Saving, Investment, and the Financial System

Introduction to Macroeconomics Session 5: Saving, Investment, and the Financial System [Chapter 26] Sebastian Koch Lauder Business School Summer 2016 1

Course Description UPDATED! M & T Chapters covered Session 1: Ch23 Measuring GDP Session 2: Ch24 Measuring the cost of living Session 3: Ch25 Production & Growth Session 4: Ch28 Unemployment & the natural Rate Session 5: Review and completion of above sessions Session 6: Midterm Exam: APRIL 11 Session 7: Ch26 Saving, Investment, financial system Session 8: Ch29 The Monetary System + Ch30 Money Growth and Inflation Session 9: Ch34 AS-AD model Session 10: Ch35 Monetary and Fiscal Policy Session 11: Ch36 Trade-off between Inflation and Unemployment Session 12: Review Session 13: Final Exam: JUNE 27 2

Outline 1. The Financial System 2. Saving and Investment in the National Income Accounts 3. The market for loanable funds & public policy 3

The Financial System The Financial System : group of institutions in the economy that help to match persons saving interest with persons investment interest. It moves the economy s scarce resources from savers to borrowers. The Financial System is made up of financial institutions that coordinate the actions of savers and borrowers. 4

Financial Institutions Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. Financial markets are the institutions through which savers can directly provide funds to borrowers: Stock Market Bond Market Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers: Banks Investment Funds Credit unions Pension funds Insurance companies Loan sharks 5

The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Stocks are traded on exchanges such as the London Stock Exchange and the Frankfurt Stock Exchange. Compared to bonds, stocks offer both higher risk and potentially higher returns. Most newspaper stock tables provide the following information: Price (of a share) Volume (number of shares sold) Dividend (profits paid to stockholders) Price-earnings ratio 6

The Stock Market (rebased: 01.01.1995 = 100) 7

The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond: Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. 8

The Bond Market: 10-year government bonds yields 9

The Bond Market: 10-year government bonds yields 10

The Bond Market: yield spreads (compared to German government bond 10y) 11

Financial Intermediaries Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. Investment Funds An investment fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify. 12

REMEMBER THIS SLIDE FROM SESSION 3? Economic growth and Public Policies Government Policies That Raise Productivity and Living Standards Encourage saving and investment. Encourage investment from abroad Encourage education and training. Establish secure property rights and maintain political stability. Promote free trade. Promote research and development 14

REMEMBER THIS SLIDE FROM SESSION 3? Economic growth and Public Policy: Investment 15

REMEMBER THIS SLIDE FROM SESSION 3? Economic growth and Public Policy: Investment from Abroad Governments can increase capital accumulation and long-term economic growth by encouraging investment from foreign sources. Investment from abroad takes several forms: 1. Foreign Direct Investment Capital investment owned and operated by a foreign entity. 2. Foreign Portfolio Investment Investments financed with foreign money but operated by domestic residents. 16

Saving and Investment in the National Income Accounts GDP is both total income in an economy and total expenditure on the economy s output of goods and services: Y = C + I + G + NN Assume a closed economy one that does not engage in international trade: Y = C + I + G Subtract C and G from both sides of the equation: Y C G = I left side of the equation: the total income in the economy after paying for consumption and government purchases, it is called national saving, or saving (S) 17

Saving and Investment Important Identities Substituting S for Y C G, the equation can be written as S = I National saving, or saving, is equal to S = I S = Y C G National saving is the total income in the economy that remains after paying for consumption and government purchases. Dividing national saving into private and public saving: S = Y T C + T G 18

Private and Public Saving National Saving: S = Y T C + T G Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private Saving = Y T C Public Saving Public saving is the amount of tax revenue that the government has left after paying for its spending. Public Saving = T G 19

Public Saving & National Saving If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If T < G, the government runs a budget deficit because it spends more money than it receives in tax revenue. For the economy as a whole, saving must be equal to investment: S = I 20

The Market for Loanable Funds 22

The Market for Loanable Funds To keep things simple, we assume that the economy has only one financial market, called the market for loanable funds. Financial markets coordinate the economy s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save funds (= supply) and those who want to borrow to invest funds (= demand). Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. 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 24

The Market for Loanable Funds: Government Policies Government Policies That Affect Saving and Investment Decisions Taxes and saving Taxes and investment Government budget deficits Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. 25

Policy 1: Saving Incentives What happens if the government introduces a tax incentive for saving? Interest Rate Supply, S 1 S 2 5% 4% 2.... which reduces the equilibrium interest rat e... 1. Tax incentives for saving increase the supply of loanable fund s... Demand 0 1,200 1,600 3.... and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of euros) Copyright 2004 South-Western

Policy 1: Saving Incentives What happens if the government introduces a tax incentive for saving? 27

Policy 1: Saving Incentives What happens if the government introduces a tax incentive for saving? A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases. If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. 28

Policy 2: Investment Incentives What happens if the government introduces an investment tax credit? Interest Rate 6% 5% Supply 1. An investment tax credit increases the demand for loanable fund s... 2.... which raises the equilibrium interest rate... Demand, D 1 D 2 0 1,200 1,400 3.... and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of euros) Copyright 2004 South-Western

Policy 2: Investment Incentives What happens if the government introduces an investment tax credit? 30

Policy 2: Investment Incentives What happens if the government introduces an investment tax credit? An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. 31

Policy 3: Government Budget Deficits and Surpluses What happens if the government runs a budget deficit? Interest Rate National Saving: S = S 2 Y T C + T G Supply, S 1 2.... which raises the equilibrium interest rat e... 6% 5% 1. A budget deficit decreases the supply of loanable fund s... Demand 0 800 1,200 3.... and reduces the equilibrium quantity of loanable funds. Loanable Funds (in billions of euros) Copyright 2004 South-Western

Policy 3: Government Budget Deficits and Surpluses What happens if the government runs a budget deficit? National Saving: S = Y T C + T G 33

Policy 3: Government Budget Deficits and Surpluses What happens if the government runs a budget deficit? National Saving: S = National Saving: S = Y T C + T G Y T C + T G When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. T < G The accumulation of past budget deficits is called the government debt. Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments. 34

Policy 3: Government Budget Deficits and Surpluses The Market for Loanable Funds When government reduces national saving by running a deficit, the interest rate rises and investment falls. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. 35

Financial Institutions: who s missing Speaking about financial institutions, who is missing? Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. Financial markets are the institutions through which savers can directly provide funds to borrowers: Stock Market Bond Market Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers: Banks Investment Funds Credit unions Pension funds Insurance companies Loan sharks Exactly, the central banks: - ECB = the European Central Bank - FED = Federal Reserve Bank - BoE = Bank of England - BoJ = Bank of Japan 36

Excursus: The Big Short The Big Short : http://www.imdb.com/title/tt1596363/?ref_=nv_sr_2 - Scene1: Margot Robbie explains subprime mortgage bonds - Scene2: Buying Credit Default Swaps at Goldman Sachs - Scene3: Collateralized Debt Obligations 37

Excursus: The Big Short 38