Copyright © 2004 South-Western Saving, Investment, and the Financial System Mod 22 & 24

Copyright © 2004 South-Western The Financial System financial systemThe financial system consists of the group of institutions in the economy that help to match one person’s saving with another’s investment. The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. It moves the economy’s scarce resources from savers to borrowers.

Copyright © 2004 South-Western The Expanded Circular-Flow Diagram

Copyright © 2004 South-Western Why do we need to understand the Financial Markets in Macro? Because in the Macro economy, growing businesses takes financial capital to spend on physical capital. Investment spending requires a source of funding beyond a business’s financial resources. Example: Upcoming Alibaba IPO—$15 B

Copyright © 2004 South-Western Theory behind the Savings-Investment Identity Recall that GDP is both total income in an economy and total expenditure— Remember Circular Flow!!

Copyright © 2004 South-Western Some Important Identities closed economyAssume a closed economy – one that does not engage in international trade: Total Income = Total Spending Total Income = Consumption + Savings Total Spending = Consumption + Investment Consumption + Savings = Consumption + Investment Savings = Investment Savings = Investment Savings is equal to Investment Spending

Copyright © 2004 South-Western Where Savings in the Macroeconomy comes from Private Saving vs Public Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) The Budget Balance (BB) So... S = (Y – T – C) + (T – G) S + BB = I

Copyright © 2004 South-Western One Other Source of Savings Now, make the Macro Economy OPEN—to foreign trade In a global economy, savings can be either kept within a country—domestically—or sent out to other countries—abroad. In the macro economy, this works like N(X)— whichever inflow or outflow is bigger makes for either a + or – number. The “net” is the Capital Inflow So… now we have S + BB + CI = I

Copyright © 2004 South-Western The Meaning of Saving and Investment In other words, the money available FOR investment is whatever is left from Y as savings, plus the net of the BB, plus the net of CI. If people are not using all of their money to consume or pay taxes, and if the government is not using all of its tax money for spending, and if CI is +, then we are left with money that becomes the source of national savings.

Copyright © 2004 South-Western THE MARKET FOR LOANABLE FUNDS Loanable fundsLoanable funds refers to all income that is available from entities that have chosen to save and lend out, rather than use for their own consumption The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. market for loanable funds.Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

Copyright © 2004 South-Western FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial institutions can be grouped into two different categories: financial markets and financial intermediaries: Financial Markets: savers can directly provide funds to borrowers. Stock Market Bond Market Financial Intermediaries: savers can indirectly provide funds to borrowers. Banks, Credit Unions Mutual Funds, Pension Funds, Life Insurance

Copyright © 2004 South-Western Financial Markets and Assets: The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. An IPO is the “Initial Public Offering” or first sale of stock by a company to the public. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the NYSE, the NYSE AMEX, and NASDAQ.

Copyright © 2004 South-Western Reading a Stock Ticker

Copyright © 2004 South-Western Financial Markets and Assets: The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. In other words—an I.O.U! Characteristics of a Bond: Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. IOU

Copyright © 2004 South-Western Financial Intermediaries: Mutual Funds A mutual fund is a financial intermediary that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify. Other funds: Pension Funds Life Insurance

Copyright © 2004 South-Western Financial Intermediaries: Banks Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers higher interest on their loans. Credit Unions Function as banks, but are jointly owned by the depositors

Copyright © 2004 South-Western Tasks of Financial Institutions Reducing Transaction Costs Reducing Risks Providing Liquidity

Copyright © 2004 South-Western The Time Value of Money When you are doing investment spending to expand business, it is important that you understand the effect of time on cost/benefit analysis for $$ Want a $ today or a $ next year?

Copyright © 2004 South-Western Using Present Value Using Present Value Net Present Value Formula: PV = FV/(1+r) n

Copyright © 2004 South-Western Defining Present Value Defining Present Value Let fv = future value of $ pv = present value of $ r = real interest rate n = # of years The Simple Interest Formula pv = fv / (1 + r) n

Copyright © 2004 South-Western Sample AP Problem If the annual interest rate is 5 percent, then the present value of $1.00 received one year from now is closest to (A) $1.50 (B) $1.05 (C) $1.00 (D) $0.95 (E) $0.05

Copyright © 2004 South-Western Time Value of Money Worksheet/practice