Savings, Investment Spending, and the Financial System

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Savings, Investment Spending, and the Financial
System
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Savings Investment

• Savings-Investment Spending Identity Savings and
  investment spending are always equal for the
  economy as a whole.
• Budget Surplus Government spends less than it
  collects in taxes.
• Budget Deficit Government spends more than it
  collects in taxes.
• Real GDP per capita is five times the 1929 level,
  and 7 times the 1900 level

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Savings Investment

• Budget Balance The difference between tax
  revenue and government spending.
• National Savings The sum of private savings
  plus the budget balance (public savings), is the
  total amount of savings generated within the
  economy.

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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
• I NS
• Investment Spending National Savings
• in a closed economy

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Budget Surplus
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Budget Deficit
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Open Economy

• GDP C I G NX
• Capital Inflow (KI) -NX (IM - X)
• I SPrivate SGovernment (IM - X) NS KI
• I NS KI
• Investment Spending National Savings Capital
  Inflow
• in an open economy

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Open Economy U.S. 2003
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Open Economy Japan 2003
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Market for Loanable Funds

• Loanable Funds Market Hypothetical model that
  examines the market outcome of the demand for
  funds generated by borrowers and the supply of
  funds provided by lenders.
• The interest rate is the price, calculated as a
  percentage of the amount borrowed, charged by the
  lender to a borrower for the use of their savings
  for one year.

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Market for Loanable Funds
The rate of return of a project is the profit
earned on the project expressed as a percentage
of its cost.
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Demand for Loanable Funds
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Supply of Loanable Funds
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Equilibrium in Loanable Funds
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Invest or Not Invest

• The Cuppa Coffee Company is considering investing
  in a new high tech coffee roaster
• Interest rate in the loanable funds market 7
• Projected revenue from new roaster 100,500
• Estimated cost of the new project 93,000
• Would it be rational for the Cuppa Coffee Company
  to borrow the funds necessary to invest in the
  new roaster?

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Invest or Not Invest

• YES! It would be rational for them to borrow the
  money necessary for the new roaster.

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Savings, Investment Govt Policy
Quantity of private loanable funds demanded falls
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Savings, Investment Government Policy

• Crowding Out The negative effect of budget
  deficits on private investment.
• You should be able to draw out the previous graph
  and use it to explain crowding out!

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Increase in Private Savings
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Functions of the Financial System

• The three primary tasks of a financial system
  are
• Reducing Transaction Costs
• Reducing Risk
• Providing Liquidity

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Financial System - Definitions

• Wealth Households value of its accumulated
  savings.
• Financial Asset A paper claim that entitles the
  buyer to future income from the seller.
• Physical Asset A claim on a tangible object that
  gives the owner the right to dispose of the
  object as he or she wishes.
• Liability Requirement to pay income in the
  future.
• Transaction costs Expenses of negotiating and
  executing a deal.
• Financial Risk Uncertainty about future outcomes
  that involve financial losses and gains.

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Risk-Averse Gains vs. Losses
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Financial System More Definitions

• Diversification Investing in several different
  things so that the possible losses are
  independent events.
• An asset is liquid if it can be quickly converted
  into cash.
• An asset is illiquid if it cannot be quickly
  converted into cash.

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Financial System More Definitions

• There are four main types of financial assets
• Loans
• Bonds
• Stocks
• Bank Deposits
• Loan A lending agreement between a particular
  lender and a particular borrower.
• Bank Deposit A claim on a bank that obliges the
  bank to give the depositor his or her cash when
  demanded.

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Functions of the Financial System

• The three primary tasks of a financial system
  are
• Reducing Transaction Costs
• Reducing Risk
• Providing Liquidity

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Financial Intermediaries

• Financial Intermediary An institution that
  transforms the funds it gathers from many
  individuals into financial assets.
• Mutual Fund A financial intermediary that
  creates a stock portfolio and then resells shares
  of this portfolio to individual investors.
• Pension Fund A type of mutual fund that holds
  assets in order to provide retirement income to
  its members.

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Financial Intermediaries

• Life Insurance Company Sells policies that
  guarantee a payment to a policyholders
  beneficiaries when the policyholder dies.
• Bank Financial intermediary that provides
  liquid assets in the form of bank deposits to
  lenders and uses those funds to finance the
  illiquid investments or investment spending needs
  of borrowers.

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Financial Fluctuations

• Financial market fluctuations can be a source of
  macroeconomic instability.
• The demand for stocks
• Stock prices are determined by supply and demand
  as well as the desirability of competing assets,
  like bonds when the interest rate rises, stock
  prices generally fall and vice versa.
• Stock market expectations
• Expectations drive the supply of and demand for
  stocks expectations of higher future prices push
  todays stock prices higher and expectations of
  lower future prices drive them lower.

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Stock Market Expectations

• Efficient markets hypothesis Holds that the
  prices of financial assets embody all publicly
  available information thus, prices only change
  when new news comes out.
• Implies that fluctuations are inherently
  unpredictablethey follow a random walk.

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Stock Market Expectations

• Many market participants and economists believe
  that, based on actual evidence, financial markets
  are not as rational as the efficient markets
  hypothesis claims.
• Such evidence includes the fact that stock price
  fluctuations are too great to be driven by
  fundamentals alone.

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Irrational ExuberanceThe SP 500 Index from
October 1982 to April 2005