Text transcription of Chapter 8 – Savings, Investment and the Financial System

Welcome to the Chapter 8 Lecture on Savings, Investment and the Financial System.

Savings and investment are key ingredients for economic growth. This was covered in Chapter 7 under “Public Policy to increase productivity”. The financial system as a whole is comprised of institutions that help match one person’s savings with another person’s investment. The financial system helps move the economy’s scarce resource (money) from savers to borrowers. Savers are people who spend less than they earn and borrowers are people who spend more than they earn.

Savers are the source of supply of funds. Savers supply their funds to the financial system with the expectation they will get their money back PLUS some interest. If the financial system did not offer the incentive of interest, no one would supply their money to the system. Interest is the reward for saving money. Borrowers are the source of demand of funds. Borrowers demand funds from the financial system with the knowledge that they are required to the pay the money back that they borrow PLUS interest. Borrowers can’t borrow for free. Interest is the cost of borrowing money. The financial system is made of institutions that help coordinate savers and borrowers. Financial institutions are divided into two main groups: Financial Markets and Financial Intermediaries.

Financial markets consists of institutions that directly match people who want to save with people who want to borrow. The two most important financial markets are the bond market and the stock market. It is important to note that this not an exclusive list of the financial markets. The bond and stock market are just the two most important and common financial markets.

Bonds are defined as a certificate of indebtedness that specifies the obligation of the borrower to the holder of the bond. It sounds like a really complicated definition, but bonds are quite simple. The easy definition of the bond is an I.O.U. A certificate of indebtedness is a piece of paper, that specifies the obligation, states how much is owed between the borrower and the holder of the bond. An example of a bond would be if Nike wanted to build a new factory but didn’t have the cash to do so. If they didn’t want to go to the bank and get a loan, they would borrow money by issuing bonds. Buyers of the bond would give money to Nike in exchange for promise of repayment plus interest.

There are three characteristics of all bonds. First is called “Term”. Bond term is the length of time until the bond matures. The maturity date is when the holder of the bond gets their money back plus the interest. Bond term can range from a few months to 30 years. Long-term bonds are relatively risky because holders have to

wait longer for repayment. To compensate for the risk, long-term bonds usually pay higher interest rates than short-term bonds.

The second characteristic is credit risk. Credit risk is the probably of default, which is when the borrower fails to pay the interest and/or the principle. Borrowers with higher credit risk who issue bonds will have to pay higher interest rates to compensate for the risk. The third characteristic is tax treatment, which is the way tax laws treat the interest earned on bonds. Interest earned is taxable income and the holder must pay federal income taxes on the interest earned. State and local bonds are called municipal bonds and they are tax-free, therefore the holder does not have to pay taxes on the interest earned. However, municipal bonds typically pay a lower interest rate.

The other type of financial market is the stock market. Stock is defined as ownership in a firm, therefore a claim to the profits that the firm makes. Corporations issue stock by selling share of their company to the

public. Once the corporation sells the shares, the shares are traded among stockholders on organized stock exchanges. The two stock exchanges in the United States are the New York Stock Exchange (NYSE) and the NASDQAQ. The prices of stock are determined by supply and demand.

Because stock represents ownership, the demand for stock (and thus it’s price) reflects people’s perception of the firm’s future profitability. When people perceive a firm to do well in the future, they increase their demand and bid up the price of the stock. When people perceive a firm to do poorly in the future, they decrease their demand and the price of the stock falls.

Stock indexes monitor the overall level of stock prices. A stock index is an average of a group of stock prices. The two most common indexes are the Dow Jones and S&P 500. The Dow Jones is an average of a group of 30 stocks. The S&P 500 is an average of a group of 500 stocks. Because stock prices reflect expected profitability, indexes are watched as possible indicators of future economic conditions.

Financial intermediaries are the other half of the financial system. Financial intermediaries are institutions that indirectly match people who want to save with people who want to borrow. The two most important financial intermediaries are banks and mutual funds.

We are going to discuss banks in much greater detail in chapter 11, so this is just a quick introduction about banks. The primary job of banks to take deposits in from savers and uses those deposits to make loans to borrowers. The bank acts as the middleman that indirectly matches the savers with the borrowers. Banks pay interest on deposits and charge higher interest on loans. The difference between the two interest rates covers costs and returns profits to bank owners. The other job of banks is to facilitate purchases by allowing people to write checks against their deposits. Nowadays people don’t write checks very often, so banks facilitate purchases by allowing people to use their ATM cards, which are essentially electronic checks.

Mutual Funds are institutions that sells share to the public and use the proceeds to buy a selection (or portfolio) of various stocks and/or bonds. The mutual fund acts as the intermediary because the savers are giving their money to fund, which then uses the money to buy the stocks and bonds. The primary advantage of mutual funds is it allows people will small amounts of money to diversify. Rather than having their entire savings wrapped up in a single stock or bond, the saver has their money spread out over numerous stocks and bonds. The secondary advantage of mutual funds is the skills of professional money managers. Most people who work for mutual funds have degrees in Finance, so they have a much better understanding of the markets than the average Joe.

Let’s turn our attention to the Market for Loanable Funds. If you are following along with the textbook, I skipped over the section regarding National Income Accounts. That section is not covered in this course. The purpose the market for loanable funds is to explain how the economy coordinates savings and investment, and analyze the affect of government policies. First, a list of assumptions: The economy has only one financial

market, which is called the market for loanable funds; Loanable funds refers to income that people have chosen to save and lend out; and there is only one interest rate – The return to savings and the cost of borrowing is the same.

Savers are the sources of supply of loanable funds, since they are spending less than earn, they have extra income to lend out. Borrowers are the sources of demand of loanable funds, since they are spending more than what they earn. Higher interest rates makes savings more attractive, therefore the supply curve is upward sloping. At the same time, higher interest rates makes borrowing more expensive, therefore the demand curve is downward sloping.

Let’s look at this market on the diagram - Vertical and horizontal axes; the horizontal axis is labeled quantity of loanable funds and the vertical axis is labeled interest rates. The supply curve is upward sloping, the demand curve is downward sloping. There is one unique point at which the curves interest called equilibrium, which

gives us the equilibrium interest rates, labeled I* and the equilibrium quantity of loanable funds, labeled L*. We are going to analyze how this market changes when the government conducts three different policies.

Policy 1 is a savings incentive. The U.S. personal savings rate was negative in 2006 and 2007. Economists suggest this is partly caused by tax laws that discourage savings. Tax of interest income reduces the future payoff of current savings, which reduces the incentive for people to save. Suppose, for sake of argument, the government expands eligibility and benefits of IRAs, IRA stands for individual retirement account.

The change in the tax code would hypothetically encourage people to contribute more or open an Individual Retirement Account. This policy would impact savers therefore the supply curve would increase. The demand curve does not change because this policy does not impact borrowers. As a result, interest rates will decrease and the amount of loanable funds available will increase. Let’s look at this on a diagram.

Quantity of loanable funds is on the horizontal axis and interest rates are on the vertical axis. The supply curve is upward sloping and the demand curve is downward sloping. Equilibrium occurs at the one point at which the supply and demand curves intersect, giving us I* and L*. If the government changed the tax code to make IRAs more attractive, more people would save their money. The supply curve would increase, shift to the right. The new equilibrium would occur at the intersection of the new supply curve and the original demand curve. Equilibrium interest rates would decrease and the equilibrium quantity of loanable funds would increase.

Policy 2 is an Investment Incentive. Suppose that Congress passes a tax reform aimed at making investment more attractive. Remember, investment means the purchase of capital. There is a tax credit for purchasing capital, like equipment and structures. This tax reform impacts borrowers, giving them an incentive to purchase new capital due to the tax credit. Supply for loanable funds is not affected since this policy does not impact savers. Demand for loanable funds will increase because borrowers will need money in order to purchase the

new capital. As a result of the demand curve increasing, interest rates will increase and the quantity of loanable funds available will increase. Let’s look at this on a diagram.

Quantity of loanable funds on the horizontal and interest rates on the vertical. Supply curve representing savers is upward sloping and the demand curve representing borrowers is downward sloping. Equilibrium occurs at the one unique spot at which the supply and demand curves intersect, giving us equilibrium interest rate I* and equilibrium quantity of loanable funds L*. If the government passes an investment incentive, more people will need to borrow money in order to finance these investments, therefore the demand curve will increase and shift right. The resulting equilibrium will have higher interest rates and greater quantity of loanable funds.

Policy 3 is a Government Budget Deficit. When the government collects less in tax revenues than they spend on their purchases, they run a budget deficit. The government funds budget deficits by borrowing cash in the bond market. Deficits occur over a one-year period of time. Accumulation of past government borrowing is

called debt. Let’s assume that the budget starts off balanced. Then, due to a tax cut or increased spending, the government starts running a budget deficit.

Savings for the nation is divided into two parts – Private savings by households and public savings by the government. A budget deficit represents a change in public savings therefore this policy will impact the supply curve. Deficits reduce savings, shifting the supply curve to the left as a decrease. The result is higher interest rates and a smaller quantity of loanable funds available. Let’s look at this on a diagram.

Quantity of loanable funds on the horizontal and interest rates on the vertical. Supply curve representing savers is upward sloping and the demand curve representing borrowers is downward sloping. Equilibrium occurs at the one unique spot at which the supply and demand curves intersect, giving us equilibrium interest rate I* and equilibrium quantity of loanable funds L*. If the government runs a budget deficit, the supply curve will

decrease and shift to the left. The resulting equilibrium is higher interest rates and a smaller quantity of loanable funds.

If interest rates are rising, it will be more expensive to finance investment. The fall in investment due to government borrowing is called “crowding out”. The government crowds out private borrowers who are trying to finance investments. Because investment is important for economic growth, deficits reduce the economy’s growth rate, which can be very problematic if it occurs for years upon years. Budget surplus, when tax revenues are greater than government spending, work the exact opposite. A budget surplus will cause interest rates to fall, increasing the quantity of loanable funds, investments become cheaper to finance and the economy’s growth rate will increase.

This is the end of the chapter 8 lecture on Savings, Investment and the Financial System. If you have any questions about the key concepts from this chapter please send me an email or post a question in “Ask Professor Pakula” discussion board.