1 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

TThe Financial System:he Financial System:Institutions and the Loanable-Funds Market Institutions and the Loanable-Funds Market

Introduction to Political Economy: Introduction to Political Economy: MacroeconomicsMacroeconomicsWashington University – St. LouisWashington University – St. Louis

Mark VaughanMark VaughanFall 2008Fall 2008

2 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Lecture OutlineLecture Outline

• Overview of U.S. Financial System Functions

Financial Markets: Debt vs. Equity

Financial Institutions: Depository Institutions vs. Mutual Funds

• A Model for Matching Savers and Investors The Loanable-Funds Market

• Analyzing Pro-Growth Policies with the Loanable-Funds Market

Economic Impact of tax breaks for private saving Economic Impact of tax breaks for private investment

• Analyzing Government Deficits with the Loanable-Funds Market

3 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

U.S. Financial SystemU.S. Financial System

• Consists of institutions that match savers and borrowers• Functions

- Funding investment opportunities- Smoothing consumption- Allocating risk efficiently

• Can be decomposed into two categories: - Financial markets- Financial intermediaries

4 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

• Financial markets: Channel funds directly from savers to borrowers- Equity Market- Debt Market

• Financial intermediaries: Channel funds indirectly from savers to borrowers.- Depository institutions- Mutual funds- Other non-depository institutions

(pension funds, insurance companies, etc.)

U.S. Financial SystemU.S. Financial System

5 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Financial Markets: Financial Markets: Debt MarketDebt Market

• A debt security is an IOU supported by legal paperworkIOU supported by legal paperwork.• Debt market largerlarger than equity market.• Characteristics of debt securities

- Term: Time until maturity- Cash Flows: Periodic interest + principal at maturity- Credit Risk: Probability interest or principal will not be repaid- Liquidity Risk: Probability of significant “fire sale” loss- Call Risk: Probability issuer will “call” before maturity- Tax Treatment: Municipal bonds exempt from federal taxes

• Types of debt securities- Money market: maturity ≤ 1 year ((ExEx: T-bills, commercial paper): T-bills, commercial paper)

- Bond market: maturity > 1 year ((ExEx: T-notes/bonds, corporates, Agencies): T-notes/bonds, corporates, Agencies)

6 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Financial Markets: Financial Markets: Equity MarketEquity Market

• Equity – Ownership stake- Preferred stock – no voting rights, dividend paid first- Common stock – voting rights, dividends paid last

• Stocks offer potentially higher returns -- but with more risk

• Stock prices change when: - Opportunity cost of invested funds changes (↑ causes prices to ↓)(↑ causes prices to ↓)

- Expected dividends changes (↑ causes prices to (↑ causes prices to ↓)↓)

• Important U.S. stock markets (secondary markets) - New York Stock Exchange- American Stock Exchange- NASDAQ (over the counter)

7 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Financial Intermediaries:Financial Intermediaries:Depository InstitutionsDepository Institutions

• Take deposits and funds loans (i.e., intermediate)(i.e., intermediate)

- Profit chiefly from spread between interest on deposits and (higher) interest on loans.

• Help create medium of exchangemedium of exchange by allowing checks to be written against deposits.

• Types (as of 6/30/08)(as of 6/30/08)

- Banks: 7,203 holding $11.4 trillion in assets- Thrifts: 1,208 holding $1.9 trillion in assets- Credit Unions: 8,101 holding $753.5 billion in assets

Source: FDIC, NCUA

8 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Financial Intermediaries:Financial Intermediaries:Mutual FundsMutual Funds

• Sell shares to public, buy portfolios of debt & equity securities• Industry size / scope (year-end 2007):

- ≈8,000 U.S. funds with ≈$12 trillion in assets.- ≈66,000 funds worldwide with ≈$66 trillion in assets

• Permit small investors to diversify cheaply

• Types (by portfolio, U.S., year-end 2007):- Equity = 54.3 % (of $12 trillion in assets)- Bond = 14.0%- Money Market = 25.8%- Hybrid = 5.9%

• Types (by fund strategies)(by fund strategies)- Actively managed- Index funds (11% of total assets, year-end 2007)

Source: 2008 Investment Company Fact Book

9 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Financial Intermediaries:Financial Intermediaries:Mutual FundsMutual Funds

Special Type of Actively Managed Mutual Fund: Hedge FundsHedge FundsCater to wealthy, sophisticated investorsSeek high returns with advanced strategies (misnomer)Employ significant leverageRequire large initial minimum investment (illiquid)Faces minimal regulationUnfairly blamed for torpedoing companies by short selling

Economically Important≈ over 7,000 funds with nearly $2 trillion in assets (worldwide estimates)

10 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Loanable-Funds MarketLoanable-Funds Market• Links suppliers & demanders of loanable funds

• Supply of loanable funds by savers - Households and government

- (Y – T – C(Y – T – Cnd+snd+s) + [t – (tr + G)]*) + [t – (tr + G)]* *t > (tr + G) = surplus (public saving) *(tr + G) > t = deficit (public dissaving)

• Demand for loanable funds by borrowers

- Firms and households

- IIs+es+e + (I + (Irhrh + C + Cdd ))

• Interest rate:- Real (not nominal) is key rate - Price of borrowing: Decline in real rate reduces borrowing costs, spurring borrowing by

businesses to purchase structures / equipment ((IIs+es+e)) and households to purchase

homes / durable goods (I(Irhrh + C + Cdd ).).

- Return to saving: Increase in real rate increases incentive to saving, prompting households to save a larger fraction of income (increasing pool of national savings)

- Equilibrates quantity supplied /demanded of loanable funds

In Pictures: The Loanable Funds Market

Loanable Funds(in billions of dollars)

0

InterestRate

Supply

Demand

5%

$1,200

Real

Shifts caused by non-interest-rate determinants of

Demand for/Supply of Loanable Funds

12 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Policy 1: Saving IncentivesPolicy 1: Saving Incentives• Taxes on interest income/capital gains reduce incentive to save.

• Relatively high U.S. taxes on saving lower growth of productivity and per capita real GDP.

• Reducing taxes on savings (revenue neutral) increases incentive to save at every real interest rate (rightward shift in supply of loanable-funds curve)(rightward shift in supply of loanable-funds curve)..

Impact of Savings IncentivesImpact of Savings Incentives:: Increase in savings pool (a) creates “excess supply of loanable funds,” putting

downward pressure on real interest rate.

Fall in real interest rate spurs (b) borrowing by firms to purchase structures/ equipment (I(Is+es+e)) and by households to purchase new homes (I(Irhrh))/consumer

durables ((CCdd)).

Fall in real interest rate (c) reduces incentive to save, offsetting some (but not all) of the impact of tax incentive.

Results: Lower real interest rate and higher quantity of loanable funds (savings = investment) Increase in capital stock boosts growth of productivity and real GDP per capita.

In Pictures: Impact of Savings Incentives

Loanable Funds(billions of dollars)

0

Supply, S1

Demand

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

5%

$1,200

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

Result: Increase in capital stock, productivity, and real GDP growth

S2

2. which reducesequilibriumreal interestrate…

cb

a

4%

$1,600

InterestRate

Real

%

14 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Policy 2: Investment IncentivesPolicy 2: Investment Incentives• Investment tax credit (ITC) is tax break for firms purchasing new structures

and equipment.

• Increase in ITC (revenue neutral) increases demand for loanable funds at every real interest rate (rightward shift in demand curve).(rightward shift in demand curve).

Impact of Investment IncentiveImpact of Investment Incentive::

Increase in business spending on structures / equipment (I(Is+es+e) ) (a) creates

“excess demand for loanable funds,” putting upward pressure on real interest rate.

Increase in real interest rate (b) increases household savings and (c) reduces household spending on consumer durables (C(Cdd)) and new homes ((IIrhrh))..

Increase in real interest rate also (d) reduces some (but not all) of increase in business spending on structures / equipment (I(Is+es+e)),

Results: Higher real interest rate and higher quantity of loanable funds (savings = investment) Increase in capital stock boosts growth of productivity and real GDP per capita.

In Pictures: Impact of Investment Incentives

Loanable Funds(in billions of dollars)

0

Supply

Demand, D1

D2

5%

$1,200

6%

$1,400

1. Tax incentives for investment increases demand for loanable funds…

3. …and raises equilibrium quantity of loanable funds.

Result: Increase in capital stock, productivity growth, and real GDP growth

b

2. …which raisesthe equilibriumreal interestrate…

c,d

a

InterestRate

Real

%

16 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Equity – Efficiency TradeoffEquity – Efficiency Tradeoff

• Tax breaks for savings and investment will increase future productivity and real GDP per capita.

• But such tax breaks could disproportionately benefit wealthy in the short run.

17 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Policy 3: Budget DeficitsPolicy 3: Budget Deficits• Government borrowing to finance deficits reduces supply of loanable funds

available to borrowers (crowding out). (crowding out). - “Government” refers to consolidated position of public sector (federal/state/local)

• Graphically: Increase in deficit decreases supply of loanable funds (i.e., reduces savings pool) at every real interest rate (shifts supply curve to left)(shifts supply curve to left).

Impact of Increase in Budget DeficitImpact of Increase in Budget Deficit:: Reduction in savings pool (a) creates “excess demand for loanable funds,” putting upward

pressure on real interest rate.

Increase in real interest rate (b) reduces business spending on structures / equipment (I(Is+es+e))

as well as household spending on consumer durables (C(Cdd)) and new homes ((IIrhrh).).

Increase in real interest rate raises savings rate, thereby offsetting some (but not all) of decline in national savings.

Results: Higher real interest rate and lower quantity of loanable funds (savings = investment) Decline in capital stock reduces growth of productivity and real GDP per capita.

Real Cost of DeficitsReal Cost of Deficits

In Pictures: Impact of Increase in Budget Deficit

Loanable Funds(billions of dollars)

0

S2

1. Increase in deficit decreases supply of loanable funds…

3. …and lowers the equilibrium

quantity of loanable funds.

Result: Decline in capital stock, productivity growth, and real GDP growth

Supply, S1

a

2. …which raisesequilibriumreal interestrate…

b

c

Demand

$800

6%

$1,200

5%

InterestRate

Real

%

19 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Should We Worry about Deficits?Should We Worry about Deficits?

Depends on: • Size of deficits, relatively speaking:

Nominal Federal Deficit / Nominal GDP Nominal Federal Debt / Nominal GDP

• Economic circumstances: Recession (good) vs. boom (bad)

• Reasons (besides business cycle) for deficits: Public investment or war (good) vs. consumption (bad) Cut in taxes (could be good)

• Impact deficits have on private investment: Small (good) vs. large (bad)

(High ratios are bad)(High ratios are bad)

20 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Recent Deficits in Historical PerspectiveRecent Deficits in Historical Perspective

U.S. Government Debt in Long-Run Historical PerspectivePercentof GDP

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

RevolutionaryWar

2010

CivilWar World War I

World War II

0

20

40

60

80

100

120

Even with recent run-up, Debt/GDP ratio is not

high by historical standards.

Note: Accumulation of past budget deficits is called government (or national) debt.

22 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

How Important is Crowding Out?How Important is Crowding Out?

Evidence points to modest “crowding out” effect in U.S.: Deficits do not raise real interest rates that much. Increases in real interest rate attracts foreign savings. Private investment spending more sensitive to current state

of the economy than real interest rates.

Upshot: Even at current levels, impact of U.S government budget deficits on future productivity and real GDP growth is likely to be small.

23 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

Bottom Line on DeficitsBottom Line on Deficits

• At current levels, “much ado about nothing”

• Focus should be on government spending (represents public sector’s claim on private resources)(represents public sector’s claim on private resources)

• How that spending is financed (taxes, borrowing, money (taxes, borrowing, money

creation)creation) is second order.

24 - 23Last Edited: 04/18/23

Vaughan–104/Fall 2008The Financial System

TThe Financial System:he Financial System: Institutions and the Loanable-Funds MarketInstitutions and the Loanable-Funds Market??

Introduction to Political Economy: Introduction to Political Economy: MacroeconomicsMacroeconomicsWashington University – St. LouisWashington University – St. Louis

Mark VaughanMark VaughanFall 2008Fall 2008

Questions over