Savings, Investment Spending,
and the Financial System
Matching Up Savings and
Investment Spending
•
The Savings-Investment Spending Identity
•
•
Savings and Investment spending are always
equal.
Closed Economy
GDP = C + I + G + X - IM
GDP = C + I + G + 0 - 0
=
GDP = C + G + S
GDP = C + I + G
C+G+S
S
=
C+I+G
=
I
=
Matching Up Savings and
Investment Spending
•
Households can save.
•
Governments can save.
•
Budget surplus exists when tax revenue is
greater than government spending.
•
Budget deficit exists when tax revenue is
less than government spending.
SG = T – G - TR
SN = SG + S P
SN = I
Brittania (Closed Economy)
•
Given:
•
•
•
•
GDP = $1,000 million
T = $50 million
C = $850 million
G = $100 million
No government transfers
What is the level of investment spending
and private savings?
GDP = C + I + G
•
What is the budget balance?
SG = T – G - TR
•
Is national savings equal to investment
spending?
S =S +S
N
G
P
Matching Up Savings and
Investment Spending
•
Open Economy
Net capital inflow is the total inflow into a country minus
the total outflow of funds out of a country.
NCI = IM - X
+NCI means investment spending funded by
savings from foreigners.
-NCI means investment spending funded by
investment in other countries.
GDP = C + I + G + (X – IM)
GDP – C – G – X + IM = I
I = GDP – C – G – X + M
I = SN – X + IM
I = SN + NCI
GDP = C + G + SN
GDP – C – G = SN
SN = SG + S P
SN – X + IM = I
or
SN + NCI = I
Share
Of GDP
25%
20%
Japan, 2007
United States, 2007
Capital
Inflow
15%
Investment
Spending
10%
Investment
Spending
Private
Savings
Private
Savings
5%
Budget Deficit
Capital Inflow
Budget Deficit
Regalia (Open Economy)
•
Given:
•
•
•
•
•
GDP = $1,000 million
G = $100 million
C = $850 million
X = $100 million
T = $50 million
IM = $125 million
No government transfers
What is the level of investment spending
and private savings?
SG = T – G - TR
I = (GDP – C – G) + (IM – X)
•
SN = SG + S P
What are the budget balance and net
capital inflow?
SG = T – G - TR
NCI = IM - X
Capsland
•
Capsland
•
•
•
•
Investment spending as percentage of GDP = 20%
Private savings as a percentage of GDP = 10%
Net capital inflow as a percentage of GDP = 5%
What is the budget balance as a percentage of
GDP?
Practice: Marsalia
•
Marsalia
•
•
•
•
Investment spending as percentage of GDP = 20%
Private savings as a percentage of GDP = 25%
Net capital inflow as a percentage of GDP = -2%
What is the budget balance as a percentage of
GDP?
Open Economy Examples
SN + NCI = I
•
•
NCI = IM - X
SN = SG + S P
SG = T – G - TR
If X = $125 m., IM = $80 m., BB = -$200 m., I = $350 m.,
what is private savings?
If X = $60 m., IM = $95 m., PS = $325 m., I = $300 m,,
what is the budget balance?
Open Economy Practice
SN + NCI = I
•
•
NCI = IM - X
SN = SG + S P
SG = T – G - TR
If X = $85 m., IM = $135 m., BB = $100 m., PS = $250 m.,
what is I?
If PS = $325 m., I = $400 m., BB = 10 m., what is NCI?
Market for Loanable Funds (LF)
•
•
•
•
•
•
Financial markets channel the
savings of households to
business that want to borrow to
purchase capital equipment.
Financial markets bring together
borrowers and lenders.
Examples of different financial
markets are bond markets and
stock markets.
There is a demand for loanable
funds and a supply of loanable
funds.
The price determined in the
loanable funds market is the
interest rate.
Note the model shows real
interest rate.
S
12%
A
E
B
4%
D
$150
$500
Shifts of the Demand for LF
• Changes
•
•
in Business Expectations
Optimism leads to increased demand of LF.
Pessimism leads to declining demand of LF.
• Changes
in Government Borrowing
• •Increased
government borrowing leads to
increased demand of LF.
•
Decreased government borrowing leads to
declining demand of LF.
Demand and Supply of LF
Market for Loanable Funds (LF)
•
•
•
•
•
•
Increase in demand shifts
demand curve outward.
This leads to an increase in the
interest rate.
Cost of businesses to borrow to
finance capital investment
increases (ir )leading to less
capital investment by business.
If government is borrowing, then
the rise in the interest rate
crowds out private business
investment.
Concerns about crowding out
are one key reason to worry
about increasing or persistent
budget deficits.
Crowding out may not occur if
the economy is depressed.
S1
12%
E2
E1
D2
4%
D1
$150
$500
Shifts of the Supply for LF
• Changes
•
•
More savings increases the supply of LF.
Less savings decreases the supply of LF.
•
Between 2000 and 2006, rising home prices made
homeowners feel richer, making then spend more
and save less.
• Changes
• •Increased
LF.
•
in Private Savings Behavior
in Net Capital Inflows
capital inflows increases the supply of
Decreased capital inflows leads to declining
supply of LF.
Market for Loanable Funds (LF)
•
•
Increase in supply shifts the
supply curve outward.
This leads to an decrease in the
interest rate.
S1
12%
E1
S2
E2
4%
D1
$150
$500
What happens in the market for LF?
•
•
•
•
•
Assume closed economy.
The government reduces
the size of its deficit to zero.
At any given interest rate,
consumers decide to save
more. Assume the budget
balance is zero.
At any given interest rate,
businesses become very
optimistic about the future
profitability of investment
spending. Assume the
budget balance is zero.
•
What happens to:
•
•
•
Private savings
Private investment spending
Interest rate
Practice: Loanable Funds
•
•
•
Assume a closed economy.
The government is running a
budget balance of zero
where it decides to increase
education spending by $100
billion and finance the
spending by selling bonds.
Use the diagram to show:
How will the equilibrium
interest rate and the
equilibrium quantity of
loanable funds change?
Is there any crowding out in
the market?
Inflation and Interest Rates
•
•
•
•
•
•
•
•
•
•
Shifts in the supply and demand curves for LF changes
the interest rate. Model based upon real interest rate.
Real interest rate = Nominal interest rate – Inflation rate.
Loans to borrowers are specified with the nominal interest.
Economist named Fisher modeled how the expectations
of borrowers and lenders about future inflation rate
impact the real interest rate.
The expected real
interest rate is
unaffected by
changes in
expected
future inflation.
D
(Fisher)
10
•
Fifty Years of US Interest Rates
Where are the large movements in
US interest rates?
Other surveys reveal that expected
inflation didn’t change. What
happened?
The Financial System
•
•
•
•
•
•
Financial markets are where households invest
their current savings and their accumulated
savings, or wealth by purchasing financial assets.
A financial asset is a paper claim that entitles the
buyer to future income from the seller.
A physical asset is a tangible object that can be
used to generate future income.
An investment is the purchase of a financial or
physical asset.
A liability is a requirement to pay
income in the future.
Loans, stocks, bonds, and bank deposits are
types of financial assets.
Three Tasks of a Financial System
1.
Reduce the transaction costs
2.
Reduce the financial risk
3.
Provide liquidity
Types of Financial Assets
•
•
•
•
A loan is a lending agreement between
an individual lender and an individual
borrower.
The seller of a bond agrees to pay a fixed
sum of interest each year and to repay
the principal.
Loan-backed securities are assets created
by pooling individual loans and selling
shares in a pool.
A share of a stock is a financial asset from
its owner’s point of view and a liability
from the company’s point of view.
Financial Intermediaries
•
•
•
•
A mutual fund is a financial intermediary that
creates a stock portfolio and then resells shares
of this portfolio to individual investors.
A pension fund is a type of mutual fund that
holds assets in order to provide retirement
income to its members.
Life insurance companies sell policies which
guarantee a payment to policyholder’s
beneficiaries when the policyholder dies.
A bank deposit is a claim on a bank that obliges
the bank to give the depositor his or her cash
when demanded.
Financial Fluctuations
•
•
•
•
Demand for stocks is based upon investors’
beliefs about the future value or price of the
asset.
Stock prices are determined by the supply and
demand for shares.
Stock prices are also affected by changes in the
attractiveness of substitute assets, like bonds.
Demand for other assets is similar
to stock—including physical assets
like real estate.
Asset Price Expectations
The efficient markets hypothesis means that
asset prices always embody all publicly
available information and so at any point in
tick stock prices are fairly valued.
1.
1.
2.
Prices change only in response to new information
about the underlying fundamentals; hence
movement of prices follow a random walk.
Markets often behave irrationally.
Asset Prices and Macroeconomics
•
•
Economists generally believe in efficient
markets hypothesis--imply no government
interference.
Concern about two huge asset bubbles
which created major macroeconomic
problems when it burst.
•
•
Late 1990’s, the price of technology stocks
collapsed and caused the 2001 recession.
In 2008, the collapse of housing prices
triggered the severe financial crisis followed
by a deep recession.
Practice:
•
•
•
•
•
•
For each of the following, is it an example of
investment spending, investing in financial assets,
or investing in physical assets?
Rupert Moneybucks buys 100 shares of existing
Coca Cola stock.
Rhonda Moviestar spends $10 million to buy a
mansion built in the 1970s.
Ronald Baskerballstar spends $10 million to build
a new mansion with a view of the Pacific Ocean.
Rawlings builds a new plan to make catcher’s
mits.
Russia buys $100 million, in US government bonds.
Practice:
• How
would you respond to a friend
who claims that the government
should eliminate all purchases that
are financed by borrowing because
such borrowing crowds out private
investment spending?
Practice:
•
•
•
•
•
Explain the effect on a company’s stock price
today of each of the following events, other
things held constant.
The interest rate on bonds falls.
Several companies in the same sector announce
surprisingly higher sales.
A change in the tax law passed last year
reduces this year’s profit.
The company unexpectedly announces that
due to an accounting error, it must amend last
year’s accounting statement and reduce last
year’s reported profit by $5 million. It also
announces that this change has no implications
for future profits.
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