Principles of Macroeconomics: Saving, Investment, and the Financial System

Chapter 13: Saving, Investment, and the Financial System

Chapter Objectives

• By the end of this chapter, you should be able to:
  • Categorize an event as either saving or investment.
  • Explain how financial intermediaries connect borrowers and savers.
  • Analyze the relationship between bond prices and the interest rate.
  • Explain how financial markets connect borrowers and savers.
  • Explain the difference between the bond market and the stock market.
  • Explain how government borrowing can lead to crowding out.
  • Analyze how changes in demand impact equilibrium in the market for loanable funds.
  • Describe the loanable funds market.
  • Explain the relationship between national saving, public saving, and private saving.
  • Analyze how changes in the government budget impact equilibrium in the market for loanable funds.
  • Explain the saving and investment identity.
  • Analyze how changes in supply impact equilibrium in the market for loanable funds.
  • Analyze the relationship between interest rates and quantity demanded.
  • Analyze the relationship between interest rates and quantity supplied.
  • Identify market equilibrium in the loanable funds market.

13-1 Financial Institutions in the U.S. Economy

The Financial System and Financial Institutions

• Financial System: A group of institutions in the economy that help match one person’s saving with another person’s investment.
• Financial Institutions: Institutions through which savers can directly provide funds to borrowers:
  • Financial Markets: Include the bond market and the stock market.
  • Financial Intermediaries: Institutions, such as banks and mutual funds, that facilitate indirect lending of funds to borrowers.

Financial Markets

Definition and Types

• Financial Markets: Institutions through which savers can directly provide funds to borrowers.
  • The Bond Market: A marketplace for issuing and trading bonds.
  • The Stock Market: A marketplace for buying and selling stock shares.

The Bond Market

Bond Definition

• Bond: A certificate of indebtedness that specifies the obligations of the borrower to the buyer of the bond.
  • Components of a Bond:
  • Date of Maturity: The time at which the loan will be repaid.
  • Rate of Interest: Paid periodically until the date of maturity.
  • Principal: Amount borrowed.

Bond Characteristics

• Term: Length of time until the bond matures.

  • Types:
  • Short Term: Maturities of a few months.
  • Long Term: 10-30+ years.
  • Perpetuities: Never mature.
  • Risk Consideration: Long-term bonds are riskier than short-term bonds and usually provide higher interest rates.

• Credit Risk: The probability of borrower default.

  • Higher interest rates correlated with higher default risk.
  • U.S. government bonds typically offer low interest rates due to perceived low risk.
  • High-Yield Bonds (Junk Bonds): Offer very high interest rates due to high default risk.

• Tax Treatment: Interest on most bonds is taxable income.

  • Municipal Bonds: Issued by state and local governments, typically tax-exempt with lower interest rates.

• Inflation Protection:

  • Treasury Inflation-Protected Securities (TIPS): Indexed to inflation; when prices rise, payments rise proportionately.

The Stock Market

Stock Definition

• Stock: A claim to partial ownership in a firm and a claim to some of the profits the firm makes.
  • Equity Finance: Raising money through the sale of stock.
  • Debt Finance: Raising money by selling bonds.

Stock Market Dynamics

• Organized Stock Exchanges: Facilitate trading of stock shares, but the issuing business does not receive money from trades between shareholders.
• Stock Prices: Determined by the supply and demand for the stock in the market; influenced by various factors such as performance and investor perception.
• Stock Index: An average of a group of stock prices—examples include the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 Index.

Financial Intermediaries

Definition and Importance

• Financial Intermediaries: Institutions through which savers can indirectly provide funds to borrowers.
  • Main types include banks and mutual funds.

Banks

• Primary Role:
  • Accept deposits from savers (pay a lower interest rate).
  • Use these deposits to make loans to borrowers (charge a higher interest rate).
• Secondary Role: Facilitate purchases of goods and services using checks and debit cards (serving as a medium of exchange and store of value).

Mutual Funds

• Mutual Fund: An institution that sells shares to the public and uses the proceeds to buy a diversified portfolio of stocks and bonds.
  • Advantages:
  • Allows individuals with small amounts of money to diversify their holdings (reducing risk).
  • Provides access to professional money management.
  • Index Funds: A type of mutual fund that buys all stocks in a stock index, generally performing slightly better on average than actively managed mutual funds.

Summing Up

• The U.S. economy has a diverse range of financial institutions, including bond markets, stock markets, banks, mutual funds, pension funds, credit unions, and insurance companies.
• All financial institutions share the crucial objective of directing resources from savers to borrowers efficiently.

13-2 Saving and Investment in the National Income Accounts

Important Identities

• Identity: An equation that is always true because of the way the variables are defined. It helps clarify how different economic variables relate to one another.

Gross Domestic Product (GDP)

• Gross Domestic Product (Y): Total income = Total expenditure.
  • Mathematical Representation: $Y = C + I + G + NX$
  • Where:
    • C: Consumption
    • I: Investment
    • G: Government Purchases
    • NX: Net Exports

Closed and Open Economies

• Closed Economy: An economy that does not engage in international trade; in such cases, $NX = 0$.
• Open Economy: An economy that interacts with other economies; in such cases, $NX <br /> eq 0$.

National Saving in a Closed Economy

• National Saving (S): The total income in an economy remaining after paying for consumption and government purchases.
  • In a closed economy:
  • Mathematical Representation: $S = Y - C - G$
  • This can be equated to investment: $S = I$.

Private and Public Saving

Definitions

• T: Taxes minus transfer payments.

• Private Saving: The income households retain after paying taxes and consumption expenses.

  • Mathematical Representation: $S_{private} = Y - T - C$

• Public Saving: Government revenue after public spending.

  • Mathematical Representation: $S_{public} = T - G$

• National Saving: The total of private and public saving.

  • Mathematical Representation: $S = S<em>{private} + S</em>{public}$

Budget Surplus and Deficit

Definitions

• Budget Surplus: Occurs when tax revenue exceeds government spending ( T - G > 0 ); contributes positively to public saving.
• Budget Deficit: Occurs when government spending exceeds tax revenue ( T - G < 0 ); results in negative public saving.

Active Learning: Applying the Concepts

• Given Values:

  • GDP: $$ 19 ext{ trillion}$

  • C: $13 ext{ trillion}$$

  • G: $$ 2.5 ext{ trillion}$

  • Budget Deficit: $1.2 ext{ trillion}$$

  • Calculate:

  • Public Saving:

    • $T - G = -1.2 ext{ trillion}$

  • Net Taxes (T):

    • $G - T = 1.2 <br /> ightarrow G = 2.5, T = 2.5 - 1.2 = 1.3 ext{ trillion}$

  • Private Saving: $Y - T - C = 19 - 1.3 - 13 = 4.7 ext{ trillion}$

  • National Saving (S) / Investment (I): $S = Y - C - G = 19 - 13 - 2.5 = 3.5 ext{ trillion}$

  • National saving equals investment: $S = I = 3.5 ext{ trillion}$

The Meaning of Saving and Investment

Definitions

• Private Saving: Income remaining after households pay taxes and consumption expenses. Examples of private savings activities include:

  • Buying corporate bonds or equities.
  • Purchasing certificates of deposit at banks.
  • Investing in mutual funds.
  • Keeping funds in savings or checking accounts.

• Investment: The purchase of new capital. Examples of investment activities include:

  • General Motors investing $$ 250 ext{ million}$ in a new factory.
  • An individual purchasing $5,000$$ worth of computer equipment for business purposes.
  • Spending $$ 300,000$ to build a new house.

13-3 The Market for Loanable Funds

Overview

• Market for Loanable Funds: The marketplace where those who save supply funds and those who want to borrow to invest demand funds, essentially functioning as a supply-demand model for the financial system. It helps understand how saving and investment interact, alongside the impact of government policies and other influencing factors.

Supply and Demand for Loanable Funds

Structure

• Assume there is only one financial market:
  • All savers deposit their savings here, and all borrowers take out loans from this market.
  • A single interest rate serves as both the return to saving and the cost of borrowing.

The Supply of Loanable Funds

• Source: Saving.
  • Households with extra income can lend it out to earn interest.
  • If public saving is positive, it adds to national saving and the supply of loanable funds; if negative, it reduces both.

The Demand for Loanable Funds

• Source of Demand: Investment, as firms borrow the funds needed for new equipment or infrastructure and households borrow for new houses.

Reaching Equilibrium in the Loanable Funds Market

• If Interest Rate < Equilibrium:

  • Quantity Supplied (QS) < Quantity Demanded (QD). This results in a shortage of loanable funds.
  • Consequences:
  • Encourages lenders to raise the interest rate.
  • Encourages saving (increase QS) and discourages borrowing for investments (decrease QD).

• If Interest Rate > Equilibrium:

  • There is a surplus of loanable funds.
  • This will result in a decrease in interest rates.

Supply and Demand Curves

• Equilibrium Interest Rate Example:
  • At the equilibrium interest rate of 5%, the quantity of loanable funds supplied and demanded is $1,200 ext{ billion}$$.

Fiscal Policy and Saving

• Implication of Policies:
  • Sustained tax and spending policies that boost consumption but reduce saving rates may decrease long-term living standards.

Policy 1: Saving Incentives

• Impact of Tax Law Changes:
  • If tax laws encourage greater saving, the resulting effect is lower interest rates and increased investment.
  • According to the Ten Principles of Economics, people respond to incentives, leading to an increase in supply and shifting the equilibrium to lower interest rates and higher quantities of loanable funds saved and invested.

Saving Incentives: Visual Example

• Effect of Tax Incentives:
  • A tax law change stimulating savings shifts the supply of loanable funds from curve S1 to S2.
  • As a result, the equilibrium interest rate drops from 5% to 4%, and the equilibrium quantity of loanable funds saved and invested rises from $$ 1,200 ext{ billion}$ to $1,600 ext{ billion}$$.

Policy 2: Investment Incentives

• Impact of Investment Tax Credit:
  • If reformed tax laws promote greater investment, the demand for loanable funds increases, leading to higher interest rates and increased saving.
  • The demand curve shifts right and establishes a new equilibrium with higher interest rates and higher quantity of loanable funds.

Investment Incentives: Visual Example

• Effect of Tax Credit on Investment:
  • The demand shift from D1 to D2 leads to an increase in equilibrium interest rates from 5% to 6% and a rise in the equilibrium quantity of loanable funds from $$ 1,200 ext{ billion}$ to $1,400 ext{ billion}$$.

The Decline in the Real Interest Rate

• Historical Overview:
  • The real interest rate fluctuated significantly between 1984 and 2020, with various hypotheses proposed for these changes rooted in economic conditions and policies.
  • The real interest rate calculated is the yield on 10-year Treasury bonds subtracting the core inflation rate, which is derived based on the Personal Consumption Expenditure (PCE) deflator, excluding food and energy items.

Policy 3: Government Budget Deficits and Surpluses

Definitions

• Budget Deficit: Occurs when government spending exceeds tax revenue, contributing to government debt.
• Accumulation of Government Debt: Reflects years of past borrowing and inadequate balancing of revenues versus expenditures.
• Budget Surplus: Happens when there is an excess of tax revenue over spending, effectively increasing public savings.
• Balanced Budget: A fiscal state where government spending exactly equals tax revenue.

Adjustments Due to Budget Changes

• Scenario of Government Deficit:
  • Starting with a balanced budget and moving to a deficit increases the borrowing needs, leading to:
  • A decrease in the supply of loanable funds.
  • A leftward shift of the supply curve, resulting in a higher interest rate and decreased quantity of available loanable funds.

Crowding Out

• Definition: A phenomenon where increased government borrowing leads to reduced investment by the private sector.
  • The budget deficit can diminish national saving, cause a decrease in the supply of loanable funds, elevate interest rates, and thus lead to a reduction in overall investment.
  • Conversely, a budget surplus enhances the supply of loanable funds, lowers interest rates, and fosters investment.

Effect of Government Budget Deficit

• Illustrative Example:
  • Under conditions of a budget deficit, national savings decrease, resulting in an upward pressure on the equilibrium interest rate.
  • The shift from S1 to S2 moves the equilibrium interest rate from 5% to 6%, and the corresponding equilibrium quantity of loanable funds decreases from $$ 1,200 ext{ billion}$ to $800 ext{ billion}$$.

The U.S. Government Debt

• Historical Data Trends:
  • Government debt as a percentage of GDP has varied significantly, typically increasing during wars and major economic downturns. Data here specifically examines government debt publicly held, excluding government-held accounts like Social Security.

13-4 Conclusion

• Summary of Market Efficiency:
  • The concept that markets, as largely effective mechanisms for organizing economic activity, serves to link current resources with future needs. Financial markets play an integral role in aligning the supply and demand for loanable funds to ensure efficient allocation of economic resources.

Think-Pair-Share Activity

• Discussion Questions:
  • Consider the implications of a presidential candidate's statements concerning economic growth, tax incentives, and government budget deficits.
  • Analyze the inconsistency that arises if government spending (G) remains unchanged while also proposing tax decreases and a reduction of the budget deficit.

Self-Assessment

• Understanding Questions:
  • Define a government budget deficit and assess its subsequent effects on interest rates, investment, and economic growth.