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Transcript of Chap18 Investments Savings
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18Saving, Investment,
and the FinancialSystem
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Context
Continue with a sequence of topics which deal with the
production of output in the long run. In the previous lecture, we found that capital and labor are
among the primary determinants of output.
The purpose of the present lecture is to show how saving
and investment are coordinated by the loanable fundsmarket.
Within the framework of the loanable funds market, we willstudy the effects of taxes and government deficits on saving,
investment,
the accumulation of capital,
the growth rate of output.
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The Financial System
The financial system consists of the group of
institutions in the economy that help to match one
persons saving with another persons investment.
It moves the economys scarce resources from savers to
borrowers.
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FINANCIAL INSTITUTIONS IN THE U.S.ECONOMY
Thefinancial system is made up of financial
institutions that coordinate the actions of
savers and borrowers.
Financial institutions can be grouped into twodifferent categories:
financial markets and
financial intermediaries.
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FINANCIAL INSTITUTIONS IN THE U.S.ECONOMY
Financial markets are the institutions through which
savers can directlyprovide funds to investors.
Stock Market
Bond Market
Financial intermediaries are financial institutions
through which savers can indirectlyprovide funds to
investors.
Banks
Mutual Funds
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Financial Markets
The Bond Market A bond is a certificate of indebtedness that
specifies obligations of the borrower tothe holder of the bond.
Characteristics of a Bond Rate of interestthat will be paid periodically until the loan
matures.
Term: The length of time until the bond matures. All else equal, long-term bonds pay higher rates of interest than short-term bonds.
Credit Risk: The probability that the borrower will fail to paysome of the interest or principal. All else equal, the more risky a bond is, the higher its interest rate.
Tax Treatment: The way in which the tax laws treat the intereston the bond. Municipal bonds are federal tax exempt.
IOU
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Financial Markets
The Stock Market
Most newspaper stock tables provide the following
information:
Price (of a share)
The price of a stock generally reflects the perception of a companys futureprofitability.
Volume (number of shares sold)
Dividend (profits paid to stockholders)
A corporation's earnings, or accounting profit, is the amount of
revenue it receives for the sale of its products minus its costs of
production as measured by its accountants.
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The Stock Market(cont)
Earnings per share is the company's total earnings divided
by the number of shares of stock outstanding.
Theprice-earnings ratio(P/E), is the price of a
corporation's stock divided by the amount the corporation
earned per share over the past year. Historically, the typical price-earnings ratio is about 15.
High P/E indicates that a corporation's stock is expensive relative
to its recent earnings;
this might indicate either that people expect earnings to rise in the future orthat the stock is overvalued.
Low P/E indicates that a corporation's stock is cheap relative to its
recent earnings;
this might indicate either that people expect earnings to fall or that the stock
is undervalued.
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Financial Intermediaries: Role of Banks
Their primary role is to take deposits from people who want
to save and use the deposits to make loans to people whowant to borrow.
Pay depositors interest on their deposits and charge
borrowers a higher rate of interest to cover the costs ofrunning the bank and provide the bank owners with some
amount of profit
Create a medium of exchangeby providing checking
accounts and allowing people to write checks against theirdeposits.
A medium of exchanges is an item that people can easily use to
engage in transactions.
This facilitates the purchases of goods and services.
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Financial Intermediaries: 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.
Index fundsare mutual funds that buy all of the
stocks of a given stock index.
Generally perform better than funds with active fundmanagement.
they trade stocks less frequently and they do not have to pay the
salaries of fund managers.
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Assignment
1. Assume you have $100,000 in savings.
2. Create a portfolio of securities worth $100,000.
3. Decide what financial instruments you would like to use, then
find their current prices in the newspaper.
4. Calculate your holdings of each security, based on current prices.
What objectives do you have for this portfolio? Was it chosen to
maximize short-term gains, long-term stability, or some other
objective?
Explain how each of the following economic events would affect
the value of your portfolio.
an increase or decrease in interest rates
a recession
rapid inflation
a depreciation of the U.S. dollar
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Financial Intermediaries
Other Financial Institutions
Credit unions
Pension funds
Insurance companies
Loan sharks
S G S
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SAVING AND INVESTMENT IN THENATIONAL INCOME ACCOUNTS
Recall:
GDP is both total income in an economy and total
expenditure on the economys output of goods
and services
GDP can be divided up into four components:
consumption, investment, government purchases, and
net exports.
Y = C + I + G + NX
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Some Important Identities
Assume a closed economy
i.e., one that does not engage in international trade
This implies that GDP can now be divided into
only three components:
Y = C + I + G
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Some Important Identities
National saving, or saving, is equal to:
S = I
S = YCG
We can add and subtract taxes:S = YCG + TT
After rearrangement:
S = (Y
T
C) + (T
G)
S = Sprivate
+ Spublic
Two types of saving.
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The Meaning of Saving and Investment
National Saving
National savingis the 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 TC)
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The Meaning of Saving and Investment
Surplus and Deficit
If T > G, the government runs a budget surplusbecauseit receives more money than it spends.
Budget surplus:an excess of tax revenue over governmentspending.
The surplus of T - Grepresentspublic saving.
If G > T, the government runs a budget deficitbecause itspends more money than it receives in tax revenue.
Budget deficit:a shortfall of tax revenue from government
spending. To make up for this shortfall, the government must go to the
loanable funds market and borrow the money.
This will reduce the supply of loanable funds available for
investment.
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The Meaning of Saving and Investment
Public Saving
Public saving is the amount of tax revenue that the
government has left after paying for its spending.
Public saving = (TG)
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An illustration
Suppose that GDP is $8 trillion, taxes are $1.5 trillion, private saving
is $0.5 trillion, and public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption, government
purchases, national saving, and investment.
Given that Y = 8 and T = 1.5,
Sprivate = 0.5 = YTC,Spublic= 0.2 = TG.
Since Sprivate= YTC, then a rearrangement gives
C = YTSprivate= 81.50.5 = 6.
Since Spublic = T - G, then rearranging gives
G = TSpublic= 1.50.2 = 1.3.
Since S = national saving = Sprivate+ Spublic= 0.5 + 0.2 = 0.7.
Finally, since I = investment = S, I = 0.7.
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THE MARKET FOR LOANABLE FUNDS
Coordination of the economys saving and investment
occurs in the market for loanable funds. The market for loanable funds (LF) is the market in which those
who want to savesupply funds and those who want to borrow
(and invest) demand funds.
LF is all income that people have chosen to save and lendout, rather than use for their own consumption.
The supply of LFcomes from people who have extra income they
want to save and lend out.
They buy stocks and bonds
The demand for LFcomes from households and firms that wish to
borrow to make investments.
Families borrow to invest in new homes while firms may borrow to purchase
new equipment or to build factories.
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The Meaning of Saving and Investment
Outside of the economics profession, most people use
the terms saving and investing interchangeably.
In macroeconomics, investment refers to the purchase of
new capital, such as equipment or buildings.
What is the meaning of the identity: S = I ? For the economy as a whole, saving must be equal to
investment.
The bond market, the stock market, banks, mutual funds, and
other financial markets and institutions stand between the two
sides of the S=Iequation.
These markets and institutions take in the nation's saving and
direct it to the nation's investment.
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Supply and Demand for Loanable Funds
Markets for loanable funds work much like other
markets in the economy.
The equilibrium of the supply and demand for loanable
funds determines the price of a loan
The real 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.
f
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Figure 1 The Market for Loanable Funds
Loanable Funds
(in billions of dollars)0
Interest
RateSupply/Saving
Demand/Investing
All else equal, as the interest rate rises, the quantity of loanable funds supplied will
increase.
All else equal, as the interest rate rises, the quantity of loanable funds demandedwill fall.
Fi 1 Th M k f L bl F d
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Figure 1 The Market for Loanable Funds
Loanable Funds
(in billions of dollars)0
Interest
Rate
Supply/Saving
Demand/Investing
5%
$1,200
If the quantity of funds demanded is smaller than the quantity
of funds supplied, lenders would compete for borrowers,
driving the interest rate down.
If the quantity of funds demanded is greater than the
quantity of funds supplied, the shortage of loanablefunds would encourage lenders to raise the interest rate.
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Supply and Demand for Loanable Funds
Government Policies That Affect Saving and
Investment Saving incentives
Investment Incentives
Government budget deficits
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Policy 1: Saving Incentives
Taxes on interest income substantially reduce the
future payoff from current saving and, as a result,reduce the incentive to save.
A tax reduction increases the incentive for
households to save at any given interest rate. The loanable funds supply curve shifts to the right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds increases.
Figure 2 An Increase in the Supply of Loanable
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Figure 2 An Increase in the Supply of LoanableFunds
Loanable Funds
(in billions of dollars)
0
Interest
Rate
Supply, S1 S2
2. . . . whichreduces theequilibrium
interest rate . . .
3. . . . and raises the equilibriumquantity of loanable funds.
Demand
1. Tax incentives for
saving increase the
supply of loanablefunds . . .
5%
$1,200
4%
$1,600
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Policy 1: Saving Incentives
Conclusion?
If a change in tax law encourages greater saving,
the result will be lowerinterest rates andgreater
investment.
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Policy 2: Investment Incentives
An investment tax credit increases the incentive to
borrow.
Reduces taxes for any firm building a new factory or
buying a new piece of equipment
=>Increases the demand for loanable funds. =>Shifts the demand curve to the right.
=>Results in a higher interest rate and a greater quantity
saved. If a change in tax laws encourages greater
investment, the result will be higherinterest rates
andgreatersaving.
A I i th D d f L bl F d
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An Increase in the Demand for Loanable Funds
Loanable Funds
(in billions of dollars)
0
Interest
Rate 1. An investment
tax credit
increases the
demand for
loanable funds . . .
2. . . . which
raises the
equilibrium
interest rate . . .
3. . . . and raises the equilibrium
quantity of loanable funds.
Supply
Demand, D1
D2
5%
$1,200
6%
$1,400
Policy 3: Government Budget Deficits and
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Policy 3: Government Budget Deficits andSurpluses
When the government spends more than it receives
in tax revenues, the shortfall is called the budgetdeficit.
The accumulation of past budget deficits is called
the government debt.
Government borrowing to finance its budget deficit
reduces the supply of loanable funds available to
finance investment by households and firms:SPublic=> S
Which curve does this affect?
Policy 3: Government Budget Deficits and
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Policy 3: Government Budget Deficits andSurpluses
A budget deficit decreases the supply of loanable
funds.
Shifts the supply curve to the left.
Increases the equilibrium interest rate.
Reduces the equilibrium quantity of loanable funds.
Figure 4: The Effect of a Government Budget
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Figure 4: The Effect of a Government BudgetDeficit
Loanable Funds
(in billions of dollars)
0
Interest
Rate
3. . . . and reduces the equilibrium
quantity of loanable funds.
S2
2. . . . which
raises the
equilibrium
interest rate . . .
Supply, S1
Demand
$1,200
5%
$800
6%1. A budget deficit
decreases the
supply of loanable
funds . . .
Copyright2004 South-Western
Policy 3: Government Budget Deficits and
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Policy 3: Government Budget Deficits andSurpluses
When government reduces national saving by
running a deficit, the interest rate risesandinvestmentfalls.
This fall in investment is referred to as crowding
out. The deficit borrowing crowds out private borrowers who
are trying to finance investments.
SPrivate+ SPublic= S= I. A budget surplus increasesthe supply of loanable
funds, reducesthe interest rate, andstimulates
investment.
The U S Government Debt
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The U.S. Government Debt
Percent
of GDP
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990
RevolutionaryWar
2010
CivilWar World War I
World War II
0
20
40
60
80
100
120
Copyright2004 South-Western
Th U S G t D bt
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The U.S. Government Debt
In recent years, government debt has been about 50
percent of GDP. Throughout history, the primary cause of
fluctuations in government debt has been wars.
However, the U.S. debt also increased substantiallyduring the 1980s when taxes were cut butgovernment spending was not.
By the late 1990s, the debt to GDP ratio begandeclining due to budget surpluses.
As of 2002, the Congressional Budget Office wasprojecting that the debt-GDP ratio would decline
over the next decade to reach 15 percent in 2012.
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The Financial Crisis of 20082009
A financial crisis led to a deep recession in the U.S.
and around the world. A few unemployment rates:
3
45
6
7
8
9
10
11
12
-2007
01
-2008
02
-2008
03
-2008
04
-2008
05
-2008
06
-2008
07
-2008
07
-2008
08
-2008
09
-2008
10
-2008
11
-2008
12
-2008
01
-2009
02
-2009
03
-2009
04
-2009
05
-2009
06
-2009
07
-2009
08
-2009
09
-2009
10
-2009
11
-2009
12
-2009
%
oflaborforce
USAFranceU.K.CanadaSweden
El t f Fi i l C i
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FYI: Elements of Financial Crises
Large decline in some asset prices 20082009: Housing prices fell 30%.
Insolvencies at financial institutions
2008
2009:Banks and other institutions failed when many
homeowners stopped paying their mortgages.
Decline in confidence in financialinstitutions
20082009:Customers with uninsured deposits began
pulling their funds out of financial institutions.
El t f Fi i l C i
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FYI: Elements of Financial Crises
Credit crunch 20082009: Borrowers unable to get loans
because troubled lenders not confident inborrowers credit-worthiness.
Economic downturn
20082009: Failing financial institutions anda fall in investment caused GDP to fall and
unemployment to rise.
Vicious circle
20082009: The downturn reduced profits
and asset values, which worsened the crisis.
CNN Vid A M tt f P i iti
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CNN Video: A Matter of Priorities
There are many, including President Bush, who
argue for a tax cut. What are their arguments?
The arguments for the tax cuts are twofold.
because of the economic slowdown, a tax cut is needed to
stimulate the economy. the surplus arises because taxpayers have overpaid, i.e.,
provided more money than was needed to finance the activities
of the government.
Do taxpayers benefit if the debt is repaid? Who decides how the surplus is going to be used?
S
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Summary
The U.S. financial system is made up of financial
institutions such as the bond market, the stockmarket, banks, and mutual funds.
All these institutions act to direct the resources of
households who want to save some of their incomeinto the hands of households and firms who want to
borrow.
S
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Summary
National income accounting identities reveal some
important relationships among macroeconomicvariables.
In particular, in a closed economy, national saving
must equal investment. Financial institutions attempt to match one persons
saving with another persons investment.
S
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Summary
The interest rate is determined by the supply and
demand for loanable funds.
The supply of loanable funds comes from
households who want to save some of their income.
The demand for loanable funds comes fromhouseholds and firms who want to borrow for
investment.
S
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Summary
National saving equals private saving plus public
saving.
A government budget deficit represents negative
public saving and, therefore, reduces national saving
and the supply of loanable funds. When a government budget deficit crowds out
investment, it reduces the growth of productivity
and GDP.