Saving, Investment, and the Financial System

Human capital Physical Capital The Source of Physical Capital What is the relationship between Savings

SAVING and INVESTMENT

Saving and Investment This is called the saving-investment spending identity When you add government and the foreign sector, it becomes more intense SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 4 Saving = investment in a closed economy

Budget Deficits and Surpluses impact investment Budget surplus = an excess of tax revenue over govt spending = T – G = public saving Budget deficit = a shortfall of tax revenue from govt spending = G – T = – ( public saving) 5

Foreign Markets also impact investment A dollar generated by national savings and a dollar generated by capital inflow are not equivalent. Investment spending financed by capital inflow comes at a higher national cost (the interest that must eventually be paid to a foreigner), than a dollar borrowed from national savings.

THE INTEREST RATE The interest rate is the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year.

Interest Rates and Inflation What are interest rates? Why do lenders charge them? Who is willing to lend me $100 if I will pay a total interest rate of 100%? (I plan to pay you back in 2050) If the nominal interest rate is 10% and the inflation rate is 15%, how much is the REAL interest rate? Real Interest Rates- The percentage increase in purchasing power that a borrower pays. (adjusted for inflation) Real = nominal interest rate - expected inflation Nominal Interest Rates- the percentage increase in money that the borrower pays not adjusting for inflation. Nominal = Real interest rate + expected inflation

Nominal vs. Real Interest Rates Example #1: You lend out $100 with 20% interest. Inflation is 15%. A year later you get paid back $120. What is the nominal and what is the real interest rate? Nominal interest rate is 20%. Real interest rate was 5% In reality, you get paid back an amount with less purchasing power. Example #2: You lend out $100 with 10% interest. Prices are expected to increased 20%. In a year you get paid back $110. What is the nominal and what is the real interest rate? Nominal interest rate is 10%. Real rate was –10% In reality, you get paid back an amount with less purchasing power.

So far we have only been looking at NOMINAL interest rates. What about REAL interest rates?

Loanable Funds Market Is an interest rate of 50% good or bad? Bad for borrowers but good for lenders The loanable funds market is the private sector supply and demand of loans. This market shows the effect on REAL INTEREST RATE Demand- Inverse relationship between real interest rate and quantity loans demanded Supply- Direct relationship between real interest rate and quantity loans supplied This is NOT the same as the money market. (supply is not vertical) 11

Real Interest Rate 12 D Borrowers S Lenders Loanable Funds Market Quantity of Loans Q Loans rere At the equilibrium real interest rate the amount borrowers want to borrow equals the amount lenders want to lend.

Real Interest Rate 13 D Borrowers S Lenders Loanable Funds Market Quantity of Loans Q Loans D1D1 rere r1r1 Q1Q1 Example: The Gov’t increases deficit spending? Government borrows from private sector Increasing the demand for loans Real interest rates increase causing crowding out!!

14 Loanable Funds Market 1.Changes in private savings behavior 2.Changes in public savings 3.Changes in foreign investment 4.Changes in expected profitability 1.Changes in perceived business opportunities 2.Changes in government borrowing Budget Deficit Budget Surplus Demand Shifters Supply Shifters

Loanable Funds Market – Handout 15

Personal Finance Assets- Anything of monetary value owned by a person or business. Investment refers to business spending. Personal investments refers to the asset management of individuals Liabilities – what you owe 16

Bond--- Bonds are loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. The bond holder has NO OWNERSHIP of the company. Bonds vs. Stocks 17

Stockowners can earn a profit in two ways: 1. Dividends, which are portions of a corporation’s profits, are paid out to stockholders. 2. A capital gain is earned when a stockholder sells stock for more than he or she paid for it. A stockholder that sells stock at a lower price than the purchase price suffers a capital loss. 18 Stock – Part ownership in a company

BONDSBONDS vs Stocks

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