SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Chapter 25

The Financial System

• The financial system moves money from savers to borrowers.

Types of Financial Institutions

• Financial Markets - savers directly provide funds to borrowers

Stock MarketBond Market

• Financial Intermediaries - savers indirectly provide funds to borrowers

BanksMutual Funds

Financial Markets: The Bond Market

• A bond is a certificate of indebtedness

Characteristics of a Bond

• Term: The length of time until maturity.

• Credit Risk: The probability of repayment.

• Tax Treatment: How tax laws treat the interest on the bond.

Municipal bonds are federal tax exempt.

• Stock is a claim to partial ownership in a firm.

• Selling stock to raise money is called equity financing.

Financial Markets: The Stock Market

Financial Intermediaries:Banks

• Banks are middlemen between savers and borrowers.

• Mutual fund - for small investors

Other Financial Institutions

• Credit unions

• Pension funds

• Insurance companies

• Loan sharks

Saving and Investment in the National Income Accounts

• Recall that GDP is:

Y = C + I + G + NX

Some Important Identities

• Assume a closed economy:

Y = C + I + G

Saving and Investment

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

S = I

Public Saving

• Public saving - tax revenue minus government spending.

Public saving = (T – G)

• The supply of loanable funds comes from savers.

• The demand for loanable funds comes from borrowers.

Supply and Demand for Loanable Funds

Supply and Demand for Loanable Funds

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

Taxes and Saving

• Taxes on savings reduce the incentive to save.

• The supply of loanable funds curve shifts to the left.

Taxes and Saving

• A tax decrease increases the incentive to save.

The supply of loanable funds curve shifts

to the right.

Government Policies That Affect Saving and Investment

• An investment tax credit increases the incentive to borrow.

Increases the demand for loanable funds.

Government Policies That Affect Saving and Investment

• When the government spends more than it receives in tax revenues, the short fall is called the budget deficit.

• The accumulation of past budget deficits is called the government debt.

Government Policies That Affect Saving and Investment

• Government borrowing reduces the supply of loanable funds available to finance investment by households and firms.

This deficit borrowing crowds out private

borrowers who are trying to finance investments.

Government Policies That Affect Saving and Investment

• A budget deficit decreases the supply of loanable funds.

Shifts the supply curve to the left.

Conclusion

• Financial markets are like other markets in the economy.

The real interest rate—the price in the loanable funds market—is governed

by the forces of supply and demand.

Conclusion

• Financial markets coordinate borrowing and lending, helping to allocate the economy’s scarce resources efficiently.

• The U.S. financial system includes financial institutions such as the bond market, the stock market, banks, and mutual funds.

Conclusion

• A government budget deficit reducing the supply of loanable funds.

• It crowds out investment and reduces growth and GDP.