The Financial SystemFINANCIAL INSTITUTIONS IN THE U.S. ECONOMYSlide 3Bond MarketThe Stock MarketFinancial MarketsBonds vs. StocksFinancial IntermediariesSlide 9SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTSSlide 11National SavingThe Meaning of Saving and InvestmentTHE MARKET FOR LOANABLE FUNDSSupply and Demand for Loanable FundsFigure 1 The Market for Loanable FundsGovernment Policies That Affect Saving and InvestmentSupply of Loanable Funds: Saving IncentivesFigure 2 An Increase in the Supply of Loanable FundsDemand for Loanable Funds: Investment IncentivesFigure 3 An Increase in the Demand for Loanable FundsGovernment Budget Deficits and SurplusesPolicy 3: Government Budget Deficits and SurplusesFigure 4: The Effect of a Government Budget DeficitFigure 5 The U.S. Government DebtSummarySlide 27Slide 28Slide 29Slide 30The Financial SystemFINANCIAL INSTITUTIONS IN THE U.S. ECONOMY•The financial system is made up of financial institutions that coordinate the actions of savers and borrowers.•Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY•Financial Markets–Stock Market–Bond Market•Financial Intermediaries–Banks–Mutual Funds–OthersBond Market•A bond is a certificate of indebtedness thatspecifies obligations of the borrower to the holder of the bond.•Characteristics of a Bond•Term: The length of time until the bond matures.•Credit Risk: The probability that the borrower will fail to pay some of the interest or principal.•Tax Treatment: The way in which the tax laws treat the interest on the bond.–Municipal bonds are federal tax exempt.IOUThe Stock Market•Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes.•The sale of stock to raise money is called equity financing.–Compared to bonds, stocks offer both higher risk and potentially higher returns.•The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.Financial Markets •Most newspaper stock tables provide the following information:•Price (of a share)•Volume (number of shares sold)•Dividend (profits paid to stockholders)•Price-earnings ratioBonds vs. Stocks•Importance difference is that bonds are debt and stocks are the owners claims on the residuals of the company.•If bankruptcy occurs, bondholders are paid of before stockholders.Financial Intermediaries•Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.•Banks–take deposits from people who want to save and use the deposits to make loans to people who want to borrow.–pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.–Banks help create a medium of exchange by allowing people to write checks against their deposits.•A medium of exchanges is an item that people can easily use to engage in transactions.–A medium of exchange facilitates the purchases of goods and services by removing the coincidence of wants and lowering transaction costs•Mutual Funds–A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both.•They allow people with small amounts of money to easily diversify.•Other Financial Institutions –Credit unions–Pension funds–Insurance companies–Loan sharksSAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS•Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:Y = C + I + G + NXY = C + I + G + NX•Assume a closed economyclosed economy – one that does not engage in international trade:Y = C + I + GY = C + I + G•Now, subtract C and G from both sides of the equation:Y – C – G =IY – C – G =I•The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).•Substituting S for Y - C - G, the equation can be written as:S = IS = I•National saving, or saving, is equal to:S = IS = IS = Y – C – G S = Y – C – G S = (Y – T – C) + (T – G)S = (Y – T – C) + (T – G)•Note that we have subtracted T from Y to get private saving = Note that we have subtracted T from Y to get private saving = (Y – T – C)(Y – T – C) and added taxes to get government saving = and added taxes to get government saving = (T – G)(T – G)National Saving•Total income in the economy that remains after paying for consumption and government purchases. •Private Saving–Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.Private saving = (Y – T – C)Private saving = (Y – T – C) •Public Saving–Public saving is the amount of tax revenue that the government has left after paying for its spending.Public saving = (T – G)Public saving = (T – G)The Meaning of Saving and Investment•Surplus and Deficit–If T > G, the government runs a budget surplus because it receives more money than it spends.–The surplus of T - G represents public saving.–If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.•Remember from above that for the economy as a whole, saving must be equal to investment. S = IS = ITHE MARKET FOR LOANABLE FUNDS•Financial markets coordinate the economy’s saving and investment in the market for loanable funds.market for loanable funds. •The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.•Loanable fundsLoanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.Supply and Demand for Loanable Funds•The supply of loanable funds comes from people who have extra income they want to save and lend out.•The demand for loanable funds comes from households and firms that wish to borrow to make investments.•The interest rate is the price of the loan.•It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.•The interest rate in the market for loanable funds is the real interest rate.•Financial markets work