Chapter 7. SAVING, INVESTMENT and FINIANCE. Income not spent is saved. Where do those dollars go?

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1 Chapter 7 SAVING, INVESTMENT and FINIANCE Income not spent is saved. Where do those dollars go? Describe financial markets Explain how financial markets channel saving to investment Explain how governments impact financial markets Financial Institutions and Financial Markets Important Concepts Distinguish between - Physical capital and financial capital Finance and money Physical Capital: machines, tools, buildings, computer systems and other items that have been produced in the past and that are used today to produce goods and services. Financial capital: The funds that firms use to buy physical capital bank loans, stocks, bonds, called financial instruments. 1

2 Financial Institutions and Financial Markets Important Concepts Finance looks at how households and firms use financial instruments (loans, stocks, bonds) and how they manage the risks that associated with this activity. The study of money looks at how households and firms use money, how much of it they hold, how banks create money, and how its quantity of money influences the economy. We talk a lot about Money in Chapter 8. Financial Institutions and Financial Markets More Concepts Investment and Capital Gross investment is the total amount spent on purchases of new physical capital and on replacing depreciated capital. Depreciation is the decrease in the quantity of physical capital that results from wear and tear and obsolescence. Net investment is the change in the quantity of capital. Net investment = Gross investment Depreciation. Capital and Investment Example - assume 6% depreciation: 1/1/2011: an economy has $500 billion worth of capital during 2011: gross investment = $60 billion 1/1/2012: economy will have $530 billion worth of capital $530 = $500 + ($60 $30) What is the value of net investment? 2

3 Economist Distinguish between Stocks and Flows A stock is a quantity measured at a point in time. E.g., The U.S. capital stock was $26 trillion on January 1, Flow Stock A flow is a quantity measured per unit of time. E.g., U.S. investment was $2.5 trillion during Stocks vs. Flows - examples stock a person s wealth balance on your credit card the govt debt flow a person s annual saving dollars added to your credit card this month the govt budget deficit Financial Institutions and Financial Markets More Concepts Wealth and Saving Wealth is the value of all the things that people own it is a stock. Saving is the amount of income that is not paid in taxes or spent on consumption of goods and services it is a flow. Saving increases wealth. 3

4 Financial Institutions and Financial Markets More Concepts Wealth also increases when the market value of assets rise - called capital gains - and decreases when the market value of assets falls - called capital losses. Buy and house for $300,000 and sell for $500,000. The capital gain is $200,000. Markets for Financial Capital Saving is the source of funds used to finance investment. These funds are supplied and demanded in three types of financial markets: Loan market Bond market Stock market Loans and Loan Markets Business borrows from a bank to buy a new computer system. You borrow from a bank to buy a car Households borrow to buy a home called a mortgage loan. These are examples of financing called loans that take place in the loan markets. Loans are legal contracts. 4

5 Bonds and Bond Markets A bond is a promise by a borrower to make specified payments on specified dates. Bonds are issued by corporations and governments. The buyer of a bond is a lender and the seller of the bond is a borrower. Bonds are legal contracts. Notice that loans and bonds are promises. Stocks and Stock Markets A certificate of ownership and claim on firm s profits. Traded in stock markets. Financial Institutions A financial institution is a firm that operates in the markets for financial capital. Key financial institutions are: Commercial banks Insurance companies Mutual funds Pension funds The Federal Reserve 5

6 Financial Institutions and Financial Markets Solvency and Insolvency A financial institution s net worth is the total market value of its assets lent minus the market value of what it has borrowed. Net worth = Assets Liabilities If net worth is positive, the institution is solvent and can remain in business. But if net worth is negative, the institution is insolvent and will go out of business. Assets (Funds lent) $1,000 $900 Liabilities (Funds borrowed) $100 Net Worth Financial Institutions and Financial Markets Illiquidity A financial institution can be solvent but illiquid. This can happen if the institution borrows short-term and makes long-term investments. Interest Rates and Asset Prices The interest rate on a financial asset is the interest received expressed as a percentage of the price of the asset. For example, if the price of the asset is $50 and the interest received is $5, then the interest rate is 10 percent: $5 = 0.10 or 10% $50 6

7 Interest Rates and Asset Prices If the asset price rises (say to $100), other things remaining the same, the interest rate falls to 5 percent. $5 $100 =.05 or 5%. If the asset price falls (say to $20), other things remaining the same, the interest rate rises to 25 percent. Interest rates and asset prices are inversely related Where interest rates are determined The market for funds that finance investment. Y = national income Y is either consumed (C), saved (S) or taxed (T): Y = C + S + T We know from Chapter 4: Y = C + I + G + X M We get: C + S + T = C + I + G + X M Solve for I: I = S + (T - G) + (M - X) I = S + (T - G) + (M - X) This equation tells us that funds that finance investment (I) come from three sources: 1. Household saving (S), called private saving. 2. Government budget surplus (T G), called public saving. NOTE: S + (T- G) is called national saving. 3. Borrowing from the rest of the world (M X). National saving plus foreign borrowing finance domestic investment. 7

8 The interest rate determined in the loanable funds market is the Real Interest Rate The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed and lent. In our example, the annual interest paid on a $50 loan is $5, the nominal interest rate is 10 percent per year. Nominal and Real Interest Rates The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the purchasing power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. real interest rate = nominal interest rate inflation For example, if the nominal interest rate is 5 percent a year and the inflation rate is 2 percent a year, the real interest rate is 3 percent a year. 3% = 5% - 2% Example: I borrow $100 from a lender and agree to pay $105 after one year: Loan amount = $100 Interest payment = $5 Nominal Interest rate = $5/ $100 = 5% The lender has $105 at the end of the year. Suppose inflation is 2%. What cost $100 a year earlier now cost $102. The lender s purchasing power increases by $3 not $5. The real interest rate is 5% - %2 = 3% 8

9 More on the Costs of Inflation The real interest rate represents: the increase in purchasing power to the lender the real cost of the loan to the borrower. If borrowers and lenders know the rate of inflation, they know the real cost and purchasing power of the loan Unexpected inflation shifts purchasing power between lenders and borrowers. More on the Costs of Inflation 1) Inflation rate higher than expected Harms those awaiting payment (lenders) Benefits the payers (borrowers) I lend money at 5% expecting 2% inflation I expect a real return of 3% If inflation turns out to be 4%, my actual real return is 1% 2) Inflation rate lower than expected Harms the payers (borrowers) Benefits those awaiting payment (lenders) If inflation turns out to be 1%, my actual return as a lender is 4%. The market for loanable funds determines the real interest rate, the quantity of funds loaned, saving, and investment. We ll start by ignoring the government (T G) and the rest of the world (M X). In this case, the only source of loanable funds is private saving (S). 9

10 The Demand for Loanable Funds The quantity of loanable funds demanded (how much business firms want to borrow) depends on 1. The real interest rate 2. Expected profit Demand for Loanable Funds Curve The demand for loanable funds curve is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. Business investment (I) is the main item that makes up the demand for loanable funds. Demand for loanable funds curve. A rise in the real interest rate decreases the quantity of loanable funds demanded. A fall in the real interest rate increases the quantity of loanable funds demanded. Changes in the Demand for Loanable Funds When the expected profit changes, the demand for loanable funds changes. The greater the expected profit from investment, investment increases and the demand for loanable fund increases. The DLF curve shifts to the right. The lower the expected profit from investment, investment decreases and the demand for loanable fund decreases. The DLF curve shifts to the left. 10

11 Change in the Demand for Loanable Funds Real Interest Rate DLF3 DLF1 DLF2 Loanable Funds The Supply of Loanable Funds The quantity of loanable funds supplied (household saving) depends on 1. The real interest rate 2. Disposable income 3. Expected future income 4. Wealth 5. Default risk this is the probability the lender will not be repaid. The Supply of Loanable Funds Curve The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. For now we focus just on private saving (S). 11

12 As the real interest rate increases, households save more, the quantity of loanable funds supplied increases. A fall in the real interest rate decreases the quantity of loanable funds supplied as households save less. Changes in the Supply of Loanable Fund A change in disposable income, expected future income, wealth, or default risk changes the supply of loanable funds. Household saving and the supply of loanable funds will increase when - There is an increase in disposable income, There is a decrease in expected future income, There is a decrease in wealth (e.g., loss in the stock market or real estate), There is a decrease in default risk Change in the Supply of Loanable Funds Real Interest Rate SLF3 SLF1 SLF2 Loanable Funds 12

13 Equilibrium in the Loanable Funds Market The loanable funds market is in equilibrium at the real interest rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied. This figure illustrates the loanable funds market. At 7 percent a year, there is a surplus of funds and the real interest rate falls households save more than business firms want to borrow. At 5 percent a year, there is a shortage of funds and the real interest rate rises. Equilibrium occurs at a real interest rate of 6 percent a year. E What Happens When Things Change? Increase in Demand for Loanable Funds An increase in expected profits increases DLF. DLF shifts to the right. The real interest rate rises. With higher real interest rates, household saving increases and quantity of loanable funds supplied increases movement from E to F. E F 13

14 Increase in the Supply of Loanable Funds If one of the influences on saving changes and saving increases, the supply of funds increases. (recall the influences that will increase supply?) The real interest rate falls. Investment increases. E F Long-run changes in Demand and Supply The book states on p. 171 that in the long-run both supply and demand for loanable funds tend to increase over time at similar pace: the real interest rate has no trend. Let s look at what has been going on: Now Add the Government to the Loanable Funds Market Government enters the loanable funds market when it has a budget surplus or deficit. Budget = Tax revenues (T) minus Government spending (G). = T - G A government budget surplus (T>G) increases the supply of funds. A government budget deficit (T<G) increases the demand for funds. 14

15 Government in the Loanable Funds Market: Budget Surplus of $1.0 Trillion Note: PSLF is Private Supply of Loanable Funds household saving (S) The budget surplus of $1 trillion increases supply of funds $1trillion at each interest rate. The real interest rate falls. Two things happen: Private saving decreases - in this example by $0.5 trillion to $1.5 trillion. Investment increases in this example by $0.5 trillion to $2.5 trillion. H E F Government in the Loanable Funds Market: Budget Deficit of $1 Trillion Note: PSLF is Private Demand for Loanable Funds business investment (I) A budget deficit increases demand for funds by $1trillion at each interest rate. The real interest rate rises. Two things happen: Private saving increases - to by $0.5 trillion to $2.5 Investment decreases - is crowded out as the real interest rate rises. I falls to by $0.5 trillion to $1.5 trillion. The Crowding Out Effect The tendency for government budget deficits to raise real interest rates and decrease private spending both C and I. Public spending crowds-out private spending. 15

16 The Ricardo Barro Effect A budget deficit increases the demand for funds. Budget deficits today means taxes must rise in the future and disposable income will be lower. Rational, forward looking taxpayers increase saving today, which increases the supply of funds. Increased private saving finances the deficit. In the extreme, crowding-out is avoided - the real interest rate does not rise and investment does not fall. 16