Saving, investment, and the financial system Econ 100 Lecture 14 How saving and investment are coordinated by (the intermediation of) the financial system in the economy: Saving, investment, and the financial system

In the last lecture, we have seen that in order that an economy grows faster, it has to invest more so that its (physical as well as human) capital stock grows faster. And in order to invest more, the economy has to save more. Saving is the source of investment. But saving must be channeled to investment. This is done by the financial system.

In this lecture, we will Have an overview of the financial system See what saving is and how it is related to investment See how financial system coordinates saving and investment

The financial system The financial system (or institutions) consists of Financial markets Financial intermediaries There are many different types of financial markets. We will see only two of them: The bond market The stock market There are many different types of financial intermediaries. Again, we will see only two of them: Banks Investments funds

The bond market The bond market is the market in which bonds are bought and sold. A bond is a loan contract or a certificate of indebtedness that specifies the issuer of the bond (the borrower) the face value the date of maturity the coupon rate (if it is a coupon bond)

The buyer of the bond at the time when it is issued will be the lender to the issuer. Later on, the first buyer can sell the bond to another saver or financial investor (we say the bond is sold in the “secondary market”) and the borrower makes the interest payments as well the payment of the face value when they are due to whomever is holding the bond at that time.

The length of the time until the bond matures is called the “term” of the bond. Bonds can be of short-term or long-term. Long-term bonds are usually coupon bonds (original term longer than a year), Short-term bonds are usually discount bonds (original term shorter than a year).

Risks associated with bonds: Credit (or default) risk Interest rate risk Long-term bonds are more risky. Therefore, they usually pay a higher rate of return than the short-term bonds (to compensate for the higher risk).

The stock market The stock market is the market in which shares of stock of companies are bought and sold. A share of stock gives the holder the right to share the ownership of the company. As an owner, the shareholder is entitled to a share in the distributed profits of the company (proportional to his/her share in the stock of the company). The company may have issued some bonds and some shares of stock. It has to fulfill first its obligations to the bondholders. After the obligations due to debt (principal or interest payments) are fulfilled, the residual profits will be distributed among shareholders.

Shares of stock are more risky than bonds Shares of stock are more risky than bonds. Therefore, they usually pay a higher rate of return to the holder. Also, more risky shares of stock pay higher rates of return than less risky shares. Like bonds, shares of stock also circulate in the secondary market. When it is time to pay distributed profits (dividends) to shareholders, the payment will be made to whomever is holding the share at that time.

Banks Banks are financial intermediaries that accept deposits from savers and make out loans to those who need to borrow money. They pay a relatively low interest rate to deposits and charge a relatively high interest rate to loans. Banks make out loans as deposit holders still own the funds in their deposits and can make payments out of their deposits. This means that banks create money in addition to the money created by the government.

Investment funds An investment fund (or mutual fund) is an institution that pools together the savings of a large number of small savers (or financial investors) by selling its shares to them and invests this large sum of funds in a large number of bonds and stock to creat a large portfolio of such financial instruments. Those who have a share in an investment fund will benefit from increases (and lose because of decreases) in the value of the portfolio. The advantage of an investment fund to the shareholder is the elimination of risks as a result of diversification.

The loanable funds market Bonds and stocks are different financial instruments with different characteristics. For one thing, the risks involved with them are different. Therefore, the rate of return on bonds will not be equal to the rate of return on stocks, and, moreover, they will not necessarily move in the same direction, in general. However, both bonds and stocks are alternative ways of earning some return for savings (by lending) and they are also alternative ways of raising funds for investment (by borrowing).

Therefore, as savers increase their saving, they will increase their purchases of both bonds and stocks more or less, and the prices of bonds as well as of prices of stocks will be affected positively, although in different degrees in general. Consequently, rates of return on bonds and stocks will be affected similarly. Similarly, as firms increase their investment, they will increase their issues of both new bonds and stocks more or less, and the prices of bonds as well as of prices of stocks will be affected negatively, although in different degrees in general. Consequently,again, rates of return on bonds and stocks will be affected similarly.

As the rates of return on bonds and stocks are affected in the same way, say, they are increasing, they will increase by different amounts, and the rate of return on bonds may increase more or less than the rates of return on stocks, but since they all increase more or less, an average rate of return representing them all will increase also.

Therefore, when we want to study the effects of events that cause saving and/or investment change in general, we can lump together all markets for financial instruments used as devices of borrowing and lending, including bonds and stocks, as if they are all of the same kind, and represent their rates of return by some average rate of return, called “the interest rate”. This general market for funds that can be loaned or borrowed, we will call “the loanable funds market”.

Saving Y = Profits + Wages and Salaries + Rent + Interest Income = Y Private disposable income = Y – T Private saving, Sp = Y – T – C Public saving, Sg = T – G National saving, S = Sp + Sg = Y – T – C + T – G = Y – C – G

Recall that Y = C + I + G + NX Notice that, for a closed economy, NX = 0, and Y = C + I + G This means that S = Y – C – G = C + I + G – C – G = I So it looks like, in a closed economy, S = I automatically. Then, why do we need to study the loanable funds market to understand how S becomes equal to I ?

The answer lies in the fact that there is a difference between actual saving and desired (or planned) saving, and there is a difference between actual investment and desired (or planned) investment. Actual saving automatically equals actual investment. But actual saving may be different from desired saving and actual investment may be different from desired investment. And desired saving and desired investment are not automatically equal to each other. The determination of the real interest rate in the loanable funds market is the same process that brings the equality between the desired saving and investment.

Demand and supply analysis for the loanable funds market Saving is the supply of funds into the loanable funds market. It depends positively on the real interest rate which represents the reward for saving and lending. So, the saving curve is a positively sloped curve. Investment is the demand for funds from the loanable funds market. It depends negatively on the real interest rate which represents the price (cost) of borrowing and investing. So, the Investment curve is a negatively sloped curve.

The real interest rate at the intersection of saving and investment curves will be the equilibrium interest rate. At that interest rate, desired S = desired I. What happens if the actual r is different than the equilibrium r? If the actual r happens to be larger than the equilibrium r for some time, S > I. Savers will want to buy more than the available bonds and stocks, and the prices of bonds and stocks will go up, which means that the interest rates on them will go down. The real interest rate will approach the equilibrium.

And if the actual r happens to be smaller than the equilibrium r for some time, S < I. Borrowers will want to sell more bonds and stocks than the savers want to buy, and the prices of bonds and stocks will go down, which means that the interest rates on them will go up. Again, the real interest rate will approach the equilibrium. Notice that, since S = Y – C – G, any discrepancy between S and I can be removed not only by a change in r but also by a change in Y. But in the above, we have assumed that Y is constant at its long-run value, and the burden of adjustment to a disequilibrium between S and I falls entirely on r.

Let us now examine some examples of how the analysis of loanable funds market sheds light upon what happens as a result of changes in connditions of borrowing and lending in the economy.

A reduction in taxes on interest income As the tax rate on interest income is reduced, after-tax real interest rate to be earned by lenders increases at any before-tax real interest rate. Saving increases at any before-tax real interest rate (saving curve shifts right) whereas investment remains the same (investment curve does not shift). In the new equilibrium, real interest rate decreases and investment increases.

Tax breaks on investment expenditures If new incentives for investments are provided (by making the investment expenditures tax-deductible, for example), the profitability of investment will increase and firms will want to increase their investment expenditures at any real interest rate (investment curve shifts right) whereas saving remains the same (saving curve does not shift). In the new equilibrium, real interest rate increases and saving increases.

An increase in government purchases Suppose the government increases its purchases of goods and services without increasing taxes, causing a budget deficit that has to be covered by increasing government borrowing. This means that saving will decrease at any real interest rate (saving curve shifts left) whereas investment remains the same (investment curve does not shift). In the new equilibrium, real interest rate increases and investment decreases (crowding-out).