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Chapter 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM1725SAVING, INVESTMENT, AND THE FINANCIAL SYSTEMWHATS NEW:The section on “Policy 3” now discusses budget deficit and surplus effects on the supply of loanable funds. The Case Study on government debt has been rewritten and is now called “The History of U.S. Government Debt.” There is also a new Case Study on “The Debate over the Budget Surplus.” In addition, there is a new In the News box on “The Stock Market Boom of the 1990s” and a new FYI box on “Present Value.”LEARNING OBJECTIVES:By the end of this chapter, students should understand: some of the important financial institutions in the U.S. economy. how the financial system is related to key macroeconomic variables. the model of the supply and demand for loanable funds in financial markets. how to use the loanable-funds model to analyze various government policies. how government budget deficits affect the U.S. economy.KEY POINTS:1. The U.S. financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.2. National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one persons saving with another persons investment.3. The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The demand for loanable funds comes from households and firms who want to borrow for investment. To analyze how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds.4. National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.CHAPTER OUTLINE:I.Definition of Financial System: the group of institutions in the economy that help to match one persons saving with another persons investment.II.Financial Institutions in the U.S. EconomyA.Financial Markets1.Definition of Financial Markets: financial institutions through which savers can directly provide funds to borrowers.2.The Bond Marketa.Definition of Bond: a certificate of indebtedness.b.A bond identifies the date of maturity and the rate of interest that will be paid.c.One important characteristic that determines a bonds value is its term. The term is the length of time until the bond matures. All else equal, long-term bonds pay higher rates of interest than short-term bonds.d.Another important characteristic of a bond is its credit risk, which reveals the probability that the borrower will fail to pay some of the interest or principal. All else equal, the more risky a bond is, the higher its interest rate.e.A third important characteristic of a bond is its tax treatment. For example, when state and local governments issue bonds (called municipal bonds), the interest income earned by the holders of these bonds is not taxed by the federal government. This makes these bonds more attractive, thus lowering the interest rate needed to entice people to buy them.3.The Stock Marketa.Definition of Stock: a claim to partial ownership in a firm.b.The sale of stock to raise money is called equity finance; the sale of bonds to raise money is called debt finance.c.Stocks are sold on stock exchanges (like the New York Stock Exchange or NASDAQ) and the prices of stocks are determined by supply and demand.d.The price of a stock generally reflects the perception of a companys future profitability.e.FYI: How to Read the Newspapers Stock Tablesshows an example of a stock table from the newspaper and then explains what each of the columns means.B.Financial Intermediaries1.Definition of Financial Intermediaries: financial institutions through which savers can indirectly provide funds to borrowers.2.Banksa.The primary role of banks is to take in deposits from people who want to save and then lend them out to others who want to borrow.b.Banks pay savers interest on their deposits and charge borrowers a higher rate of interest to cover the costs of running the bank and provide the bank owners with some amount of profit.c.Banks also play another important role in the economy by allowing individuals to use checking deposits as a medium of exchange.3.Mutual Fundsa.Definition of Mutual Fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds.b.The primary advantage of a mutual fund is that it allows individuals with small amounts of money to diversify.c.Mutual funds called “index funds” buy all of the stocks of a given stock index and have generally performed better than funds with active fund managers. This may be true because they trade stocks less frequently and they do not have to pay the salary of a fund manager.C.In the News: The Stock Market Boom of the 1990s1.The U.S. stock market experienced a quadrupling of stock prices during the 1990s.2.This is an article from The Wall Street Journal suggesting that this rise in prices occurred because investors began viewing stocks as less risky than the previously thought.D.Summing Up1.There are many financial institutions in the U.S. economy.2.These institutions all serve the same goalmoving funds from savers to borrowers.Make sure that you work through all of the algebraic steps here. Students will not understand this material if you skip steps.III.Saving and Investment in the National Income AccountsA.Some Important Identities1.Remember that GDP can be divided up into four components: consumption, investment, government purchases, and net exports.2.We will assume that we are dealing with a closed economy (an economy that does not engage in international trade). This implies that GDP can now be divided into only three components:3.To isolate investment, we can subtract C and G from both sides:4.The left-hand side of this equation (Y C G) is the total income in the economy after paying for consumption and government purchases. This amount is called national saving.5.Definition of National Saving (Saving): the total income in the economy that remains after paying for consumption and government purchases.6.Substituting saving (S) into our identity gives us:7.This equation tells us that saving equals investment.8.Lets go back to our definition of national saving once again:9.We can add taxes (T) and subtract taxes (T):10.The first part of this equation (Y T C) is called private saving; the second part (T G) is called public saving.a.Definition of Private Saving: the income that households have left after paying for taxes and consumption.b.Definition of Public Saving: the tax revenue that the government has left after paying for its spending.c.Definition of Budget Surplus: an excess of tax revenue over government spending.d.Definition of Budget Deficit: a shortfall of tax revenue from government spending.The important point to make here is that with a government budget deficit, public saving is negative and the public sector is thus “dissaving.” To make up for this shortfall, it must go to the loanable funds market and borrow the money. This will reduce the supply of loanable funds available for investment.11.The fact that S = I means that for the economy as a whole saving must be equal to investment.B.The Meaning of Saving and Investment1.In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings.You will have to keep reminding students what the term “investment” means to macroeconomists. Outside of the economics profession, most people use the terms “saving” and “investing” interchangeably. 2.If an individual spends less than he earns and uses the rest to buy stocks or mutual funds, economists call this saving.IV.The Market for Loanable FundsA.Definition of Market for Loanable Funds: the market in which those who want to save supply funds and those who want to borrow to invest demand funds.B. Supply and Demand for Loanable FundsFigure 25-11.The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary.2.The demand for loans comes from households and firms who wish to borrow funds to make investments. Families generally invest in new homes while firms may borrow to purchase new equipment or to build factories.3.The price of loanable funds is the interest rate.Students will wonder which interest rate is the price of loanable funds. Explain to them that interest rates in the economy do vary because of the things discussed earlier (term, risk, and tax treatment), but that these interest rates tend to move together when changes in the loanable funds market occur. Thus, it is appropriate to talk of one interest rate.a.All else equal, as the interest rate rises, the quantity of loanable funds supplied will increase.b.All else equal, as the interest rate rises, the quantity of loanable funds demanded will fall.Make sure that you spend time discussing why the demand for loanable funds is downward sloping and why the supply of loanable funds is upward sloping. It is important for students to understand the relationships between the interest rate, saving, and investment.Supply (saving)Interest Rater*Demand (investment)Loanable Funds1,2004.At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied. a.If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded would be smaller than the quantity of funds supplied. Lenders would compete for borrowers, driving the interest rate down.b.If the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded would be greater than the quantity of funds supplied. The shortage of loanable funds would result in upward pressure on the interest rate.It is a good idea to remind students that the supply of loanable funds comes from saving and the demand for loanable funds comes from investment by putting “(saving)” next to the supply curve and “(investment)” next to the demand curve as shown above.5.The supply and demand for loanable funds depends on the real interest rate because the real rate reflects the true return to saving and the true cost of borrowing.C.FYI: Present Value1.Money today is more valuable than the same amount of money in the future.2.When comparing dollar amounts received today versus dollar amounts to be received in the future, we use the method of present value.3.The general formula if present value is that, if r is the interest rate, then an amount ($X) to be received in N years has a present value of:When examining the next three sections on different policies, encourage students to follow the three-step process developed in Chapter 4. First, determine which curve is affected. Then, decide which way it shifts to determine the effects on the equilibrium interest rate and quantity of funds.D.Policy 1: Taxes and SavingFigure 25-21.Savings rates in the United States are relatively low when compared with other countries such as Japan and Germany.2.Suppose that the government changes the tax code to encourage greater saving.a.This will cause an increase in saving, shifting the supply of loanable funds to the right.b.The equilibrium interest rate will fall and the equilibrium quantity of funds will rise.3.Thus, the result of the new tax laws would be a decrease in the equilibrium interest rate and greater saving and investment.S1Interest RateS25%4%Demand1,6001,200Loanable FundsIf you would like, now would be a good time to discuss the debate in Chapter 34 concerning whether the tax laws should be reformed to encourage saving.E.Policy 2: Taxes and InvestmentFigure 25-31.Suppose instead that the government passed a new law lowering taxes for any firm building a new factory (through the use of an investment tax credit).a.This will cause an increase in investment, causing the demand for loanable funds to shift to the right.b.The equilibrium interest rate will rise, and the equilibrium quantity of funds will increase as well.Point out that both Policy 1 (a law to increase saving) and Policy 2 (a law to increase investment) each lead to an increase in both saving and investment. The difference between these two policies lies in their effects on the interest rate.2.Thus, the result of the new tax laws would be an increase in the equilibrium interest rate and greater saving and investment.SupplyInterest Rate6%5%D2D1Loanable Funds1,4001,200F.Policy 3: Government Budget DeficitsFigure 25-41.A budget deficit occurs if the government spends more than it receives in tax revenue.2.This implies that public saving (T G) falls which will lower national saving.a.The supply of loanable funds will shift to the left.b.The equilibrium interest rate will rise, and the equilibrium quantity of funds will decrease.S2S1Interest Rate6%5%Demand8001,200Loanable Funds3.When the interest rate rises, the quantity of funds demanded for investment purposes falls.4.Definition of Crowding Out: a decrease in investment that results from government borrowing.5.When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls.6.Government budget surpluses work in the opposite way. The supply of loanable funds increases, the equilibrium interest rate falls, and investment rises.Now might be a good time to move to the section in Chapter 34 concerning the debate on whether or not the government should balance its budget.7.Case Study: The Debate Over the Budget Surplusa.In the late 1990s, the U.S. government found itself with a budget surplus.b.This created a debate on what to do with this surplus.c.Some policymakers wanted to leave the surplus alone, while others felt that the surplus should be used to finance additional government spending or tax cuts.8.Case Study: The History of U.S. Government DebtFigure 25-5a.Figure 25-5 shows the debt of the U.S. government expressed as a percentage of GDP. In recent years, government debt has been about 50 percent of GDP.Table 25-1b.Throughout history, the primary cause of fluctuations in government debt has been wars. However, the U.S. debt also increased substantially during the 1980s when taxes were cut but government spending was not.c.By the late 1990s, the debt to GDP ratio began declining due to budget surpluses.ADJUNCT TEACHING TIPS AND WARM-UP ACTIVITIES:1. After discussing the section on the bond market and the stock market, have the students build portfolios. You can then ask them to report on the performance of the portfolio each week. Award a small prize (such as a candy bar) each week to the student with the highest return. Permit students to change their portfolios each week if desired, but subtract a small transaction fee from their returns if they do so.SOLUTIONS TO TEXT PROBLEMS:Quick Quizzes1.A stock is a claim to partial ownership in a firm. A bond is a certificate of indebtedness. They are different in numerous ways: (1) a bond pays interest (a fixed payment determined when the bond is issued), while a stock pays dividends (a share of the firms profits that can increase if the firm is more profitable); (2) a bond has a fixed time to maturity, while a stock never matures; and (3) if a company that has issued both stock and bonds goes bankrupt, the bondholders get paid off before the stockholders, so stocks have greater risk and potentially greater return than bonds. Stock and bonds are similar in that both are financial instruments that are used by companies to raise money for investment, both are traded on exchanges, both are subject to credit risk, and the returns to both are taxed (usually).2.Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. National saving is equal to the total income in the economy that remains after paying for consumption and government purchases. Investment is the purchase of new capital, such as equipment or buildings.These terms are related in two ways: (1) National saving is the sum of public saving and private saving, by definition. (2) In equilibrium, national saving equals investment.3.If more Americans adopted a “live for today” approach to life, theyd spend more and save less. This would shift the supply curve to the left in the market for loanable funds, causing the interest rate to rise. In equilibrium, there would be less saving and investment, and a higher interest rate.Questions for Review1.The financial systems role is to help match one persons saving with another persons investment. Two markets that are part of the financial system are the bond market, through which large corporations, the federal government, or state and local governments borrow, and the stock market, through which corporations sell ownership shares. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and mutual funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets.2.It is important for people who own stocks and bonds to diversify their holdings because then they will have only a small stake in each asset, which reduces risk. Mutual funds make such diversification easy by allowing a small investor to purchase parts of hundreds of different stocks and bonds.3.National saving is the amount of a nations income that isnt spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving.4.Investment refers to the purchase of new capital, such as equipment or buildings. It is equal to national saving by an accounting identity.5.A change in the tax code that might increase private saving is the introduction of a consumption tax to replace the income tax. Since a consumption tax wouldnt tax the returns to saving, it would increase the supply of loanable funds, thus lowering inter
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