FINAL EXAM CHAPTERS GDP INF UN N CH 10 11 15 LF Model open closed Chp 13 18 19 Monetary Policy Chp 16 17 Chapter 13 Saving Investment and the Financial System These notes more closely follow the book but also lecture notes Financial system consists of the institutions that help match one person s saving with another person s investment When a country saves a large portion of GDP more resources are available for capital investments higher capital raises productivity and standard for living I Financial institutions in the U S economy A Financial markets the institutions through which a person who wants to can directly supply funds to a person who wants 1 The bond market i Bond certificate of indebtedness that specifies the obligations of the borrower to the holder IOU ii Debt finance iii Three characteristics that differentiate bonds a Term length of time until the bond matures 1 Long term bonds are riskier than short term because takes longer to repay principal 2 Long term usually pay higher interest rates b Credit risk probability the borrower will fail to pay some of the interest or principal default 1 Safe credit risk like government pay low interest rates 2 Junk bonds pay high interest rates used by financially unstable companies 3 Can judge risk by using various private agencies ex Standard Poor s c Tax treatment the way tax laws treat the interest earned 1 On most bonds is taxable income 2 Municipal bonds issued by state and local government owners not required to pay taxes on interest lower interest rate than company or federal government bonds 2 The stock market i Stock represents ownership in a firm a claim to profits ii Equity finance 1 iii Stock prices determined by supply and demand of stock demand reflects people s perception of the company s future profitability iv Stock index computed as an average of a group of stock prices A Ex Dow Jones Industrial Average B Financial intermediaries financial institutions through which savers can indirectly provide funds to borrowers 1 Banks i Primary job is to take in deposits from people who want to save and use deposits to make loans to people who want to borrow a Pay depositors interest on deposits and charge borrowers slightly higher interest on loans ii Facilitate purchase of goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards act as a medium of exchange 2 Mutual funds institution that sells shares to public and uses the proceeds to buy a selection portfolio of various types of stocks bonds or both i Value rises shareholder benefits value falls shareholder suffers loss ii Advantage allow people with small amounts of money to diversify their holdings a People who have diverse portfolio face less risk because they have a small stake in each company iii Advantage give ordinary people access to professional money managers II Saving and investment in the national income accounts GDP equation Y C I G NX Y GDP income C consumption I investment G government purchases NX net exports Closed economy no outside interaction no NX Y C I G Y C G I S I S Y C G national saving A Saving 2 1 National saving saving total income in the economy that remains after paying for consumption and government purposes i S Y C G 2 Private saving amount of income that households have left after paying taxes and for consumption i Y T C 3 Public saving amount of tax revenue government has left after paying for spending T G If T G gov t has budget surplus i i i IF T G gov t has budget deficit a a T G positive T G negative B The meaning of saving and investment 1 Investment refers to the purchase of new capital e g buildings or equipment i Y C T T G I Private saving public saving investment national savings III The market for loanable funds A Market for loanable funds market in which those who want to save supply funds and those who want to invest demand funds 1 Loanable funds refers to all 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 i One interest rate a Return to saving b Cost of borrowing 2 Three steps to work loanable funds model i Determine which curve supply or demand is affected ii Determine which direction the curve shifts iii Use the model to determine what will happen to the interest rates and quantity of loanable funds exchanged 3 When more funds are supplied interest rates falls and more funds are exchanged When more funds are demanded interest rate rises and more funds are exchanged B Supply and demand for loanable funds 1 Saving is the source of the supply of loanable funds i Comes from people who have extra income they want to save and lend out 4 a Direct household buys bond b Indirect household makes a deposit 2 Investment is the source of demand for loanable funds Comes from when people take out loans to buy homes capital 3 Interest rate is the price of a loan Amount that borrowers pay for loans and amount lenders receive on their saving i i ii Nominal interest rate is usually reported iii Real interest rate nominal IR inflation rate a More accurately reflects return to saving and cost of borrowing b Model depends on real interest rate C Policy 1 Saving Incentives D Policy 2 Investment Incentives 5 E Policy 3 Gov t budget deficits and surpluses 1 Gov t budget Budget deficit is an excess of spending over tax revenue i ii Budget surplus is an excess tax revenue over spending iii Gov t spending tax revenue balanced budget 2 Ex Suppose gov t runs a deficit i public saving negative a Reduces national saving reduces supply i Doesn t alter amount firms want to borrow demand not affected by deficit Interest rate rises ii i a Alters behavior of households and firms demanders are discouraged and quantity demanded decreases fall in investment Crowding out a decrease in investment that results from gov t borrowing ii When the government reduces national saving by running a budget deficit the interest rate rises and investment falls This leads to a reduction in the future standard of living iii gov t finances a deficit by borrowing selling government bonds 6 1 debt GDP ratio measures ability to raise taxes to get out of debt IV Summary from book A The U S financial system is made up of many institutions such as the bond market stock market banks and mutual funds Every institution matches the resources households who want to save income and households
View Full Document
Unlocking...