Saving Investment and the Financial System ESO is a student organization that brings in corporations that are interested in hosting summer interns We offer one on one or group tutoring sessions The officers take and review resumes Food is always served On March 11th we are hosting our Alumni networking event with several well known keynote speakers This is a great opportunity to distinguish yourself Meetings are every Wednesday in Hanson Hall Email us at umn umn edu Fallow us on Twitter and Facebook for weekly updates Outline The Supply of Savings The Demand to Borrow Equilibrium in the Market for Loanable Funds The Role of Intermediaries Banks Bonds and Stock Markets What Happens When Intermediation Fails The Financial Crisis of 2007 2008 Introduction The bankruptcy of Lehman Brothers was serious because Assets 691 billion Financial intermediary Credit dried up Shadow banking system collapsed Worst economic crisis since the Great Depression Introduction Financial intermediaries Bridge the gap between savers and borrowers Gather savings and allocate it to the most profitable investments Promote economic growth through capital Saving and Investment Some Important Definitions Saving income that is not spent on consumption goods Investment purchase of new capital tools machinery factories Caution Investment is not defined by economists the same way a stockbroker defines investment Supply of Saving What Determines the Supply of Savings Smoothing consumption Impatience Market and psychological factors Interest rates Consumption Smoothing Consumption Smoothing Save during working years to provide for retirement Manage fluctuations in income Save during good times in order to ride out the bad times Important application AIDS has lowered life expectancies in Africa How has this affected savings rates Impatience Time preference the desire to have goods and services sooner rather than later Anything with immediate costs and future benefits must overcome time preference College education Crime is a reflection of impatience The greater the preference for things now the smaller will be saving Marketing and Psychology Two ways of presenting a savings plan Option 1 Automatic enrollment in savings plan with ability to opt out Option 2 Employees must choose the savings plan otherwise they don t participate Result With the automatic enrollment in a savings plan 25 more people participated in the savings plan Marketing and Psychology Switching the default Default 1 Automatic enrollment with 3 of income deposited in retirement account Default 2 Automatic enrollment with 6 of income deposited in retirement account Result When the company switched from Default 1 to Default 2 the number of workers choosing 3 fell from 25 to almost zero The Interest Rate The market price of savings Interest is the reward for saving Other things being equal the quantity supplied of savings increases as the interest rate increases Supply of Savings Demand for Borrowing What determines the demand for savings Smoothing consumption Financing large investments The interest rate Consumption Smoothing Again Lifecycle Theory of Saving Nobel laureate Franco Modigliani Brought the demand to borrow and save together By borrowing saving and dissaving at different times in life workers can smooth their consumption path improving their overall satisfaction Consumption Smoothing Again Economic Investment Some investments require large amounts of money to get started Is it easy to purchase a new building with cash on hand Without borrowing cannot make profitable investments like Students Education Government Interstate Highway System Builder New apartment building The Interest Rate 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 The relation between borrowing and the interest rate is shown in the next figure Demand for Borrowing Loanable Funds Market Market for Loanable Funds occurs when suppliers of loanable funds savers trade with demanders of loanable funds borrowers Determines The equilibrium interest rate The equilibrium quantity of savings borrowing Equilibrium Interest rate Surplus 10 8 6 200 250 280 Quantity of funds Equilibrium Interest rate 10 8 Shortage 6 190 250 300 Quantity of funds Shifting Supply and Demand Factors that shift the supply and demand curves change the equilibrium interest rate and the equilibrium quantity of savings borrowing Let s use the model to analyze two examples People become more thrifty Korea in the 1960s and 1970s Investors become less optimistic Interest rate People More Thrifty Demand Supply People are saving more therefore supply will increase Q Interest rate Investors Less Optimistic Demand Supply Less optimistic less likely to invest and borrow to finance the investment Q Role of Intermediation Financial Intermediaries reduce the costs of moving savings from savers to borrowers and investors Coordinate financial markets Move savings to more highly valued uses We examine three financial intermediaries Banks Bond market Stock market Banks Gather savings Reduce cost of mobilizing savings to productive uses Specialize in evaluating risk Division of labor Full time bank employees become better at evaluating risk than individual savers depositors Spread risk Losses due to default are spread among many savers depositors Bond Market Bond A sophisticated IOU that documents who owns how much and when payment must be paid Issuing bonds allows borrowing directly from the public Lender one who buys a bond Borrower one who issues a bond Corporations and governments at all levels borrow money by issuing bonds The Bond Market All bonds involve a risk Major issues are graded by rating companies Grades range from lowest risk AAA bonds in current default D The higher the risk the greater the interest rate required to get lenders to buy the bonds The Bond Market Higher risk means higher return Berkshire Hathaway Warren Buffett Borrows at an Interest rate March 2010 0 5 Manchester United Soccer team in U K Borrows at Interest rate 9 0 The Bond Market Why are home mortgage rates lower than vacation loans Collateral Something of value that by agreement becomes the property of the lender if the borrower defaults The Bond Market Governments borrow by issuing bonds Government borrowing can crowd out private spending Crowding out Decrease in private spending that occurs when government
View Full Document
Unlocking...