SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM Chapter 25

The Financial System • The financial system moves money from savers to borrowers.

Types of Financial Institutions • Financial Markets - savers directly provide funds to borrowers • Stock Market • Bond Market • Financial Intermediaries - savers indirectly provide funds to borrowers • Banks • Mutual Funds

Financial Markets: The Bond Market • A bond is a certificate of indebtedness

Characteristics of a Bond • Term: The length of time until maturity. • Credit Risk: The probability of repayment. • Tax Treatment: How tax laws treat the interest on the bond. ä Municipal bonds are federal tax exempt.

Financial Markets: The Stock Market • Stock is a claim to partial ownership in a firm. • Selling stock to raise money is called equity financing.

Financial Intermediaries: Banks • Banks are middlemen between savers and borrowers. • Mutual fund - for small investors

Other Financial Institutions • Credit unions • Pension funds • Insurance companies • Loan sharks

Saving and Investment in the National Income Accounts • Recall that GDP is: Y = C + I + G + NX

Some Important Identities • Assume a closed economy: Y = C + I + G

Saving and Investment • For the economy as a whole, saving must be equal to investment. S = I

Public Saving • Publicsaving - tax revenue minus government spending. Public saving = (T – G)

Supply and Demand for Loanable Funds • The supply of loanable fundscomes from savers. • The demand for loanable fundscomes from borrowers.

Supply and Demand for Loanable Funds • The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Taxes and Saving • Taxes on savings reduce the incentive to save. • The supply of loanable funds curve shifts to the left.

Taxes and Saving • A tax decrease increases the incentive to save. ä The supply of loanable funds curve shifts to the right.

Government Policies That Affect Saving and Investment • An investment tax credit increases the incentive to borrow. ä Increases the demand for loanable funds.

Government Policies That Affect Saving and Investment • When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. • The accumulation of past budget deficits is called the government debt.

Government Policies That Affect Saving and Investment • Government borrowing reduces the supply of loanable funds available to finance investment by households and firms. ä This deficit borrowing crowds out private borrowers who are trying to finance investments.

Government Policies That Affect Saving and Investment • A budget deficit decreases the supply of loanable funds. • Shifts the supply curve to the left.

Conclusion • Financial markets are like other markets in the economy. ä The real interest rate—the price in the loanable funds market—is governed by the forces of supply and demand.

Conclusion • Financial markets coordinate borrowing and lending, helping to allocate the economy’s scarce resources efficiently. • The U.S. financial system includes financial institutions such as the bond market, the stock market, banks, and mutual funds.

Conclusion • A government budget deficit reducing the supply of loanable funds. • It crowds out investment and reduces growth and GDP.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM