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•

•Saving,

Investment, and

•the

Financial System

•Financial

Institutions

•Financial

system:

Group of

institutions in the economy

that help

match one person’s saving with another

person’s investment.

–Moves

the economy’s scarce resources from savers to borrowers.

•Financial

institutions:

1.

Financial markets.

2.

Financial intermediaries.

•Financial

Markets

•Financial

markets:

–Savers

can directly provide funds to borrowers.

1.

The bond

market.

2.

The stock

market.

•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

risk – probability of default.

–Tax treatment.

•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

index:

Average of

a group of stock prices

•Financial

Intermediaries

•Financial

intermediaries:

–Savers

can indirectly provide funds to borrowers.

1.

Banks.

2.

Mutual funds.

•Financial

Intermediaries

•Banks:

–Take

in deposits from savers.

•Banks

pay interest.

–Make

loans to borrowers.

•Banks

charge interest.

–Facilitate

purchasing of goods and services.

•Checks

– medium of exchange.

•Financial

Intermediaries

•Mutual

funds:

–Institution

that sells shares to the public.

–Uses

the proceeds to buy a portfolio of stocks and bonds.

–Advantages:

•Diversification.

•Access

to professional money managers.

–

•National

Income Accounts

•Rules

of national income accounting:

–Important

identities.

•Identity: An equation

that must be true because of the way the variables in the equation are defined.

–Clarify

how different variables are related to one another.

•Accounting

Identities

•Gross

domestic product (GDP):

–Total

income

MUSE EQUAL

–Total

expenditure.

•Y = C

+ I + G + NX.

•Y=

gross domestic product GDP.

•C

= consumption.

•G

= government purchases.

•NX

= net exports.

•Accounting

Identities

•Closed

economy:

Doesn’t interact

with other economies.

–NX = 0.

•Open economy: Interact

with

other economies

–NX ≠ 0.

•Accounting

Identities

•Assumption:

close economy: NX = 0:

•Y

= C + I + G.

•National

saving (saving), S: Total

income

in the economy that remains after paying for consumption and government purchases.

•Y

– C – G = I.

•S

= Y – C –

G.

•S

= I.

•Accounting

Identities

•T =

taxes minus transfer payments:

•S

= Y – C – G.

•S

= (Y – T – C) + (T – G).

•Private

saving, Y – T – C: Income

that

households have left after paying for taxes and consumption.

•Public

saving, T – G:

Tax revenue

that the government has left after paying for its spending

•Accounting

Identities

•Budget

surplus: T – G > 0: Excess

of

tax revenue over government spending.

•Budget

deficit: T – G

•Saving

and Investing

•Accounting

identity: S = I.

•Saving

= Investment:

–For

the economy as a whole, One person’s

savings can finance another person’s investment.

•

•The

Market for Loanable Funds

•Market

for loanable funds:

–Market:

•Those

who want to save supply funds.

•Those

who want to borrow to invest demand funds.

–One

interest rate:

•Return

to saving.

•Cost

of borrowing.

–Assumption:

•Single

financial market.

•The

Market for Loanable Funds

•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.

•The

Market for Loanable Funds

•Supply

and demand of loanable funds

–As

interest rate rises,

•Quantity

demanded declines.

•Quantity

supplied increases.

–Demand

curve:

•Slopes

downward.

–Supply

curve:

•Slopes

upward.

•Figure

1

•The

Market for Loanable Funds

•Government

policies:

–Can

affect the economy’s saving and investment.

•Saving

incentives.

•Investment

incentives.

•Government

budget deficits and surpluses.

•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

•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

•Policy

3: Budget Deficit/Surplus

•Government

- starts with balanced budget:

–Then

starts running a budget deficit.

•Change

in supply of loanable funds.

•Decrease

in supply:

–Supply

curve shifts left.

•New equilibrium.

–Higher

interest rate.

–Smaller

quantity of loanable funds.

•Figure

4

•Policy

3: Budget Deficit/Surplus

•Crowding

out:

–Decrease

in investment.

–Results

from government borrowing.

•Government

- budget deficit:

–Interest

rate rises.

–Investment

falls.

•Policy

3: Budget Deficit/Surplus

•Government

– budget surplus:

–Increase

supply of loanable funds.

–Reduce

interest rate.

–Stimulates

investment.

•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

•The

history of U.S. government debt

•Rising

debt-GDP

–Government

indebtedness is increasing relative to its ability to raise tax revenue

•Fiscal

policy cannot be sustained forever at current levels

•War –

primary cause of fluctuations in government debt:

–Debt

financing of war – appropriate policy

•Tax

rates – smooth over time

•Shifts

part of the cost to future generations

•Figure

5

•The

history of U.S. government debt

•President

Ronald Reagan, 1981

–Large

increase in government debt – not explained 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

•The

history of U.S. government debt

•President

Bill Clinton, 1993

–Major

goal - deficit reduction

–And

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

•The

history of U.S. government debt

•President

George W. Bush

–Debt-GDP

ratio - started rising again

–Budget

deficit

•Several

major tax cuts

•2001

recession - decreased tax revenue and increased government spending

•Spending

on homeland security

–Following

the September 11, 2001 attacks

–Subsequent

wars in Iraq and Afghanistan

–Increases

in government spending

•The

history of U.S. government debt

•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 administrations

•Aimed

at combating the recession

•Reduced

tax revenue

•Increased

government spending

•The

history of U.S. government debt

•2009

and 2010

–Federal

government’s budget deficit = 10% of GDP

–Borrowing

to finance budget deficit

–Substantial

increase in the debt-GDP ratio

•Policy

challenges for future generations

–Putting

the federal budget back on a sustainable path

•Stable

or declining debt-GDP ratio

•

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