Lecture Outline – Saving, Investment, and the Financial SystemA. Introduction to the Financial System1. What is the role of the financial system?a. Bring savers and borrows togetherb. Why do people save money?1. They don’t want to spend all they money they earn right now2. Saving for future consumption.3. They hope to lend their money to borrowers to receive a rate of re-turn.4. Households, Firms, Venture Capitalistsc. Why do people borrow money?1. Borrowers need money for investment purposes.2. Firms need to borrow to buy physical capital3. Physical capital leads to economic growth4. Firms, Entrepreneurs, Households2. What is the relationship between saving and investment in a closed economy?a. When we say that an economy is closed, what do we mean?1. No net exportsb. How is national savings defined in a closed economy?1. S=Y-C-G2. Savings=investment3. Money that we need to buy more physical capital is going to from savingsB. Role of Intermediaries: Banks, Bonds, and Stock Markets1. Bridge brings savers and borrowers together2. What is a financial intermediary?a. Banks, Bonds, Stock marketsb.Middle menc. Redirecting money from savers to borrowers3. What is the function of a bank?a. Gather savings from depositors and transfer it to borrowers1b. How do banks play the role of a financial intermediary?1. Bank minimizes information costs2. The bank evaluates the borrower’s ability to pay off loans3. The savings get redirected to the most productive users4. Spread risk: when a borrower defaults on a loan the bank spreads the loss among many depositorsc. Why do people use money to funnel their savings to borrowers instead of per-forming this function themselves?1. Loans need to be given to most productive users. Banking experts do this best.4. What is a bond?a. A sophisticated IOU that documents who owes how much and when pay-ment must be paidb. Who issues (i.e. sells) bonds?1. Borrower2. Issuing bonds allows borrowing directly from the public3. Ussued by corporations and governments at all levelsc. Who buys a bond?1. Lender/saverd. Why do bonds have different ratings? What do these ratings mean?1. Lowest Risk (AAA) - borrower will repay2. Bonds in current default (D)e. What is the relationship between risk and the interest rate paid by the bor-rower?1. The higher the risk the greater the interest rate that the bond will promise to pay2. Major issues are grade y rating companies: 3. Standard and Poor’s 4. Moody’sBerkshire Hathaway (Warren Buffett)2Bond rating: AAAInterest rate: 4.48%Ford Motor CompanyBond Rating: BInterest Rate: 5.76%f. What is the difference between a T-bond, T-note, and T-bill?1. T-bonds: 30 year maturity, pay interest every 6 moths2. T-notes: 2 to 10 year maturity, pay interest every 6 months3. T-bills: maturity in 2 days to 26 weeks, pay interest only at matu-rity4. Maturity: when the borrower has to pay back the saver(govern-ment) pay the principleg. What is a zero-coupon bond?1. Bonds that pay interest at maturity2. Short term us government bonds are the safest assetts. Low rate of interest5. What is a stock? Why do firms sell stocks?a. Stock (or a share) is a certificate of ownership in a corporation.b.To get a share of the firms profitsc. What is a stock exchange?1. Stocks are traded inmarkets called stock exchanged2. New York stock exchange (largest) Tokyo stock exchange (second largest)d. What is the difference between an initial public offering (IPO) and a sec-ondary stock?1. The first time a corporation sells stock to the public in order to raise capital2. Typically used to buy new capital goods.3. Secondary stock is one that has been purchased previously but nowjust trading hands3a. Ownership rights are being transferred from one person to another.b. Corporation is not earning any more capital on the stock marketc. Stock market brings borrowers and savers togetherd. Stock markets encourage investment and growth.C. Market for Loanable Funds1. Why is the demand for loanable funds downward sloping?a. interest rate on the y axis. Interest rate represents the cost of borrowingb.Inverse relationshipc. At higher interest rates, firms will not want to borrow as much money. As interest rate falls, firms will borrow more money. Movement Along the de-mand curved.If something happens that gives borrower incentive to borrow more at ev-ery interest rate, there is an increase in demand for loanable fundse. Who demands loanable funds?1. Borrowers demand loanable funds2. Firms, governmentsf. What is the cost of borrowing in the loanable funds market?2. Why is the supply of loanable funds upward sloping?a. As interest rate increases, Q of loanable funds supplied will increaseb.Interest rat on the y axis because that is the price that the saver receives when they lend moneyc. Opportunity cost of saving is what you could have consumed. At higher interest rates, consumption is expensive so you will save more.d.At lower interest rate, q of savings is much lower (q of money supplied)e. Anything that makes you want to save more makes the supply curve shift.1. Ex. Brighter outlook on the future, reduction of taxes on savingsf. Who supplies loanable funds?1. Savers. Difference between income-consumptiong. What is the price received for providing loanable funds?43. How are interest rates determined?a. Competition among savers drive the interest rate down if interest rate is above market equilibrium.b.Pressures between consumers that drive interest rate up interest rate is be-low market equilibrium.4. How does a change in the supply of loanable funds affect the quantity of savings/borrowing and the equilibrium interest rate? Give an example of some-thing that would increase/decrease the supply of loanable funds.a. When there is a surplus, savers will be willing to lend money at lower in-terest rates to get people to borrow. As interest rate falls, firms will borrowmore money until you get to equilibrium where savings=investment1. as opportunity cost goes up there is more savings5. How does a change in the demand for loanable funds affect the quantity of sav-ings/borrowing and the equilibrium interest rate? Give an example of something that would increase/decrease the demand for loanable funds.a. As borrowers increase interest rate, the cost of investment may exceed in-vested returnD. Government Borrowing and Crowding Out1. Investment Tax Credit: makes purchasing capital cheaper to firmsa. Increase q of loanable funds. Amount of saving and investment has in-creased.2.