Saving, Investment, and the Financial System
Financial Institutions in the U.S. Economy
The Financial System and Financial Institutions
Financial system: Groups that match savers with investors.
Financial institutions: Places where savers give money to borrowers, either directly or indirectly.
Financial markets
Financial intermediaries
Financial Markets
Financial markets: Places where savers give money directly to borrowers.
The bond market
The stock market
The Bond Market
Bond: A promise to pay back borrowed money with interest.
Specifies:
Date of maturity: When the loan is paid back.
Rate of interest: How much extra is paid until the loan is done.
Principal: How much was borrowed.
Bond Characteristics
Term: How long until the bond is done.
Short term (months), long term (10-30+ years), never-ending.
Longer bonds are riskier.
Longer bonds usually pay more interest.
Credit risk: Chance the borrower won't pay.
Higher risk means higher interest.
U.S. bonds are usually low risk.
"Junk bonds" are high risk and pay lots of interest.
Tax treatment:
Most bond interest is taxed.
Municipal bonds: From local governments, not taxed, so lower interest.
Inflation protection:
Special bonds that rise with inflation.
Payments go up when prices go up.
The Stock Market
Stock: Owning a piece of a company and getting some of its profits.
Equity finance: Selling stock to get money.
Debt finance: Selling bonds to get money.
Stock markets let people trade stocks easily.
The company doesn't get money from these trades.
Stock prices: Depend on how much people want to buy or sell the stock.
Stock index: A number that shows how a group of stocks is doing.
Examples: Dow Jones, Standard & Poor’s 500.
Financial Intermediaries
Financial intermediaries: Groups that help savers give money to borrowers indirectly.
Banks and mutual funds are most important.
Banks
Banks:
Take savings from people (pay a little interest).
Loan that money to borrowers (charge more interest).
Banks also:
Help people buy things with checks and cards.
Act as a safe place to keep money.
Mutual Funds
Mutual fund: A fund that sells shares to people and uses the money to buy stocks and bonds.
Advantages:
Lets people invest small amounts in many things (less risk).
Gives regular people access to professional money managers.
Index funds buy all stocks in an index.
Usually do better than other mutual funds.
Summing Up
The U.S. has many financial helpers: bond market, stock market, banks, mutual funds, and more.
They all do the same thing: move savings to borrowers.
Saving and Investment in the National Income Accounts
Some Important Identities
National income rules lead to important connections.
Identity: An equation that's always true because of how it's defined.
Identities show how things relate.
GDP
Gross domestic product (GDP, Y): Total income = Total spending.
Y = GDP
C = consumption
I = investment
G = government purchases
NX = net exports
Closed and Open Economies
Closed economy: Doesn't trade with other countries;
Open economy: Trades with other countries; NX < \neq 0
Closed Economy
National saving (S): Income left after paying for spending and government.
If we don't trade with other countries:
Private and Public Saving
Let = Taxes minus payments from the government
, or
Private saving : Money people have left after taxes and spending.
Public saving : Money the government has left after spending.
National saving = Private saving + Public saving
Budget Surplus and Deficit
Budget surplus (T – G > 0): Government makes more than it spends.
Budget deficit (T – G < 0): Government spends more than it makes.
Active Learning: Applying the Concepts
Given:
GDP = $19 trillion, = $13 trillion, = $2.5 trillion, and Budget deficit = $1.2 trillion.
Find: public saving, net taxes, private saving, national saving, and investment.
Answers
Public saving: T – G = –$1.2 trillion
Net taxes: T = $1.3 trillion
, so
Private saving: $4.7 trillion
National saving = Investment: S = I = $3.5 trillion
= Private + Public saving =
The Meaning of Saving and Investment
Private Saving
Money left after people pay taxes and spend.
People can:
Buy bonds or stocks.
Buy a bank CD.
Buy mutual fund shares.
Keep it in a bank account.
Investment
Buying new equipment.
Examples:
GM builds a new factory.
You buy computers for your business.
Your parents build a new house.
The Market for Loanable Funds
Market for Loanable Funds
Market for loanable funds: Where savers lend money and borrowers get loans.
A supply-demand model for money.
Helps us see:
How saving and investment work together.
How government and other things change saving, investment, and interest rates.
Supply and Demand for Loanable Funds
Imagine one big money market.
Savers put money in.
Borrowers take loans out.
One interest rate for both saving and borrowing.
The Supply of Loanable Funds
Saving is where the money comes from.
People with extra money can lend it out for interest.
Government saving:
Adds to the money if positive.
Reduces the money if negative.
The Demand for Loanable Funds
Investment is why people want to borrow.
Businesses borrow to buy equipment.
People borrow to buy houses.
Reaching Equilibrium
If interest is too low:
Not enough money, so people want to save more.
Lenders raise interest rates.
Saving goes up.
Borrowing goes down.
If interest is too high: Too much money, so interest goes down.
Interest finds the right balance between saving and borrowing.
Savers provide money, and borrowers demand money.
Here, the sweet spot is 5 percent interest, with $1,200 billion changing hands.
Policy 1: Saving Incentives
If tax laws help people save, interest rates go down, and investment goes up.
People do what they're encouraged to do.
More money available.
New balance.
Lower interest.
More money changing hands.
More saving and investment.
Helping Americans save shifts the money supply to the right.
So, interest falls, and investment rises.
Here, interest falls from 5 percent to 4 percent, and $1,200 billion rises to $1,600 billion.
Policy 2: Investment Incentives
If tax laws help businesses invest, interest rates and saving go up. Investment tax break.
More demand for money.
Demand shifts right.
New balance.
Higher interest.
More money changing hands.
More saving and investment.
If businesses are encouraged to invest, demand for money rises.
So, interest rises, and saving rises.
Here, demand shifts, interest rises from 5 percent to 6 percent, and $1,200 billion rises to $1,400 billion.
Policy 3: Government Budget Deficits and Surpluses
Budget deficit: Government spends more than it makes.
Government debt: All past borrowing.
Budget surplus: Government makes more than it spends.
Balanced budget: Government spends exactly what it makes.
Government starts balanced, then spends too much.
Money supply changes.
Less money available.
Supply shifts left.
New balance.
Higher interest.
Less money changing hands.
Crowding out: Government borrowing makes it harder for businesses to borrow.
A deficit lowers saving, lowers money supply, raises interest, and lowers investment.
A surplus raises money supply, lowers interest, and raises investment.
When the government borrows, it takes money from businesses that need it.
So, interest rises.
Here, money supply shifts, interest rises from 5 percent to 6 percent, and $1,200 billion falls to $800 billion.
Conclusion
Markets are a good way to organize things.
When money markets balance saving and borrowing, they help use resources efficiently.
Money markets link now and later.
Good money markets help both current and future people.