Harcourt Brace & Company Chapter 25 Saving, Investment and the Financial System

Harcourt Brace & Company Financial Markets... ... matching one person’s saving with another person’s investment (directly) ... move the economy’s scarce resources from savers to borrowers. ... are opportunities for savers to channel unspent funds into the hands of borrowers.

Harcourt Brace & Company The Bond Market A bond is a debt instrument. 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: municipal bonds interest is tax exempt.

Harcourt Brace & Company Types of Bonds (debt securities) Corporate Bonds Municipal Bonds U.S.Treasury Bonds and Notes U.S. Treasury Bills Commercial Paper

Harcourt Brace & Company Stock represents ownership in a firm (equity finance) Risk vs. Return Primary vs. Secondary Market Major U.S. Markets: – New York Stock Exchange – NASDAQ The Stock Market

Harcourt Brace & Company Financial Institutions in the U.S. Economy Institutions that indirectly allow savers to provide funds to borrowers are called financial intermediaries. Types of Financial Intermediaries: – Banks - Credit Unions – Savings Banks - Mutual Funds – Other

Harcourt Brace & Company Financial Intermediaries: Banks Banks take in deposits and make loans. Banks pay depositors interest and charge borrowers higher interest on their loans. Other functions: checkable deposits, supply currency, safe deposit boxes

Harcourt Brace & Company Financial Intermediaries: Mutual Funds A Mutual Fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. Allows people with small amounts of money to diversify and to reduce risk.

Harcourt Brace & Company Financial Intermediaries: Other  Other financial intermediaries include: – Savings Banks (S&L’s) – Credit Unions – Pension Funds – Insurance Companies – Finance Companies

Harcourt Brace & Company Saving and Investment in the National Income Accounts 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 Assume a closed economy (NX=0): Y = C + I + G National Saving or Saving is equal to: Y - C - G = I = S

Harcourt Brace & Company Saving and Investment in the National Income Accounts 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 Two components of national saving: Private Saving = (Y - T - C) Public Saving = (T - G)

Harcourt Brace & Company For Example IF Y=$6,000, T=$1,000, C=$4,000 and G=$1,200, then I=S=$800 (Y-C-G) Private Savings=$1000 (Y-T-C) Public Savings=-$200 (T-G)

Harcourt Brace & Company Saving and Investment Private Saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public Saving is the amount of tax revenue that the government has left after paying for its spending. For the economy as a whole, saving must be equal to investment.

Harcourt Brace & Company Financial markets coordinate the economy’s saving and investment in The Loanable Funds Market The Supply of Loanable Funds comes from private and public savings. The Demand for Loanable Funds comes from households and firms who wish to borrow. The Market For Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Interest Rate Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Interest Rate Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 5% $1,200

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 5% $1,200 Movement to equilibrium is consistent with principles of supply and demand.

Harcourt Brace & Company The Market For Loanable Funds 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. Saving represents the supply of loanable funds, while investment represents demand.

Harcourt Brace & Company Government Policy That Affects The Economy’s Saving and Investment Policies that influence the loanable funds market: – Taxes and Saving (Fig. 25-2) – Taxes and Investment (Fig. 25-3) – Gov. Budget Deficits (Fig. 25-4) Observe how policy affects equilibrium, interest rates and funds.

Harcourt Brace & Company Government Policy That Affects The Economy’s Saving and Investment Taxes on savings impact the incentive to save, e.g. A tax decrease would alter the incentive for households to save at any given interest rate and would affect the supply of loanable funds.

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate 5% $1,200 Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 5% $1,200 Lower taxes on savings will likely increase the supply of loanable funds

Harcourt Brace & Company $1,200 The Market For Loanable Funds Supply Demand Interest Rate 5% 4% $1,300 Loanable Funds

Harcourt Brace & Company Government Policy That Affects The Economy’s Saving and Investment A Tax Break on investment would increase the incentive to borrow if an investment tax credit were given.

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate 5% $1,200 Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate 5% $1,200 Loanable Funds Tax Break on investment would increase the incentive to borrow altering the demand for loanable funds.

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 5% $1,200 6% $1,300

Harcourt Brace & Company Government Policy That Affects The Economy’s Saving and Investment 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.

Harcourt Brace & Company Government Policy That Affects The Economy’s Saving and Investment When the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms. This deficit borrowing “crowds out” the private borrowers who are trying to finance investments.

Harcourt Brace & Company Crowding Out Defined as the “fall in investment as a result of increased government borrowing”

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate 5% $1,200 Loanable Funds

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate 5% $1,200 Loanable Funds Government borrowing to finance its budget deficit, reduces the supply of loanable funds.

Harcourt Brace & Company The Market For Loanable Funds Supply Demand Interest Rate Loanable Funds 6% $1,000 5% $1,200

Harcourt Brace & Company Debt vs. Deficit/Surplus Federal Debt (2002)---$6.1 Trillion (but declining as a % of GDP, Fig. 25-5). Federal Deficit of $292 Billion in 1992 Surplus of $127 Billion FY2001 Deficit of $159 Billion in FY2002

Harcourt Brace & Company Conclusion Financial markets coordinate borrowing and lending and thereby help allocate the economy’s scarce resources efficiently. Financial markets are like other markets in the economy. The price in the loanable funds market - interest rate - is governed by the forces of supply and demand.