MODULE 22SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM

INTRODUCTIONTwo instrumental sources of economic growth are:

1. Improvements in human capital (through increasing the skills and knowledge of the people in the workforce)

2. Increases in physical capital (goods used to make other goods)

Private investment spending is mostly done with other people’s money.

3. They may raise this money by selling their company’s stock

4. Or they may raise this money by borrowing from financial institutions

If they borrow money to create physical capital, they are charged an interest rate.

THE INTEREST RATE

The interest rate is the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year.

THE SAVING-INVESTMENT SPENDING IDENTITY

The most important idea to remember about savings and investment is that they are always equal

This is a fact of accounting called the savings-investment spending identity:

Total income = Total spending

Total income = Consumer spending + Savings

Total spending = Consumer spending + Investment spending

Consumer spending + Savings = Consumer spending + Investment spending

Savings = Investment spending

THE BUDGET BALANCE

This simplified economy changes in two ways when government and the rest of the world enter the picture. The first case:

Government, as well as households, can save if it collects more tax revenue than it spends. When this happens, the difference is called a budget surplus (and is equivalent to savings by government).

If the difference is negative, because government spending is greater than tax revenue, this is called a budget deficit (and is equivalent to dissaving by government).

The term budget balance refers to both cases, being positive (a budget surplus) or negative (a budget deficit).

National savings is equal to the sum of private savings and the budget balance, while private savings is disposable income minus consumption.

THE CAPITAL INFLOW

Second, because any one country is part of a wider world economy, savings are not necessarily spent on physical capital located in the same country in which the savings are generated (savings of people who live in any one country can be used to finance investment spending in other countries).

Any given country can receive inflows of funds (foreign savings that finance investment spending in that country), and any given country can generate outflows of funds (domestic savings that finance investment spending in another country).

The net effect of international inflows and outflows of funds on the total savings available for investment spending is known as the capital inflow into that country, and can be positive or negative:

Capital inflow = Total inflow of foreign funds – Total outflow of domestic funds to other countries

THE CAPITAL INFLOW

From a national perspective, a dollar generated by national savings and a dollar generated by capital inflow are not equivalent.

Borrowed money must be repaid with interest. If the money comes from national savings, the interest is

repaid with interest to someone domestically. If the money comes from capital inflow, it must be repaid with

interest to a foreigner. Therefore, a dollar of investment spending financed by

capital inflow comes at a higher national cost (the interest that must eventually be paid to a foreigner), than a dollar borrowed from national savings.

THE CAPITAL INFLOW

The application of the savings-investment spending identity to an economy open to inflows or outflows of capital means that investment spending is equal to savings, where savings is equal to national savings plus capital inflow.

In an economy with a positive capital inflow, some investment spending is funded by the savings of foreigners.

In an economy with a negative capital inflow (a net outflow), some portion of national savings is funding investment spending in other countries.

THE FINANCIAL SYSTEM

Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.

A financial asset is a paper claim that entitles the buyer to future income from the seller.

A household can also invest its current savings or wealth by purchasing a physical asset, which is a claim on a tangible object (such as a house or piece of equipment), which it can then dispose of as he or she wishes, such as rent it or sell it.

A loan is an important financial asset in the real world; it is owned by the lender.

When a loan is made, a liability is created. A liability is a requirement to pay money in the future.

THREE TASKS OF A FINANCIAL SYSTEM

The three tasks of a financial system are to reduce the problems facing borrowers and lenders:

1. Transaction costs

2. Risk

3. Desire for liquidity In reducing these problems in a cost-effective way, they

enhance the efficiency of financial markets, so that lenders and borrowers make mutually beneficial trades, which make society as a whole richer.

REDUCING TRANSACTION COSTS

Transaction costs are the expenses of putting together and executing a deal.

When a large business wants to borrow money, they can either get a loan from a bank or sell bonds in the bond market.

Getting a loan from a bank avoids large transaction costs because there is only one borrower and one lender.

The principal reason there is a bond market is that it allows companies to borrow large sums of money without incurring in large transaction costs.

THE FINANCIAL SYSTEM

In addition to loans, other types of financial assets include stocks, bonds, and bank deposits.

A financial asset is a claim to future income that someone has to pay, and it also becomes someone else´s liability.

A well functioning financial system is critical in achieving long-run growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently.

REDUCING RISK

Financial risk is uncertainty about future outcomes that involve financial losses or gains.

Financial risk is a problem because the future is uncertain; it holds the potential for losses as well as gains.

A well-functioning financial system helps people reduce their exposure to risk, by allowing them to engage in diversification.

Diversification is done by investing in several assets with unrelated, or independent, risks. This lowers the total risk of loss.

The desire of individuals to reduce their total risk by engaging in diversification is why there are stocks and a stock market.

PROVIDING LIQUIDITY

The third task of the financial system is to provide investors with liquidity, which is important because the future is uncertain.

An asset is said to be liquid if it can quickly be converted into cash without much loss of value. If it cannot, then it is said to be illiquid.

Stocks and bonds are a partial answer to the problem of liquidity.

Banks provide a further way for individuals to hold liquid assets and still finance illiquid investments.

TYPES OF FINANCIAL ASSETS

There are four main types of financial assets:

1. Loans

2. Bonds

3. Stocks

4. Bank deposits Additionally, financial innovation has allowed the creation of a

wide range of loan-backed securities.

LOANS

A loan is a lending agreement between an individual lender and an individual borrower.

Most people and small businesses encounter loans in the form of bank loans.

Advantage of loans: A given loan is usually tailored to the needs of the borrower and his ability to repay.

Disadvantage of loans: Making a loan to an individual person or a business typically involves a lot of transaction costs (such as the cost of negotiating the terms of the loan, checking the borrower´s credit history and ability to repay)

To minimize these costs, corporations or governments often sell (issue) bonds to borrow money.

BONDS

A bond is an IOU issued by the borrower. The seller of the bond promises to pay fixed amount of interest each year and to repay the principal (the value stated on the face of the bond) to the owner of the bond on a particular date.

A bond is a financial asset from its owner´s point of view and a liability from the issuers´s point of view.

A bond issuer sells a number of bonds with a given interest rate and maturity date to whoever is willing to buy them.

BONDS

Bond purchasers can acquire information (free of charge) on the quality of the bond issuer from bond rating agencies, instead of having to investigate for themselves.

A concern for investors is the possibility of a default (the risk that the bond issuer might fail to make payments as specified by the bond contract.

Once the bond´s risk of default has been rated, it can be sold on the bond market as a more or less standardized product (with clearly defined terms and quality).

In general, bonds with a higher default risk must pay a higher interest rate to attract investors.

BONDS

Another important advantage of bonds is that they are easy to resell, which provides liquidity to bond purchasers.

A bond may pass through many hands before it comes due, while loans are much more difficult to resell because they are not standardized (they may differ in size, quality, terms, etc.)

So loans are a lot less liquid than bonds.

LOAN-BACKED SECURITIES Loan-backed securities are assets created by pooling

individual loans and selling shares in that pool (a process called securitization).

Mortgage-backed securities are the best-known example, but has also been widely applied to student loans, crediti card loans, and auto loans.

These loan-backed securities trade on financial markets like bonds and may be preferred by investors because they provide more diversificaion and liquidity than individual loans.

However, with so many loans packaged together, it can be difficult to assess the true quality of the asset.

With the bursting of the housing bubble in 2007-2008, widespread defaults on mortgages led to large losses for holders of mortgage-backed securities.

STOCKS

A stock is a share in the ownership of a company. A share of stock is a financial asset from its owner´s point of

view and a liability from the company´s point of view. Although not all companies sell shares of their stock

(“privately held” companies are owned by an individual or by few partners, who get to keep all of the company´s profit).

However, most large companies do sell stock. Companies sell stock because of risk: few individuals are

risk-tolerant enough to face the risk involved in being the sole owner of a large company.

STOCKS

However, reducing the risk that business owner´s face is not the only way that stocks improve a society´s welfare; they also improve the welfare of investors who buy stocks (shareowners or shareholders).

Shareholders are able to enjoy the higher returns over time that stocks generally offer in comparison to bonds (historically, stocks have yielded about 7% after adjusting to inflation, and bonds have yielded only about 2%)

STOCKS

However, owning stocks is riskier than owning bonds, because legally, a company must pay what it owes its lenders (bondholders), before it distributes any profit to shareholders.

If a company should fail (be unable to pay its obligations and file for bankrupcy) its physical and financial assets go to the bondholders (its lenders), while its shareholders typically receive nothing.

Although a stock generally proveds a higher return to an investor than a bond, it also carries a higher risk.

FINANCIAL INTERMEDIARIES

The financial system has devised ways to help investors as well as business owners simultaneously manage risk and enjoy somewhat higher returns through the services of institutions known as financial intermediaries.

A financial intermediary is an institution that transforms funds gathered by many individuals into financial assets.

The most important types of financial intermediaries are:

1. Mutual funds

2. Pension funds

3. Life insurance companies

4. Banks

MUTUAL FUNDS

Stock investors can lower their total risk by diversifying. By owning a diversified portfolio of stocks (a group of stocks in which risks are unrelated, or offset, one another), rather than concentrating investment in the shares of a single company or group of related companies.

Financial advisers almost always advise to diversify not only their stock portfolio, but their entire weath by holding other assets in addition to stock: bonds, real estate, and cash (and plenty of insurance in case of accidental losses!)

Diversified stock portfolios can incur in high transaction costs (mostly fees paid to stockbrokers) because they are buying a few shares of a lot of companies.

MUTUAL FUNDS

A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.

This allows investors can indirectly hold a diversified portfolio, achieving a higher return for any given level of risk without incurring in high transaction costs.

PENSION FUNDS AND LIFE INSURANCE COMPANIES

Pension funds are non-profit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire.

They invest in a diverse array of financial assets, allowing their members to achieve more cost-effective diversifications and conduct more market research than they would be able to do individually.

Life insurance companies guarantee a payment to the policyholder´s beneficiaries when the policyholder dies. By enabling policyholders to protect their beneficiaries from financial hardship arising from death, life insurance companies also improve welfare by reducing risk.

BANKS

A keeps only a fraction of its customers´deposits in the form of ready cash.

Most of the deposits are lent out to businesses, buyers of new homes, and other borrowers.

A bank enables those who want to borrow for long lengths of time to use the funds of those who wish to lend but simulaneously want to maintain the ability to get their case back on demand.

A bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and used their funds to finance the illiquid investment spending needs of its borrowers.

BANKS

A bank is an institution that helps resolve the conflict between lenders´need for liquidity and the financing needs of borrowers who don´t want to use the stock or bond markets.

A bank works by accepting funds from depositors: when they put their money in a bank, they are becoming lenders by lending the bank their money.

In return, they receive credit for a bank deposit: a claim on the bank, which is obliged to give you your cash if and when you demand it.

A bank deposit is a financial asset owned by the depositor and a liability to the bank that holds it.

BANKS

How can a bank lend for long periods of time but also be subject to the condition that its depositors can demand their funds back at any time?

The bank counts on the fact that on the average, only a small fraction of its depositors will want their cash at the same tiem.

On any given day, some people will make withdrawals while others will make deposits; this will roughly cancel each other out.

BANKS

So the bank only needs to keep a limited amount of cash on hand to satisfy its depositors.

If a bank were to become financially incapable of paying its depositors, individual bank deposits are currently guaranteed to depositors up to $250,000 by the FDIC (Federal Depositary Insurance Corporation), which is a federal agency.

This reduces the risk to a depositor of holding a bank deposit, while reducing the incentive to withdraw funds if concerns about the financial state of the bank should arise.

Banks play a key economic role by reconciling the needs of savers for liquid assets with the needs of borrowers for long-term financing.