Saving, Investment, and the Financial System

• Chapter 26: Saving, Investment, and the Financial System
  • 26-1: Financial Institutions in the U.S. Economy
  • 26-2: Saving and Investment in the National Income Accounts
  • 26-3: The Market for Loanable Funds

Chapter 26: Saving, Investment, and the Financial System

• The financial system consists of the institutions that match one person’s savings with another perosn’s investments
  • Think of banks; people can deposit money into banks, and the banks use that money to give loans out

26-1: Financial Institutions in the U.S. Economy

• Various incentives for people to both save and borrow, so the financial system matches the two together
• Financial institutions can be grouped into two categories: financial markets and financial intermediaries

Financial Markets

• Financial Markets are institutions where people who want to save can directly give funds to people who want to borrow
  • Two main financial markets: bond and stock market

Bond Market

• When a company wants to borrow money, they can sell bonds to do so
• Bonds are essentially IOU agreements, and the bond buyer loans money to the bond seller
• Bonds identify the date of maturity, or when the loan will be repaid, and the rate of interest the seller will pays until the loan matures and the principal, or initial amount borrowed, is paid off
• Bonds have four different characteristics that differentiate them
  • Term: How long it will take for the bond to mature; occasionally, this will be indefinite, and such a bond is called a *perpretuity
    • Long-term bonds are riskier than short-term bonds because you might need the money back faster, so long-term bonds usually have higher interest rates
  • Credit Risk: The likelihood that the bond seller will fail to pay the interest or principal
    • Failure to pay is called a default, and corporations with higher chances of defaulting will issue junk bonds which have high interest rates in the hopes that someone will buy their bond
  • Tax Treatment: The way that taxes affect the interest earned on a bond
    • State or local government issued bonds called municipal bonds are not taxable, so they have lower interest rates than corporate or federal bonds
  • Inflation Protection: Whether or not a bond will increase the interest paid back over time to reflect changes in inflation
    • Bonds with inflation protections typically pay a lower interest rate than those without it

Stock Market

• A stock is a piece of the company that one can purchase in order for the company to raise funds
• Selling stocks to raise money is known as equity finance, while the sale of bonds is called debt finance
• Stockholders will gain a profit if the company they hold stock in is profitable while bondholders will not, but if the company does poorly, then the bondholders will maintain their same interest rates while stockholders will have stocks with a lower value
  • Overall, stocks are more risky but more lucrative
• After a corporation begins selling stocks, the shares are traded amongst stockholders on stock exchanges, such as the NYSE and NASDAQ
  • The price of shares depends on the supply and demand of the stock
• A stock index is the average of a group of stock prices, such as the SNP 500 or Dow Jones Inudstrial

Financial Intermediaries

• Financial intermediaries are institutions in which savers indirectly provide money to borrowers
  • Two main types: banks and mutual funds

Banks

• Banks use deposits from people who wants to save and uses it to finance loans from borrowers
• Banks are profitable because the interest rates on their loans are higher than the interest rates they pay back on deposits
• Banks also provide a medium of exchange in the form of credit/debit cards which allow people to easily make transactions
  • Included in this is that they allow for a store of value for wealth that people have saved

Mutual Funds

• Mutual funds are institutions that sells shares to the public and uses the money raised to buy a portfolio of different stocks and bonds
  • Shareholders of a mutual fund accept the risk associated with the portfolio; if it rises in value, then they benefit, but if it falls, then they suffer the loss
• One advantage of mutual funds is that they allow those with small amounts of money to diversify their holdings, as it’s difficult to buy a fraction of a stock share
• Another advantage is that it gives ordinary people access to the skills of professional portfolio managers, thus making it a more effective use of money
  • This advantage is controversial, as it is often difficult to “beat the market”, and typically, index funds outperform mutual funds

26-2: Saving and Investment in the National Income Accounts

• Various macroeconomic variables affect the financial markets, and this section will focus on using accounting to calculate the effects of these factors

Some Important Identities

• GDP is total income in an economy and the total expenditure on the economy’s goods and services
  • Therefore, GDP (Y) is divided into the four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX)
  • $${Y = C + I + G + NX}$$
• Making an assumption that an economy is a closed economy that does not engage in trade makes it easier to analyze this identity
  • In closed economies, there is no trade, so NX = 0
  • $${Y = C + I + G}$$
  • Therefore, every output sold in an economy is consumed, invested, or bought by the government
• Using algebra we get the following:
  • $${Y - C - G = I}$$
• Y - C - G is the total income in the economy that remains after consumption and government pourchases, which is also known as national saving or saving (S)
  • Thus, ${S = I}$
• Let T represent the amount that the government collects in taxes minus the amount it pays back to households in the form of transfer payments (such as Social Security and welfare)
  • With T, we can define S as ${S = Y - C - G = (Y - T - C) + (T - G)}$
• This splits saving into private saving (Y - T - C) and public saving (T - G)
  • Private saving is the income (Y) households have left over after paying taxes (T) and consumption (C)
  • Public saving is the tax revenue (T) the governments has left over after paying for its spending (G)
    • If T > G, then the government has a budget surplus, and if T < G, then the government has a budget deficit
• The identity that S = I reveals an important fact: For the economy as a whole, saving must equal investment
  • This is done through financial intermediaries that turn savings into investment

The Meaning of Saving and Investment

• Investing refers to the purchase of new capital, such as a loan to buy a new house or build a building
• Saving refers to excess income that is stored somewhere, whether it’s the stock or bond market

26-3: The Market for Loanable Funds

• Assume that the economy has one financial market which is called the market for loanable funds
  • Loanable funds refers to the income that people chose to save and lend out which investors borrow to fund new investment projects
  • In this market, there is one interest rate which is the equal to the return to saving and the cost of borrowing

Supply and Demand for Loanable Funds

• The supply in this market comes from those with extra income who wish to save and lend out, either directly (bonds/stocks) or indirectly (banks)
  • In other words, saving is the source of supply for loanable funds
• The demand in this market comes fromm households and firms who wish to borrow in order to invest, such as getting a mortgage on a house or building a new factory
  • In other words, investing is the source of demand for loanable funds
• The interest rate represents the price of a loan, as it is the amount that borrowers pay for their loans and the amount lenders receive for loaning
  • Higher interest rate means less people will borrow and more will save, and lower interest rate means more people will borrow and less will save
  • An equilibrium occurs in the market: if the interest rate were lower, then more people will borrow causing lenders to raise the interest rate, and vice versa
  • Graph of supply vs. demand:
• The interest rate in this market refers to the real interest rate rather than nominal
• Similar to other markets, we can analyze different government policies and their effects on saving and investment based on the shifts in supply and demand

Policy 1: Saving Incentives

• Saving is vital to creating resources for capital accumulation and raising the GDP, thus leading to policies incentivizing saving
  • Tax laws especially can be amended to encourage saving, such as putting a lower tax on bond interest payments
• A policy that incentivizes saving will shift the supply of loanable funds to the right because more money will be saved and lent out
  • This will thus lead to a lower interest rate and more investment
  • Graphic:

Policy 2: Investment Incentives

• An investment tax credit gives a tax advantage to a firm investing in capital, thus incentivizing investment
• This policy would shift the demand of loanable funds to the right because more people will borrow in order to make investments
  • Therefore, this policy will lead to a higher interest rate and greater saving
  • Graphic:

Policy 3: Government Budget Deficits and Surpluses

• If the government runs a budget deficit, then there is a lower supply of loanable funds because national saving is equal to private saving plus public saving
  • Therefore, the supply of loanable funds will shift to the left because there is a lower amount of national saving
  • This causes a higher interest rate and less investment
  • Graphic:
  • The fall in investing due to government borrowing is called crowding out because, when the government borrows to finance its deficit, it “crowds out” private borrowers and investors
  • The negative effects of a budget deficit can be felt regardless of whether it was caused by excess government spending or tax cuts
• If the government runs a budget surplus, it uses its savings to get rid of its government debt which contributes to national saving
  • Thus, a budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment