Chapter 26: Saving, Investment, and the Financial System

• Financing capital investments can be done in many ways.

• Borrowing from a bank, friend, or other person (likely with interest) is an option

• Financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment

• The interest rate balances supply and demand

Chapter 26.1: Financial Institutions in the US Economy

• The financial system moves resources from savers to borrowers

• Savers save to use money at later dates to improve their standard of living

• Savers supply their money, expecting interest

• Borrowers demand money from savers, expecting to pay interest

• 26.1a: Financial Markets

  • Financial markets: financial institutions through which savers can directly provide funds to borrowers

  • Bond: a certificate of indebtedness

    • Date of maturity: the date a loan is repaid, identified by a bond

    • Principal: amount borrowed

    • Term: length of time until a bond matures

    • Perpetuity: a type of bond that never matures, issued by the British government. the principal is never repaid but the interest is forever collected

    • Credit risk: the probability a borrower will fail to pay some interest or principal. To compensate for credit risk, higher interest rates are put into place

    • Default: a failure to pay off the interest and capital, usually defaulted by declaring bankruptcy

    • Junk bonds: bonds that pay very high interest rates, used by financially shaky corporations as a way to raise money

    • Tax treatment: the way the tax laws treat the interest earned on bond

    • Municipal bonds: bonds issued by states and local governments, usually having a lesser interest rate

  • Stock: a claim to partial ownership in a firm

    • Equity finance: selling of stock to raise money

    • Debt finance: selling of bonds to make money

    • Stockholders receive portions of profits, while bondholders receive an interest. Stocks have a higher risk but a higher potential pay

    • Prices of stocks are determined by the supply and demand for that particular stock. If confidence in the company goes up, it is likely the price of the stock will increase

    • Stock index: average of a group of stock prices.

      • Dows Jones Industrial Average

      • Standards & Poor’s 500 Index

• 26.1b: Financial Intermediaries

  • Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers

  • Intermediary: the role of institutions between savers and borrowers

  • Banks

    • The main role of a bank is to take in deposits from people who want to save use these deposits to make loans to people who want to borrow

    • Banks ay deposits interest on their deposits and charge borrowers slightly higher interest on their loans

    • Medium of exchange: an item people can easily use to engage in transactions

    • Bank deposits offer a store of value

  • Mutual funds

    • Mutual fund: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and and bonds

    • Portfolio: a selection of stocks, bonds, or both stocks and bonds

    • Mutual funds allow for a diversified portfolio, which mean less risk

    • Mutual funds give ordinary people access to higher skills

    • Index funds: mutual funds which buy all the stocks in a given stock index

Chapter 26.2: Saving and Investment in National Income Accounts

• Accounting: the way in which various numbers are defined and added up

• Identity: an equation that must be true because of the way t he variables in the equation are defined

• Chapter 26.2a: Some Important Identities

  • Open economies: an economy that interacts with other economies

    • GDP = consumption + investment + government purchases + net exports

  • Closed economy: an economy that does not interact with other economies

    • GDP = consumption + investment + government purchases

    • GDP - consumption - government purchase = investment

    • savings = investment

    • National saving (saving): the total income in the economy that remains after paying for consumption and government purchases

    • savings = GDP - consumption - government purchases

  • Private saving: the income that households have left after paying for taxes and consumption (T>G)

  • Public saving: the tax revenue that the government has left after paying for its spending (G>T)

  • Budget surplus: an excess of tax revenue over government spending (T-G=+)

  • Budget deficit: a shortfall of tax revenue from government spending (T-G=-)

  • For the economy as a whole, saving must equal investment

• 26.2b: The Meaning of Saving and Investment

  • Investment refers to the purchase of new capital

  • Saving refers to the money kept away from saving

  • Saving and investment are equal in the economy, however, it is not equal for every individual household

26.3: The Market for Loanable Funds

• Market for loanable funds: the market in which those who want to save supply and those who want to borrow to invest demand funds

• Loanable funds: reference to the total income people have chosen to save and lend out

• 26.3a: Supply and Demand for Loanable Funds

  • Saving is the source of the supply of loanable funds

  • Investment is the source of the demand for loanable funds

  • Interest rate is a price of a loan, a higher interest rate makes borrowing more expensive

  • A high interest rate makes saving more attractive

  • The demand curve for loanable funds slopes downward and the supply curve for loanable funds slopes upwards

  • The nominal interest rate is the monetary return to saving and the monetary cost of borrowing

  • The real interest rate is the nominal is the nominal interest rate corrected for inflation

• 26.3b: Policy 1: Saving Incentives

  • Tax changes alter the incentive for households to save at any given interest rate, it affects the quantity of loanable funds at each interest rate

  • Saving taxed less heavily would increase the saving rates of other households

  • If a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment

• 26.3c: Policy 2: Investment Incentives

  • Investment tax credit: a tax reform aimed at making investment more attractive

  • The tax credit would not affect the amount that households save at any given rate, it would not affect the supply of loanable funds

  • The demand curve for loanable funds would move to the right

  • If the reform of the tax laws encouragedencourage greater investment, the result would be higher interest rates and greater saving

• 26.3d: Policy 3: Government Budget Deficits and Surpluses

  • Budget deficit: an excess of government spending over tax revenue

  • Government debt: the accumulation of past government borrowing

  • Balanced budget: when government spending equals tax revenue

  • Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds

  • During a budget deficit, national saving declines

  • Crowding out: a decrease in investment that results from government borrowing

  • When government reduces national saving by running a budget deficit, the interest rate rises and investment falls

  • A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment

  • Debt financing of war allows the government to keep tax rates smooth over time and shifts part of the cost of wars to future generations