Lecture 5

Principles of Macroeconomics

• Instructor: Alvaro Boitier

• Institution: Babson College

• Course: Principles of Macroeconomics, Fall 2024

Lecture 5: Saving, Investment, and the Financial System

• Reference: Chapter 13 - Mankiw Principles of Macroeconomics [10th edition]

Introduction

• Scenario: Starting a business without sufficient start-up capital.

• Solution: Access the financial system.

  • Definition: The group of institutions in the economy that helps match savers' savings with borrowers' investments.

  • Function: Moves scarce resources from savers to borrowers.

• Financial Institutions: Include both financial markets and financial intermediaries.

Financial Markets & Intermediaries

• Financial Markets: Platforms where savers can directly provide funds to borrowers.

  • Types include:

    • Bond Market

    • Stock Market

    • Commodities Market

    • Forex Market

    • Derivatives Market

    • Cryptocurrency Market

• Financial Intermediaries: Institutions that facilitate the flow of funds between savers and borrowers.

  • Examples include:

    • Banks

    • Mutual Funds

    • Credit Unions

    • Insurance Companies

    • Pension Funds

    • Stock Exchanges

    • Building Societies

The Bond Market

• Bond: A certificate of indebtedness.

• Key Definitions:

  • Date of Maturity: When the loan will be repaid.

  • Rate of Interest: Paid periodically until maturity (referred to as the coupon).

  • Principal: The amount borrowed.

• Bonds are used by large institutions to borrow from the public (households).

• Types of Bonds:

  • Treasury Bonds

  • Corporate Bonds

  • Mortgage Related Bonds

  • Municipal Bonds

Bond Characteristics

• Term: Length of time until maturity; ranges from a few months to 30 years or more.

  • Long-term bonds are generally riskier and offer higher interest rates compared to short-term bonds.

• Credit Risk: The probability that a borrower may default on interest or principal payments.

  • Higher credit risk usually leads to higher interest rates; U.S. government bonds typically offer lower rates compared to junk bonds which have higher rates due to higher risk.

• Tax Treatment: Interest on most bonds is taxable income except for municipal bonds which are often tax-exempt at the federal level, leading to lower interest rates.

• Inflation Protection: Funds typically yield nominal payments; some bonds like Treasury Inflation-Protected Securities (TIPS) adjust their coupon rate according to inflation.

Bond Market in Numbers (World 2022)

• Top Countries by Total Debt Outstanding:

  1. U.S.: $51.3 Trillion (39%)

  2. China: $20.9 Trillion (16%)

  3. Japan: $11.0 Trillion (8%)

  • Followed by France, U.K., Canada, Germany, Italy.

The Stock Market

• Stock: A claim to partial ownership in a firm and a claim to its profits.

• Organized through stock exchanges like NYSE, NASDAQ.

• Stock Prices: Determined by supply and demand dynamics.

• Equity Finance: Sale of stock to raise money.

• Stock Index: Average of a group of stock prices; e.g., S&P 500.

Financial Intermediaries: Banks

• Banks take in deposits from savers (pay interest) and make loans to borrowers (charge interest).

• Facilitate purchasing of goods/services, acting as a medium of exchange.

Financial Intermediaries: Mutual Funds

• Institutions that sell shares to the public and use the proceeds to buy a portfolio of stocks and bonds.

• Advantages include diversification and professional management.

Key Banks in the U.S. (as of June 2023)

1. JPMorgan Chase

2. Bank of America

3. Citibank

4. Wells Fargo

5. US Bank

6. PNC Bank

7. Truist Bank

8. Goldman Sachs

9. Capital One

10. TD Bank

National Income Accounting

• GDP: Total income = Total expenditure

  • Formula: Y = C + I + G + NX

    • Y = Gross Domestic Product

    • C = Consumption

    • I = Investment

    • G = Government Purchases

    • NX = Net Exports

• Definitions:

  • Closed Economy: Zero interactions with other economies.

  • Open Economy: Interacts with other economies.

  • National Saving (S): Total income that remains after consumption and government purchases.

Accounting Identities

• In a closed economy, national saving is equal to investment (S = I).

• Societies face trade-offs between consuming and saving; reduced consumption today allows for increased future productivity through savings.

Adding Taxes to National Saving

• Tax Impact: T = taxes minus subsidies.

  • National Saving formula adjusts to S = Y - C - G + T - T.

  • Private Saving: Income left after taxes and consumption.

  • Public Saving: Government tax revenue after spending.

Public Saving Analysis

• Budget Surplus: When T - G > 0 (excess tax revenue over spending).

• Budget Deficit: When T - G < 0 (shortfall in tax revenue from spending).

• Balanced Budget: When spending equals revenue.

Government Budget Deficit and Investment

• Deficit Consequences: Involves borrowing (selling bonds) leading to accumulated government debt.

• Impacts on Loanable Funds Market: Increasing government spending reduces national saving, shifting supply left, raising interest rates, and decreasing loanable funds available.

Activity Overview

• Understanding the implications of tax laws on savings and investment using the loanable funds model.

• Analyzing market behaviors based on investment incentives and economic climates.

Historical Data Analysis

• Observing trends in U.S. debt as a percentage of GDP and personal savings rates from 1959-2022.

• Identifying reasons for significant shifts in real interest rates and analyzing potential influences.

Conclusion and Next Steps

• Questions and comments are welcomed for further clarification on topics covered in the lecture.