Chapter 9. Savings, Investment, and the Financial System

What Happens When Intermediation Fails?

*The bridge between saving and investment breaks down. *Economic growth suffers. *Insecure property rights; Politicized lending; Government banks; Interest rate controls; Inflation; Bank failures and panics...... WASTE.

1. Justine buys a $500,000 home by making a down payment of $25,000 and borrowing the rest. Her owner's equity is 2. Her leverage ratio is 3. In general, higher leverage ratios are _____________ than lower leverage ratios. 4. An insolvent firm has 5. All of the following are shadow banks except 6. Leading up to the 2008 financial crisis, mortgage-backed securities were purchased by

1. $25,000. [E=V-D: 500,000-25,000=475,000; 500,000-475,000=25,000] 2. 19. [D/E: 475,000/25,000=19] 3. Riskier. 4. Debts that exceed its assets. 5. Commercial banks. 6. American pension funds; Dentists in Germany; and Banks.

Supply of Savings What are the four major factors that determine the supply of savings?

Four major factors determine the supply of savings: (1) Smoothing consumption. (2)Impatience. (3) Marketing and psychological factors. (4) Interest rates.

Why save (the supply of loanable funds)? Marketing and psychological factors.

Marketing and psychological factors. (Individuals save more if saving is presented as the natural or default alternative.) In which case people save more? 1. Automatic enrollment in a retirement savings plan or requiring employees to request such a plan? ANSWER: Automatic enrollment. 2. The default savings of a retirement plan: 3 percent or 6 percent? ANSWER: 6 percent.

Why borrow (the demand for loanable funds)? The individuals want to smooth consumption.

The individuals want to smooth consumption. The life cycle theory of savings put both borrowing and saving together. • When do you borrow? ANSWER: while attending college, when buying first homes. • When do you save?ANSWER: During the prime working years. • When do you dissave (reduce the amount of savings)?ANSWER: After retirement.

Professor Philip Zimbardo (of the famous Stanford prison experiment) conveys how our individual perspectives of time affect our work, health and well-being with the animation expertise at RSA Animate. Time influences who we are as a person, how we view relationships and how we act in the world.

Video link: https://www.youtube.com/watch?v=A3oIiH7BLmg&themeRefresh=1 [0:00-6:00]

The Consequences of Interest-Rate Ceilings Payday loans are usually between $300 and $400 where low-income people wait until the next paydays to repay their loans.

• For a two-week loan, payday lenders typically charge $15 for every $100 lent. • It amounts to about 390% annual interest rate.Oregon put a ceiling at 36%. • ¾ of the hundreds of payday lenders closed down. • The consequences could be: --> More expensive overdraft fees, late fees on credit cards, cars repossessed, electricity cut off, etc.

When one bond pays a higher interest rate than another bond, is that mostly because of less supply of loanable funds or more demand for loanable fund?

•Other things equal, people don't want to buy riskier bonds.(They don't want to supply funds). • The supply of loanable funds is less. • It raises the interest rate.

What will happen to the market for loanable funds if the government borrows to finance the budget deficit?

•They demand loanable funds, which increases the demand for loanable funds. • The interest rate rises as the quantity of loaned funds increases. • When the interest rate is higher, there will be less private investment (and to some extent, consumption). • Private consumption and investment are CROWDED OUT.

The Demand to Borrow The Interest Rate

The Interest Rate •Determines the cost of the loan. - An investment will be profitable only if its rate of return is greater than the interest rate. •The higher the interest rate, the smaller the quantity demanded of savings will be: 👎

Why save (the supply of loanable funds)? The Interest Rate.

The Interest Rate. A higher interest rate usually means YOU save MORE. *Right now with low interest rates, there aren't a lot of incentives for you to buy long-term CDs, bonds, etc. *The supply curve of loanable funds is upward-sloping.

Gwen is a real estate agent, and she knows that she will have some good years and some bad years, but she wants to smoothe her consumption over time. She figures that half the time she'll earn $90,000 per year, and half the time she'll earn $20,000 per year. These numbers are after taxes and after saving for retirement, so these numbers are all she has to worry about. 1. If we ignore interest costs just to keep things simple, how much should Gwen consume in an average year? 2. How many dollars will she save during the good years? 3. How many dollars will she borrow during the bad years? (Note: "Borrowing," in this context, is basically the same as "pulling money out of savings.") 4. The typical savings supply curve has a positive slope. If a nation's saving supply curve is perfectly vertical, what would that mean? 5. Sometimes, in supply and demand models, it's not clear who "supplies" and who "demands." For instance, in the labor market, it's individual workers (not firms) who supply labor. In the loanable funds market, who is usually the supplier and who is usually the demander?

1. $55,000. [(90,000+20,000)/2] 2. $35,000. 3. $35,000. [(90,000-20,000)/2] 4. People in this country save the same amount no matter what the interest rate is. 5. Entreprenuers demand loanable funds and savers supply loanable funds.

1. Suppose Company D is selling a zero-coupon bond with a face value of $2000 which matures in one year for $1850. What is the implied rate of return? 2. Suppose Company E is selling a zero-coupon bond with a face value of $1400 maturing in a year for $1300 today. Which company is offering the higher rate of return? 3. Suppose Company F has a zero-coupon bond with a face value of $250 maturing in one year and with an implied rate of return of 3%. Approximately what is the bond's sale price today? 4. Suppose Company G is selling a zero-coupon bond with a face value of $100 that matures in two years at a price of $82.64 today. What is the implied rate of return? (Hint: this one is tricky!)

1. 8%. [((2,000-1,850)/1,850) x 100≈8.108%] 2. Company D. [Company E: (1400-1300=100/1300≈0.0769 x100≈7.69%)] 3. $243 [$250 x 3%=7.5; 250-7.5=242.5] 4. 10%

In this video, we focus on two big functions that banks perform: i. They evaluate business ideas to see to whom it's worth lending. ii. They spread an investment's risk among many different projects. None of these functions are unique to banks. In the following 4 anecdotes, which function is the person performing? 1. Emmanuel donates a little money to five different charities, in the hopes that at least one of them will do some good in the world. 2. In Maria's family, she's the one who everyone asks for restaurant recommendations. 3. Scooter wants a good education, so he takes a variety of different classes: some history, some economics, some physics. 4. Frances subscribes to Consumer Reports to decide which washing machine to buy. 5. The financial analysts at Lexmark have evaluated three major projects. Each project, if it actually goes forward, will be financed by going to a bank to borrow the money. They've calculated a "break-even interest rate": If they can borrow cash to pay for the project at less than that rate, the project will likely be a success; if the rate is higher, then it's not worth it. If the interest rate is 11%, which projects will Lexmark take on? CHART: PROJECT: A; B; C. COST: $100 million; $50 million; $150 million. BREAK-EVEN INTEREST RATE: 8%; 12%; 10%

1. Function ii. 2. Function i. 3. Function ii. 4.Function i. 5. B only.

1. Which comes first, interest payments on bonds or dividends? 2. Which has, on average, higher returns, bonds or stocks?

1. Interest payments. 2. Stocks.

Saving and Investment in the market for loanable funds 1. What is saving? 2. What is investment?

1. Saving is income that is NOT spent on consumption goods. *It is the source of the supply of loanable funds. 2. Investment is the purchase of new capital goods. *It is the source of the demand for loanable funds.

Saving or Investment? 1. Tom purchases a bond issues by Star-Kist. 2. Jerry purchases stock issued by IBM. 3. Alice builds a new restaurant. 4. Nancy buys new machinery for her factory.

1. Saving. 2. Saving. 3. Investment. 4. Investment

The Meaning of Saving and Investment 1. What is the meaning of Saving? 2. What is the meaning of Investment?

1. Saving: Buying stocks or bonds, depositing money in checking/savings accounts, keeping money under the matter, etc. Saving: provides funds for investment. 2. Investment: Purchased of new capital goods (machines, equipment, buildings, etc.). Investment: increases production capacity of the economy in the future.

Which curve shifts which way in the market for loanable fund? 1. Under current U.S. law, businesses are allowed to automatically enroll you in a savings plan that puts 5 percent of your salary in a retirement fund. Suppose Congress abolishes this law. 2. If Americans all go to see the classic Robin Williams/Ethan Hawke film Dead Poet Society and decide to carpe diem (enjoy the moment), or if they read the quotes of a famous Mediterranean preacher who said, "Take therefore no thought for the morrow," or if they watch the appalling 1970s sitcom One Day at a Time, what will happen to the market for loanable funds?

1. Supply decreases. 2. Supply decreases.

1. If savers don't feel safe putting their money in banks or buying bonds, which of the following best summarizes what's happening in the market for loanable funds? 2. When governments outlaw high interest rates and the ceiling is binding, what likely happens to the total amount of money borrowed? 3. If financial intermediation breaks down, what category of GDP will probably fall the most: 4. During the Great Depression banking panics led people to pull their money from the banking system. Which of the following would NOT be an effect of a banking panic? 5. The purpose of the FDIC is to 6. On Oct. 3, 2008 the FDIC temporarily raised the insured amount on a bank account from $100,000 to $250,000 (since made permanent). Why did the FDIC raise the insured amount at this time?

1. Supply of savings falls and the interest rate rises. 2. It falls because savers aren't willing to lend as much money at this lower interest rate. 3. Investment. 4. NOT an effect: Greater savings. EFFECTS: Reduced investment; fewer loans; and firms having difficulty paying wages on times. 5. Insure bank deposits to prevent widespread panics. 6. A run was developing at investment banks and the FDIC wanted to make sure that the panic didn't extend to commercial banks.

For the following 3 questions, answer either "bank account," "bonds," or "stocks." 1. Which is a corporate IOU? 2. Which one gives you an ownership, or "share," in a company? 3. Which one is offered by the U.S. government as well as by private corporations? 4. Government bonds and corporate stocks are: 5. Which bond will usually pay a higher interest rate? 6. Which bond will usually pay a higher interest rate? 7. Which bond will usually pay a higher interest rate? 8. Suppose you'd like to invest in a company and you've narrowed your choice down to three firms: Company A is offering a zero-coupon bond with a face value of $1000 to be repaid in 1 year for $963. Company B has the same face value and maturity date but sells for $871. And company C also has the same face value and maturity but sells for $985. In which would you rather invest?

1. bonds. 2. stocks. 3. bonds. 4. substitutes. 5. Bond rated BBB. 6. General Motors bond. 7. Citibank bonds that gets repaid in 30 years. 8. Cannot be determined with the given information.

In each of the following, answer either "bank account" or "stocks." 1. Which investment is typically the riskiest? 2. Which one usually lets you "withdraw" part of your investment at any time, for any reason? 3. Which form of investment usually spreads your money over the largest number of investment projects?

1. stocks. 2. bank account. 3. bank account.

The Stock Market What is a stock (or share)?

A stock or a share is a certificate of ownership in a corporation, and is, therefore, a claim to the profits that the firm makes. A bond owner gets interest payment. How do shareholders gain? When the firm makes profits, either • They receive dividends. • The profits are reinvested by the firm which possibly raise the price of the firm's stock.

Why borrow (the demand for loanable funds)? Borrowing Is Necessary to Finance Large Investments.

Borrowing Is Necessary to Finance Large Investments. Without the ability to borrow, many profitable investments will not happen. - Example: • Fred Smith and FedEx. • Why couldn't Fred Smith have "started small"? • To be successful in the transportation and delivery industry, you need a national network.

Why save (the supply of loanable funds)? Individuals want to smooth consumption.

Individuals want to smooth consumption. (Save in working years and dissolve after retirement.) *Lower life expectancy means Lower saving rates. *When people win a lottery, they tend to save or spend on assets, such as houses and cars, most of it for later.

What will happen to the market for loanable funds if the government imposes a ceiling on interest rates?

Less loans will be made. Shortage.

Why save (the supply of loanable funds)? Some individuals are more patient than others.

Some individuals are more patient than others. *If you are impatient, you will rather want to consume now than later (less saving). Impatience (or patience) also is reflected in any economic situation where people must compare costs and benefits over time. *Patient people tend to go to college more.(You have to wait for four years to get higher returns, but you pay the tuition or spend time right away.) *Impatient people tend to commit more crimes.(The benefits are immediate, but you have to bear the costs over time, running away from the police, getting caught, jailed, etc.)