Study Notes on Saving, Investment, and the Financial System

Saving, Investment, and the Financial System

Overview
  • Chapter Title: Saving, Investment, and the Financial System
  • Author: N. Gregory Mankiw
  • Edition: Principles of Economics, Ninth Edition, 2021
  • Publisher: Cengage Learning
Objectives
  • Identify main types of financial institutions in the U.S. economy and their functions
  • Understand the three kinds of saving
  • Differentiate between saving and investment
  • Analyze how the financial system coordinates saving and investment
  • Evaluate how government policies impact saving, investment, and interest rates

Financial Institutions

Definition
  • Financial System: A group of institutions in the economy that helps match the saving of one person with the investment of another.
  • Financial Institutions: Institutions through which savers can directly provide funds to borrowers.
    • Financial Markets: Platforms where savers can directly provide funds to borrowers.
    • Financial Intermediaries: Institutions that act as middlemen, such as banks and mutual funds.

Financial Markets

Components
  • Bond Market: A market where bonds (certificates of indebtedness) are traded.
  • Stock Market: A market where stocks (claims to partial ownership in a firm) are bought and sold.
The Bond Market
  • Bond Characteristics:
    • Principal: The amount borrowed.
    • Date of Maturity: The time when the loan must be repaid.
    • Rate of Interest: The interest the borrower pays periodically until maturity.
    • Bond Buyer: Acts as a lender and can hold the bond until maturity or sell it earlier.
  • Debt Finance: The process of raising money through the sale of bonds.
Four Characteristics of Bonds
  1. Term: Duration until maturity, with long-term bonds being riskier but yielding higher interest.
    • Perpetuity: Bonds that never mature.
  2. Credit Risk: The probability that the borrower may default on payment.
    • High Default Probability: Leads to higher interest rates, represented by junk bonds with high interest rates from financially unstable corporations.
  3. Tax Treatment: The tax implications of bond interest.
    • Taxable Income: Most bond interests are taxable.
    • Municipal Bonds: Issued by local governments with no tax on interest but lower interest rates.
  4. Inflation Protection: Whether bonds offer protection against inflation.
    • Nominal Terms: Payments in fixed dollars.
    • Indexed to Inflation: Payments rise with inflation, usually yielding lower interest rates.
The Stock Market
  • Shares of Stock: Represents ownership in a firm and claims on profits.
    • Risk vs Return: Stocks carry greater risk than bonds but offer potential for higher returns.
  • Equity Finance: The sale of stock to raise funds for the firm.
  • Stock Exchange: A marketplace for trading stock shares; however, the company does not receive money from reselling stocks.
Pricing and Valuation in Stock Markets
  • Price Determination: Prices of shares are influenced by supply and demand within the stock market.
  • Stock Demand: Reflects perceptions of future profitability of the corporation.
  • Stock Index: Measures average stock prices; examples include the Dow Jones Industrial Average and Standard & Poor’s 500 Index.

Financial Intermediaries

Definition
  • Financial Intermediaries: Institutions like banks and mutual funds through which savers indirectly lend funds to borrowers.
Banks
  • Primary Role: Accept deposits from savers at a lower interest rate and lend these deposits at a higher interest rate.
  • Secondary Role: Facilitate purchases and serve as a medium of exchange via checks and debit cards while acting as a store of value.
Mutual Funds
  • Definition: Sell shares to the public and invest proceeds in diversified portfolios of stocks and bonds.
  • Advantages:
    • Allow small investors to diversify their holdings, reducing personal risk.
    • Provide access to professional money management.
  • Skeptical View from Financial Economists: Difficulty in consistently outperforming the market.

Important Identities in Economics

Gross Domestic Product (GDP)
  • Formula: Y=C+I+G+NXY = C + I + G + NX
    • Where:
    • YY = GDP
    • CC = Consumption
    • II = Investment
    • GG = Government Purchases
    • NXNX = Net Exports
In a Closed Economy
  • Assumption: NX=0NX = 0
  • Identity: I=Y−C−GI = Y - C - G
  • National Saving Formula: S=Y−C−GS = Y - C - G
  • Key Relationship: Saving equals investment for a closed economy: S=IS = I.
Saving Definitions
  • Private Saving: Sprivate=Y−T−CS_{private} = Y - T - C
    • Remaining income after taxes and consumption.
  • Public Saving: Spublic=T−GS_{public} = T - G
    • Tax revenue remaining after government spending.
  • National Saving: S=S<em>private+S</em>publicS = S<em>{private} + S</em>{public}.
Budget Surplus and Deficit
  • Budget Surplus: T - G > 0
    • Indicates excess tax revenue over government spending.
  • Budget Deficit: T - G < 0
    • Indicates a shortfall, leading to negative public saving: G−TG - T.

Active Learning Examples

Example 1 Calculations with Given Values
  • Given: GDP = $19 trillion, C = $13 trillion, G = $2.5 trillion, Budget Deficit = $1.2 trillion
  • Public Saving Calculation: S_{public} = T - G = -$1.2 trillion
  • Net Taxes Calculation:\
    T = G - Budget ext{ deficit} \
    T = 2.5 - 1.2 = 1.3
  • Private Saving Calculation: Sprivate=Y−T−C=19−1.3−13=4.7S_{private} = Y - T - C = 19 - 1.3 - 13 = 4.7
  • National Saving and Investment: S=Y−C−G=19−13−2.5=3.5S = Y - C - G = 19 - 13 - 2.5 = 3.5
    • Result: National Saving = Investment = $3.5 trillion.

The Market for Loanable Funds

Overview
  • Definition: The loanable funds market is a supply-demand model of the financial system which illustrates how saving and investment balance out.
  • Mechanics: All savers deposit their savings in this market, and all borrowers take loans from it with one prevailing interest rate.
Supply of Loanable Funds
  • Source: Saving from households and public saving, which, when positive, increases the national saving and the supply of loanable funds. Conversely, negative public saving reduces these supplies.
Slope of the Supply Curve
  • Observation: Higher interest rates incentivize increased saving, which enhances the quantity of loanable funds supplied.
Demand for Loanable Funds
  • Source: Borrowing for investment by firms and households (new houses, factories).
  • Slope of the Demand Curve: When interest rates decrease, the cost of borrowing declines, increasing the demand for loanable funds.

Equilibrium in the Loanable Funds Market

Conditions for Equilibrium
  • The interest rate adjusts to equate the supply and demand of loanable funds.
  • The equilibrium quantity corresponds to both savings and investments.
Consequences of Imbalance in Interest Rates
  • If the interest rate is below equilibrium: a shortage of funds arises, prompting lenders to raise rates and encouraging saving while discouraging borrowing.
  • Conversely, if the interest rate is above equilibrium: a surplus occurs, causing lenders to reduce rates.

Government Budget Policies

Policy Effects
  1. Saving Incentives: Increase supply of loanable funds by creating tax incentives, thereby lowering equilibrium rates and stimulating investment.
  2. Investment Incentives: Investment tax credits raise demand, increasing equilibrium interest rates and quantity.
  3. Government Budget Deficits/Surpluses:
    • Deficits: Lead to excess spending relative to tax revenues, reducing national saving and supply of loanable funds, increasing interest rates.
    • Surpluses: Enhance saving, increase loanable fund supply, and decrease interest rates.

Historical Context of U.S. Government Debt

Government Financing of Deficits
  • Deficits are financed by selling government bonds, which accumulates to the national debt.
  • Debt-to-GDP Ratio: A measure of government indebtedness relative to revenue generation capabilities, typically rising during wartime.
Financial Crisis of 2008-2009
  • Elements leading to the crisis:
    • Significant asset price decline (30% drop in housing prices).
    • Failure and insolvency of financial institutions due to a rise in mortgage defaults.
    • Widespread borrower credit issues leading to a credit crunch.
    • Resulting economic downturn causing GDP to shrink and unemployment rates to rise.

Final Summary

  • The U.S. financial system incorporates various institutions, including bond and stock markets that mobilize savings toward investments.
  • Important national income accounting identities align saving with investment in closed economies.
  • The interest rate is contingent upon the interplay between supply and demand within the market for loanable funds, significantly influenced by budgetary policies and fiscal intervention.