ct6e_lectureslides_ch09_macro_ch29_econ

Modern Principles of Economics: Chapter 9 - Saving, Investment, and the Financial System

Outline

• The Supply of Savings

• The Demand to Borrow

• Equilibrium in the Market for Loanable Funds

• The Role of Intermediaries: Banks, Bonds, and Stock Markets

• What Happens When Intermediation Fails?

• The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking

• Takeaway

Introduction

• Savings are essential for capital accumulation.

• More capital invested leads to greater GDP per capita.

• Connecting savers and borrowers enhances trade gains and promotes economic growth.

Key Definitions

• Saving: Income not spent on consumption goods.

• Investment: The purchase of new capital goods.

Supply of Savings

• Determined by four major factors:

  • Smoothing Consumption: Consumers save during working years to maintain consumption levels during retirement or in emergencies.

  • Impatience: People tend to prefer immediate consumption, affecting their savings rates. This impatience can be more pronounced in certain groups (e.g., criminals, addicts).

  • Marketing and Psychological Factors: Defaults in savings plans can increase participation rates, with automatic enrollment leading to higher saving rates.

  • Interest Rates: Higher interest rates incentivize increased savings.

Smoothing Consumption

• Individuals often have higher consumption during their working years and lower consumption in retirement.

• Saving allows individuals to maintain consumption levels across different life stages and provide a buffer against unexpected financial difficulties.

Impatience

• Impatience affects individuals' willingness to save and can result in lower savings rates.

• Economic situations that require time-cost comparison can further illustrate this tendency among various demographics.

Time Preference

• Time preference: The inclination to prefer consumption sooner rather than later, impacting savings decisions.

Marketing Psychology in Savings

• Savings behavior can be influenced by how saving options are presented to individuals, such as making saving the default option, which can lead to increased participation and savings rates.

Interest Rate Influences

• Higher interest rates encourage a larger quantity of savings as they yield greater returns.

Demand to Borrow

• Borrowing helps to smooth consumption over time. It is notable among young adults who borrow to invest in their education.

• The lifecycle theory of savings connects the demand to borrow with savings behavior across an individual's life.

• Often, individuals with the most promising business ideas lack sufficient personal savings, and the ability to obtain loans amplifies investment capabilities and economic growth.

• Conversely, lower interest rates lead to increased borrowing demand.

Market for Loanable Funds

• Comprises interactions between savers and borrowers that dictates the equilibrium interest rate.

Equilibrium in the Market for Loanable Funds

• At equilibrium, the quantity of loanable funds supplied equals the quantity demanded.

• Adjustments in interest rates help reach equilibrium.

• A surplus occurs if the interest rate exceeds the equilibrium, causing lenders to lower rates.

Shifts in Supply and Demand

• Changes in economic conditions can shift supply or demand in the loanable funds market, affecting equilibrium interest rates and savings quantities.

Role of Financial Intermediaries

• Include banks, bond markets, and stock markets that facilitate the movement of savings from savers to borrowers more efficiently.

• Financial intermediaries reduce transaction costs and help allocate resources effectively.

Banks and Their Functions

• Banks accumulate deposits, provide loans, and evaluate investment risks, thus playing a vital role in the economy’s financial system.

• Specializing in loan evaluation mitigates risks and maximizes efficiency for both savers and borrowers.

Bond Market

• Corporations issue bonds to raise capital, introducing both repayment obligations and risks associated with default.

• Bonds can increase or decrease based on credit risk and market conditions.

• Collateral: Asset pledged to secure a loan, becoming the lender's property if the borrower defaults.

Financial Crisis of 2007–2008

• High levels of borrowing, especially within the mortgage sector, and risky lending practices led to widespread defaults.

• The securitization of mortgage loans allowed poor-quality loans to be sold as investments, thereby spreading financial risk globally.

• Shadow banking emerged as a less regulated system that significantly contributed to financial instability during the crisis.

Government Response to the Financial Crisis

• After significant market disruptions, regulatory measures were implemented to reinforce the banking system and protect consumers.

Takeaway

• Saving and borrowing provide mechanisms for individuals, firms, and governments to achieve financial stability over time.

• Financial intermediaries bridge gaps in finance, ensuring efficient allocation of resources.

• The health of financial systems can be severely impacted by insecure property rights, inflation, politicized lending, and other factors that inhibit intermediation.

Modern Principles of Economics: Chapter 9 - Saving, Investment, and the Financial System

Outline

• The Supply of Savings

• The Demand to Borrow

• Equilibrium in the Market for Loanable Funds

• The Role of Intermediaries: Banks, Bonds, and Stock Markets

• What Happens When Intermediation Fails?

• The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking

Takeaway

• Saving is essential for capital accumulation, leading to economic development, higher productivity, and increased GDP per capita.

• Effective connection between savers and borrowers can enhance trade gains and promote substantial economic growth.

Introduction

Savings are critical for funding future investments. Increased capital stock, nurtured through savings, contributes to increased productivity, job creation, and higher standards of living. By facilitating the effective allocation of resources through financial markets, savings and investments become fundamental to economic well-being on both individual and societal levels.

Key Definitions

• Saving: Income not spent on consumption goods, which serves as an essential buffer against economic uncertainties.

• Investment: The purchase of new capital goods, which are necessary for businesses to expand their operations and meet consumer demand.

Supply of Savings

Determinants of Savings

The supply of savings is influenced by several factors:

• Smoothing Consumption: Individuals typically experience higher income during working years, so they save to ensure stable consumption during retirement or periods of unemployment, providing financial stability in times of need.

• Impatience: Psychological factors come into play as individuals often favor immediate gratification over future rewards, leading to a lower rate of savings especially among certain demographics, including those in high-stress situations such as low-income earners or marginalized groups.

• Marketing and Psychological Factors: Innovative marketing strategies, such as automatic enrollment in savings plans and defaults set to saving options, can significantly improve savings rates by simplifying the decision-making process.

• Interest Rates: The relationship between savings and interest rates is crucial; higher interest rates not only reward savers with better returns but can also signal increased economic confidence, thereby stimulating more saving behaviors.

Smoothing Consumption

Maintaining a consistent consumption pattern is a central motivation for saving. During retirement, individuals face declining income, making previous savings critical for sustaining living standards. Additionally, unexpected costs such as medical expenses can threaten financial security, emphasizing the need for adequate savings.

Impatience

Time preference varies; some individuals have a strong inclination towards immediate consumption versus long-term savings. Economic behavior is affected by these preferences and can notably differ based on personal circumstances and immediate incentives.

Time Preference

The concept of time preference reflects the degree to which an individual values present consumption over future consumption. This impacts overall savings rates, with higher time preference leading to reduced savings.

Marketing Psychology in Savings

The manner in which savings options are presented can influence consumer behavior. Defaults that favor saving (automatic enrollment in savings plans) can lead to substantial increases in participation and savings, exemplifying the role of behavioral economics in financial decision-making.

Interest Rate Influences

When interest rates are elevated, they not only provide better returns on savings but also motivate individuals to save a greater share of their income, as the opportunity cost of using funds for consumption increases.

Demand to Borrow

The Lifecycle Theory of Savings

Borrowing plays a critical role in smoothing consumption over time. It is particularly prevalent among young adults who often take loans for education, thereby enhancing their future earning potential. The lifecycle theory of savings connects borrowing to different stages in life, acknowledging that individuals often save to invest in human capital or significant life events such as home purchases.

Investment Capability

Access to borrowing allows innovators and entrepreneurs with promising business ideas but limited initial capital to secure funding, further driving economic expansion and job creation.

Market for Loanable Funds

This market represents the dynamics between savers providing funds and borrowers seeking funds, setting the stage for determining equilibrium interest rates based on supply and demand interactions.

Equilibrium in the Market for Loanable Funds

At equilibrium, the quantity of loanable funds supplied matches the quantity demanded. When the interest rate deviates from this equilibrium, market forces adjust rates to bring supply and demand into balance. This dynamic process reflects the innate responsiveness of financial markets to economic conditions.

Shifts in Supply and Demand

Economic fluctuations can lead to shifts in the supply or demand within the loanable funds market. For example, increased business confidence might boost borrowing demand, hence adjusting equilibrium interest rates and potentially influencing overall savings behaviors.

Role of Financial Intermediaries

Financial intermediaries - banks, bond markets, and stock markets - play a pivotal role in the economy by efficiently channeling savings from individuals to borrowers. They reduce the transaction costs associated with lending and borrowing and help allocate resources to their most productive uses.

Banks and Their Functions

Banks act as financial intermediaries by accumulating savings deposits, providing loans, and assessing the risk of potential investments. Their specialized processes in evaluating creditworthiness help mitigate loan defaults, fostering trust in the financial system and promoting stability.

Bond Market

Corporations issue bonds to gather capital while promising returns to bondholders. This creates a variety of investment options but also introduces risks related to default and market volatility. The bond market serves as a significant indicator of financial health and investor confidence within the economy.

Financial Crisis of 2007–2008

The crisis was characterized by unprecedented levels of mortgage borrowing paired with lax lending standards, leading to widespread defaults. Securitization facilitated the distribution of high-risk mortgage loans as investment products, diffusing financial risk across the global market.

Emergence of Shadow Banking

Lack of regulation in shadow banking allowed high-risk financial practices to flourish, creating systemic vulnerabilities that exacerbated the crisis.

Government Response to the Financial Crisis

In the aftermath of the crisis, governments worldwide implemented regulatory reforms aimed at reinforcing the banking system. These measures sought to enhance consumer protections and restore confidence within financial markets.

Takeaway

The intricate interplay of saving and borrowing mechanisms supports individual financial stability as well as broader economic growth. Financial intermediaries are crucial for optimizing resource allocation in economies, and the resilience of financial systems hinges on secure property rights, stable inflation, and sustainable lending practices.