financial intermediaries are banks and mutual funds. ● Store of value - something that can change value over time and that can buy you goods and services (money, assets, stocks, bonds) ● Medium of Exchange - provided by banks (credit cards, checks, money/cash)

Banks and Mutual Funds ● Banks: ○ A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. ○ Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. ○ Banks also facilitate purchases of goods and services by creating special assets that people can use as a medium of exchange like checks and debit cards. ● Mutual Funds: ○ An institution that sells shares to the public and uses the money to buy a portfolio of stocks and bonds. The primary advantage of a mutual fund is that it allows individuals with small amounts of money to diversify. ○ Minimizes risk

National Income Accounts ● Accounting Identities ○ Accounting refers to how various numbers are defined and add up. ○ An identity is an equation that must be true because of the way the variables in the equation are defined. ● Gross Domestic Product ○ Y = C + I + G + NX ○ Y- GDP, C- Consumption, I- Investment, G- Government spending NX- Net exports

Closed Economy

● A closed economy is an economy that does not engage in international trade or international borrowing and lending. NX = 0 !! ● GDP: Y=C+I+G ● No international investment, all domestic saving ● To isolate investment, we can subtract C and G from both sides: Y-C-G=I ● I=Savings if in a closed economy Y-C-G= National Saving (S) ○ Two Savings (Households (firms, banks, private) and Government (public) ○ HH+G=National Saving ● The left hand side of this equation in called National Saving. National Saving (S): The total income in the economy that remains after paying for consumption and government spending. S=I

Adding Taxes ● Let T denote the amount that the government collects from households in taxes, minus the amount it pays back in the form of transfer payment. ● We can rewrite the national saving equation as: ● S = (Y - T - C) + (T - G) ● The first part of this equation (Y-T-C ) is called private saving HH; the second part (T-G) is called public saving Gov. ● Private Saving- The income that households have left after paying for taxes and consumption. ● Public Saving- Tax revenue that the government has left after paying for its spending. ● Budget Surplus: If T - G > 0 Excess of tax revenue over government spending. ● Budget Deficit: If T - G < 0 Shortfall of tax revenue from government spending. * with a government budget deficit, public saving is negative and the public sector is thus dissaving. To make up for this shortfall, it must go to the loanable funds market and borrow the money. This will reduce the supply of loanable funds available for investment.

Saving and Investment ● S = I for the economy as a whole. ● The bond market, the stock market, banks, mutual funds, and other financial markets and institutions stand between the two sides of the S = I equation. ● These markets and institutions take in the nation’s saving and direct it to the nation’s investment. ● One person’s savings can finance another person’s investment.

The Market for Loanable Funds ● Definition: the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

● Assumptions: ○ The economy has only one financial market called the market of loanable funds. ○ All savers go to this market to deposit their saving and all borrowers go to this market to take our their loans. ○ One interest rate which is the cost of borrowing and the return on saving.

Supply and Demand of Loanable Funds ● ● ● ●

The source of the supply of loanable funds is saving. The source of the demand of loanable funds is investment. The interest rate is the price of the loan. As interest rates rise borrowing is more expansive and the quantity demanded for funds decline. ● Higher interest rate makes saving more attractive and the quantity of loanable funds supplies rises.

Equilibrium ● At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied. ● If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded would be smaller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down. ● If the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded would be greater than the quantity of funds supplied. The shortage of loanable funds would encourage lenders to raise the interest rate they charge

Government Policies

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● Government policies can affect the economy’s saving and investment: ○ Saving incentive. ○ Investment incentive. ○ Government budget deficit and surplus.

Policy 1: Saving Incentives ● A change in the tax laws to encourage people to save more.

● The supply shifts to the right from S1 to S2. Which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds.

Policy 2: Investment Incentives ● A tax reform aimed to making investment more attractive.

● An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds.

Policy 3: Government Budget Deficit and Surplus ● A budget deficit occurs if the government spends more than it receives in tax revenue. This implies that public saving (T-G) falls, which will lower national saving.

○ T-G...