Macroeconomics

Lecture 5

Saving, Investment & the Financial System

Chapter 26

Lecture Objectives Learn about financial institutions. Consider how the financial system is

related to key macroeconomic variables. Develop a model of the supply and

demand for loanable funds. Use the loanable funds model to analyze

various government policies. Consider how budget deficits and

surpluses affect the economy.

The Financial System

Consist of institutions that help to match one person’s saving with another person’s investment.

Move the economy’s scarce resources from savers to borrowers.

Financial Institutions

Financial institutions:

Categories

Financial InstitutionsFinancial Markets

Financial markets:

Categories

Financial InstitutionsFinancial Intermediaries

Financial intermediaries

Categories

Financial MarketsBond Market

A bond: a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.

Debt financing: sale of bond to raise money

IOU

Financial MarketsBond Market

Characteristics of a Bond: Term

Credit Risk

Tax Treatment

Stock represent ownership in a firm a claim to

the profits that the firm makes. offer both higher risk and potentially higher

returns in comparison with bonds Equity financing

sale of stock to raise money.

Financial MarketsStock Market

Financial IntermediariesBanks

Take deposits from people who want to save

Make loans from deposits to people who want to borrow. pay depositors interest on their deposits charge borrowers slightly higher interest on

their loans.

Financial IntermediariesBanks

Create a medium of exchange by allowing people to write checks against their deposits. A medium of exchanges: an item that people

can easily use to engage in transactions, facilitates the purchases of goods and services.

Financial IntermediariesMutual Funds

A mutual fund (USA)/ managed fund (Australia): an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both. allow people with small amounts of

money to easily diversify.

Financial IntermediariesOthers

Credit unions Pension funds Insurance companies Loan sharks

Financial Instruments in the US

US household wealth (2014)

Saving and Investment in the National Income Accounts

GDP = total income = total expenditure

Y = C + I + G + NX

Some Important Identities

A closed economy without international trade:

Y = C + I + G

Some Important Identities

Subtract C and G from both sides of the equation:

Y – C – G =I National saving, or just saving (S): total

income in the economy after paying for consumption and government purchases and is called

Some Important Identities Substituting S for Y-C-G

S = I National saving, or saving:

S = I

S = Y – C – G S = (Y – T – C) + (T – G)

where “T” = taxes - transfers

Private Saving & Public Saving

Private saving: the amount of income that households have left after paying their taxes and paying for their consumption.

Public saving: the amount of tax revenue that the government has left after paying for its spending.

Surplus and Deficit

T>G: budget surplus

G>T: budget deficit

Saving and Investment

For the economy as a whole, saving must be equal to investment.

S = I

Saving and Investment in the National Income Accounts

National Saving or Saving:

Y - C - G = I = S or

S = (Y - T - C) + (T - G)where “T” = taxes - transfers

Two components of national saving: Private Saving Public Saving

Open economy

NX= NCO = NCIY=C+I+G+NX

I=(Y-T-C)+ (T-G)-NCO

The Market for Loanable Funds

Market for loanable funds: coordinate the economy’s saving and investment.

Loanable funds: all income that people have chosen to save and lend out, rather than use for their own consumption.

The supply of loanable funds

The demand for loanable funds

Supply and Demand for Loanable Funds

Interest rate: price of the loan. the amount that borrowers pay for loans the amount that lenders receive on their

saving. Interest rate in the market for loanable

funds: real interest rate.

Supply and Demand for Loanable Funds

Loanable Funds (in billions of

dollars)

0

Real Interest

Rate

Demand

Supply

5%

$1,200

Market for Loanable Funds

The equilibrium of the supply and demand for loanable funds determines the real interest rate.

E

Government Policies That Affect Saving and Investment

Taxes and saving Taxes and investment Government budget deficits

Taxes and Saving Taxes on interest income

substantially reduce the future payoff from current saving and

reduce the incentive to save.

A tax decrease

increases the incentive for households to save at any given interest rate.

S2

1. Tax incentives for saving increase the supply of loanable funds...

An Increase in the Supply of Loanable Funds

Loanable Funds (in billions of

dollars)

0

InterestRate

5%

Supply, S1

$1,200

Demand

$1,600

3. ...and raises the equilibrium quantity of loanable funds.

4%

2. ...which reduces the equilibrium interest rate...

Taxes and Saving

Change in tax law encouraging saving

lower interest rates & greater investment Supply of loanable funds curve Equilibrium interest rate Quantity demanded for loanable funds

Taxes and Investment

An investment tax credit (tax reduction to encourage investment) increase the incentive to borrow. the demand for loanable funds the demand curve interest rate quantity saved

An Increase in the Demand for Loanable Funds

Loanable Funds(in billions of

dollars)

0

InterestRate

5%

$1,200

Supply

Demand, D1

1. An investment tax credit increases the demand for loanable funds...

D2

6%

2. ...whichraises the equilibrium interest rate...

$1,4003. ...and raises the equilibrium quantity of loanable funds.

Government Budget Deficits

Budget deficit

Government debt

Government Budget Deficits

Government borrowing to finance its budget deficit

reduce the supply of loanable funds available to finance investment by households and firms Crowding out

Crowding out: fall in private investment due to deficit borrowing

S2

1. A budget deficit decreases the supply of loanable funds...

The Effect of a Government Budget Deficit

Loanable Funds(in billions of dollars)

0

InterestRate

$1,200

Supply, S1

Demand

5%

$8003. ...and reduces the equilibrium quantity of loanable funds.

2. ...which raises the equilibrium interest rate...

6%

Government Budget Deficits

A budget deficit decrease the supply of loanable funds: Supply curve Equilibrium interest rate Equilibrium quantity of loanable funds

Government Budget Deficits and Surpluses

Deficit

Surplus

U.S. government debt (% of GDP 1970-2007)

0%

20%

40%

60%

80%

100%

120%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Global loanable fund market

Global intergration

Capital mobility

Real Interest rate differences

Global loanable fund market

Lecture Review

Financial Markets and Intermediaries Saving and Investment Market for Loanable Funds Government policies that affect the

economy’s savings and investment Government Budget deficits and surplus