chapter 26_saving, investment & financial system

7/26/2019 Chapter 26_Saving, Investment & Financial System

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PowerPoint Slides prepared by:Andreea CHIRITESCUEastern Illinois University

Saving, Investment, and

the Financial System

1 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use aspermitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


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Financial Institutions

Financial system

Group of institutions in the economy

That help match one persons saving with

another persons investment

Moves the economys scarce resources

from savers to borrowers

Financial institutions

Financial markets

Financial intermediaries



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Financial Markets

Financial markets

Savers can directly provide funds toborrowers

The bond market The stock market



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Financial Markets

The bond market

Bond - certificate of indebtedness

Time of maturity - the loan will be repaid

Rate of interest

Principal - amount borrowed

Term - length of time until maturity

Credit riskprobability of default Tax treatment



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Financial Markets

The stock market

Stock - claim to partial ownership in a firm

Organized stock exchanges

Stock prices: demand and supply Equity finance

Sale of stock to raise money

Stock indexAverage of a group of stock prices



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Financial Intermediaries

Financial intermediaries

Savers can indirectly provide funds toborrowers

Banks Mutual funds



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Banks

Take in deposits from savers

Banks pay interest

Make loans to borrowers Banks charge interest

Facilitate purchasing of goods and

services Checksmedium of exchange



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Mutual funds

Institution that sells shares to the public

Uses the proceeds to buy a portfolio of

stocks and bondsAdvantages

Diversification

Access to professional money managers



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National Income Accounts

Rules of national income accounting

Important identities

Identity

An equation that must be true because ofthe way the variables in the equation aredefined

Clarify how different variables are relatedto one another



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Accounting Identities

Gross domestic product (GDP)

Total income

Total expenditure

Y = C + I + G + NX Y= gross domestic product GDP

C = consumption

G = government purchases NX = net exports



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Closed economy

Doesnt interact with other economies

NX = 0

Open economy Interact with other economies

NX 0



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Assumption: close economy: NX = 0

Y = C + I + G

National saving (saving), S

Total income in the economy that remainsafter paying for consumption andgovernment purchases

YCG = I S = YC - G

S = I



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Budget surplus: TG > 0

Excess of tax revenue over governmentspending

Budget deficit: TG < 0 Shortfall of tax revenue from government

spending



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Saving and Investing

Accounting identity: S = I

Saving = Investment

For the economy as a whole

One persons savings can finance anotherpersons investment



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The Market for Loanable Funds

Market for loanable funds

Market

Those who want to save supply funds

Those who want to borrow to invest demandfunds

One interest rate

Return to saving

Cost of borrowing

Assumption

Single financial market16 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


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Supply and demand of loanable funds

Source of the supply of loanable funds

Saving

Source of the demand for loanable funds Investment

Price of a loan = real interest rate

Borrowers pay for a loan Lenders receive on their saving



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Supply and demand of loanable funds

As interest rate rises

Quantity demanded declines

Quantity supplied increases

Demand curve

Slopes downward

Supply curve Slopes upward


Fi 1


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Figure 1



Interest

Rate

Loanable Funds

(in billions of dollars)

0

Supply

Demand

5%

$1,200

The interest rate in the economy adjusts to balance the supply and demand forloanable funds. The supply of loanable funds comes from national saving, includingboth private saving and public saving. The demand for loanable funds comes fromfirms and households that want to borrow for purposes of investment. Here theequilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are suppliedand demanded.


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Government policies

Can affect the economys saving and

investment

Saving incentives

Investment incentives

Government budget deficits and surpluses



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Policy 1: Saving Incentives

Shelter some saving from taxation

Affect supply of loanable funds

Increase in supply

Supply curve shifts right New equilibrium

Lower interest rate

Higher quantity of loanable funds Greater investment


Figure 2


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Figure 2


Saving Incentives Increase the Supply of Loanable FundsInterest

Rate

Loanable Funds(in billions of dollars)

0

Supply, S1

Demand

5%

$1,200

A change in the tax laws to encourage Americans to save more would shift the supplyof loanable funds to the right from S1to S2. As a result, the equilibrium interest ratewould fall, and the lower interest rate would stimulate investment. Here the equilibriuminterest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanablefunds saved and invested rises from $1,200 billion to $1,600 billion.

S2

4%

$1,600

1. Tax incentives for savingincrease the supply ofloanable funds . . .

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

2. . . . whichreduces theequilibriuminterest rate. . .


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Policy 2: Investment Incentives

Investment tax credit

Affect demand for loanable funds

Increase in demand

Demand curve shifts right New equilibrium

Higher interest rate

Higher quantity of loanable funds Greater saving


Figure 3


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Figure 3


Investment Incentives Increase the Demand for LoanableFunds Interest

Rate


0

Supply

Demand, D1

5%

$1,200

If the passage of an investment tax credit encouraged firms to invest more, thedemand for loanable funds would increase. As a result, the equilibrium interest ratewould rise, and the higher interest rate would stimulate saving. Here, when thedemand curve shifts from D1to D2, the equilibrium interest rate rises from 5 percentto 6 percent, and the equilibrium quantity of loanable funds saved and invested rises

from $1,200 billion to $1,400 billion.

D2

6%

$1,400

1. An investment taxcredit increases thedemand for loanablefunds . . .2. . . . which

raises the

equilibrium

interest rate. . .

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


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Figure 4


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Figure 4


The Effect of a Government Budget DeficitInterest

Rate


0

Supply, S1

Demand

5%

$1,200

When the government spends more than it receives in tax revenue, the resulting budget deficitlowers national saving. The supply of loanable funds decreases, and the equilibrium interestrate rises. Thus, when the government borrows to finance its budget deficit, it crowds outhouseholds and firms that otherwise would borrow to finance investment. Here, when the supplyshifts from S1to S2, the equilibrium interest rate rises from 5 to 6 percent, and the equilibriumquantity of loanable funds saved and invested falls from $1,200 billion to $800 billion.

S2

6%

$800

1. A budget deficitdecreases the supply ofloanable funds . . .

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

2. . . . whichraises the

equilibriuminterest rate. . .


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Policy 3: Budget Deficit/Surplus

Crowding out

Decrease in investment

Results from government borrowing

Government - budget deficit Interest rate rises

Investment falls



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Policy 3: Budget Deficit/Surplus

Governmentbudget surplus

Increase supply of loanable funds

Reduce interest rate

Stimulates investment


The history of U S government debt


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The history of U.S. government debt

Debt of U.S. federal government

As a percentage of U.S. GDP Fluctuated

0% of GDP in 1836

107% of GDP in 1945 Declining debt-GDP ratio

Government indebtedness is shrinking

relative to its ability to raise tax revenue Government - living within its means




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Rising debt-GDP

Government indebtedness is increasingrelative to its ability to raise tax revenue

Fiscal policy cannot be sustained forever atcurrent levels

Warprimary cause of fluctuations ingovernment debt:

Debt financing of warappropriate policy Tax ratessmooth over time

Shifts part of the cost to future generations


Figure 5


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Figure 5


The U.S. Government Debt

The debt of theU.S. federalgovernment,expressed hereas a percentageof GDP, has

variedthroughouthistory. Wartimespending istypicallyassociated with

substantialincreases ingovernmentdebt.



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President Ronald Reagan, 1981

Large increase in government debtnotexplained by war

Committed to smaller government and

lower taxes Cutting government spending - more

difficult politically than cutting taxes

Period of large budget deficits Government debt: 26% of GDP in 1980 to

50% of GDP in 1993




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President Bill Clinton, 1993

Major goal - deficit reductionAnd Republicans took control of

Congress, 1995

Deficit reduction Substantially reduced the size of the

government budget deficit

Eventually: surplus By the late 1990s: debt-GDP ratio -

declining




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President George W. Bush

Debt-GDP ratio - started rising again Budget deficit

Several major tax cuts

2001 recession - decreased tax revenue andincreased government spending

Spending on homeland security

Following the September 11, 2001 attacks

Subsequent wars in Iraq and Afghanistan

Increases in government spending




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2008, financial crisis and deep recession

Dramatic increase in the debt-GDP ratio Increased budget deficit

Several policy measures passed by the

Bush and Obama administrationsAimed at combating the recession

Reduced tax revenue

Increased government spending




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2009 and 2010

Federal governments budget deficit =10% of GDP

Borrowing to finance budget deficit

Substantial increase in the debt-GDPratio

Policy challenges for future generations

Putting the federal budget back on asustainable path

Stable or declining debt-GDP ratio

2011 C L i All Ri ht R d M t b i d d d li t d i h l i t t f

chapter 26_saving, investment & financial system

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