FINANCE, SAVING, AND INVESTMENT
Macroeconomics Notes: Finance, Saving, and Investment Chapters
Introduction to Finance, Saving, and Investment
Key Learning Objectives:
Describe the flow of funds in financial markets.
Explain how financial decisions are made and the associated risks.
Understand the interaction of lending and borrowing decisions in financial markets.
Analyze how governments influence financial markets.
Financial Markets and Financial Institutions
Distinction between Finance and Money, and Physical Capital and Financial Capital:
Finance:
Studies how households and firms obtain and use financial resources.
Examines how they manage the risks inherent in these activities.
Money:
Studies how households and firms utilize money, how much they hold.
Explores how banks create and manage money.
Investigates how the quantity of money impacts the economy.
Capital (Physical Capital):
Refers to the tangible assets like tools, instruments, machines, buildings, and other items.
These assets were produced in the past and are currently used to produce goods and services.
Financial Capital:
Represents the funds that firms use specifically to purchase physical capital.
Capital and Investment:
Gross Investment: The total expenditure on acquiring new capital (e.g., new machines, buildings) and replacing capital that has depreciated.
Depreciation: The reduction in the quantity of capital due to wear, tear, and obsolescence over time.
Net Investment: The actual change in the quantity of capital during a period.
Formula: \text{Net investment} = \text{Gross investment} - \text{Depreciation}
Illustration (Figure 7.1 Concept):
Initial Capital (e.g., \$30 \text{ thousand} on Jan. 1, 2018).
During 2018, there is Gross Investment and Depreciation.
Net Investment for the period is the difference.
Final Capital (e.g., \$40 \text{ thousand} on Dec. 31, 2018) is initial capital plus net investment.
Wealth and Saving:
Wealth: The total market value of all assets owned by individuals.
Saving: The portion of income that is not used for taxes or consumption of goods and services.
Impact of Saving on Wealth: Saving directly increases wealth.
Other Factors Affecting Wealth:
Capital Gains: Increases in wealth when the market value of assets rises.
Capital Losses: Decreases in wealth when the market value of assets falls.
Financial Capital Markets:
Saving serves as the primary source of funds for financing investment.
These funds are exchanged (supplied and demanded) in three main types of financial markets:
Loan markets
Bond markets
Stock markets
Financial Institutions:
Definition: A firm that participates on both sides of financial capital markets, acting as a borrower in one market and a lender in another.
Key Types of Financial Institutions:
Commercial banks
Government-sponsored mortgage lenders
Mutual funds and Pension funds
Insurance companies
The Federal Reserve (the central bank)
Sources of Funds that Finance Investment:
Funds available for investment originate from three principal sources:
Household Saving ( S ): Funds saved by individuals and households.
Government Budget Surplus ( T - G ): When government tax revenue ( T ) exceeds government spending ( G ).
Borrowing from the Rest of the World ( M - X ): When imports ( M ) exceed exports ( X ), indicating an inflow of foreign capital.
Flows of Funds (Figure 7.2 Concept):
Households supply saving to financial markets and institutions.
Firms borrow from financial markets for investment.
Governments participate through borrowing (deficit) or debt repayment (surplus).
The rest of the world interacts via lending to or borrowing from domestic financial markets, influencing net exports ( X - M ).
Financial Decisions and Risk
The Time Value of Money:
Concept: Money available today is worth more than the same amount in the future due to its potential earning capacity.
Converting Future Dollars to Current Dollars:
Future Value: The amount of money at a future date.
Present Value: The equivalent value of a future amount in current dollars.
Formula for Present Value: \text{Present value} = \frac{\text{Future amount}}{ (1 + r)^n }
Where r is the interest rate and n is the number of years in the future.
Net Present Value (NPV):
Definition: The present value of all future money flows resulting from a financial decision, minus the initial cost of that decision.
Example: Jack's Game Bot:
Initial Cost: \$500
Future Sale Price (after 2 years): \$2,420
Interest Rate: 10\% per year (or 0.1 )
Calculation of Present Value:
\text{PV} = \frac{\$2,420}{(1 + 0.1)^2} = \frac{\$2,420}{(1.1)^2} = \frac{\$2,420}{1.21} = \$2,000Calculation of Net Present Value:
\text{NPV} = \text{PV of future flows} - \text{Initial cost} = \$2,000 - \$500 = \$1,500
Financial Decision Rule:
Risk-Free Scenario: If the net present value is positive (e.g., \$1,500 in Jack's example), the decision should be undertaken (it maximizes wealth).
Risky Scenario: If the future money flows are uncertain, the rule is modified: undertake the project if the net present value is sufficiently large to make a loss unlikely.
Financial Risk: Insolvency and Illiquidity:
Financial Institution's Net Worth: The market value of its lent assets minus the market value of its borrowed liabilities.
Solvency: If net worth is positive, the institution is solvent and can continue operations.
Insolvency: If net worth is negative, the institution is insolvent and will cease business operations.
(Illiquidity is mentioned as a risk but not explicitly defined in the provided text beyond being grouped with insolvency).
Market Risk: Interest Rates and Asset Prices:
Interest Rate on a Financial Asset: The interest received expressed as a percentage of the asset's price.
Inverse Relationship: The price of an existing financial asset and its interest rate move in opposite directions.
Example:
Asset Price: \$50
Interest: \$5
Interest Rate: (\$5 / \$50) \times 100\% = 10\%
If Asset Price Rises to \$200 (Interest \$5 ): Interest Rate Falls to (\$5 / \$200) \times 100\% = 2.5\%
If Asset Price Falls to \$20 (Interest \$5 ): Interest Rate Rises to (\$5 / \$20) \times 100\% = 25\%
Getting Real: Nominal vs. Real Interest Rates:
Nominal Interest Rate: The stated interest rate; the number of dollars paid/received in interest per year as a percentage of the dollars borrowed/lent.
Example: For a \$500 loan with \$25 annual interest, the nominal rate is (\$25 / \$500) \times 100\% = 5\% per year.
Real Interest Rate: The nominal interest rate adjusted for inflation, reflecting the change in the buying power of money.
Approximation Formula: \text{Real interest rate} \approx \text{Nominal interest rate} - \text{Inflation rate}
Example: If nominal interest rate is 5\% and inflation rate is 2\% , the real interest rate is 5\% - 2\% = 3\% per year.
Significance: The real interest rate represents the true opportunity cost of borrowing.
The Loanable Funds Market
Overview:
The aggregate of all individual financial markets.
Determines the real interest rate, the quantity of funds loaned, saving levels, and investment levels.
Initial analysis often ignores government and international borrowing/lending.
The Demand for Loanable Funds ( D_{LF} ):
Definition: The relationship between the quantity of loanable funds demanded and the real interest rate, assuming all other factors influencing borrowing plans are constant.
Main Component: Business investment.
Determinants:
The Real Interest Rate: An inverse relationship. A higher real interest rate discourages borrowing for investment, decreasing the quantity of loanable funds demanded.
Expected Profit: A direct relationship. Higher expected profits from new capital projects increase the demand for loanable funds.
Demand Curve (Figure 7.3 Concept):
Slopes downward: As the real interest rate falls, the quantity of loanable funds demanded increases (and vice-versa).
Changes in Demand: A change in expected profit shifts the entire D_{LF} curve.
Greater expected profit \implies greater investment \implies greater demand for loanable funds ( D_{LF} shifts rightward).
The Supply of Loanable Funds ( S_{LF} ):
Definition: The relationship between the quantity of loanable funds supplied and the real interest rate, assuming all other factors influencing lending plans are constant.
Main Component: Saving.
Determinants:
The Real Interest Rate: A direct relationship. A higher real interest rate incentivizes saving, increasing the quantity of loanable funds supplied.
Disposable Income: An increase in disposable income (income after taxes) increases saving and thus S_{LF} .
Expected Future Income: A decrease in expected future income typically leads to increased current saving to prepare for the future, increasing S_{LF} . An increase in expected future income might decrease current saving.
Wealth: A decrease in wealth often prompts individuals to save more to rebuild their financial position, increasing S_{LF} . An increase in wealth might decrease saving.
Default Risk: A fall in default risk (lower perceived risk that borrowers will not repay) makes lending more attractive, increasing S_{LF} .
Supply Curve (Figure 7.4 Concept):
Slopes upward: As the real interest rate rises, the quantity of loanable funds supplied increases (and vice-versa).
Changes in Supply: A change in disposable income, expected future income, wealth, or default risk shifts the entire S_{LF} curve.
An increase in disposable income, a decrease in expected future income, a decrease in wealth, or a fall in default risk all increase saving and thus increase the supply of loanable funds ( S_{LF} shifts rightward).
Equilibrium in the Loanable Funds Market:
Definition: Occurs at the real interest rate where the quantity of loanable funds demanded equals the quantity of loanable funds supplied.
Market Adjustment (Figure 7.5 Concept):
Surplus of Funds: If the real interest rate is above equilibrium (e.g., 7\% ), the quantity supplied exceeds the quantity demanded, causing the real interest rate to fall.
Shortage of Funds: If the real interest rate is below equilibrium (e.g., 5\% ), the quantity demanded exceeds the quantity supplied, causing the real interest rate to rise.
Equilibrium: The market settles at a rate (e.g., 6\% ) where demand and supply are balanced.
Changes in Demand and Supply:
Financial markets exhibit short-run volatility but long-run stability.
Volatility Drivers: Fluctuations in either the demand for or supply of loanable funds.
Consequences: These fluctuations lead to changes in the real interest rate, the equilibrium quantity of funds, and asset prices.
Increase in Demand (Figure 7.6(a) Concept):
Caused by: Increased expected profits.
Effect: The D_{LF} curve shifts rightward.
Outcome: The real interest rate rises, and the quantity of loanable funds (and saving) increases.
Increase in Supply (Figure 7.6(b) Concept):
Caused by: Changes influencing saving (e.g., increased disposable income, decreased expected future income, decreased wealth, or fall in default risk).
Effect: The S_{LF} curve shifts rightward.
Outcome: The real interest rate falls, and investment increases.
Government in the Loanable Funds Market
The government influences the loanable funds market through its budget decisions (surplus or deficit).
Government Budget Surplus ( T > G ):
Effect: A government budget surplus increases the overall supply of funds in the market.
Outcome (Figure 7.7 Concept):
The S_{LF} curve (or available funds for private use) shifts rightward.
The real interest rate falls.
Private saving may decrease (as lower interest rates reduce the incentive to save).
Investment (private) increases (due to lower borrowing costs).
Government Budget Deficit ( G > T ):
Effect: A government budget deficit increases the overall demand for funds (as the government must borrow to cover the deficit).
Outcome (Figure 7.8 Concept):
The D_{LF} curve shifts rightward (representing increased demand for funds).
The real interest rate rises.
Private saving may increase (as higher interest rates incentivize saving).
Investment (private) decreases, a phenomenon known as crowding-out, because the government's borrowing consumes funds that would otherwise be available for private investment.
The Ricardo-Barro Effect:
Context: Addresses the impact of a government budget deficit.
Hypothesis: Rational taxpayers, anticipating future tax increases to pay off the government debt from a deficit, will increase their current saving.
Effect on Market (Figure 7.9 Concept):
The budget deficit initially increases the demand for loanable funds ( D_{LF} shifts rightward).
However, the increased private saving, in anticipation of future taxes, causes the supply of loanable funds ( S_{LF} ) to also shift rightward.
Outcome: This compensatory increase in private saving helps finance the deficit, and thus, the crowding-out of private investment is avoided or significantly reduced. The real interest rate may remain relatively stable or change less dramatically than it would without this effect.