Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

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Mankiw Brief Principles of Macroeconomics,
Second Edition (Harcourt, 2001)

• Ch. 8 Saving and Investment, and the Financial
  System

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Financial Markets

• Entrepreneurs are people with ideas.
• They need funds to put their ideas into fruition.
• People who have funds would like to get a high
  return for them.
• Financial markets bring the savers with funds
  (lenders) together with borrowers.
• Savers supply loanable funds and borrowers demand
  loanable funds.

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Financial Markets

• Bond Market
• Stock Market
• Foreign Exchange Market

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Bonds

• A bond is an IOU.
• Lender gives a sum of money to borrower.
• Borrower gives a piece of paper that indicates
• The amount of interest payment per year to be
  paid to the bondholder.
• The amount of principal (face value) to be paid
  to the bondholder at the maturity date.
• The date the principal will be paid.

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Primary and Secondary Markets

• When the bond is first issued it goes to the
  primary market.
• The borrower (the issuing firm) gets the funds
  and the lender gets the bond.
• The bonds can be resold in the secondary market.
• The ownership of the bond changes.
• The issuer gets nothing.
• The price of the bond depends on the supply and
  demand for similar bonds.

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Bond Prices and Interest Rates

• A bond that pays 100 per year for 30 years and
  sold for 1000 yields an interest return of how
  much?
• Roughly 10.
• The same bond is sold for 1250. What is the
  interest return?
• Roughly 8.
• The same bond is sold for 500. What is the
  interest rate?
• Roughly 20.

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Bond Prices and Interest Rates

• Bond prices and interest rates are always
  inversely related.
• The higher the interest rate, the lower is the
  bond price.
• The higher the bond price, the lower is the
  interest rate.

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Different Bonds

• Would you be willing to pay the same price for
  the following bonds?
• US Federal Government bond.
• ATT bond.
• Cleveland City bond.
• LTV Steel bond.

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Why Do Bonds Have Different Prices?

• Risk
• The higher the risk of default (inability of the
  issuer to pay interest or principal), the lower
  is the price (the higher is the interest rate).
• Liquidity
• The easier it is to convert the bond into cash in
  the future, the higher is the price (the lower is
  the interest rate).
• Tax considerations
• If the interest payments are tax-free, there will
  be more demand for it. Higher price and lower
  interest rate.
• Maturity
• The farther the maturity date, the lower will be
  the price (the higher the interest rate).

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Stocks

• A firm may choose to raise funds by issuing
  stock.
• The stock holder becomes part owner, sharing the
  future profits and losses.
• The firm gets the funds from the primary market.
• The stock exchanges hands in the secondary
  market, transferring ownership.

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Financial Intermediaries

• Financial intermediaries are institutions that
  channel the savers funds to the borrowers.
• Banks
• Take deposits from savers.
• Lend funds to borrowers.
• Mutual Funds
• Take deposits from savers.
• Buy stock.

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National Investments Match Savings

• Y C I G NX
• Y C S T
• C S T C I G NX
• S (T G) NX I
• Investments will have to be matched by private
  savings (S), government savings (T-G), and
  foreign savings (-NX).
• NX Exports Imports
• -NX Imports - Exports

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Financing US Investments

• In the eighties and well into the nineties the
  budget of the government was in deficit.
• How did US keep its investments high?
• Foreign indebtedness.
• The twin deficits were, therefore, related.

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Loanable Funds
Real Interest rate
The supply of loanable funds are provided by
savers, i.e., lenders. The demand for loanable
funds comes from borrowers. The
market equilibrium is reached at a specific real
interest rate.
S
D
Loanable Funds
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What Happens When

• Tax laws are changed to eliminate taxes from
  savings.
• Tax laws are changed to give tax breaks for
  investments.
• Government budget deficit increases.
• Government budget surplus increases.

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Repealing Taxes on Savings
Suppose taxes on interest earnings were
eliminated. Or income taxes were replaced by
sales taxes. Or savings to be used for
retirement purposes were tax free. What would
happen To the real interest rate and amount of
savings available?
S
S
i1
i2
D
1200
1000
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Why Dont We Do It?

• Who benefits from the tax cut?
• How do sales taxes affect the poor and the rich?
• Who puts more value to present consumption over
  future consumption?

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Investment Tax Credit
When government allows investment expenditures to
be deducted from earnings (instead of just
depreciation), firms will have more incentive to
expand. Demand to borrow funds will increase,
raising the real interest rate and the amount
borrowed.
S
6
5
D
D
Loanable Funds
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Government Budget Surplus
Interest rate
When the government budget shows a surplus, the
amount of savings in the economy rises public
saving is positive. The additional funds
available will shift the supply curve to
the right, reducing the interest rate and
increasing the funds used for investment
purposes.
S
S
D
Loanable funds
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Crowding Out

• When government runs a deficit, national savings
  drop because public saving becomes negative.
• The supply curve in the loanable funds market
  shifts left.
• Interest rates rise.
• Private entities find it more expensive to
  borrow, so they borrow less and undertake lower
  levels of investments.
• Private investment is crowded out by the
  governments borrowing.

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