LSU ECON 2010 - Chapter 8: Saving, Capital Formation and Financial Markets

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Chapter 8: Saving, Capital Formation and Financial MarketsoInvestment and the Financial SystemoIf the key driver of economic growth is investment, the markets and sectors producing investment must be understoodoAll players in society can be positively adversely effected by thefinancial sectoroSavings and WealthoSaving - current income minus spending on current needs-The saving rate is saving divided by incomeoWealth - the value of assets minus liabilities-Assets are anything of value that one owns-Liabilities are the debts one owes-The balance sheet is a list of an economic unit's assets andliabilitiesSpecific dateEconomic unit (business, household, etc.)oFlow Values and Stock ValuesoA flow value is defined per unit of time-Income - spending-Saving - WageoA stock value id defined at a point in time-Wealth - DebtoThe flow of savings causes the stock of wealth to change -Every dollar a person saves adds to his wealthoA high relate of saving today leads to an improved stand of living in the futureoCapital Gains and LossesoWealth changes when the value of your assets change-Capital gains increase the value of existing assetsHigher value for stock-Capital losses decreases the value of existing assetsCar accident damages bumper and front headlightoChange in wealth = (savings) + (Capital gains) - (capital losses)oSaving, Investment and the Financial SystemoFinancial system - the system of financial markets and financial intermediaries through which firms acquire funds from householdsoAn overview of the financial system-Financial markets - markets where financial securities, suchas stock and bonds, are bought and sold-Financial intermediaries - firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowersoThe Macroeconomics of Saving and Investment-Y=C+I+G+NX-Y=C+I+G-I=Y-C-G-Sprivate = Y+TR-C-T-SPublic = T-G-TR-S = SPrivate + Spublic -So we can conclude that total savings must equal total InvestmentS=IoNational SavingsoMacroeconomics studies total savings in the economy-Household savings is one component-Business and government savings are other partsoStart with the definition of production and income for the economy-Y=C+I+G+NXY - Aggregate incomeC - consumption expenditureG - government purchases of goods and servicesI - Investment spendingNX - net exportsoCalculate National SavingsoAssume NX = 0 for simplicityoNational savings (S) is current income less spending on current needs-Current income is GDP or YoSpending on current needs-Exclude all investment spending (I)-Most consumption and government spending is for current needsWe assume all of c and g are for current needsS = Y -C- GoPrivate SavingoPrivate saving is house hold plus business savingoHouseholds pay taxes (T) from this income-Government transfer payments increase household incomeTransfer payments are made by the government to households with receiving any goods in return -Interest is paid to government bond holders-T = Taxes - Transfers - government interest paymentoPrivate saving is after-tax income less consumption-Sprivate = Y - T- CoPrivate saving is done by households and businesses-Household saving or personal saving is done by families and individuals-Business savings makes up the majority of private saving in the USBusiness savings is revenues less operating costs less dividends to shareholdersBusiness savings can purchase new capital equipmentoExplaining U.S. Household Savings RateoSavings rate may be depressed by-Social security, Medicare, and other government programs from the elderly-Mortgages with small or no down payment-Confidence in a prosperous future-Increasing value of stock and growing home values -Readily available home equity loans-Demonstration effects and status goodsoPublic Saving and National SavingoPublic saving is the amount of the publi sector's income that is not spent on current needs-Public sector income is net taxes-Public sector spending on current needs is GSpublic = T-GoNational Saving (S) is private savings plus public savings-Sprivate + Spublic = (Y-T-C) +(T-G)oThe Government BudgetoBalanced budget occurs when government spending equals nettax receipts-Government budget surplus is the excess of government net tax collections over spending (T-G)Budget surplus is public savings-Government budget deficit is the excess of government spending over net tax collectionsBudget deficit is public dissavingsoSaving and the Real Interest RateoSavings often take the form of financial assets that pay a return-Interest - bearing checking: bonds-Savings: CDs-Mutual funds: StocksoThe Real interest rate ® is the nominal interest rate (i) minus the rate of inflation (pie)-The increase in purchasing power from a financial asset-Marginal benefit of the extra savingoInvestment and Capital FormationoInvestment is the creation of new capital goods and housingoFirms buy new capital to increase profits-Cost-benefit principle-Cost is the cost of using the machine or other capital-Benefit is the value of the marginal product of the capitaloInvestment DecisionoTwo Important costs-Price of the capital goods-Real interest ratesOpportunity cost of the investmentoValue of the marginal product of the capital is its benefit-Net of operating and maintenance expenses and of taxes on revenues generated-Technical innovation increases benefits lower taxes increase benefits-Higher price of the output increases benefitsoSaving, Investment, and Financial MarketsoThe market for loanable funds-The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged-Demand and supply in the loanable funds market--An increase in the demand for loanable funds--Crowding Our - a decline in private expenditures as a resultof an increase in government purchases-The effect of a budget deficit on the market for loanable funds-oSupply of savings (s) is the amount of savings that would occur at each possible real interest rate ®-The quantity supplied increase as r increasesoDemand for investment (I) is the amount of savings borrowed ateach possible real interest rate-The quantity demanded is inversely related to roFinancial Markets are MarketsoFinancial markets adjust to surpluses and shortages as any other market does-Equilibrium principle holdsoChanges in factors other than real interest rates will shift the savings or investment curves-New

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LSU ECON 2010 - Chapter 8: Saving, Capital Formation and Financial Markets

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