ECON 205 1st Edition Lecture 10 Outline of Last Lecture How is unemployment measured Factors of unemployment Efficiency wages Outline of Current Lecture Role of financial institutions Savings and investment How government policies affect saving investment an interest rate Current Lecture Financial Institutions Financial system group of institutions that help match savings of one person to the investment of another person Financial markets institutions through which savers can directly provide funds to borrowers o Stock market o Bond market Financial Intermediaries institutions through which savers can indirectly provide funds to borrowers o Banks o Mutual funds institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds Other Types of Savings Private saving portion of household s income that is not used for consumption or taxes o Y T C income minus taxes minus consumption Public Saving tax revenue minus government spending o T G National Saving private saving and public saving o Y T C T G Y C G saving is the investment in a closed economy Budget Deficits and Surpluses Budget surplus an excess of tax revenue over government spending o T G Budget Saving a shortfall of tax revenue from government spending o G T o Negative public saving The Market for Loanable Funds A supply demand model of the financial system Assume there is only one financial market o All savers deposit their saving in this market o All borrowers take loans from this market o There is only one interest rate which is both the return to saving and the cost of borrowing The supply of loanable funds comes from saving The increase of interest rates makes saving more attractive and increases the quantity of loanable funds Demand for loanable funds comes from investment o People take out loans to buy capital Interest rate adjusts to equate supply and demand Tax incentives for saving increase the supply of Loanable Funds o I e 401k A budget deficit decreases national saving and the supply of Loanable funds o Creates an increase in equilibrium interest rates Budget Deficits Crowding Out and Long Run Growth Crowding out when budget deficits reduce investment o The government borrows money and reduces the supply for other people to take out loans Investment is key to long run growth Real interest rate nominal interest rate inflation rate Government Debt Government finances deficits by borrowing Deficits increase during times of war The ratio of government debt to GDP is a measure of the government s indebtedness Persistent deficits lead to a rising government debt