2 Financial Institutions Financial systemGroup of institutions in the economyThat help match one person’s saving with another person’s investmentMoves the economy’s scarce resources from savers to borrowersFinancial institutionsFinancial marketsFinancial intermediaries
3 Financial Markets Financial markets Savers can directly provide funds to borrowersThe bond marketThe stock market
4 Financial Markets The bond market Bond - certificate of indebtedness Time of maturity - the loan will be repaidRate of interestPrincipal - amount borrowedTerm - length of time until maturityCredit risk – probability of defaultTax treatment
5 Financial Markets The stock market Stock - claim to partial ownership in a firmOrganized stock exchangesStock prices: demand and supplyEquity financeSale of stock to raise moneyStock indexAverage of a group of stock prices
6 Financial Intermediaries Savers can indirectly provide funds to borrowersBanksMutual funds
7 Financial Intermediaries BanksTake in deposits from saversBanks pay interestMake loans to borrowersBanks charge interestFacilitate purchasing of goods and servicesChecks – medium of exchange
8 Financial Intermediaries Mutual fundsInstitution that sells shares to the publicUses the proceeds to buy a portfolio of stocks and bondsAdvantagesDiversificationAccess to professional money managers
9 National Income Accounts Rules of national income accountingImportant identitiesIdentityAn equation that must be true because of the way the variables in the equation are definedClarify how different variables are related to one another
10 Accounting Identities Gross domestic product (GDP)Total incomeTotal expenditureY = C + I + G + NXY= gross domestic product GDPC = consumptionG = government purchasesNX = net exports
11 Accounting Identities Closed economyDoesn’t interact with other economiesNX = 0Open economyInteract with other economiesNX ≠ 0
12 Accounting Identities Assumption: close economy: NX = 0Y = C + I + GNational saving (saving), STotal income in the economy that remains after paying for consumption and government purchasesY – C – G = IS = Y – C - GS = I
13 Accounting Identities T = taxes minus transfer paymentsS = Y – C – GS = (Y – T – C) + (T – G)Private saving, Y – T – CIncome that households have left after paying for taxes and consumptionPublic saving, T – GTax revenue that the government has left after paying for its spending
14 Accounting Identities Budget surplus: T – G > 0Excess of tax revenue over government spendingBudget deficit: T – G < 0Shortfall of tax revenue from government spending
15 Saving and Investing Accounting identity: S = I Saving = Investment For the economy as a wholeOne person’s savings can finance another person’s investment
16 The Market for Loanable Funds Those who want to save supply fundsThose who want to borrow to invest demand fundsOne interest rateReturn to savingCost of borrowingAssumptionSingle financial market
17 The Market for Loanable Funds Supply and demand of loanable fundsSource of the supply of loanable fundsSavingSource of the demand for loanable fundsInvestmentPrice of a loan = real interest rateBorrowers pay for a loanLenders receive on their saving
18 The Market for Loanable Funds Supply and demand of loanable fundsAs interest rate risesQuantity demanded declinesQuantity supplied increasesDemand curveSlopes downwardSupply curveSlopes upward
19 Figure 1 The Market for Loanable Funds Interest Rate Supply 5% Demand $1,200Loanable Funds(in billions of dollars)The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national saving, including both private saving and public saving. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied and demanded.
21 Policy 1: Saving Incentives Shelter some saving from taxationAffect supply of loanable fundsIncrease in supplySupply curve shifts rightNew equilibriumLower interest rateHigher quantity of loanable fundsGreater investment
22 Figure 2 Saving Incentives Increase the Supply of Loanable Funds InterestRateSupply, S1DemandS21. Tax incentives for saving increase the supply of loanable funds . . .5%which reduces the equilibrium interest rate . . .$1,2004%$1,600Loanable Funds(in billions of dollars)and raises the equilibrium quantity of loanable funds.A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S1 to S2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion.
23 Policy 2: Investment Incentives Investment tax creditAffect demand for loanable fundsIncrease in demandDemand curve shifts rightNew equilibriumHigher interest rateHigher quantity of loanable fundsGreater saving
24 Figure 3 Investment Incentives Increase the Demand for Loanable Funds InterestRateD2SupplyDemand, D11. An investment tax credit increases the demand for loanable funds . . .6%whichraises theequilibriuminterest rate . . .$1,4005%$1,200Loanable Funds(in billions of dollars)and raises the equilibrium quantity of loanable funds.If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion.
25 Policy 3: Budget Deficit/Surplus Government - starts with balanced budgetThen starts running a budget deficitChange in supply of loanable fundsDecrease in supplySupply curve shifts leftNew equilibriumHigher interest rateSmaller quantity of loanable funds
26 Figure 4 The Effect of a Government Budget Deficit Interest Rate S2 Supply, S1Demand6%1. A budget deficit decreases the supply of loanable funds . . .whichraises theequilibriuminterest rate . . .$8005%$1,200Loanable Funds(in billions of dollars)and reduces the equilibrium quantity of loanable funds.When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion.
27 Policy 3: Budget Deficit/Surplus Crowding outDecrease in investmentResults from government borrowingGovernment - budget deficitInterest rate risesInvestment falls
28 Policy 3: Budget Deficit/Surplus Government – budget surplusIncrease supply of loanable fundsReduce interest rateStimulates investment
29 The history of U.S. government debt Debt of U.S. federal governmentAs a percentage of U.S. GDPFluctuated0% of GDP in 1836107% of GDP in 1945Declining debt-GDP ratioGovernment indebtedness is shrinking relative to its ability to raise tax revenueGovernment - living within its means
30 The history of U.S. government debt Rising debt-GDPGovernment indebtedness is increasing relative to its ability to raise tax revenueFiscal policy cannot be sustained forever at current levelsWar – primary cause of fluctuations in government debt:Debt financing of war – appropriate policyTax rates – smooth over timeShifts part of the cost to future generations
31 Figure 5 The U.S. Government Debt The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied throughout history. Wartime spending is typically associated with substantial increases in government debt.
32 The history of U.S. government debt President Ronald Reagan, 1981Large increase in government debt – not explained by warCommitted to smaller government and lower taxesCutting government spending - more difficult politically than cutting taxesPeriod of large budget deficitsGovernment debt: 26% of GDP in 1980 to 50% of GDP in 1993
33 The history of U.S. government debt President Bill Clinton, 1993Major goal - deficit reductionAnd Republicans took control of Congress, 1995Deficit reductionSubstantially reduced the size of the government budget deficitEventually: surplusBy the late 1990s: debt-GDP ratio - declining
34 The history of U.S. government debt President George W. BushDebt-GDP ratio - started rising againBudget deficitSeveral major tax cuts2001 recession - decreased tax revenue and increased government spendingSpending on homeland securityFollowing the September 11, 2001 attacksSubsequent wars in Iraq and AfghanistanIncreases in government spending
35 The history of U.S. government debt 2008, financial crisis and deep recessionDramatic increase in the debt-GDP ratioIncreased budget deficitSeveral policy measures passed by the Bush and Obama administrationsAimed at combating the recessionReduced tax revenueIncreased government spending
36 The history of U.S. government debt 2009 and 2010Federal government’s budget deficit = 10% of GDPBorrowing to finance budget deficitSubstantial increase in the debt-GDP ratioPolicy challenges for future generationsPutting the federal budget back on a sustainable pathStable or declining debt-GDP ratio