Chapter 10 Section 2 Saving Investment and Financial System The process of economic growth depends on the ability of firms to expand their operations buy additional equipment train workers and adopt new technologies Retained earnings profits that are reinvested in the firm rather than paid to the firm s owners Financial system the system of financial markets and financial intermediaries through which firms acquire funds from households o Financial markets o Financial intermediaries Without a well functioning financial system economic growth is impossible o Firms will be unable to expand and adopt new technologies Financial System Financial markets markets where financial securities are bought and sold o Financial securities a document that states the terms under which funds pass from the buyer of the security to the seller Stocks partial ownership of a firm Bonds promises to repay a fixed amount of funds Financial intermediaries firms that borrow funds from savers and lend them to borrowers o Banks mutual funds pension funds and insurance companies Make investments in stocks and bonds on behalf of savers Mutual funds sell shares to savers and then use the funds to buy a portfolio of stocks bonds mortgages and other financial securities o Pool the funds of many small savers to lend to many individual borrowers o Pay interest to savers in exchange for the use of savers funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loans Provides 2 key services for savers and borrowers 1 Risk sharing the chance that the value of a financial security will change relative to what you expect a Provides risk sharing by allowing savers to spread their money among many financial investments 2 Liquidity the ease with which a financial security can be exchanged for money a Provides the service of liquidity by providing savers with markets in which they can sell their holdings of financial securities 3 Information collection and communication of facts about borrowers and expectations about returns on financial securities Macroeconomics of Saving and Investment Funds available to firms through the financial system come from saving When firms use funds to purchase machinery factories and office building they are engaging in investment The total value of saving in the economy must equal the total value of investment GDP is measure of both total production in the economy and total income Relationship between saving and investment is in a closed economy o No trading or borrowing and lending with other economies o In a closed economy net exports 0 o Y C I G I Y C G o Private savings Sprivate Y TR C T Y households receive income for supplying the factors of production to firms TR households receive income from government in the form of transfer payments Social Security payments unemployment insurance payments C what households retain of their income after purchasing goods and services T tax revenue o Public savings Spublic T G TR o S Sprivate Spublic S total saving in the economy S Y TR C T T G TR S Y C G o Total savings S Total investment I When the government spends the same amount that it collects in taxes there When the government spends more than it collects in taxes there is a budget o T is less than G TR meaning the public saving is negative o Negative saving is dissaving o When households borrow more than they save total amount of saving When the government spends less than it collects in taxes there is a budget is a balanced budget deficit will decrease surplus o Increase public saving and total level of saving in the economy o Higher level of investment spending in the economy when there is a budget surplus than when there is a balanced budget Market for Loanable Funds the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged No interactions between households and firms in the US and other countries Demand in the Loanable funds market o Determined by the willingness of firms to borrow money to engage in new investments projects Building new factories carrying out research and development of new products Firms can compare the return they expect to make on an investment with the interest rate they must pay to borrow the necessary funds Supply in the Loanable funds market o Determined by the willingness of households to save and by the extent of government saving or dissaving When households save they reduce the amount of goods and service they can consume and enjoy Willingness to save rather than consume determined by the interest rate they receive when they lend their savings Higher the interest rate greater the reward for saving and larger amount of funds households will save Nominal interest rate is the state interest rate on a loan Real interest rate corrects the nominal interest rate for the effect of inflation o Nominal interest rate inflation rate Movements in Saving Investment and Interest Rates Equilibrium determines the quantity of loanable funds that will flow from o Determines real interest rate that lenders will receive and that lenders to borrowers borrows must pay o Examples If profitability of new investment increases due to technological change then firms will increase their demand for loanable funds Demand curve shifts to the right o Increasing investment increases the capital stock and the quantity of capital per house worked helping to increase economic growth Running a budget deficit reduces the level of total saving in the economy o By increasing the interest there is also a reduction in the level of investment spending by firms o Crowding out a decline in private expenditures as a result of an increase in government purchases o Lower investment spends means that the capital stock and quantity of capita per hour worked will not increase much Budget surplus increase the total amount of saving in the economy shifting supply of loanable funds to the right o Increases the level of saving and investment