Saving, Investment and the

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Chapter 13

• Saving, Investment and the
• Financial System

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Financial Markets. . .

• . . . are the markets in the economy that help to
  match one persons saving with another persons
  investment.
• . . . move the economys scarce resources from
  savers to borrowers.
• . . . are opportunities for savers to channel
  unspent funds into the hands of borrowers.

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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

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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.

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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.

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Understanding Bond Prices

• Quoted as 100 bond
• is an agreement to pay
• coupon rate each year until maturity
• 100 at maturity

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Example from Wall Street Journal

• coupon rate6
• MaturityOct. 1999
• Buyer of the bond gets
• 6of 1006 coupon payment in Oct. 1999, would
  get it every year until maturity
• 100 in Oct. 1999
• Price is 10122 or 111 22/32

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Price of a Bond

• Price present value of future income
• For a 100 one year bond
• Pricecoupon payment/(1r)
• 100/(1r)

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Back to our example

• Coupon rate and maturity are determined when the
  bond is issued
• Price is determined in the market
• Lets find the yield, r

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Use the formula

• Pricecoupon/(1r)100/(1r)
• 101 22/326/(1r)100/(1r)
• Solving implies
• r106/(101 22/32)-1
• .04244.24
• Differs from WSJ a bit because we assume exactly
  one year, but WSJ counts exact number of days

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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

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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.

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Financial Intermediaries Other

• Other financial intermediaries include
• Savings and Loans Associations
• Credit Unions
• Pension Funds
• Insurance Companies
• Loan Sharks

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Quick Quiz!

• What is stock?
• What is a bond?
• How are they different?
• How are they similar?

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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 economys 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

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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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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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Quick Quiz!

• Define private saving, public saving, national
  saving, and investment.
• How are they related?

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The Market For Loanable Funds

• Financial markets coordinate the economys 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.

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

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Government Policy That Affects The Economys
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.

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The Market For Loanable Funds
Interest Rate
Supply
5
Demand
Loanable Funds
1,200
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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
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Government Policy That Affects The Economys
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.

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The Market For Loanable Funds
Interest Rate
Supply
5
Demand
Loanable Funds
1,200
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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
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Government Policy That Affects The Economys
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.

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Government Policy That Affects The Economys
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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The Market For Loanable Funds
Interest Rate
Supply
5
Demand
Loanable Funds
1,200
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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
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The Market For Loanable Funds
Interest Rate
Supply
6
5
Demand
Loanable Funds
1,000
1,200
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Conclusion

• Financial markets coordinate borrowing and
  lending and thereby help allocate the economys
  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.