Principles of Macroeconomics: Ch. 13 First Canadian Edition Overview-8 u Financial Markets and Intermediaries u Saving and Investment u Market for Loanable Funds u Government policies that affect the economy’s savings and investment

Principles of Macroeconomics: Ch. 13 First Canadian Edition Financial Markets... u... are the markets in the economy that help to match one person’s saving with another person’s investment (spending). u... move the economy’s scarce resources from savers to borrowers. u... are opportunities for savers to channel unspent funds into the hands of borrowers.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Financial Institutions in the Canadian Economy u Institutions that allow savers and borrowers to interact are called financial intermediaries. u Types of Financial Intermediaries: –Banks - Bond Market –Stock Market - Mutual Funds –Other

Principles of Macroeconomics: Ch. 13 First Canadian Edition Financial Intermediaries: Banks u Banks take in deposits from people who want to save and make loans to people who want to borrow. u Banks pay depositors interest and charge borrowers higher interest on their loans. u Banks help create a medium of exchange, by allowing people to write cheques against their deposits.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Financial Intermediaries: The Bond Market u A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. u Characteristics of a bond: –Term: the length of time until maturity. –Credit Risk: the probability that the borrower will fail to pay some of the interest or principal. –Tax Treatment: The interest on most bonds is taxable income.

Principles of Macroeconomics: Ch. 13 First Canadian Edition u Stock represents ownership in a firm, thus the owner has claim to the profits that the firm makes. u Sale of stock implies “equity finance” but offers both higher risk and potentially higher return. u Markets in which stock is traded: –Toronto Stock Exchange--TSX –Vancouver Stock Exchange Financial Intermediaries: The Stock Market

Principles of Macroeconomics: Ch. 13 First Canadian Edition Financial Intermediaries: Mutual Funds u A Mutual Fund is an institution that sells units to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. u Allows people with small amounts of money to diversify.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Tutorials etc u ODD # groups begin next week u Assignment 1 ODD and EVEN are now on my web page—Due in 2nd meeting u Reading week impact on schedule. u Chapter 5,and 6 notes are up-7 soon u Deferred December exam (med cert. and other valid reasons-NOT a grade-raiser) Location etc to be announced in class soon. Likely Feb. 4

Principles of Macroeconomics: Ch. 13 First Canadian Edition Saving and Investment in the National Income Accounts u Recall: GDP is both total income in an economy and the total expenditure on the economy’s output of goods and services: Y = C + I + G + NX u Assume a closed economy: Y = C + I + G u National Saving or Saving is equal to: Y - C - G = I S=I

Principles of Macroeconomics: Ch. 13 First Canadian Edition Saving and Investment in the National Income Accounts u National Saving or Saving is equal to: Y - C - G = I = S or S = (Y - T - C) + (T - G) where “T” = taxes net of transfers u Two components of national saving: Private Saving = (Y - T - C) Public Saving = (T - G)-- deficit or surplus

Principles of Macroeconomics: Ch. 13 First Canadian Edition Previous equation Y - C - G = I = S or S= Y-T-C+T-G That is, add & subtract T to get S = (Y - T - C) + (T - G)

Principles of Macroeconomics: Ch. 13 First Canadian Edition Saving and Investment u Private Saving is the amount of income that households have left after paying their taxes and paying for their consumption. u Public Saving is the amount of tax revenue that the government has left after paying for its spending. u For the economy as a whole, saving must be equal to investment.

Principles of Macroeconomics: Ch. 13 First Canadian Edition u Financial markets co-ordinate the economy’s saving and investment in The Loanable Funds Market u The Supply of Loanable Funds comes from people who have income (Yi>Ci) that they want to loan out. u The Demand for Loanable Funds comes from those who wish to borrow to make investments. Dlf>>>K The Market For Loanable Funds

Principles of Macroeconomics: Ch. 13 First Canadian Edition The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 5% $120 Movement to equilibrium is consistent with principles of supply and demand.

Principles of Macroeconomics: Ch. 13 First Canadian Edition The Market For Loanable Funds u The supply and demand for loanable funds depends on the real interest rate. Movement to equilibrium is the process of determining the real interest rate in the economy. u Saving represents the supply of loanable funds, while investment (spending) represents demand.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Government Policy That Affects The Economy’s Saving and Investment u Policies that influence the loanable funds market: –Taxes and Saving –Taxes and Investment –Government Budget Deficits u Observe how policy affects equilibrium, interest rates and loanable funds.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Government Policy That Affects The Economy’s Saving and Investment u Taxes on savings reduce the incentive to save. A TAX DECREASE would increase the incentive for households to save at any given interest rate and would affect the supply of loanable funds resulting in the: –Supply curve shifting to the right. –Equilibrium interest rate would drop. –Quantity demanded for funds would rise.

Principles of Macroeconomics: Ch. 13 First Canadian Edition $120 The Market For Loanable Funds Supply Demand Interest Rate 5% 4% $140 Loanable Funds

Principles of Macroeconomics: Ch. 13 First Canadian Edition Government Policy That Affects The Economy’s Saving and Investment u A Tax Reduction on investment spending would increase the incentive to borrow if an investment tax credit were given. u An investment tax credit would: –Alter the demand for loanable funds. –Cause the demand curve to shift to the right. –Result in a higher interest rate and greater saving.

Principles of Macroeconomics: Ch. 13 First Canadian Edition The Market For Loanable Funds Supply Demand Interest Rate 5% $120 Loanable Funds Tax credit on investment would increase the incentive to borrow altering the demand for loanable funds.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Government Policy That Affects The Economy’s Saving and Investment u Government Budget Deficit: –When the government spends more than it receives in tax revenues the accumulation of past budget deficits is called the government debt. u The budget deficit: –Alters the supply curve, reducing supply. –Causes the supply to shift to the left. –Results in Crowding Out.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Government Policy That Affects The Economy’s Saving and Investment u When the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms. u This deficit borrowing “crowds out” the private borrowers who are trying to finance investments.

Principles of Macroeconomics: Ch. 13 First Canadian Edition The Market For Loanable Funds Supply Demand Interest Rate 5% $120 Loanable Funds Government borrowing to finance its budget deficit, reduces the supply of loanable funds.

Principles of Macroeconomics: Ch. 13 First Canadian Edition Conclusion u Financial markets coordinate borrowing and lending and thereby help allocate the economy’s scarce resources efficiently. Affects growth. u Financial markets are like other markets in the economy. The price in the loanable funds market – the real interest rate - is governed by the forces of supply and demand.