Chapter 8: Saving, Investment, and the Financial System

1. Chapter 8: Saving, Investment, and the Financial System

2. Introduction • In this chapter we learn how the loanable funds market: • brings savers and borrowers together to make both better off. • gathers savings and allocates it to the most profitable investments. • promotes economic growth.

3. Introduction • Some Important Definitions • Saving: income that is not spent on consumption goods. • Investment: purchase of new capital goods. • Caution: Investment is not defined by economists the same way a stockbroker defines investment.

4. The Supply of Savings • What Determines the Supply of Savings? • Smoothing consumption • Impatience • Market and psychological factors • Interest rates • Let’s look at these in turn.

5. The Supply of Savings • Individuals Want to Smooth Consumption • Save during working years to provide for retirement. • Important application • Lower life expectancies in developing countries contribute to lower saving rates. Why? • Manage fluctuations in income. • Save during good times in order to ride out the bad times.

6. The Supply of Savings • Individuals Are Impatient • Time preference: the desire to have goods and services sooner rather than later. • Anything with immediate costs and future benefits must overcome time preference. • College education • Crime is a reflection of impatience. • The greater the preference for things now the smaller will be saving.

7. The Supply of Savings • Individuals Are Impatient (cont.) • An interesting study: • Four-year old children were asked whether they wanted one cookie now or two cookies in 20 minutes. • Many years later the same children were evaluated again. • Result: the children who waited were less impulsive and had higher grades than the children who had not waited.

8. The Supply of Savings • Marketing and Psychological Factors • The way choices are presented makes a difference. • Real Example 1: Retirement savings plans • Result: Participation in the savings plan was 25% higher for companies with automatic enrollment. • Real Example 2: Default savings rate • Result: When the company switched from Default 1 (3%) to Default 2 (6%), the number of workers choosing 3% fell from 25% to almost zero.

9. The Supply of Savings • The Interest Rate • Interest is the reward for savings. • It is the “market price” of savings. • Other things being equal, the quantity supplied of savings increases as the interest rateincreases. The relation between the interest rate and the supply of savings is shown in the next diagram.

10. The Supply of Savings The Interest Rate (cont.) Interest rate Supply of savings 10% The higher the interest rate, the greater the amount of savings. 5% $200 $280 Savings (billions of dollars)

11. The Demand to Borrow • What determines the demand for savings? • Smoothing consumption • Financing large investments • The interest rate • Let’s look at these in turn.

12. The Demand to Borrow • Smoothing Consumption • Lifecycle Theory of Saving • Nobel laureate Franco Modigliani • By borrowing, saving, and dissaving at different times in life, workers can smooth their consumption path, improving their overall satisfaction. The next figure illustrates the lifecycle theory of saving.

13. The Demand to Borrow By borrowing, saving, and dissaving, workers can smooth their consumption. Income Consumption Saving Consumption Path Income Borrowing Dissaving Time College, buying first home Prime working years Retirement

14. The Demand to Borrow Income Consumption Path A: consumption = income, Path B: By saving during working years, consumption can be smoothed. Saving Path B Dissaving Path A Time Working Years Retirement

15. The Demand to Borrow • Borrowing Is Necessary to Finance Large Investments • Some investments require large amounts of money to get started. • Without the ability to borrow many profitable investments will not happen. • Example: • Fred Smith and FedEx • Why couldn’t Fred Smith have “started small”?

16. The Demand to Borrow • The Interest Rate • Determines the cost of the loan. • An investment will be profitable only if its rate of return is greater than the interest rate. • The higher the interest rate the smaller the quantity demanded of savings will be: • because there are fewer investments with a rate of return higher than the interest rate. The relation between borrowing and the interest rate is shown in the next figure.

17. The Demand to Borrow Interest rate The higher the interest rate, the lower the demand to borrow. 10% 5% Demand to borrow $190 $300 Savings (billions of dollars)

18. Equilibrium in the Market for Loanable Funds • The Market for Loanable Funds Determines: • the equilibrium interest rate. • the equilibrium quantity of savings/borrowing. • We are ready to put everything together in one model.

19. Equilibrium in the Market for Loanable Funds Interest rate Supply of savings Surplus → ↓ i 10% Equilibrium interest rate 8% 5% Shortage → ↑ i Demand to borrow $190 $200 $250 $280 $300 Savings/borrowing (in billions of dollars) Equilibrium quantity of savings/borrowing

20. Equilibrium in the Market for Loanable Funds • Shifts in Supply and Demand • Factors that shift the supply and demand curves change the equilibrium interest rate and the equilibrium quantity of savings/borrowing. • Let’s use the model to analyze some examples. • The stock market crashes reducing household wealth → people become more thrifty in order to restore their wealth. • The economy goes into a recession and investors become more pessimistic.

21. Equilibrium in the Market for Loanable Funds • People Become More Thrifty Result: Lower equilibrium interest rate Greater savings/borrowing Interest rate Supply of savings New supply of savings 8% 5% Demand to borrow $250 $300 Savings/borrowing (in billions of dollars) 21

22. Equilibrium in the Market for Loanable Funds • Investors Become More Pessimistic Interest rate Supply of savings Result: Lower equilibrium interest rate Lower savings/borrowing 8% 5% Demand to borrow New demand to borrow $200 $250 Savings/borrowing (in billions of dollars) 22

23. How will greater patience shift the supply of savings and change the interest rate and quantity of savings? How will an increase in investment demand change the equilibrium interest rate and quantity of savings?

24. Role of Intermediation: Banks, Bonds, Stock Markets • Financial Intermediaries - reduce the costs of moving savings from savers to borrowers and investors. • Help coordinate financial markets. • Help move savings to more highly valued uses. • We examine three financial intermediaries: • Banks • Bond market • Stock market

25. Role of Intermediation: Banks, Bonds, Stock Markets • Banks • Gather savings. • Reduce risk by evaluating ability to pay off loans. • Spread risk • When a borrower defaults on a loan, the bank spreads the loss among many lenders. • Coordinate lenders and borrowers. • Minimize information costs. • Conclusion: Banks help gather savings and allocate it to the most productive uses.

26. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market • Definition: A bond is a sophisticated IOU that documents who owns how much and when payment must be paid. • Issuing bonds allows borrowing directly from the public. • Lender: one who buys a bond • Borrower: one who issues a bond • Corporations and governments at all levels borrow money by issuing bonds.

27. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market (cont.) • All bonds involve a risk. • Major issues are graded by rating companies. • Standard and Poor’s • Moody’s • Grades range from • lowest risk (AAA) • bonds in current default (D) • The higher the risk the greater the interest rate required to get lenders to buy the bonds.

28. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market: Examples • Berkshire Hathaway (Warren Buffett) • Bond rating: AAA • Interest rate: 4.48% • Ford Motor Company • Bond rating: B • Interest rate: 5.76% • Home mortgage rates are lower than vacation loans because mortgage loans are backed by collateral. • Conclusion: the higher the risk the higher will be the rate of return. Note: lower bond ratings increase the cost of borrowing

29. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market (cont.) • Governments issue bonds to borrow money. • Government borrowing can crowd out private spending. • Crowding-out: the decrease in private consumption and investment that occurs when government borrows more. • Here’s how crowding-out works: ↑Saving ↓consumption ↓Investment ↑borrowing→ ↑interest rate → Let’s use our model to illustrate crowding out.

30. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market: Crowding Out (cont.) Interest rate Govt. borrows $100 billion Supply of savings ↑govt. borrowing: a→b Result: a→c ↑interest rate ↓private spending = $50 billion 9% b c 7% a Private demand +$100 billion govt. demand Private demand $150 $200 $250 Savings/borrowing (in billions of dollars)

31. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market (cont.) • Different kinds of U.S. bonds • T-bonds: 30 year maturity, pay interest every 6 months. • T-notes: 2 to 10 year maturity, pay interest every 6 months. • T-bills: mature in 2 days to 26 weeks, pay interest only at maturity. • Bonds that pay interest at maturity are called zero-coupon bonds. • Short-term U.S. government bonds tend to be the safest assets.

32. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market (cont.) • Bond Prices and Interest Rates • A bond can be sold any time before maturity. • Sellers of bonds compete to attract lenders. • Face Value (FV): how much the bond is worth at maturity. • Rate of Return (RoR): the implied interest rate (%) the bond earns. • Market price of the bond.

33. Role of Intermediation: Banks, Bonds, Stock Markets • The Bond Market (cont.) • Bond Prices and Interest Rates • Example: Suppose a low risk bond will pay $1,000 one year from now. If you pay $950 for the bond now, the RoR on the bond will be:

34. Role of Intermediation: Banks, Bonds, Stock Markets Conclusions: Unless the market rate of interest is less than 5.26%, no one will buy the bond. The less paid for the bond, the greater will be the RoR. The higher the market rate of interest, the less anyone will pay for the bond.

35. Role of Intermediation: Banks, Bonds, Stock Markets • The Stock Market • A stock is a certificate of ownership in a corporation. • Stocks are traded in organized markets called stock exchanges. • New York Stock Exchange (NYSE) is the largest. • Tokyo Stock Exchange (TSE) is the second largest. • Sales of new shares: • Called an IPO (initial public offering). • Typically used to buy new capital goods. • Stock markets encourage investment and growth.

36. What is the primary role of financial intermediaries? If your $1,000 corporate bond pays you $60 in interest every year and the interest rate falls to 4 percent, what happens to the price of the bond? What happens if the interest rate rises to 8 percent? Why does an IPO increase net investment in the economy but your purchase of 200 shares of IBM stock does not increase investment?

37. What Happens When Intermediation Fails? • The bridge between saving and investment breaks down. • Economic growth suffers. • Four causes of failure: • Insecure property rights • Controls on interest rates and inflation • Politicized lending and government owned banks • Bank failures and panics • Let’s look at these in turn.

38. What Happens When Intermediation Fails? • Insecure Property Rights • Some governments fail to protect property rights. • Saved funds are not immune to confiscation, freezes, and other restrictions. • Result: people are reluctant to put their savings in domestic institutions. • Example: Argentina and Brazil • Both have a history of freezing bank accounts. • Argentines and Brazilians save less. • Result: less investment and lower economic growth.

39. What Happens When Intermediation Fails? • Controls on Interest Rates and Inflation • Usury Laws: create legal ceilings on interest rates. • Result: less saving and investment. • Most American states have usury laws but: • they often have loopholes (e.g., don’t apply to credit cards). • set at levels too high to affect most loan markets. We can use the loanable funds market model to illustrate the effect of a usury law.

40. What Happens When Intermediation Fails? Controls on Interest Rates and Inflation (cont.) Interest rate Supply of savings 10% Market Equilibrium Results: Shortage of savings Less savings/investment Slower economic growth 8% Controlled Interest rate Shortage Demand $190 $250 $300 Savings/borrowing (in billions of dollars) Effect of Usury Laws

41. What Happens When Intermediation Fails? • Controls on Interest Rates and Inflation (cont.) • Inflation • When combined with controls on interest rates, inflation destroys the incentive to save. • Nominal and real interest rates: • Nominal interest rate: the named rate; the rate on paper. • Real interest rate: the rate of return after adjusting for inflation. • Therefore:

42. What Happens When Intermediation Fails? • Controls on Interest Rates and Inflation (cont.) • Inflation (cont.) • Example: Suppose interest rates are controlled at a nominal rate of 10% and the rate of inflation is 30%. Then: • Result: • Savers are losing 20% a year. • Saving is discouraged. • Less investment and slower economic growth • The following table shows the effect of negative interest rates on growth of per capita GDP.

43. Negative Interest Rates and Economic Growth What Happens When Intermediation Fails?

44. What Happens When Intermediation Fails? • Politicized Lending and Government Owned Banks • Example: Japan 1990 to 2005. • Many banks were bankrupt or propped up by the government. • They were not loaning funds for efficient uses. • Other banks were pressured to lend money to well-connected political allies. • Result: economic growth was zero during this period.

45. What Happens When Intermediation Fails? • Politicized Lending and Government Owned Banks (cont.) • Government ownership of banks • Useful to authoritative regimes that use the banks to direct capital to political supporters. • The larger the fraction of government-owned banks a country had in 1970: • the slower the growth in per capita GDP. • the slower the productivity growth.

46. What Happens When Intermediation Fails? • Bank Failures and Panics • Systemic problems usually lead to large-scale economic crises. • During the Depression, between 1929-1933: • 11,000 banks (almost half of U.S. banks) failed. • Ripple effects: • Businesses could not get working capital. • Many people lost their life savings, resulting in lower spending. • Result: many businesses failed.

47. What Happens When Intermediation Fails? • Bank Failures and Panics (cont.) • Financial Crisis 2007-2008 • Many mortgage loans were bundled and sold as if they had very low risk. • Some were sold on false terms. • Credit rating agencies failed at their job. • People expected housing prices to continue to rise.

48. What Happens When Intermediation Fails? • Bank Failures and Panics (cont.) • Financial Crisis 2007-2008 (cont.) • Housing prices fell. • Many people defaulted on their mortgages. • Result: • Huge amounts of bad loans on the books of financial institutions. • Banks could not get funds to loan. • The bridge between savers and borrowers collapsed.

49. How do usury laws (controls on interest rates) cause savings to decline? • Besides decreasing the number of banks, how do bank failures hinder financial intermediation? • How does awarding bank loans by political criteria or by cronyism (to your pals) affect the efficiency of the economy?

50. Takeaway • Financial institutions bridge the gap between savers and borrowers. They: • collect savings. • evaluate investments and reduce risk. • Banks, bond markets, and stock markets serve as financial intermediaries.