Chapter 13 Saving Investment and the Financial System 1 Financial Institutions Financial Markets Financial Intermediaries Financial system o Group of institutions in the economy that help math one person s saving with another person s investment o Moves the economy s scarce resources from savers to borrowers Financial markets o Savers can directly provide funds to borrowers o The Bond Market Bond certificate of indebtedness IOU Date of maturity when the loan will be repaid Rate of interest paid periodically until the date of maturity Principal amount borrowed Borrowing from the public Used by large corporations the federal govt or state and local govt What differentiates one bond from another Term length of time until maturity a few months 30 years perpetuity long term binds are riskier than short term bonds o long term bonds usually pay higher interest rates Credit risk probability of default Probability that the borrower will fail to pay some of the interest or principal Higher interest rates for higher probability of default U S government bonds tend to pay low interest rates Junk bonds very high interest rates o Issued by financially corporations Tax treatment Interest on most bonds is taxable income Municipal bonds o Issued by state and local governments o Owners are not required to pay federal income tax on the interest income o Lower interest rate o The Stock Market Stock claim to partial ownership in a firm a claim share to the profits that a firm makes Organized stock exchanges Stock prices demand and supply Equity finance Sale of stock to raise money Chapter 13 Saving Investment and the Financial System 2 Stock index average of a group of stock prices Incentive to buy stocks receive dividends Initial Public Offering IPO any share being offered to the public for the first time by investment banks Investment banks provide advice to firms in acquisition take care of logistics of offerings to make shares available through banks Financial intermediaries o Savers can indirectly provide funds to borrowers o Banks Take in deposits from savers Banks pay interest Make loans to borrowers Banks charge interest Facilitate purchasing of goods and services Checks medium of exchange o Mutual funds Institutions that sell share to the public Use the proceeds to buy a portfolio of stocks and bonds Advantages diversification professional money managers National Income Accounts o Rules of national income accounting o Important identities o Identity o an equation that must be true because of the way the variables in the equation are defined o clarify how different variables are related to one another Accounting Identities o Gross Domestic Product GDP o Total income o Total expenditure o Y C I G NX o Y GDP o C Consumption o I Investment o G government purchases o NX net exports o Closed economy o Open economy o Doesn t interact with other economies NX O o Interact with other economies NX 0 Chapter 13 Saving Investment and the Financial System 3 o Total income in the economy that remains after paying for the consumption and government purchases o Assume CLOSED ECONOMY NX 0 o Y C I G o National saving S o Y C G I S o T taxes transfer payments o S Y C G T G o Private saving Y T C consumption o Public saving T G o Income that households have left after paying for taxes and o Tax revenue that the government has left after paying for its spending o Balanced Budget Matched earnings expenditure o Budget surplus T G 0 o Excess of tax rev over govt spending o Budget deficit T G 0 o Shortfall of tax revenue from government spending o Accounting identity Saving S Investment I o For the economy as a whole o One person s savings can finance another person s investment Market for loanable funds o Market o Those who want to save supply funds o Those who want to borrow to invest demand funds o One interest rate o Return to saving o Cost of borrowing o Assumption o Single financial market o Supply and demand of loanable funds o Source of the supply Saving o Source of the demand Investment o Price of a loan real interest rate Borrowers pay for a loan Lenders receive on their saving o As interest rate rises Quantity demanded declines Q supplied increases Chapter 13 Saving Investment and the Financial System 4 o Demand curve slopes down Supply curve slopes upward o Government policies o Can affect the economy s saving and investment Saving incentives Investment incentives Government budget deficits and surpluses o Policy 1 Saving Incentives Shelter some saving from taxation Affect supply of loanable funds SLF New equilibrium Increase supply right shift o Lower interest rate o Higher quantity of loanable funds Greater investment o Policy 2 Investment Incentives Affect demand for loanable funds Increase in demand Chapter 13 Saving Investment and the Financial System 5 Demand curve shifts right New equilibrium Higher interest rate Higher quantity of loanable funds o Greater saving o Policy 3 Budget Deficit Government starts with balanced budget Then starts running a budget deficit o Change in supply of loanable funds o Decrease in supply Supply curve shifts left o New equilibrium Higher interest rate Smaller quantity of loanable funds Crowding out Decrease in investment Chapter 13 Saving Investment and the Financial System 6 Results from government borrowing Government budget deficit Interest rate rises Investment falls Government budget surplus Increase supply of loanable funds Reduce interest rate Stimulates investment The History of U S Govt debt o Debt of U S Federal Government o As a percentage of U S GDP o Fluctuated 0 of GDP in 1836 o 107 of GDP in 1945 o Declining Debt to GDP ratio revenue o Govt living within its means o Govt Debt decr OR GDP inc o Rising debt to GDP o Govt indebtedness is shrinking relative to its ability to raise tax o Govt indebtedness is increasing relative to its ability to raise tax revenue o Fiscal policy cannot be sustained forever at current levels o War primary cause of fluctuations in government debt o debt financing of war appropriate policy tax rates smooth over time shifts part of the cost to future generations Chapter 13 Saving Investment and the Financial System 7 o President Ronald Reagan 1981 o Large increase in govt debt not explained by war o Committed to smaller govt and lower taxes o Cutting govt spending more difficult politically than cutting taxes o Period of large budget deficits o Govt debt 26 of GDP in 1980 to 50 of GDP in 1993 o President Bill Clinton 1993 o