1. SAVING, INVESTMENT and FINIANCE
Chapter 7
SAVING, INVESTMENT and FINIANCE

2. Income not spent is saved. Where do those dollars go?
Describe financial markets
Explain how financial markets channel saving to investment
Explain how governments impact financial markets

3. Financial Institutions and Financial Markets Important Concepts
Distinguish between -
Physical capital and financial capital
Finance and money
Physical Capital: machines, tools, buildings, computer systems and other items that have been produced in the past and that are used today to produce goods and services.
Financial capital: The funds that firms use to buy physical capital – bank loans, stocks, bonds, called financial instruments.

4. Financial Institutions and Financial Markets Important Concepts
Finance looks at how households and firms use financial instruments (loans, stocks, bonds) and how they manage the risks that associated with this activity. The study of money looks at how households and firms use money, how much of it they hold, how banks create money, and how its quantity of money influences the economy. We talk a lot about Money in Chapter 8.

5. Financial Institutions and Financial Markets More Concepts
Investment and Capital
Gross investment is the total amount spent on purchases of new physical capital and on replacing depreciated capital.
Depreciation is the decrease in the quantity of physical capital that results from wear and tear and obsolescence.
Net investment is the change in the quantity of capital.
Net investment = Gross investment  Depreciation.

6. Capital and Investment
Example - assume 6% depreciation:
1/1/2011: an economy has $500 billion worth of capital
during 2011: gross investment = $60 billion
1/1/2012: economy will have $530 billion worth of capital
$530 = $500 + ($60 – $30)
What is the value of net investment?

7. Economist Distinguish between Stocks and Flows
A stock is a quantity measured at a point in time.
E.g., “The U.S. capital stock was $26 trillion on January 1, 2009.”
The bathtub example is the classic means of explaining stocks and flows, and appears in Chapter 2.
A flow is a quantity measured per unit of time.
E.g., “U.S. investment was $2.5 trillion during ”

8. Stocks vs. Flows - examples
a person’s wealth
a person’s annual saving
Point out that a specific quantity of a flow variable only makes sense if you know the size of the time unit.
If someone tells you her salary is $5000 but does not say whether it is “per month” or “per year” or otherwise, then you’d have no idea what her salary really is.
A pitfall with flow variables is that many of them have a very standard time unit (e.g., per year). Therefore, people often omit the time unit: “John’s salary is $50,000.” And omitting the time unit makes it easy to forget that John’s salary is a flow variable, not a stock.
Another point: It is often the case that a flow variable measures the rate of change in a corresponding stock variable, as the examples on this slide (and the investment/capital example) make clear.
balance on your credit card
dollars added to your credit card this month
the govt debt
the govt budget deficit

9. Financial Institutions and Financial Markets More Concepts
Wealth and Saving
Wealth is the value of all the things that people own – it is a stock.
Saving is the amount of income that is not paid in taxes or spent on consumption of goods and services – it is a flow.
Saving increases wealth.

10. Financial Institutions and Financial Markets More Concepts
Wealth also increases when the market value of assets rise - called capital gains - and decreases when the market value of assets falls - called capital losses.
Buy and house for $300,000 and sell for $500,000. The capital gain is $200,000.

11. Markets for Financial Capital
Saving is the source of funds used to finance investment.
These funds are supplied and demanded in three types of financial markets:
Loan market
Bond market
Stock market

12. Loans and Loan Markets
Business borrows from a bank to buy a new computer system.
You borrow from a bank to buy a car
Households borrow to buy a home – called a mortgage loan.
These are examples of financing called loans that take place in the loan markets.
Loans are legal contracts.

13. Bonds and Bond Markets
A bond is a promise by a borrower to make specified payments on specified dates.
Bonds are issued by corporations and governments.
The buyer of a bond is a lender and the seller of the bond is a borrower.
Bonds are legal contracts.
Notice that loans and bonds are promises.

14. Stocks and Stock Markets
A certificate of ownership and claim on firm’s profits.
Traded in stock markets.

15. Financial Institutions
A financial institution is a firm that operates in the markets for financial capital.
Key financial institutions are:
Commercial banks
Insurance companies
Mutual funds
Pension funds
The Federal Reserve
Financial Crisis: The fall of 2008 saw the biggest financial crisis since the Great Depression. Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in one form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.
Classroom activity
Check out Economics in Action: The Financial Crisis and the Fix

16. Financial Institutions and Financial Markets
Solvency and Insolvency
A financial institution’s net worth is the total market value of its assets lent minus the market value of what it has borrowed.
Net worth = Assets – Liabilities
If net worth is positive, the institution is solvent and can remain in business.
But if net worth is negative, the institution is insolvent and will go out of business.
$1, $900
Assets
(Funds lent)
Liabilities
(Funds borrowed)
$100
Net Worth

17. Financial Institutions and Financial Markets
Illiquidity
A financial institution can be solvent but illiquid.
This can happen if the institution borrows short-term and makes long-term investments.

18. Interest Rates and Asset Prices
The interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset.
For example, if the price of the asset is $50 and the interest received is $5, then the interest rate is 10 percent:
$5 $50 = 0.10 or 10%

19. Interest Rates and Asset Prices
If the asset price rises (say to $100), other things remaining the same, the interest rate falls to 5 percent.
$5 $100 = .05 or 5%.
If the asset price falls (say to $20), other things remaining the same, the interest rate rises to 25 percent.
Interest rates and asset prices are inversely related

20. The Loanable Funds Market
Where interest rates are determined
The market for funds that finance investment.
Y = national income
Y is either consumed (C), saved (S) or taxed (T):
Y = C + S + T
We know from Chapter 4:
Y = C + I + G + X – M
We get: C + S + T = C + I + G + X – M
Solve for I:
I = S + (T - G) + (M - X)

21. The Loanable Funds Market
I = S + (T - G) + (M - X)
This equation tells us that funds that finance investment (I) come from three sources:
1. Household saving (S), called private saving.
2. Government budget surplus (T – G), called public saving.
NOTE: S + (T- G) is called national saving.
3. Borrowing from the rest of the world (M – X).
National saving plus foreign borrowing finance domestic investment.

22. The Loanable Funds Market
The interest rate determined in the loanable funds market is the Real Interest Rate
The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent.
In our example, the annual interest paid on a $50 loan is $5, the nominal interest rate is 10 percent per year.

23. Nominal and Real Interest Rates
The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the purchasing power of money.
The real interest rate is approximately equal to the nominal interest rate minus the inflation rate.
real interest rate = nominal interest rate – inflation
For example, if the nominal interest rate is 5 percent a year and the inflation rate is 2 percent a year, the real interest rate is 3 percent a year.
3% = 5% - 2%
Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.
Classroom activity
Check out Economics in Action: Nominal and Real Interest Rates

24. Example:
I borrow $100 from a lender and agree to pay $105 after one year:
Loan amount = $100
Interest payment = $5
Nominal Interest rate = $5/ $100 = 5%
The lender has $105 at the end of the year.
Suppose inflation is 2%. What cost $100 a year earlier now cost $102.
The lender’s purchasing power increases by $3 not $5.
The real interest rate is 5% - %2 = 3%

25. More on the Costs of Inflation
The real interest rate represents:
the increase in purchasing power to the lender
the real cost of the loan to the borrower.
If borrowers and lenders know the rate of inflation, they know the real cost and purchasing power of the loan
Unexpected inflation shifts purchasing power between lenders and borrowers.

26. More on the Costs of Inflation
1) Inflation rate higher than expected
Harms those awaiting payment (lenders)
Benefits the payers (borrowers)
I lend money at 5% expecting 2% inflation
I expect a real return of 3%
If inflation turns out to be 4%, my actual real return is 1%
2) Inflation rate lower than expected
Harms the payers (borrowers)
Benefits those awaiting payment (lenders)
If inflation turns out to be 1%, my actual return as a lender is 4%.

27. The Loanable Funds Market
The market for loanable funds determines the real interest rate, the quantity of funds loaned, saving, and investment.
We’ll start by ignoring the government (T – G) and the rest of the world (M – X).
In this case, the only source of loanable funds is private saving (S).

28. The Loanable Funds Market
The Demand for Loanable Funds
The quantity of loanable funds demanded (how much business firms want to borrow) depends on
1. The real interest rate
2. Expected profit
Demand for Loanable Funds Curve
The demand for loanable funds curve is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.
Business investment (I) is the main item that makes up the demand for loanable funds.

29. The Loanable Funds Market
Demand for loanable funds curve. A rise in the real interest rate decreases the quantity of loanable funds demanded. A fall in the real interest rate increases the quantity of loanable funds demanded.

30. The Loanable Funds Market
Changes in the Demand for Loanable Funds
When the expected profit changes, the demand for loanable funds changes.
The greater the expected profit from investment, investment increases and the demand for loanable fund increases. The DLF curve shifts to the right.
The lower the expected profit from investment, investment decreases and the demand for loanable fund decreases. The DLF curve shifts to the left.

31. Change in the Demand for Loanable Funds
Real Interest Rate
DLF2
DLF1
DLF3
Loanable Funds

32. The Loanable Funds Market
The Supply of Loanable Funds
The quantity of loanable funds supplied (household saving) depends on
1. The real interest rate
2. Disposable income
3. Expected future income
4. Wealth
5. Default risk – this is the probability the lender will not be repaid.

33. The Loanable Funds Market
The Supply of Loanable Funds Curve
The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.
For now we focus just on private saving (S).

34. The Loanable Funds Market
As the real interest rate increases, households save more, the quantity of loanable funds supplied increases. A fall in the real interest rate decreases the quantity of loanable funds supplied as households save less.

35. Changes in the Supply of Loanable Fund
A change in disposable income, expected future income, wealth, or default risk changes the supply of loanable funds.
Household saving and the supply of loanable funds will increase when -
There is an increase in disposable income,
There is a decrease in expected future income,
There is a decrease in wealth (e.g., loss in the stock market or real estate),
There is a decrease in default risk

36. Change in the Supply of Loanable Funds
Real Interest Rate
SLF3
SLF1
SLF2
Loanable Funds

37. The Loanable Funds Market
Equilibrium in the Loanable Funds Market
The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied.
Classroom activity
Check out Economics in Action: The Total Quantities Supplied and Demanded

38. The Loanable Funds Market
This figure illustrates the loanable funds market. At 7 percent a year, there is a surplus of funds and the real interest rate falls – households save more than business firms want to borrow. At 5 percent a year, there is a shortage of funds and the real interest rate rises. Equilibrium occurs at a real interest rate of 6 percent a year. E

39. What Happens When Things Change?
Increase in Demand for Loanable Funds
An increase in expected profits increases DLF.
DLF shifts to the right.
The real interest rate rises.
With higher real interest rates, household saving increases and quantity of loanable funds supplied increases movement from E to F. F E

40. Increase in the Supply of Loanable Funds
If one of the influences on saving changes and saving increases, the supply of funds increases.
(recall the influences that will increase supply?)
The real interest rate falls.
Investment increases. E F

41. The Loanable Funds Market
Long-run changes in Demand and Supply The book states on p. 171 that in the long-run both supply and demand for loanable funds tend to increase over time at similar pace: “the real interest rate has no trend.” Let’s look at what has been going on:

42. Now Add the Government to the Loanable Funds Market
Government enters the loanable funds market when it has a budget surplus or deficit.
Budget = Tax revenues (T) minus Government spending (G).
= T - G
A government budget surplus (T>G) increases the supply of funds.
A government budget deficit (T<G) increases the demand for funds.

43. Government in the Loanable Funds Market: Budget Surplus of $1
Government in the Loanable Funds Market: Budget Surplus of $1.0 Trillion
Note: PSLF is Private Supply of Loanable Funds – household saving (S)
The budget surplus of $1 trillion increases supply of funds $1trillion at each interest rate.
The real interest rate falls.
Two things happen:
Private saving decreases - in this example by $0.5 trillion to $1.5 trillion.
Investment increases – in this example by $0.5 trillion to $2.5 trillion. E F H

44. Government in the Loanable Funds Market: Budget Deficit of $1 Trillion
Note: PSLF is Private Demand for Loanable Funds – business investment (I)
A budget deficit increases demand for funds by $1trillion at each interest rate.
The real interest rate rises.
Two things happen:
Private saving increases - to by $0.5 trillion to $2.5
Investment decreases - is crowded out – as the real interest rate rises. I falls to by $0.5 trillion to $1.5 trillion.

45. The Crowding Out Effect
The tendency for government budget deficits to raise real interest rates and decrease private spending – both C and I.
Public spending crowds-out private spending.

46. The Ricardo–Barro Effect
A budget deficit increases the demand for funds.
Budget deficits today means taxes must rise in the future and disposable income will be lower.
“Rational”, forward looking taxpayers increase saving today, which increases the supply of funds.
Increased private saving finances the deficit.
In the extreme, crowding-out is avoided - the real interest rate does not rise and investment does not fall.