Savings, Investment, and the Financial System
I.
The Savings- Investment Spending Identity
Savings = Investment spending
A.
Why this is true
In an economy without interaction of government or other countries:
Total income = Total Spending
Total income = Consumer spending + Savings
Total spending = Consumer spending + Investment spending
So… Consumer spending + Savings = Consumer spending + Investment spending
THEREFORE, SAVINGS = INVESTMENT SPENDING for the economy as a whole.
B.
How the government and rest of the world complicate things
1.
Government budget balance
Surplus –the difference between tax revenue and government spending when tax
revenue exceeds government spending.
Deficit –the difference between tax revenue and government spending when
government spending exceeds tax revenue.
National savings = private savings + the budget balance (total amount of savings
generated by the economy)
2.
Capital inflow
Savings are sometimes spent on physical capital in another country, resulting in inflows
and outflows of capital
Capital inflow (net effect) = total inflow of foreign funds – total outflow of domestic
funds to other countries
If foreign citizens save more money in the US, than Americans save in other nations,
there exists a positive capital inflow of money into the US. This increases domestic
investment. If Americans save more in other nations, than foreign citizens save in the US,
there exists a negative capital inflow of money in the US. This decreases domestic
investment.
Negative capital inflow is not good for a country in the long-run because…some portion
of national savings is funding investment spending in other countries.
3.
The Macro view of the Savings-Investment Identity
Investment spending = savings, whereas savings = national savings + capital inflow
II.
The Financial System
Where households invest current savings and wealth by purchasing financial assets
A.
Financial assets versus physical assets
Financial asset –a paper claim that entitles the buyer to future income from the sellers
Physical asset –a claim on a tangible object that gives the owner the right to dispose of the
object as he or she wishes
B.
Three Tasks of the Financial System
1.
Reducing transaction costs
Transaction costs –expenses of negotiating and executing a deal
How the financial market reduces these:
Instead of dealing with the high costs of negotiating individual loans from thousands of
different people, a business or household can avoid large transaction costs by involving
only a single borrower and a single lender. (Ex. Getting a loan or selling bonds or stock)
2.
Reducing risk
Risk –uncertainty about future outcomes that involve financial losses and gains
How the financial market reduces this:
A well-functioning financial system helps people reduce their exposure to risk by
allowing others to share the risk of investment, even if that requires sharing some of the
profit. The goal in combating risk is achieving diversification.
Diversification – investing in several assets with unrelated, or independent, risks
3.
Providing liquidity
Liquidity – the ability for an asset to quickly be converted into cash without much loss of
capital
How the financial market provides this:
There is always a danger of needing to get money back before the term of a loan is up.
Investing in stocks and bonds are a partial answer to the problem of liquidity.
III.
Types of Financial Assets
Asset (define)
Purpose
Loans – a lending agreement
between an individual lender and
an individual borrower
Loan-backed securities – assets
created by pooling individual loans
and selling shares in that pool (a
process called securitization)
Can help finance a car/house or
purchase of physical capital
*Extremely popular recently*
Provides avenue for a guaranteed
return on investment and
opportunity for banks to give out
more loans
How these function
Advantages/
Disadvantages
A borrower wants to make an
Loans are tailored to the needs of the
investment; a lender wants to
borrower.
make a profit by charging interest Loans typically involve high
on the principal provided up front. transaction costs.
A bank pools similar loans
Provide more diversification and
together and sells the package to
liquidity than individual loans.
investors. Now the investors will
Difficulty in assessing true quality of
receive the monthly payments of
asset.
interest rate and principal. The
bank can now continue to lend
out more money and change loan
origination fees.
Seller of bond promises to pay a
Avoids costly transaction fees and
fixed some of interest each year
easy to resell.
and repay the principal to owner
Risk of bond defaulting: the bond
by designated date.
issuer might fail to make payments
as specified by the bond contract.
Bonds – an IOU issued by the
borrower (firm)
Creates a more streamlined
approach for major corporations
and governments to receive initial
sums of money to invest without
costly negotiations involved with
loans.
Stocks – a share in the ownership
of a company
Few individuals are risk-tolerant
enough to face the risk involved in
being the sole owner of a large
company. By purchasing stock, you
can receive a high rate of return
over time.
If you purchase a share (stock) of
a company, you are entitled to
that given amount of that
company’s profit, as well as that
given amount of votes on
company decisions.
Bank deposits – a claim on a bank
that obliges the bank to give the
depositor his or her cash when
demanded
Holding assets in a bank account is
secure and the quickest way to
access cash. For many
small/moderate size companies,
the cost of issuing bonds and
stocks is too large, given the
modest amount of money needed.
A bank works by first accepting
funds from depositors; when you
put your money in a bank, you are
essentially becoming a lender by
lending the bank your money. The
bank then keeps a fraction of
ready cash and loans the rest.
Business owners can share the risk of
investment and improves welfare of
investors who buy stock.
If a company goes under,
shareholders typically receive
nothing. (Bond is a promise, Stock is
a hope.)
The bank operates on the
assumption that only a small fraction
of its depositors will want their cash
at the same time. A “run on the
bank” may enfold if too many
depositors want their money back at
once.
IV.
Financial Intermediaries
Institutions that transform funds into financial assets ( About ¾ of financial assets Americans own are through
intermediaries)
Intermediary (define)
Mutual funds – a financial
intermediary that creates a stock
portfolio and then resells shares of
this portfolio to individual investors
Pension Funds – nonprofit institutions
that collect the savings of their
members in order to provide
retirement income to its members.
Life Insurance Companies — sell
policies that guarantee a payment to
a policyholder’s beneficiaries when
the policyholder dies.
Banks – financial intermediary that
provides liquid assets in the form of
bank deposits to lenders and uses
those funds to finance the illiquid
investment spending needed of
borrowers.
Purpose
How these function
Advantages/
Disadvantages
By owning a diversified portfolio of If you don’t have a large amount of Investors with less money can hold
stocks—a group of stocks in which money to invest, building a
a diversified portfolio, and achieve
risks are unrelated to, or offset,
diversified stock portfolio can incur a better return for any given level
one another—rather than
high transaction costs. Mutual
of risk.
concentrating investment in the
funds solve this problem without
Mutual funds charge fees for their
shares of a single company or a
high cost.
services, especially if mutual funds
group of related companies,
claim to have special expertise in
investors can reduce their risk. This
investing money, your fees can be
applies to diversifying your entire
quite high.
wealth by holding other assets.
“Savings today, rewards
tomorrow.”
Provides retirees income based off
of the amount previously saved by
the retirees.
By enabling policy holders to
cushion their beneficiaries from
financial hardship arising from
their death, life insurance
companies also improve welfare
by reducing risk.
(same as bank deposits)
Pension funds function much like
“Must save for a rainy day.”
mutual funds. They invest in a
To have money in the future, you
diverse array of financial assets,
must forgo spending it now.
allowing their members to achieve
more cost-efficient diversification
and conduct more market research
than they would be able to
individually.
(same as bank deposits)
(same as bank deposits)