Definition: Markets where the government, firms, and individuals trade promises to pay in the future.
Importance:
Source of raising capital through stocks & bonds.
Facilitates borrowing, which is crucial for economic growth.
Financial markets ease the passage of money from those who have more than they want to spend to those who want to spend more than they have.
Financial Assets
Loans: Lending agreement between a lender and a borrower.
Bonds: Issued by a borrower, promising to pay a fixed sum of interest each year and repay the principal.
Loan-backed securities: Assets created by pooling individual loans and selling shares in that pool (e.g., mortgage-backed securities).
Stocks: A share in the ownership of a company.
Financial Intermediary
Definition: An institution that transforms funds from individuals into financial assets.
Examples:
Mutual fund: Creates a stock portfolio and resells shares to individual investors.
Pension fund: Holds assets to provide retirement income to its members.
Savings
Basic Identity: Income = Consumption + Savings (Y = C + S).
Savings is what's left over after consumption: S=Y−C.
Simplified Scenario (G=0, NX=0):
National income accounting identity: Y=C+I.
Rewritten: Y−C=I.
Since S=Y−C, then S=I (Savings equals investment by definition).
Adding Government Back In:
Y=C+I+G
Government actions: Taxes and borrowing.
Taxes, Disposable Income, and Savings:
Taxes reduce income available for spending and saving.
Disposable income: Y−T
Private Saving: Y−T−C
Public Saving: T−G
National Savings
Formula:
Y=C+I+G
Y–C–G=I
Y–T–C+T–G=I
(Y−T−C)+(T−G)=I
Private Saving + Public Saving = Investment
National Savings = Private Saving + Public Saving
National Savings = Investment (by definition)
Global Comparison of Savings
The United States has relatively low savings rates compared to other developed countries.
Savings rates as a percentage of GDP for various countries:
United States: Lower than countries like Italy, France, Canada, Germany, and Japan.
Exports vs. Imports
Exports: Products made domestically and sold abroad.
Imports: Products made abroad and sold domestically.
Net Exports (NX): The difference in value between exports and imports in the GDP equation.
Adding the Rest of the World
Y=C+I+G+NX
PrivateSavings+PublicSavings=I+NX
NationalSaving=I+NX
Implications:
If NX is negative (trade deficit), National Savings < I, meaning foreign savings finances domestic investment.
If NX is positive (trade surplus), National Savings > I, meaning domestic savings finances investment abroad.
Different Kinds of Capital
Physical capital: Manufactured resources like buildings and machines.
Human capital: Improvements in the labor force through education and knowledge.
Financial capital: Funds from savings available for investment spending.
Capital Inflow: A positive capital inflow occurs when funds flow into a country from abroad for investment spending.
Market for Loanable Funds
Mechanism: Explains how consumer savings get to firms to finance investment.
Definition: A hypothetical market showing the outcome of the demand for funds by borrowers and the supply of funds by lenders.
Interest rate: The price of loanable funds, expressed as a percentage of the amount borrowed.
Investment decisions depend on the interest rate.
Rate of Return: The profit earned on a project expressed as a percentage of its cost. Projects are compared to interest rates to determine investment viability.
Equilibrium: Determined by the intersection of supply and demand.
Only projects profitable at or above the equilibrium interest rate are funded.
Lenders unwilling to lend below the equilibrium interest rate do not participate.
Shifts in Demand Curve
Changes in perceived business opportunities: More opportunities shift demand to the right.
Changes in government borrowing: A government budget deficit increases demand for loanable funds.
Crowding Out Effect
Definition: A government budget deficit increases the demand for loanable funds, driving up the interest rate and reducing investment spending.
Shifts in Supply Curve
Changes in private savings behavior: Increased savings shift the supply curve to the right.
Changes in net capital inflows: Increased inflows shift the supply curve to the right.
Crowding Out of Private Investment
An increase in the government deficit leads to a rise in the equilibrium interest rate.
This results in a fall in private investment.
The extent of crowding out depends on the elasticity of the supply of loanable funds. If savers are very willing to make new loans, crowding out will be small. If there is only a fixed quantity of savings available, crowding out is 100%.
Crowding out is bad for economic growth.
Inflation and Interest Rates
Major changes in interest rates are driven by:
Changes in government policy.
Technological innovations.
Expectations about future inflation.
Real vs. Nominal Interest Rates
Real rate = nominal interest rate − inflation rate
Loan contracts specify a nominal interest rate, adjusted based on inflation expectations to determine the real rate.
The Fisher Effect
Definition: An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.
Implication: Changes in inflation expectations do not change real interest rates, and thus should not change borrowing and lending.
Shifts in the Supply of Loanable Funds
Changes in private savings behavior: Rising home prices can make homeowners feel richer, reducing savings and shifting the supply of loanable funds to the left.
Changes in capital inflows: Large capital inflows increase the supply of loanable funds.
Government Budget
Budget Balance: The difference between tax revenue and government spending.
Government Budget Surplus: Tax Revenue > Government Spending -> Public Saving > 0
Government Budget Deficit: Tax Revenue < Government Spending -> Public Saving < 0
Financing a Budget Deficit: Government Borrowing.
Government borrowing: The total amount of funds borrowed by federal, state, and local governments in the financial markets.
Trade Balance
Trade Balance: The gap between a nation’s exports and imports (also commonly called a “current account balance.”)
Trade deficits and surpluses can both be good or bad signs for an economy, depending on the circumstances.
The key question is whether the borrowing or lending makes sense given the country’s economic conditions.
Investment Spending
Investment Spending: Spending that adds to the economy’s stock of physical capital.
Current Account Balance: The change in the value of a country’s net claims on the rest of the world, or the change in its net foreign assets. Often easier to think of current account as exports – imports.
Capital Account Balance: Records the net sales of assets to foreigners. Hence, as a pure matter of accounting, the capital account balance is the negative of the current account balance, and vice versa: Current Account = - (Capital Account)
Merchandise Trade Balance
Merchandise Trade Balance: The balance of trade looking only at goods.
Unilateral Transfers: Payments that government, private charities, or individuals make in which they send money abroad without receiving any direct good or service.
Current Account
Equation: CA=Y+rB–C–G–I (where rB is interest earned on foreign assets acquired previously, r being the interest rate)
Savings S=Y+rB–C–G
CA=S–I (Saving-Investment Identity).
In a closed economy, the current account = 0: CA=0=S–I à S=I
Investment Spending in Open Economy
Open Economy: Exports and imports are allowed.
Net capital inflow: The total inflow of funds into a country minus the total outflow of funds out of a country.
A trade deficit (imports > exports) means we have financial capital inflow (capital account surplus, current account deficit).
International flows of financial capital refer to all of the ways in which private investors in one country may invest in another country—by buying real estate, companies, and financial investments like stocks and bonds.
Trade Deficit and Capital Inflow
A capital inflow means money is coming in, via investment.
A trade deficit means money is going out.
These things must be balanced.
This means that if a country is running a trade deficit (imports > exports), then it will be receiving capital inflows (foreign investment) from elsewhere.
If the US exports a bunch of goods and begins to run a trade surplus (exports > imports), then it will take that surplus and invest it abroad.
Money goes in one way and out another way.
Every country eventually runs a surplus on account of having run a deficit, and vice versa.
National Saving and Investment Identity
Supply of financial capital = Demand for financial capital
S+(M–X)=I+(G–T)
S = Saving by individuals and firms
(M – X) = imports – exports = trade deficit
I = private sector investment
G = government spending
T = taxes collected
If G > T, then the government would be a demander of financial capital. If T > G, then the government would contribute as a supplier of financial capital.
National Saving and Investment Identity: Example
Country A has a trade deficit of $200 billion, private domestic savings of $500 billion, and private domestic investment of $500 billion. What is Country A’s government budget deficit?
In the case of a trade surplus, the national saving and investment identity can be rewritten as:
Domestic Savings (both private and public) is higher than domestic investment in a trade surplus. That extra financial capital will be invested abroad.
Trade Deficits
The national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall.
In the short run, whether an economy is in a recession or on the upswing can affect trade imbalances.
A recession tends to make a trade deficit smaller, or a trade surplus larger.
While a period of strong economic growth tends to make a trade deficit larger, or a trade surplus smaller.
Borrowing from abroad
For countries, there is no economic merit in a policy of abstaining from participation in financial capital markets.
It can make economic sense for a national economy to borrow from abroad, as long as it wisely invests the money in ways that will tend to raise the nation’s economic growth over time.
Examples: U.S. in mid-1800s and South Korea in 1970s.
A borrower nation can find itself in trouble if it does not invest the incoming funds from abroad in a way that leads to increased productivity.
Examples: Mexico, Brazil, and some African nations in the 1970s and 1980s.
Credit default swaps
Credit default swaps (insurance against a country’s default) give us a glimpse into how poorly a country manages its debt: the higher the price, the higher the possibility of default.
UK: $28.21
US: $35.07
Mexico: $101.97
Brazil: $153.11
Egypt: $589.57
Is a Trade Deficit a Bad Thing?
Not necessarily
For much of the 19th century, the US ran a trade deficit.
The trade deficit resulted in a large inflow of foreign capital.
This capital was used to finance critical pieces of infrastructure like the railroad
Without this foreign capital, it is likely the construction of the railroads (to the extent that they were built) wouldn’t have been possible.
Is a Trade Surplus a Good Thing?
Not necessarily
Japan has had a huge trade surplus for many decades.
Japan has been in and out of recession since the 90s and averages a 1% growth rate per year, along with steadily increasing unemployment.
Japan’s high level of domestic savings is largely responsible for its trade surplus.
Level of Trade vs Trade Balance
A country’s level of trade tells how much of its production it exports.
Separate term than the balance of trade.
Measured as the percent of exports out of GDP.
Three factors strongly influence a nation’s level of trade:
the size of its economy,
its geographic location,
its history of trade.
Discussion Question: Do you think the following countries have a low or high level of trade?
Sweden
United States
Japan
Levels of Trade
Top 5 Countries in terms of level of trade (as percentage of GDP):
Luxembourg
Hong Kong
Singapore
San Marino
Dijibouti
United States (richest country in the world) ranks 181 out of the 193 countries measured ($2.1 trillion)
China (2nd richest country) ranks 157/193 ($3.7 trillion)
Side note: the right column helps demonstrate how rich the US is. Even though they’re ranked 181/193 in terms of exports as percentage of GDP, the value of their exports is greater than the 3rd richest country in the world (Germany), who ranks 64/193 in exports.
Merchandise Trade Balance Components of US Current Account
The third component of the current account balance, labeled “income receipts and payments,” refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States).
Flows of goods and service (top lines 1 & 3) show up in the current account.
Flow of funds (top lines 2 & 4) show up in the capital account.
Investment income (bottom lines 2 & 4) shows up in current account.
Investment to rest of the world or into the home country (bottom lines 1 & 3) show up in the capital account.
Exercises (Brief Overview)
Explain why a decrease in the government budget deficit could lead to an increase in investment by firms.
Suppose that because of a rising price level, consumer starts carrying more of their wealth as cash, in order to carry out transactions, and thus are less willing to put their wealth into other assets -such as stocks or bonds. Depict the effect this will have on the market for loanable funds, and explain what will happen to both interest rates and investment.
Suppose the market for loanable funds is current in equilibrium, with no (zero) capital inflows or capital outflows.
(a) Using a supply and demand diagram, depict this situation.
(b) Suppose that there is a change in spending, and consumers start buying more imported goods than firms are exporting, so that there is now negative net exports. Depict the effect this will have on the market for loanable funds.
Explain why attracting capital inflows can be beneficial for long run growth.