Saving, Investment, and the Financial System Study Guide

The Financial System and Its Role in the Economy

• Definition of the Financial System: A group of institutions in the economy that help match the saving of one person with the investment of another.
• Core Function: Moving funds from people who lack productive investment opportunities (savers) to those who have such opportunities (borrowers) is crucial for the health of a well-functioning economy.
• Omissions in the Simple Circular Flow Diagram: While the basic circular flow includes households and firms, it omits several key actors:     * The Government: Collects taxes and buys goods and services.     * The Foreign Sector: Handles the trade of goods, services, financial assets, and currencies with residents of other countries.     * The Financial System: Acts as the mechanism to match savers' supply of funds with borrowers' demand for loans.

Types of Financial Institutions

Financial institutions are categorized into two main groups based on how savers provide funds to borrowers.

Financial Markets

Financial markets are institutions through which savers can directly provide funds to borrowers.

1. The Bond Market:     * Definition of a Bond: A certificate of indebtedness (an IOU).     * Components of a Bond:         * Principal: The specific amount of money borrowed.         * Date of Maturity: The specific time at which the loan will be repaid.         * Rate of Interest: The periodic payment the borrower makes until the bond matures.     * Debt Finance: The sale of bonds to raise money.     * Characteristics of Bonds:         * Term: The length of time until the bond matures. Long-term bonds are generally riskier than short-term bonds and typically pay higher interest rates. A "perpetuity" is a bond that never matures.         * Credit Risk: The probability that the borrower will fail to pay some of the interest or principal (default). Shaky corporations issue "junk bonds," which carry high interest rates to compensate for high default risk.         * Tax Treatment: The way tax laws treat interest earned. Interest on most bonds is taxable. However, Municipal Bonds (issued by state and local governments) are exempt from federal income tax and thus offer lower interest rates.         * Inflation Protection: Most bonds are in nominal terms (fixed dollars). However, some are indexed to measures of inflation; if prices rise, payments rise proportionately.

2. The Stock Market:     * Definition of a Share of Stock: A claim to partial ownership in a firm.     * Equity Finance: The sale of stock to raise money.     * Characteristics: Stocks offer higher potential returns compared to bonds but carry significantly greater risk.     * Stock Exchanges: Once a corporation issues stock, these shares trade on exchanges (like the New York Stock Exchange or NASDAQ). The company itself receives no money when shares change hands between stockholders.     * Stock Prices: Determined by supply and demand, reflecting the public's perception of the corporation’s future profitability.     * Stock Indices: An average of a group of stock prices used to monitor the overall level of stock prices (e.g., the Dow Jones Industrial Average or the Standard & Poor’s 500 Index).

Financial Intermediaries

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers.

1. Banks:     * Primary Role: Banks take in deposits from people who want to save (paying them interest) and use those deposits to make loans to people who want to borrow (charging them a higher interest rate). The difference between these rates covers costs and provides profit.     * Secondary Role: Facilitating the purchase of goods and services by allowing people to write checks or use debit cards against their deposits.

2. Mutual Funds:     * Mechanism: A mutual fund sells shares to the public and uses the proceeds to buy a portfolio of various stocks and/or bonds.     * Advantages:         * Diversification: Allows individuals with small amounts of money to hold a broad portfolio, reducing risk.         * Professional Management: Provides ordinary people access to the skills of professional money managers (though economists are skeptical that managers can consistently "beat the market").

National Income Accounting and Identities

To understand the relationship between saving and investment, we use macroeconomic identities.

Basic Identities

• Total Income/Expenditure: $Y = C + I + G + NX$     * $Y$ = Gross Domestic Product (GDP)     * $C$ = Consumption     * $I$ = Investment     * $G$ = Government Purchases     * $NX$ = Net Exports
• Closed Economy Assumption: In a closed economy, $NX = 0$. Therefore:     * $Y = C + I + G$

Saving and Investment Equations

• National Saving ($S$): The total income in the economy that remains after paying for consumption and government purchases.     * $S = Y - C - G$
• Fundamental Identity for a Closed Economy: Because $I = Y - C - G$ and $S = Y - C - G$, it must be that:     * $S = I$

Private and Public Saving

To see how the financial system works, we introduce taxes ($T$), defined as taxes minus transfer payments:

• $S = (Y - T - C) + (T - G)$
• Private Saving: The income that households have left after paying for taxes and consumption.     * $\text{Private Saving} = Y - T - C$
• Public Saving: The tax revenue that the government has left after paying for its spending.     * $\text{Public Saving} = T - G$

Budget Surplus and Deficit

• Budget Surplus: If T > G, the government receives more money than it spends (T - G > 0). This adds to national saving.
• Budget Deficit: If G > T, the government spends more than it receives in tax revenue (T - G < 0). This represents negative public saving.

Distinguishing Saving and Investment

• Saving: Occurs when a person's income exceeds their consumption. Examples include:     * Buying corporate bonds or stocks.     * Purchasing a certificate of deposit (CD).     * Adding money to a savings or checking account.     * Buying shares of a mutual fund.
• Investment: Refers specifically to the purchase of new capital. Examples include:     * General Motors spending $250$ million to build a new factory.     * A business buying $5,000$ worth of new computer equipment.     * A family spending $300,000$ to have a new house built (note: new housing is categorized as investment, not consumption).
• Critical Distinction: In macroeconomic terms, buying stocks and bonds is defined as saving, NOT investment.

The Market for Loanable Funds

This supply-and-demand model explains how the financial system coordinates saving and investment.

Market Assumptions

• There is only one financial market.
• All savers deposit all their saving in this market.
• All borrowers take out all their loans from this market.
• There is one single interest rate for both saving and borrowing.

Supply and Demand

• Supply of Loanable Funds: Source is Saving.     * Households with extra income lend it out.     * Public saving adds to supply if positive, and reduces it if negative.     * Slope: The supply curve is upward-sloping. An increase in the interest rate makes saving more attractive, increasing the quantity of loanable funds supplied (e.g., at $3\%$, supply is $60$ billion; at $6\%$, supply is $80$ billion).
• Demand for Loanable Funds: Source is Investment.     * Firms borrow for new equipment and factories.     * Households borrow for new houses.     * Slope: The demand curve is downward-sloping. A fall in the interest rate reduces the cost of borrowing, increasing the quantity of loanable funds demanded (e.g., at $7\%$, demand is $50$ billion; at $4\%$, demand is $80$ billion).

Equilibrium

• The interest rate adjusts to equate the quantity supplied and quantity demanded.
• Shortage: If the interest rate is below equilibrium, demand exceeds supply; lenders will raise rates to encourage more saving and discourage borrowing.
• Surplus: If the interest rate is above equilibrium, supply exceeds demand; lenders will lower rates to attract borrowers.

Government Policies and Loanable Funds

1. Policy 1: Saving Incentives:     * Tax incentives for saving (e.g., expanding eligibility for special savings accounts) shift the supply curve to the right.     * Result: Equilibrium interest rate falls, and the equilibrium quantity of loanable funds (and thus investment) increases.
2. Policy 2: Investment Incentives:     * An investment tax credit gives a tax advantage to firms building new factories or buying equipment, shifting the demand curve to the right.     * Result: Equilibrium interest rate rises, and the equilibrium quantity of loanable funds (and thus saving) increases.
3. Policy 3: Budget Deficits:     * When the government runs a budget deficit, it reduces national saving. This shifts the supply curve of loanable funds to the left.     * Result: Interest rates rise, and the quantity of loanable funds for investment falls.     * Crowding Out: The decrease in investment that results from government borrowing.

U.S. Government Debt History

• Financing: The government finances deficits by selling bonds, which accumulates into government debt.
• Debt-to-GDP Ratio: A measure of indebtedness relative to the ability to raise tax revenue.
• Historical Trends: The ratio historically rises during major wars (Revolutionary War, Civil War, WWI, WWII) and falls during peacetime.
• Modern Shift: The ratio began to rise significantly during the early 1980s due to persistent peacetime deficits.

The Financial Crisis of 2008–2009

A deep recession caused by a breakdown in the financial system. Key elements included:

1. Asset Price Decline: Housing prices fell by approximately $30\%$.
2. Insolvencies: High numbers of homeowners stopped paying mortgages, causing banks and other financial institutions to fail.
3. Loss of Confidence: Customers withdrew funds from institutions, particularly those with uninsured deposits.
4. Credit Crunch: Troubled lenders stopped lending because they were unsure of borrowers' creditworthiness.
5. Economic Downturn: The fall in investment and institutional failures caused GDP to drop and unemployment to spike.
6. Vicious Circle: The downturn reduced asset values even further, worsening the initial crisis.

Numerical Exercise: Saving and Investment Identities

Scenario 1: Initial State:

• $Y = 19\text{ trillion}$
• $C = 13\text{ trillion}$
• $G = 2.5\text{ trillion}$
• $\text{Budget Deficit} (G - T) = 1.2\text{ trillion}$

Calculations:

• Net Taxes ($T$): $G - 1.2 = 2.5 - 1.2 = 1.3\text{ trillion}$
• Public Saving ($T - G$): $1.3 - 2.5 = -1.2\text{ trillion}$
• Private Saving ($Y - T - C$): $19 - 1.3 - 13 = 4.7\text{ trillion}$
• National Saving ($S$): $19 - 13 - 2.5 = 3.5\text{ trillion}$ (equivalent to $4.7 + (-1.2)$).
• Investment ($I$): Equal to National Saving, which is $3.5\text{ trillion}$.

Scenario 2: Tax Cut of $300\text{ billion}$ ($0.3\text{ trillion}$):

• New $T = 1.0\text{ trillion}$.
• New Budget Deficit = $1.5\text{ trillion}$.
• Case A (Consumers save the entire cut):     * $C$ remains $13$.     * Private saving increases to $5.0$ ($19 - 1.0 - 13$).     * National saving and Investment remain $3.5$ ($19 - 13 - 2.5$).
• Case B (Consumers save $1/3$ and spend $2/3$ of the cut):     * $C$ increases by $0.2$ to $13.2$.     * Private saving increases to $4.8$ ($19 - 1.0 - 13.2$).     * National saving and Investment decrease to $3.3$ ($19 - 13.2 - 2.5$).