chapter 26 savings, investment spending, and the financial system powerpoint® slides by can erbil...
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CHAPTER 26
Savings, Investment Spending, and the Financial System
PowerPoint® Slides by Can Erbil
© 2005 Worth Publishers, all rights reserved
What you will learn in this chapter:
The relationship between savings and investment spending
About the loanable funds market, which shows how savers are matched with borrowers
The purpose of the four principal types of assets: stocks, bonds, loans, and bank deposits
How financial intermediaries help investors achieve diversification
Some competing views of what determines stock prices and why stock market fluctuations can be a source of macroeconomic instability
The Savings–Investment Spending Identity in a Closed Economy
In a closed economy: GDP = C + I + G
SPrivate = GDP + TR − T − C
SGovernment = T − TR − G
NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G)
= GDP − C − G
Hence, I = NS
Investment spending = National savings in a closed economy
Budget Surplus and Budget Deficit
The Savings–Investment Spending Identity in an Open Economy
I = SPrivate + SGovernment + (IM – X) = NS + KI (10)
Investment spending = National savings + Capital inflow in an open economy
The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003
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
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 $300,000 to have a new
house built.
Remember: In economics, investment is NOT the purchase of stocks and bonds!
Remember: In economics, investment is NOT the purchase of stocks and bonds!
The Market for Loanable Funds
A supply-demand model of the financial system. Helps us understand
how the financial system coordinates saving & investment
how government policies and other factors affect saving, investment, the interest rate
The Market for Loanable Funds
Assume: only one financial market. All savers deposit their saving in this market. All borrowers take out loans from this market. There is one interest rate, which is both the
return to saving and the cost of borrowing.
The Market for Loanable Funds
The supply of loanable funds comes from saving: Households with extra income can loan it out
and earn interest.
SHIFTS in the Supply Curve:
Changes in private savings behavior Changes in capital flows
The Slope of the Supply Curve
InterestRate
Loanable Funds ($billions)
Supply
An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.
60
3%
80
6%
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.
• SHIFTS in the Demand Curve• Changes in perceived business opportunities• Changes in government’s borrowing
The Slope of the Demand Curve
InterestRate
Loanable Funds ($billions)
Demand
A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.
50
7%
4%
80
Equilibrium
InterestRate
Loanable Funds ($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
Policy 1: Saving Incentives
InterestRate
Loanable Funds ($billions)
D1
Tax incentives for saving increase the supply of L.F.S1
5%
60
S2
…which reduces the eq’m interest rateand increases the eq’m quantity of L.F.
4%
70
Policy 2: Investment Incentives
InterestRate
Loanable Funds ($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
AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : Exercise A.Exercise A.
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?
18
AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : Exercise B.Exercise B.
Use the loanable funds model to analyze the effects of tax decrease on the interest earned on savings. How does the tax decrease on interest on savings affect the market?
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?
19
Policy 3. Government Budgets
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.
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.
U.S. Government Debt U.S. Government Debt as a Percentage of GDP, 1970-2007as a Percentage of GDP, 1970-2007
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
The Financial System - Definitions
Wealth Financial asset Physical asset Liability Transaction costs Financial risk
Risk-Averse Attitudes Toward Gain and Loss
Three Tasks of a Financial System
Reducing transaction costs Reducing financial risk Providing liquid assets
Financial Intermediaries
Mutual funds
Pension funds
Life insurance companies
Banks
Financial Fluctuations
Financial market fluctuations can be a source of macroeconomic instability.
Are markets irrational?
Policy makers assume neither that markets always behave rationally nor that they can outsmart them.
The End of Chapter 26
coming attraction:Chapter 27:
Aggregate Supply and Aggregate Demand