Econ Module 8 Loanable Funds

Context of the Module

• Current Economic Events:

  • Review of the largest bank failures in the United States, including:

  • SVB Collapse (March 16, 2023) and its impact on the banking sector.

  • The seizure and sale of First Republic Bank to JPMorgan Chase (May 1, 2023).

• Motivation:

  • Inquiries on how household savings feed into the economy and their role in physical capital formation, which is crucial for long-term GDP growth.

  • This model elaborates on the investment component of aggregate expenditures explored in the previous module.

Key Concepts

The Financial System

• Components:

  • Saving and Investment

  • Loanable Funds Market

  • Present Value

• Additional Resource Overview:

  • Emphasis on physical capital and its depreciation.

  • Equation:

  • $K<em>{t+1} = K</em>t + ext{Investment}<em>t - ext{Depreciation}</em>t$

Economic Growth

• Higher GDP per capita is observed in countries with higher investment rates.

• Case Example: South Korea

  • In 1950, South Korea had an investment rate of less than 10%.

  • Investment rates increased significantly over the decades:

  • 1970s: More than doubled

  • 1990s: Exceeded 35%

Types of Financing

• Financing Methods:

  • Reinvesting profits back into the firm

  • Taking on partners

  • Borrowing from banks, governments, or family/friends

• Types of Financing Sources:

  • Indirect Finance: Flow of funds from savers to borrowers via financial intermediaries (e.g., banks).

  • Direct Finance: Flow of funds from savers to firms through financial markets (e.g., New York Stock Exchange).

The Financial System Overview

Financial Markets and Intermediaries

• Financial System:

  • Encompasses financial markets and intermediaries facilitating the acquisition of funds by firms from households.

  • Financial Markets: Where financial securities (stocks/bonds) are traded.

  • Financial Intermediaries: Institutions like banks, mutual funds, pension funds, and insurance companies that serve as conduits for funds from savers to borrowers.

Bond Market

• Definition:

  • A bond is a certificate of indebtedness specifying obligations of the borrower to the bondholder.

• Bond Features:

  • Coupon Payment: Payment made on a bond.

  • Coupon Rate: Interest rate of the bond, cost of borrowing funds expressed as a percentage.

  • Example: If Instagram issued a $1,000 bond paying $60/year, the coupon rate = rac{60}{1000} imes 100 = 6 ext{%}.

• Factors determining Interest Rates:

  • Term until maturity

  • Credit risk (likelihood of default)

  • Important driver for bond pricing and interest rates

• Interest Rates vs. Time and Amount:

  • Longer repayment periods and larger loan amounts generally lead to higher interest rates due to increased risks of borrower defaults.

Stock Market

• Definition:

  • Stock represents partial ownership in a firm, entitling the shareholder to a portion of profits (dividends).

  • Equity Financing: Raising money through the sale of stock, compared to bonds which involve debt financing.

• Major U.S. Stock Exchanges:

  • New York Stock Exchange, American Stock Exchange, NASDAQ

Mutual Funds and Exchange-Traded Funds (ETFs)

• Mutual Funds:

  • Institutions selling shares to the public and buying a portfolio of stocks/bonds, enabling diversification for smaller investors.

• ETFs:

  • Operate similarly to mutual funds

Saving and Investment

National Income Identity

• National Income (GDP):

  • Represented by $Y = C + I + G + NX$

  • For a closed economy: $Y = C + I + G$

• National Savings Equation:

  • After subtracting consumption (C) and government spending (G):

  • $Y - C - G = I$

  • The left side represents national savings (S).

Private and Public Saving

Private Saving

• Defined as the income of households remaining after consumption and transfers from the government:

  • $ext{Private saving} = Y + TR - T - C$

Public Saving

• Defined as the tax revenue remaining after government spending:

  • $ext{Public Saving} = T - G - TR$

  • Budget surplus: $T - G - TR$ (positive public savings)

  • Budget deficit: $G + TR - T$ (negative public savings)

  • To exemplify: $6.75 trillion total expenditures typically involve about $4 trillion in transfers, with revenues around $4.92 trillion leading to an approximate $1.83 trillion deficit.

National Saving Calculation

• National saving (S) calculation formula:

  • $S = I$

  • Substitute values:

  • $S = (Y + TR - T - C) + (T - G - TR)$

Loanable Funds Market

Overview

• The loanable funds market coordinates savings and investments in the economy.

• Supply sources include both private and public contributions, while demand mainly comes from businesses.

Real Interest Rate

• Defined as the price of loans and the reward for savings.

• Equilibrium interest rate is influenced by the supply and demand for loanable funds, analogous to other market dynamics.

Supply and Demand Dynamics

• Equilibrium interest rates are determined by the intersection of saving (S) and investment (I).

  • For instance, if S & I = 1.6 trillion and the interest rate is 5%, demand and supply can be illustrated through numerical examples.

Determinants of Supply and Demand

Supply Shifters

• Potential influencing factors include:

  • Income (increase leads to consumption and savings)

  • Cost

  • Population changes

  • Wealth

  • Future Income Expectations

  • Interest Rates (relationship is complex)

  • Government spending and taxation policies

Demand Shifters

• Factors affecting demand primarily concern business operations:

  • Expectations regarding future profitability

  • Technological advancements

  • Taxation policies affecting businesses

  • Cash flow conditions

Changes in Supply and Demand Effects

Impact of Shifts

• An increase in demand raises the equilibrium real interest rate and the quantity of loanable funds.

• Conversely, an increase in supply decreases the equilibrium real interest rate while increasing the quantity of loanable funds.

Predicting Effects Related to Saving, Investment, and Interest Rates

Situational Examples

1. Investment Tax Credit:

   • Buy-in spurs demand for loanable funds.

   • Real interest rates increase, bolstering both S and I.

2. Crowding Out:

   • Increased government deficits lead to a decline in private spending.

3. Consumption Tax Imposition:

   • More funds available can lead to an increase in savings.

Present Value

Definition

• Present Value (PV) is the current worth of a future sum of money accounting for interest rates.

• The principle emphasizes that receiving a sum now is more favorable than receiving the same sum later.

Present Value Formula

• Given an interest rate $r$ for a future value to be received in $N$ years:

  • $PV = rac{FV}{(1 + r)^N}$

• This process is termed "discounting" due to the effect of potential interest earnings.

Tools for Analyzing Investment Decisions

Single Future Payment

• The formula remains as described.

Multiple Future Payments Example

• Example calculation structure:

  • $PV = rac{FV<em>1}{(1 + r)^1} + rac{FV</em>2}{(1 + r)^2} + rac{FV<em>3}{(1 + r)^3} + … + rac{FV</em>N}{(1 + r)^N}$

Contest Winnings Case Study

• Example scenario for evaluating cash prize options with clear calculations based on interest rates to determine the most beneficial choice between lump sum or structured payments.

• Choice criteria include:

  • Short vs. long evaluation timelines

  • Expected rate of return compared with immediate larger prizes

Investment Evaluation Example

• Decision to invest $190,000 or save it compared at varying interest rates (1% vs. 5%) with calculations determining the better financial move based on present value comparisons.