Topic 4

Chapter 26
Saving, Investment, and the Financial
System

1
 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
– Financial markets
– Financial intermediaries
2
 Financial Markets, Part 1
• Financial markets
– Savers can directly provide funds to
borrowers
– The bond market
– The stock market

3
 Financial Markets, Part 2
• The bond market
– Bond: certificate of indebtedness
• Date of maturity, when the loan will be repaid
• Rate of interest, paid periodically until the
date of maturity
• Principal, amount borrowed
– Borrowing from the public
• Used by large corporations, the federal
government, or state and local governments

4
 Financial Markets, Part 3
• Bonds differ according to characteristics:
1. Term: length of time until maturity
• A few months, 30 years, perpetuity
• Long-term bonds are riskier than short-term
bonds
• Long-term bonds usually pay higher interest
rates

5
 Financial Markets, Part 4
• Bonds differ according to characteristics
2. Credit risk: probability of default
• Probability that the borrower will fail to pay
some of the interest or principal
• Higher interest rates for higher probability of
default
• U.S. government bonds tend to pay low
interest rates
• Junk bonds, very high interest rates: issued
by financially shaky corporations

6
Table Bond Ratings by Moody’s, Standard and Poor’s, and Fitch

Moody’s S&P Fitch Definitions

Aaa AAA AAA Prime Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA
Aa3 AA– AA–
A1 A+ A+ Upper Medium Grade
A2 A A
A3 A– A–
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB
Baa3 BBB– BBB–
Ba1 BB+ BB+ Noninvestment Grade / Speculative
Ba1 BB+ BB+
Ba3 BB– BB–
B1 B+ B+ Highly Speculative
B2 B B
B3 B– B–
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC — In Poor Standing
Caa3 CCC– —
Ca — — Extremely Speculative
C — — May Be in Default
— — D Default 7
 Sovereign Credit Ratings

Moody's S&P Fitch

United States Aaa AA+ AAA

United Kingdom Aa2 AA AA-
South Korea Aa2 AA AA-
China A1 A+ A+
Mexico A3 BBB BBB
Argentina Caa2 CCC- CC
 Financial Markets, Part 5
• Bonds differ according to characteristics
3. Tax treatment: interest on most bonds is
taxable income
• Municipal bonds
– Issued by state and local governments
– Owners are not required to pay federal
income tax on the interest income
– Lower interest rate

9
 Financial Markets, Part 6
• The stock market
– Stock: claim to partial ownership in a firm
• A claim to the profits that a firm makes
– 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

10
 Financial Intermediaries, Part 1
• Financial intermediaries
– Savers can indirectly provide funds to
borrowers
– Banks
– Mutual funds

11
 Financial Intermediaries, Part 2
• 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

12
 Financial Intermediaries, Part 3
• Mutual funds
– Institution that sells shares to the public
– Uses the proceeds to buy a portfolio of
stocks and bonds
– Advantages: diversification; professional
money managers

13
 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

14
 Accounting Identities, Part 1
• Gross domestic product (GDP, Y)
– Total income = Total expenditure
• Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports

15
 Accounting Identities, Part 2
• Closed economy
– Doesn’t interact with other economies
– NX = 0
• Open economy
– Interacts with other economies
– NX ≠ 0

16
 Accounting Identities, Part 3
• Assume closed 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
17
 Accounting Identities, Part 4
• 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
18
 Accounting Identities, Part 5
• Budget surplus: T – G > 0
– Excess of tax revenue over government
spending
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government
spending

19
 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

20
 The Market for Loanable Funds, Part 1

• 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

21
 The Market for Loanable Funds, Part 2

• Supply of and demand for 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

22
 The Market for Loanable Funds, Part 3

• Supply of and demand for loanable funds

– As interest rate rises
• Quantity demanded declines
• Quantity supplied increases
– Demand curve
• Slopes downward
– Supply curve
• Slopes upward

23
Figure 1 The Market for Loanable Funds

25
 The Market for Loanable Funds, Part 4
• Government policies
– Can affect the economy’s saving and
investment
• Saving incentives
• Investment incentives
• Government budget deficits and surpluses

26
 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

27
Figure 2 Saving Incentives Increase the Supply of Loanable Funds

29
 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

30
Figure 3 Investment Incentives Increase the Demand for Loanable Funds

32
 Policy 3: Budget Deficit/Surplus, Part 1

• 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

33
Figure 4 The Effect of a Government Budget Deficit

35
 Policy 3: Budget Deficit/Surplus, Part 2

• Crowding out
– Decrease in investment
– Results from government borrowing
• Government – budget deficit
– Interest rate rises
– Investment falls

36
 Policy 3: Budget Deficit/Surplus, Part 3

• Government – budget surplus

– Increase supply of loanable funds
– Reduce interest rate
– Stimulates investment

37
 The History of U.S. Government Debt, Part 1
• 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-to-GDP ratio
– Government indebtedness is shrinking
relative to its ability to raise tax revenue
– Government – living within its means

38
39
40
 The History of U.S. Government Debt, Part 2
• Rising debt-to-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

41
Figure 5 The U.S. Government Debt

43
44
 The History of U.S. Government Debt, Part 3
• 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
45
 The History of U.S. Government Debt, Part 4
• President Bill Clinton, 1993
– Major goal – deficit reduction
– And Republicans took control of Congress in
1995: deficit reduction
– Substantially reduced the size of the
government budget deficit
– Booming economy in the late 1990s brought
in even more tax revenue
– Eventually: surplus (federal budget)
– By the late 1990s: debt-to-GDP ratio –
declining for several years
46
 The History of U.S. Government Debt, Part 5
• President George W. Bush
– Debt-to-GDP ratio started rising again
– Budget deficit
• Several major tax cuts
• 2001 recession – decreased tax revenue
and increased government spending
• Increased government spending on
homeland security
–Following the September 11, 2001 attacks
–Subsequent wars in Iraq and Afghanistan

47
 The History of U.S. Government Debt, Part 6
• 2008, financial crisis and deep recession
– Dramatic increase in the debt-to-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

48
 The History of U.S. Government Debt, Part 7
• From 2009 to 2012
– The federal government’s budget deficit
averaged about 9% of GDP
• Levels not seen since World War II
– The borrowing to finance these deficits
• Led to the substantial increase in the debt-to-
GDP ratio (from 39% in 2008 to 70% in 2012)
• After 2012, as the economy recovered
– Budget deficits shrank, and the increases in
the debt-to-GDP ratio became smaller
– Pres. Trump's tax cut in 2018
49