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

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

Introduction

  • Savings: Necessary for capital accumulation.

  • Relationship between capital and GDP per capita: The more capital an economy can invest, the greater the GDP per capita.

  • Importance of connecting savers and borrowers: Increases gains from trade and smooths economic growth.

Definitions

  • Saving: Income that is not spent on consumption goods.

  • Investment: The purchase of new capital goods.

Supply of Savings

  • Four major factors determine the supply of savings:

    • Smoothing consumption

    • Impatience

    • Marketing and psychological factors

    • Interest rates

Smoothing Consumption

  • Consumption patterns:

    • If one consumes what they earn every year, consumption is high during working years.

    • After retirement, consumption may drop precipitously.

  • Smoothing consumption idea:

    • Save during working years and dissaving during retirement years to maintain a steady consumption level.

  • Savings provide a cushion for unemployment or unexpected health problems.

Individuals Are Impatient

  • Impatience in economic behavior:

    • Most individuals prefer to consume now rather than later.

    • Greater impatience correlates with a lower savings rate.

    • Impatience reflects in economic situations requiring costs and benefits comparisons over time.

  • Time preference: The varying desire to consume now versus later.

Marketing and Psychological Factors

  • Impact of presentation on saving behavior:

    • People tend to save more if saving is perceived as the default option.

    • Retirement savings plan participation increases by 25% with automatic enrollment versus opt-in.

    • Both the rate of saving and the amount saved can be influenced by simple psychological shifts combined with effective marketing.

The Interest Rate

  • Relationship between interest rates and savings:

    • The higher the interest rate, the greater the quantity saved.

The Demand to Borrow

  • Reasons for borrowing:

    • Smoothing consumption is a primary reason.

    • Young individuals often borrow to invest in education, allowing sacrifices to be moved to the future when financial stability is gained.

    • Borrowing, saving, and dissaving can help individuals manage consumption over their lifetime.

Lifecycle Theory of Savings

  • Connects the demand to borrow and savings together, explaining consumption patterns over different life stages.

Characteristics of Borrowing

  • Individuals with the best business ideas may not have significant savings.

  • Businesses borrow to finance substantial projects, which can lead to higher investment, increasing the standard of living and economic growth.

  • Relationship between interest rates and quantity of funds demanded:

    • The lower the interest rate, the greater the quantity of funds demanded.

Definition of Market for Loanable Funds

  • Market for loanable funds: Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers).

  • Trading determines the equilibrium interest rate.

Equilibrium in the Market for Loanable Funds

  • Conditions for equilibrium:

    • Quantity of funds supplied equals quantity of funds demanded.

    • Interest rates adjust to equalize savings and borrowing.

  • Surplus and interest rate adjustments:

    • If the interest rate exceeds equilibrium, the quantity of savings supplied surpasses quantity demanded, creating a surplus.

    • Surplus leads suppliers to lower interest rates.

Shifts in Supply and Demand

  • Changes in economic conditions can shift the supply or demand curve, impacting the equilibrium interest rate and savings quantity.

Financial Intermediaries

  • Financial intermediaries: Entities like banks, bond markets, and stock markets that reduce the costs of transferring savings from savers to borrowers.

Role of Financial Intermediaries

  • Ensure equilibrium in the market for loanable funds doesn't come about automatically.

  • Savers seek the highest returns for their capital.

  • Entrepreneurs find suitable investments and loans.

  • Mobilize savings toward productive uses.

The Business of Banking

  • Example of Banking Operations:

    • A customer deposits $1000 at 1% interest, while taking a $1000 loan at a 5% interest rate.

    • The bank receives $1050 back while the customer's savings grow to $1010. The bank retains $40 from the transaction.

Benefits of Banking Institutions

  • Specialized labor in loan evaluations (e.g., loan underwriters).

  • Coordination of savings and borrowing dynamics (supply and demand of loanable funds).

  • Risk spreading of loan defaults across various lenders.

  • Facilitation of payment processes.

The Bond Market

  • Bonds as a financing method for large corporations, representing an acknowledgment of debt.

  • Bond Contract: Details debt amount, interest rate, and payment schedule.

  • Advantages of bonds:

    • Raise substantial funds for long-term assets.

    • Repaid over an extended period, exposing the borrower to default risk.

Types of Bonds

  • Various types include:

    • T-bonds: 30-year bonds with semiannual interest.

    • T-notes: 2 to 10 years with semiannual interest.

    • T-bills: Short-term bonds maturing from days to 26 weeks, paying only at maturity.

    • Zero-coupon bonds: Bonds sold at a discount, paying only at maturity.

Crowding Out Definition

  • Crowding out: The decrease in private consumption and investment resulting from increased government borrowing.

Bond Prices and Interest Rates

  • Bond valuation at maturity referred to as face value (FV).

  • Rate of return or implied interest rate:

    • Example calculation: Purchasing a 1-year bond for $909 with a face value of $1000.

  • Concept of arbitrage in bond markets, ensuring equally risky assets have equal returns:

    • If unequal, prices will adjust until equilibrium is reached.

  • Arbitrage Definition: Buying and selling equally risky assets to ensure equal returns.

  • Interest rate and bond price relationship:

    • Interest rates and bond prices move inversely; increases in rates lead to decreases in bond prices and vice versa.

    • This introduces default risk and interest rate risk to bondholders.

The Stock Market

  • Functionality of stock markets for funding business activities through issuing shares.

  • Stocks traded on stock exchanges; buying/selling existing shares does not contribute to net investment.

  • Initial public offering (IPO): First time a corporation sells stock to raise capital.

When Intermediation Fails

  • Possible breakdowns in the savers-borrowers bridge.

Insecure Property Rights

  • Lack of secure property rights negatively affecting savings and investments:

    • Examples include Argentina's bank account freezes (2001) and Russia's shareholder value confiscation.

Controls on Interest Rates

  • Price controls and their impact:

    • Usury laws: Imposing ceilings can hamper the loanable funds market functionality.

    • Examples of loopholes in U.S. states leading to few impacts on loan markets.

  • Graphical representation of the effects of controlled interest rates, leading to slower economic growth due to shortages.

Politicized Lending

  • Government ownership in large banks may direct capital to political allies, often resulting in detrimental growth effects:

    • Historical correlation of government-owned banks with reduced GDP and productivity growth rates.

Bank Failures and Panics

  • Historical examples of bank failures resulting from the Great Depression and their impacts:

    • Significant loss of life savings and subsequent spending decreases impacting businesses.

The Financial Crisis of 2007–2008: Prologue

  • Borrowing trends leading up to the financial crisis:

    • High mortgage borrowing centered around a belief that housing prices were unlikely to fall.

    • In 2006, significant percentages of mortgages made with 0% down payments.

Key Definitions in Financial Crisis

  • Owner equity (E): Value of asset minus debt, formulated as $E = V - D$.

  • Leverage ratio (D/E): Indicates ratio of debt to equity.

Financial Crisis Mechanics

  • Securitization: Mortgage loans bundled and sold as financial assets, creating cash flow for sellers and future payment streams for buyers.

Consequences of the Financial Crisis

  • Housing market effects, delinquency, and foreclosures leading to banks holding valueless loans and assets.

Shadow Banking System

  • Distinction between commercial banks (FDIC insured) and investment banks (non-insured).

  • The notable growth of shadow banking, leading to regulatory oversight challenges and eventual market instability.

Crisis Dynamics

  • Events such as defaults leading banks toward insolvency, unclear ownership structures, and unprecedented reluctance for short-term funding extending to shadow banks.

Fire Sale Acceleration

  • Concept of a fire sale wherein forced asset sales exacerbate price declines, generating further instability.

Government Response Post-Crisis

  • Government interventions to prevent similar crises:

    • Federal Reserve's actions post-Lehman Brothers collapse.

    • Enhanced financial regulations aimed at shadow banking oversight and leveraging reductions.

Key Takeaways

  • Role of Savings and Borrowing: Allows individuals, firms, and governments to manage consumption over time, facilitated by financial intermediaries.

  • Challenges to Intermediation: Factors such as insecure property rights, inflation, politicized lending, and bank failures pose risks to savings and investments.