Saving, Investment, and the Financial System

Financial Institutions and Markets

Financial System

• Group of institutions that match savers with borrowers.

Institutions

1. Financial Markets: Savers directly provide funds to borrowers.

2. Financial Intermediaries: Savers indirectly provide funds to borrowers.

Financial Markets

• Savers can directly provide funds to borrowers.

Bond Market

• Bond: Certificate of indebtedness (IOU).

Stock Market

• Stock: Claim to partial ownership in a firm.

Bond Market Details

• Bond: An IOU specifying:

  • Principal: Amount borrowed.

  • Date of Maturity: When the loan will be repaid.

  • Interest Rate: Periodic payment until maturity.

  • Debt finance: Sale of bonds to raise money.

  • Bond buyer can hold the bond until maturity or sell it earlier.

Four Characteristics of Bonds

1. Term: Length of time until maturity.

   • Short-term or long-term.

   • Long-term bonds are riskier and have higher interest rates.

   • Perpetuity: Bond that never matures.

2. Credit Risk: Probability of borrower default.

   • High probability of default leads to higher interest rates.

   • Junk bonds (issued by shaky corporations) pay very high interest rates.

   • Issuers: Governments and Corporations

3. Tax Treatment: How tax laws treat interest earned.

   • Most bonds have taxable interest income.

   • Municipal bonds (state and local governments) are tax-free, with lower interest rates.

4. Inflation Protection: Whether the bond offers protection against inflation.

   • Nominal terms: Specific number of dollars.

   • Indexed to inflation: Payments rise proportionately with prices, resulting in lower interest rates.

Stock Market Details

Stock

• A share of stock represents ownership in a firm.

• It is a claim to some of the firm's profits.

• Carries greater risk but offers potentially higher returns.

• Equity finance: Sale of stock to raise money.

Stock Exchange

• Trading of stock shares among stockholders (shareholders).

• The company that issued the stock receives no money in these transactions.

Stock Prices

• Determined by supply and demand for the stock.

Demand for Stock

• Reflects people’s perception of the corporation’s future profitability.

Stock Index

• An average of a group of stock prices.

  • Examples:

    • Dow Jones Industrial Average

    • Standard & Poor’s 500 Index

Financial Intermediaries

• Institutions through which savers can indirectly provide funds to borrowers.

  • Examples:

    • Banks

    • Mutual Funds

Banks

Primary Role

• Take deposits from savers (at a small interest rate).

• Use deposits to make loans to borrowers (charge a higher interest rate).

Secondary Role

• Facilitate purchases of goods and services.

  • Checks and debit cards to access deposits.

  • Serve as a medium of exchange and store of value.

Mutual Funds

Mutual Funds

• Sell shares to the public and use the proceeds to buy portfolios of stocks and bonds.

Advantages

• Allow people with small amounts of money to diversify their holdings (reducing risk).

• Give ordinary people access to professional money managers' skills.

Financial Economists' View

• Skeptical about consistently “beating the market.”

National Income Accounting: Important Identities

GDP (Gross Domestic Product, $Y$)

• Total income = Total expenditure

• $Y = C + I + G + NX$

  • $Y$ = gross domestic product, GDP

  • $C$ = consumption

  • $I$ = investment

  • $G$ = government purchases

  • $NX$ = net exports

Closed Economy Assumption

• Assume closed economy: $NX = 0$

• $Y = C + I + G$, so $I = Y – C - G$

National Saving (Saving), $S$

• $S = Y – C - G$

• Total income in the economy that remains after paying for consumption and government purchases.

• By definition: $S = Y – C – G$

• It follows: Saving ($S$) = Investment ($I$) for a closed economy.

Saving Types

• Define $T$ = taxes minus transfer payments

• $S = Y – C – G$ can be rewritten as:

  • $S = (Y – T – C) + (T – G)$

Private Saving

• Private saving = $Y – T – C$

  • Income that households have left after paying for taxes and consumption.

Public Saving

• Public saving = $T – G$

  • Tax revenue that the government has left after paying for its spending.

National Saving

• National saving ($S$) = Private saving + Public saving

Budget Status

Budget Surplus

• Budget surplus: T – G > 0

  • Excess of tax revenue over government spending = public saving ($T-G$)

Budget Deficit

• Budget deficit: T – G < 0

  • Shortfall of tax revenue from government spending = – (public saving) = $G – T$

Active Learning Example

• Given: GDP = $19 trillion, C = $13 trillion, G = $2.5 trillion, and Budget deficit = $1.2 trillion.

Find:

• Public saving, net taxes, private saving, national saving, and investment.

Solution:

• GDP $Y$ = $19 tn., $C$ = $13 tn. $G$ = $2.5 tn., and Budget deficit = $G – T$ = $1.2 tn.

• Net taxes $T$ = $G$ - 1.2 = 2.5 - 1.2 = $1.3 tn.

• Public saving = $T – G$ = – $1.2 tn.

• Private saving = $4.7 tn. = $Y – T – C$ = 19 – 1.3 – 13 = 4.7

• National saving = investment, $S = I$ = $3.5 tn.

  • $S = Y – C – G$ = 19 – 13 – 2.5 = 3.5

  • $S$ = private + public saving = 4.7 – 1.2 = 3.5

Tax Cut Scenario

• Government cuts taxes by $300 billion (0.3 tn).

Scenarios

Consumers Save Entire Tax Cut

• Increase in $C$: 0

• Net taxes, $T$: 1.3 - 0.3 = $1.0 tn.

• Budget deficit: 1.2 + 0.3 = $1.5 tn.

• Public saving: $T-G$ = 1.0 – 2.5 = - $1.5 tn.

• Private saving: $Y – T – C$ = (19-1-13) = $5 tn.

• National saving, $S$ = Investment, $I$ = $Y – C – G$ = (19 -13 - 2.5) = $3.5 tn.

Consumers Save 1/3 and Spend 2/3 of Tax Cut

• Increase in $C$: 2/3 of 0.3 tn. = $0.2 tn.

• Net taxes, $T$: 1.3 - 0.3 = $1.0 tn.

• Budget deficit = $G – T$: 2.5 – 1.0 = $1.5 tn.

• Public saving = $T – G$ = 1.0 – 2.5 = - $1.5 tn.

• Private saving = $Y – T – C$ = (19-1-13.2) = $4.8 tn.

• National saving, $S$ = Investment, $I$ = $Y – C – G$ = (19 -13.2 -2.5) = $3.3 tn.

Saving and Investment

Private saving

• Income remaining after households pay their taxes and pay for consumption.

  • Examples include buying corporate bonds or equities, purchasing a certificate of deposit at the bank, buying shares of a mutual fund, and letting funds accumulate in saving or checking accounts.

Investment

• Is the purchase of new capital.

  • Examples include General Motors spending $250 million to build a new factory in Ohio, buying $5,000 worth of computer equipment for a business, and spending $300,000 to have a new house built.

  • Investment is NOT the purchase of stocks and bonds!

The Market for Loanable Funds

Loanable Funds Market

• A supply–demand model of the financial system.

• Helps understand:

  • How the financial system coordinates saving & investment.

  • How government policies and other factors affect saving, investment, the interest rate.

Assumptions

• Only one financial market.

  • All savers deposit their saving in this market.

  • All borrowers take out loans from this market.

• There is one interest rate, which is both the return to saving and the cost of borrowing.

Supply of Loanable Funds

• Saving is the source of the supply of loanable funds.

  • Households with extra income can loan it out and earn interest.

  • Public saving ($T - G$)

    • If positive, adds to national saving and the supply of loanable funds (T > G).

    • If negative, it reduces national saving and the supply of loanable funds (T < G).

Slope of the Supply Curve

• An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

Demand for Loanable Funds

• Investment is the source of the demand for loanable funds.

  • Firms borrow the funds they need to pay for new equipment, factories, etc.

  • Households borrow the funds they need to purchase new houses.

Slope of the Demand Curve

• A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

Equilibrium in the Market for Loanable Funds

• The interest rate adjusts to equate supply and demand.

• The equilibrium quantity of loanable funds = equilibrium $I$ = equilibrium $S$.

Reaching Equilibrium

• If the interest rate < equilibrium:

  • QS < QD, so shortage of loanable funds

  • Encourage lenders to raise the interest rate

  • Encourage saving (increase $Q_S$)

  • Discourage borrowing for investment (decreasing $Q_D$)

• If the interest rate > equilibrium

  • Surplus of loanable funds

  • Decrease interest rate

Policy 1: Saving Incentives

• Tax incentives for saving increase the supply of loanable funds

• …which reduces the equilibrium interest rate

• and increases the equilibrium quantity of loanable funds

• greater $S$ and $I$

Policy 2: Investment Incentives

• An investment tax credit increases the demand for loanable funds

• …which raises the equilibrium interest rate

• and increases the equilibrium quantity of loanable funds

• greater $S$ and $I$

Policy 3: Government Budget Deficits and Surpluses

Budget Deficit

• Budget deficit: G > T

  • Excess of government spending over tax revenue

Government Debt

• Accumulation of past government borrowing

Budget Surplus

• Budget surplus, T > G

  • Excess of tax revenue over government spending

  • Repay some of the government debt.

Balanced Budget

• Balanced budget: $G = T$

Active Learning Example: Budget Deficits and Surpluses

• Assume the government starts with a balanced budget and then, because of an increase in government spending (and/or decrease in taxes), starts running a budget deficit.

• Use the loanable funds model to analyze the effects of a government budget deficit:

  • Draw the diagram showing the changes in equilibrium. What happens to the equilibrium values of the interest rate and investment?

  • Analyze the effects of a budget surplus.

Effect of a Budget Deficit

• Reduces national saving and the supply of loanable funds

• …which increases the equilibrium interest rate and decreases the equilibrium quantity of loanable funds and investment.

Effect of a Budget Surplus

• Increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Policy 3: Lessons

Budget Deficits

• Reduce national saving

• Decrease the supply of loanable funds

• Interest rate rises and investment falls

Budget Surplus

• Increase national saving

• Increase the supply of loanable funds

• Reduce the interest rate and stimulates investment

History of U.S. Government Debt

• The government finances deficits by borrowing (selling government bonds).

  • Persistent deficits lead to a rising government debt.

Debt-to-GDP Ratio

• Useful measure of the government’s indebtedness relative to its ability to raise tax revenue.

• Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime—until the early 1980s.

Presidential Debate Scenario

Candidate's Statement

• “We need to get this country growing again. We need to use tax incentives to stimulate saving and investment, and we need to get that budget deficit down so that the government stops absorbing our nation’s saving.”

Discussion Points

A. If $G$ remains unchanged, what inconsistency is implied by the presidential candidate’s statement?

B. If the presidential candidate truly wishes to decrease taxes and decrease the budget deficit, what has the candidate implied about his plans for $G$?