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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 1
We have…
Realized that capital accumulation is one of the driving forces for growth.
Now…
We explore the ECONOMICS of capital accumulation.
• Why would firms purchase capital?
• Where does the capital come?
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 2
This coming Thursday, 1st Midterm
Preparations:
• Ink pens
• Non-programmable calculator
• Picture ID.
• 1 hour and 10 minutes.
• Regular lecture time and lecture room.
• scantron form
Key materials:
• GDP: product approach, income approach, and expenditure approach;
• Growth and Social Security Reform
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© 2007 Thomson South-Western, all rights reserved
N. G R E G O R Y M A N K I W
PowerPoint® Slidesby Ron Cronovich
26
ECONOMICSP R I N C I P L E S O F
F O U R T H E D I T I O N
Saving, Investment, and the Saving, Investment, and the Financial SystemFinancial System
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 4
In this chapter, look for the answers to these questions: What are the main types of financial institutions
in the U.S. economy, and what is their function?
What are the three kinds of saving?
What’s the difference between saving and investment?
How does the financial system coordinate saving and investment?
How do govt policies affect saving, investment, and the interest rate?
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 5
Robinson-Crusoe Economy Again…
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 6
Saving of Robinson Why will Robinson save?
• He may get sick one day; (save for unemployment)
• He may need a break the next day; (save for vacation)
• He plans to make fishnets the next day to catch more fishes in the future. (save for investment).
Suppose that fish is storable…
Suppose that fish is non-storable…
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 7
Yes, he can; but not alone
Suppose there are two Robinsons.
Robinson 1 Robinson 2
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 8
Two Robinsons can make arrangement
Robinson 1 gets sick one day and cannot catch fish.
Robinson 2 helps him out by sharing fish with him
But Robinson 1 makes the promise that he will return the fish back once he recovers and fishes again.
In this case, Robinson 1 is the borrower and Robinson 2 is the saver.
The income of the saver goes to the borrower.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 9
Two Robinsons can make another arrangement…
Robinson 1 wants to spend a day making fishnets to catch more fish in the future;
Robinson 2 helps Robinson 1 by sharing fish with him; Robinson 1 promises that he will give the fish back.
In this case, Robinson 2 is still the saver, but Robinson 1 is the investor.
The investment is financed by saving.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 10
When there are only two Robinsons
They talk and make arrangement;
When there are millions of people as in the real world…
Things take place through MARKET;
In this case, firms’ investment are financed by households’ saving through FINANCIAL MARKETS or FINANCIAL INTERMEDIARIES – together they constitute financial system
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 11
Financial Institutions
The financial system: the group of institutions that helps match the saving of one person with the investment of another.
• Direct interaction – Financial Markets (bonds market, stock market)
• Indirect interaction – Financial Intermediaries. (banks, mutual funds)
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 12
Direct interaction between savors and borrowers
Financial markets: institutions through which savers can directly provide funds to borrowers. Examples:
• The Bond Market. A bond is a certificate of indebtedness.
• The Stock Market. A stock is a claim to partial ownership in a firm.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 15
The Stock Market
Partial ownership by funding the purchase of capital;
Declares share of the corporate profits;
Stocks are riskier than bonds, why?
• Bond represents a firm’s obligation to pay the money back.
• Investors take the risks themselves by purchasing the partial ownership.
• Before a firm goes bankrupt, its remaining assets are used first to pay off the debts.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 16
Stock Exchange
Once stocks are issued, they change owners via the stock exchange market.
• NY Stock Exchange
• American Stock Exchange
• NASDAQ
Stock price of a firm depends on
• The firms’ profitability
• People’s perception for the firms’ future.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 17
1929 Crash of the NY Stock Exchange during the Great
Depression
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 18
NASDAQ: the world’s biggest electronic stock exchange system
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 19
Stock Price Indexes
Just like GDP deflator is the average price for all goods and services produced in the US;
Stock price indexes is the average price of different companies’ stock prices.
Depending on which companies’ stock price is included, we have:
• Dow Jones Industrial Average: 30 major US companies such as GM, AT&T…
• Standard&Poor’s 500 Index: 500 major companies.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 20
Financial Institutions
Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples:
• Banks that take deposits from the households and make loans to firms.
• Mutual funds – institutions pool savings from the public that is invested and managed on their behalf by professional money managers.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 21
Mutual Funds
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 22
Different Kinds of Saving
Private saving
= The portion of households’ income that is not used for consumption or paying taxes
= Y – T – C
Public saving
= Tax revenue less government spending
= T – G
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 23
National Saving
National saving
= private saving + public saving
= (Y – T – C) + (T – G)
= Y – C – G
= the portion of national income that is not used for consumption or government purchases
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 24
Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX (-5.8%)
For the rest of this chapter, focus on the closed economy case:
Y = C + I + G
Solve for I:
I = Y – C – G = (Y – T – C) + (T – G)
Saving = investment in a closed economySaving = investment in a closed economy
national saving
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 25
Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T – G
= public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G – T
= – (public saving)
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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : ExerciseExercise
Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget deficit of $300 billion.
Find public saving, taxes, private saving, national saving, and investment.
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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers
Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1B1B: : ExerciseExercise
Now suppose the government cuts taxes by $200 billion.
In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4.
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1B1B: : AnswersAnswers
In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion.
1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged.
2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion.
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1C1C: : Discussion questionsDiscussion questions
Which of these two scenarios do you think is the most realistic?
Why is this question important?
30
The two scenarios are:
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 31
The Meaning of Saving and Investment
Private saving is the income remaining after households pay their taxes and pay for consumption.
Examples of what households do with saving:
• buy corporate bonds or equities
• purchase a certificate of deposit at the bank
• buy shares of a mutual fund
• let accumulate in saving or checking accounts
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 32
The Meaning of Saving and Investment
Investment is the purchase of new capital.
Examples of investment:
• General Motors spends $250 million to build a new factory in Flint, Michigan.
• You buy $5000 worth of computer equipment for your business.
• Your parents spend $300,000 to have a new house built.
Remember: In economics, investment is NOT the purchase of stocks and bonds!
Remember: In economics, investment is NOT the purchase of stocks and bonds!
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 33
The Market for Loanable Funds
A supply-demand model of the financial system.
Helps us understand
• how the financial system coordinates saving & investment
• how govt policies and other factors affect saving, investment, the interest rate
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 34
The Market for Loanable Funds
Assume: only one financial market.
• All savers deposit their saving in this market.
• All borrowers take out loans from this market.
• There is one interest rate, which is both the return to saving and the cost of borrowing.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 35
The Market for Loanable Funds
The supply of loanable funds comes from saving:
• Households with extra income can loan it out and earn interest.
• Public saving, if positive, adds to national saving and the supply of loanable funds.
If negative, it reduces national saving and the supply of loanable funds.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 36
The Slope of the Supply Curve
InterestRate
Loanable Funds ($billions)
Supply
An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.
60
3%
80
6%
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 37
The Market for Loanable Funds
The demand for loanable funds comes from investment:
• Firms borrow the funds they need to pay for new equipment, factories, etc.
• Households borrow the funds they need to purchase new houses.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 38
The Slope of the Demand Curve
InterestRate
Loanable Funds ($billions)
Demand
A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.
50
7%
4%
80
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 39
Equilibrium
InterestRate
Loanable Funds ($billions)
Demand
The interest rate adjusts to equate supply and demand. Supply
The eq’m quantity of L.F. equals eq’m investment and eq’m saving.
5%
60
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 40
Policy 1: Saving Incentives
InterestRate
Loanable Funds ($billions)
D1
Tax incentives for saving increase the supply of L.F.S1
5%
60
S2
…which reduces the eq’m interest rateand increases the eq’m quantity of L.F.
4%
70
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 41
Policy 2: Investment Incentives
InterestRate
Loanable Funds ($billions)
D1
An investment tax credit increases the demand for L.F.S1
5%
60
…which raises the eq’m interest rateand increases the eq’m quantity of L.F.
6%
70
D2
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 42
Policy 3: Govt Budget Deficits
InterestRate
Loanable Funds ($billions)
D1
A budget deficit reduces national saving and the supply of L.F.
S1
5%
60
S2
…which increases the eq’m interest rateand decreases the eq’m quantity of L.F.
6%
50
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AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : ExerciseExercise
Use the loanable funds model to analyze the effects of a government budget deficit:
• Draw the diagram showing the initial equilibrium.
• Determine which curve shifts when the government runs a budget deficit.
• Draw the new curve on your diagram.
• What happens to the equilibrium values of the interest rate and investment?
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AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : AnswersAnswers
44
InterestRate
Loanable Funds ($billions)
D1
A budget deficit reduces national saving and the supply of L.F.
A budget deficit reduces national saving and the supply of L.F.
S1
5%
60
S2
…which increases the eq’m interest rate
…which increases the eq’m interest rateand decreases the eq’m quantity of L.F. and investment.
6%
50
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 45
Budget Deficits, Crowding Out, and Long-Run Growth
Our analysis: increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available for investment.
This is called crowding out.
Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy’s growth rate and future standard of living.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 46
The U.S. Government Debt
The government finances deficits by borrowing (selling government bonds).
Persistent deficits lead to a rising govt debt.
The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue.
Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime – until the early 1980s.
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U.S. Government Debt U.S. Government Debt as a Percentage of GDP, 1970-2005as a Percentage of GDP, 1970-2005
0%
20%
40%
60%
80%
100%
120%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
Revolutionary War
Civil War
WW1
WW2
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 48
CONCLUSION Like many other markets, financial markets are
governed by the forces of supply and demand.
One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.
Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future.
Financial markets help allocate the economy’s scarce resources to their most efficient uses.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 49
CHAPTER SUMMARY
The U.S. financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds.
National saving equals private saving plus public saving.
In a closed economy, national saving equals investment. The financial system makes this happen.
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CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 50
CHAPTER SUMMARY The supply of loanable funds comes from saving.
The demand for funds comes from investment. The interest rate adjusts to balance supply and demand in the loanable funds market.
A government budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment.
When a budget deficit crowds out investment, it reduces the growth of productivity and GDP.