Chapter 13 Saving Investment and the Financial Financial Institutions in the US Economy Financial Markets The Bond Market financial markets financial institutions thru which savers can directly provide funds to borrowers bond certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond date of maturity time at which the loan will be repaid principal amount of money that was originally borrowed term length of time until the bond matures perpetuity bonds pays interest forever but principal is never repaid credit risk probability that the borrower will fail to pay some of the interest or principal default failure to pay to pay interest principle junk bonds bonds that pay very high interest rates tax treatment the way the tax laws treat the interest earned on the bond municipal bonds state local gov ts issue bonds bond owners not required to pay federal income tax on the interest income stock claim to partial ownership in a firm equity finance sale of stock to raise money debt finance sale of bonds stock index computed as an average of a group of stock prices The Stock Market Banks Financial Intermediaries Mutual Funds financial intermediaries financial institutions thru which savers can indirectly provide funds to borrowers facilitate purchases of goods and services by allowing people to write checks against their deposits medium of exchange item that people can easily use to engage in transactions mutual funds institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks bonds primary advantage of mutual funds is that they allow people with small amounts of money to diversify index funds mutual funds which buy all the stocks in a given stock index Saving and Investment in the National Income Accounts accounting how various numbers are defined and added up identity an equation that must be true because of the way the variables in the equation are defined Some Important Identities GDP consumption investment government purchases net exports Y C I G NX Closed economy does not interact with other economies not engage in trade or lending borrowing Y C I G no NX because closed economy does not engage in trade I Y C G Open economy interact with other economies around the world National saving total income in the economy that remains after paying for consumption and government purchases denoted as S to substitute for Y C G S I o Private saving income that households have left after paying for taxes and consumption Y T C o Public saving tax revenue that the government has left after paying for its spending o Budget surplus excess of government receipts over government spending o Budget deficit shortfall of tax revenue from government spending o For the economy as a whole saving must be equal to investment The Market for Loanable Funds market for Loanable funds market in which those who want to save supply funds and those who want to borrow to invest demand funds Loanable funds all income that people have chosen to save and lend out and to the amount that investors have chosen to borrow to fund new investment projects Supply and Demand for Loanable Funds saving is the source of the supply of loanable funds Investment is the source of the demand for loanable funds Policy 1 Saving Incentives Because the 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 the supply of loanable funds would shift 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 if a reform of the tax laws encouraged greater saving the result would be lower interest rates and greater investment Policy 2 Investment Incentives investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment 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 By contrast because the tax credit would not affect the amount that households save at any given interest rate it would not affect the supply of loanable funds if a reform of the tax laws encouraged greater investment the result would be higher interest rates and greater saving Policy 3 Government Budget Deficits ad Surpluses government debt accumulation of past government When the government reduces national saving by running a budget deficit the interest rate rises and investment falls a budget surplus increases the supply of loanable funds reduces the interest rate and stimulates investment borrowing balanced budget government spending equals tax revenue crowding out decrease in investment that results from government borrowing
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