Savings, Investment and the Financial system

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Savings, Investment and the Financial system

• Chap 13, Mankiw

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• Chap 13 discusses
• Financial markets and institutions bond and
  stock markets, financial intermediaries
• Savings and investment in GDP accounts
• Market for loanable funds a theory of interest
  rates

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• Financial markets and institutions
• Investment creation of new physical capital
  goods, construction of new houses, addition to
  inventories financing these require big amounts
  of funds (millions, billions of ) individuals
  or individual households saving out of their
  current income cannot finance these these
  savings must be pooled and used for financing
  these activities
• several institutions help in this process
  financial markets are institutions through which
  savers/lenders and users/borrowers exchange these
  funds
• examples NYSE, NASDAQ, AMEX
• intermediaries are institutions which borrow
  funds from small savers/lenders and lend them to
  users/borrowers
• examples banks, mutual funds

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Some important types of assets traded in
financial markets Bonds a certificate of
indebtedness or IOU, specifying (i) time at which
debt will be paid off (term to maturity) (ii)
payment amounts and intervals over the life of
the bond Examples Treasury Bills, Treasury
bonds and notes, state and local government bonds
(municipal bonds), corporate bonds, British govt.
perpetuities, Even though payment amounts on
bonds are promised, bonds are not completely
risk free default risk, risks on long term
bonds Stocks represents ownership of a firm and
hence a claim to profits made by a firm owners
share in the risks faced by the firm hence
stockholders get a positive return (dividends)
when firms make profits and zero when they
dont
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Some special types of financial
intermediaries Banks collects funds through
deposits made by small savers examples
checking and savings accounts amounts
outstanding in checking accounts are part of an
economys money supply because checks are close
substitutes of paper currency Mutual Funds
institutions which sell shares to the public and
buys a selection or portfolio of stocks and bonds
with the funds collected mutual funds allow small
savers to diversify the risks of financial
investment mutual fund managers are also more
well informed about financial markets than
ordinary people and have greater expertise in
financial investment index funds are a special
type of mutual fund in which the portfolio mimics
a certain stock or bond index such as DJIA, SP
etc.
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II. Savings and investment in GDP accounts Recall
that GDP is both total income in an economy and
total expenditure on the economys output of
goods and services Y C I G NX Assume a
closed economy one that does not engage in
international trade above identity becomes Y
C I G Now, subtract C and G from both sides
of the equation Y C G I
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• The left side of the equation is the total income
  in the economy after paying for consumption and
  government purchases and is called national
  saving, or just saving (S).
• 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
• S (Y T C) (T G)

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• 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 is the amount of tax revenue that
  the government has left after paying for its
  spending.
• Public saving (T G)
• If TgtG, the government runs a budget surplus
  because it receives more money than it spends.
• The surplus of T-G represents public saving.
• If GgtT, the government runs a budget deficit
  because it spends more money than it receives in
  tax revenue.

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• III. The classical theory of interest
• From this point onwards we define C, I and G as
  planned expenditures (desired) by households,
  firms and the government instead of actual
  expenditure by the same. Y continues to be
  defined as actual GDP.
• For equilibrium in the market for goods and
  services it has to be the case that
• C I G Y
• If C I G gt Y, there is excess demand
  (shortage) of goods.
• If C I G lt Y, there is excess supply
  (surplus) of goods.

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For equilibrium in goods market, C I G
Y Transferring variables Y C - G I Or
S I
Savings plans are
made mostly by household-lenders Investment
plans by firm-borrowers. Accounting theories
(chap 10) do not tell us how they come to be
equal in practice. According to the classical
theory, market interest rates adjust in financial
markets to equate these two. Supply of funds
(savings) and demand for funds (investment)
interact to set an equilibrium interest rate, in
very much the same way the demand and supply of a
physical good interact to set an equilibrium
price of the good.
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Household consumption plans depend on the level
of disposable income, Y T Consumption is
commonly assumed to be increasing in disposable
income. To keep things simple we will assume
that consumption is a linear function of
disposable income. C a b.(Y-T), where a, b gt
0. The constant b is known as the marginal
propensity to consume. b is the proportion of
income that is consumed every-time income goes up
by an unit. Assume T 0, hence disposable income
Y. If income increases by ?Y units, consumption
increases by ?C b.?Y units. The constant a
is minimum/survival consumption. Put Y-T 0, in
the equation to see why.
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Household savings are then given by S Y - C
T Y (a b.(Y T) - T - a (1
b)(Y T) Saving plans are increasing in
disposable income The constant 1-b in the
savings equation is known as marginal propensity
to save. 1-b is the proportion of income that
is saved every-time income goes up by an
unit. Assume T 0, hence disposable income Y.
If income goes up by ?Y units, saving increases
by ?S (1 b).?Y units.
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• How to find a and b from a table of numbers,
  as in Aplia practice 1.1?
• GDP Consumption Saving
• 800 200
• 2000 1400 600
• Use the relation ?C b.?Y on the two rows of
  numbers. Note that when ?Y 1000, ?C 600.
  Therefore 600 b.1000. From this it follows that
  b 0.6. The marginal propensity to consume is
  therefore 0.6. If income goes up by 1,
  consumption will go up by 0.6 times 1 60
• Note marginal propensity to consume is not the
  same as C which is total consumption.
• As an exercise, use the same method to find the
  marginal propensity to save.

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Consumption and saving can be assumed to be
interest sensitive also. Saving usually increases
as the rate of interest increases. Consumption
usually decreases as the rate of interest
increases. In the exercises using numbers we
will not assume consumption and saving to be
interest sensitive but know that they can be
theoretically. Investment plans by firms are
assumed to be decreasing in the market rate of
interest because the firms finance these
expenditures by borrowing and have to pay
interest on these. We assume that G and T are
given and constant in this simple classical
model.
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Market for Loanable Funds equilibrium interest
rate is determined by savings and investment
Interest Rate
0
Loanable Funds (in billions of dollars)
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Effect of Tax Incentives on the Market for
Loanable Funds
Supply, S1
5
Demand
1,200
Loanable Funds (in billions of dollars)
0
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Effect of a Tax Incentive on the Market for
Loanable Funds
Supply
5
Demand, D1
0
1,200
Loanable Funds (in billions of dollars)
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The Effect of a Government Budget Deficit
Supply, S1
5
Demand
1,200
Loanable Funds (in billions of dollars)
0
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The U.S. Government Debt
100
80
60
40
20
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
2000
1995