Chapter 26 Saving, Investment, and Financial System

Important points about saving and investment

Although the accounting identity S=I shows that saving and investment are equal for the economy as a whole, this doesn't have to be true for every individual household or firm -banks and other financial inst. make individual difference between investment and saving possible by allowing one person's saving to finance another person's investment

Nominal Interest Rate

Interest rate as usually reported--the monetary return to saving and the monetary cost of borrowing

Index Funds

Mutual funds, called index funds, which buy all the stocks in a given stock index, perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers. The explanation for superior performance of index funds has to do with the fact that they keep costs low by buying and selling very rarely and by not having to pay the salaries of professional money managers.

Looking at National Saving a little differently

S=(Y-T-C)+(T-G) private saving=Y-T-C -the income that households have left after paying for taxes and consumption public saving=T-G -the tax revenue that the government has left after paying for its spending -if T exceeds G, the government runs a budget surplus because it receives more money than it spends. This surplus of T-G represents public saving.

What are some key ingredients to long-run economic growth?

Saving and investment are key ingredient to long-run economic growth: When a country saves a large portion of its GDP, more resources are available for investment in capital, and higher capital raises a country's productivity and living standard.

financial markets

The institutions through which a person who wants to save can directly supply funds to a person who wants to borrow examples: bond market and stock market

National Saving

Y-C-G=I -the total income in the economy that remains after paying for consumption and government purchases S=I

Perpetuity

a bond that never matures-issued by the British government. this bond pays interest forever but the principal is never repaid.

Public Saving

amount of tax revenue

financial intermediaries

financial institutions through which savers can indirectly provide funds to borrowers -intermediary refers to role of these institutions in standing between savers and borrowers. Two of the most important types of financial intermediaries: 1. banks 2. mutual funds

2 Categories that financial institutions can be grouped into

financial markets and financial intermediaries

Y=C+I+G+NX

flashback=gdp=total income in an economy and the total expenditure on the economy's output of goods and services.

Financial System

the group of institutions in the economy that help to match one person's saving with another person's investment

real interest rate

the nominal interest rate corrected for inflation; it equal nominal interest rate minus the inflation rate -more accurately reflects the real return to saving and the real cost of borrowing -in this chapter interest rate refers to the real interest rate -when the interest rate adjusts to balance supply and demand in the market for loanable funds, it coordinates the behavior of people who want to save and the behavior of people who want to invest

Equity Finance

the sale of stock to raise money

Reforming Tax Code to encourage greater saving (Which curve would this affect)

----->Tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate -thus quantity of loanable funds supplied would change -the demand for loanable funds would remain the same because the tax change would not directly affect the amount that borrowers want to borrow at any given interest rate -because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. households would use this additional saving to increase their deposits in banks or to buy more bonds. Supply of loanable funds would increase, and the supply of loanable funds would increase, and the supply curve would shift right from S1 to S2 -The increased supply of loanable funds reduces the interest rate. The lower interest rate raises the quantity of loanable funds demanded from 1200 billion to 1600 billion. The shift in the supply curve moves the market equilibrium along the demand curve. With a lower cost of borrowing households and firms are motivated to borrow more to finance greater investment. Reform of tax law encourages greater saving and greater investment

Bond Market

-a bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bonds -its a big IOU -it identifies the date of maturity (the time at which the loan will be repaid) and the rate of interest that will be paid periodically until the loan matures.

Market for Loanable Funds

-a model of financial markets -it is the market in which those who WANT to save supply funds and those who want to borrow to invest demand funds loanable funds=all the income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects

Policy 3-Government Budget Deficits and Surpluses Crowding out

-an excess of government spending over tax revenue -governments finance budget deficits by borrowing in the bond market, and the accumulation of past government borrowing is called government debt. -Which curve shifts when the gov. runs a budget deficit? -remeber that national saving (the source of the supply of loanable funds) is composed of private and public saving. A change in the government budget balance represents a change in public saving, and thereby, in the SUPPLY of loanable funds. -doesnt change the amount households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds -when gov runs a budget deficit, public saving is negative, and this reduces national saving -this higher interest rate then alters the behavior of households and firms that participate in the loan market. Many demanders of loanable funds are discouraged by the higher interest rate -fewer families buy new homes and fewer firms choose to build new factories Crowding out-decrease in investment that results from gov. borrowing -ULTIMATELY=When government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Since investment is important for long-run economic growth, gov. budget deficits reduce the economy's growth rate

Budget Surplus

-an excess of tax revenue over government spending can be used to repay some of the government debt. If government spending exactly equals tax revenue the government is said to have a balanced budget

Stock Market

-another way for intel to raise funds to build a new semiconductor factory is to sell stock in the company. Stock represents ownership in a firm, and is, therefore a claim to the profits that the firm makes. -Owner of a shares of intel stock is a part owner of Intel, while the owner of an intel bond is a creditor of the corporation -offer holder higher risk and higher return -NASDAQ and New York Stock Exchange among the most important stock exchanges in the US economy -because stock represents ownership in a corporation, the demand for a stock reflects people's percent of the corporations future profitability -When people become optimistic about a company's future, they raise their demand for its stock and thereby bid up the price of a share of stock.

Demand for loanable funds

-comes from households and firms who wish to borrow to make investments -this demand includes families taking out mortgages to buy new homes -firms borrowing to buy new equipment or build factories -in both cases investment is the SOURCE of the demand for loanable funds

Interest Rate

-price of a loan -the amount that borrowers pay for loans and the amount lenders receive on their saving -since high interest rates makes borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises -since a high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises. -in other words, the demand curve for loanable funds slopes downward and the supply curve for loanable funds slopes upward -it approaches the equilibrium level at which the supply and demand for loanable funds exactly balance

The Three Characteristics of Bonds

1. A bonds term-the length of time until the bond matures (some bonds have short terms such as a few months and others have long terms which last as long as 30 years) -long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait long for repayment of principal -if a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. - to compensate for the risk, long-term bonds usually pay higher interest rates than short-term bonds. 2. Credit Risk-the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default. Borrowers can default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high they demand a higher interest rate as compensation for this risk. Because the US gov. is considered a safe credit risk, government bonds tend to pay low interest rates. By contrast, shaky corporations raise money by issuing junk bonds, which pay very high interest rates. 3. Tax Treatment-the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income, that is, the bond owner has to pay a portion of the interest in income taxes. -----bonds issued by state and local governments typically pay a lower interest rate than bonds issued by corporations or the federal government.

Policy 1: Saving Incentives

American families save a smaller fraction of their incomes than their counterparts in many other countries, like Japan and Germany -as discussed earlier, saving is an important long-run determinant of a nation's productivity. -if the US could somehow raise its savings rate to the level that prevails in other countries, the growth rate of GDP would increase, and over time, US citizens would enjoy a higher standard of living -the tax on interest income substantially reduces the future payoff from current saving and, as a result reduces the incentive for people to save. -economist propose reducing the reforming the tax code to encourage greater saving

US financial instituitions

In addition to bond markets there is also the stock market, banks, and mutual funds. Additionally there are pension funds, credit unions, insurance companies, and even the local loan shark. Though these institutions differ in many ways it is important to remember that these financial institutions all serve the same goal directing the resources of savers into the hands of the borrowers.

Mutual Funds

an institution that sells shares to the public and uses the proceeds to buy a selection, or porfolio, of various types of stocks, bonds, or both stocks and bonds. -the shareholder of the mutual fund accepts all the risk and return associated with the portfolio. -if the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss. Advantages: the primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. Buyers of stocks and bonds are well advised t o heed the adage. -people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. Mutual funds make diversification easy. -with only a few hundred dollars a person can buy shares in a mutual fund and indirectly become the part owner or creditor of hundreds of major companies. -mutual funds also give ordinary people access to the skills of professional money managers.

Supply of loanable funds

comes from people who have some extra income they want to save and lend out. This lending can occur directly or indirectly (such as when a household makes a deposit to a bank, which in turn uses the funds to make loans -in both cases saving is the SOURCE of the supply of loanable funds

Closed Economy (in this chapter assume closed economy)

one that does not interact with other economies. Does not engage in international trade in g/s nor does it engaged in international borrowing and lending. Actual economies are open economies. -closed economy doesn't engage in international trade, imports and exports are exactly zero (0)!! Y=C+I+G -each unit of output sold in a closed economy is consumed, invested, or bought by the government

debt finance

sale of bonds

Banks

take deposits from people who want to save and use these deposits to make loans to people who want to borrow -banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans -they facilitate purchases goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards.

Policy 2:Investment Incentives

when =congress institutes an INVESTMENT TAX CREDIT it passes a tax reform aimed at increasing investment and making it more attractive -an investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment Would such a law affect supply or demand? Because the tax credit would reward firms that borrow and invest in new capital, it would alter investment at any given interest rate and thereby change the demand for loanable funds -wouldn't affect the supply of loanable funds (since it doesn't affect the amount households save at any given interest rate) -since firms would have an incentive to increase investment at any interest rate, the quantity of loanable funds demanded would be higher at any given interest rate. Thus demand curve moves right -increased demand for loanable funds increases the interest rate [from 5 to 6 %] and the higher interest rate in turn increases the quantity of loanable funds supplied from 1200 billion to 1400 billion, as households respond by increasing the amount they save. -thus if a reform of the tax laws encouraged greater investment, the result would be high interest rates and greater saving