Chapter: 10
Savings, Investment
>> Spending, and the
Financial System
Krugman/Wells
©2009  Worth Publishers
Matching Up Savings and Investment Spending





A major function of the financial system is to transfer
funds from those who have more than they currently
need (saving) to those who need more than they
currently have (investment spending)
Needed so that business firms will be able to purchase
the physical capital goods that are a source of
productivity growth.
Needed so that savers don’t get stuck earning nothing
on their surplus funds.
This occurs because those who purchase both
physical and human capital by necessity often use
other peoples funds for their purchases.
According to the savings–investment spending
identity, savings and investment spending are always
equal for the economy as a whole.
Indirect Finance
Funds
Deposits
Shares
Polices
Financial
Intermediaries
Commercial Banks
Savings & Loans
Credit Unions
Mutual Funds
Money Market Mutual Funds
Pension Funds
Life Insurance
Illiquid Assets
Loans, etc
Borrowers
Spenders
Funds
Lenders
Savers
Illiquid,
Risky
Assets
Funds
Funds
Financial Markets
Stocks
Bonds
Treasury Bills
Other
Direct Finance
Illiquid,
Risky
Assets
Funds
Matching Up Savings and Investment Spending
If most investment spending comes from business
firms, where does the saving come from?
1. Private saving from individual citizens, and business
firms with a lack of investment opportunities.
2. Public saving from governments

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

SG = Taxes – Transfers – Purchases
A budget surplus – positive government saving
A budget deficit – negative government saving
3. Foreign saving


If foreign citizens put funds (net) into another country
this is called a Capital inflow.
National Savings is the sum of Private Saving and
Government saving.

The total amount of savings generated within the
economy.
The Savings–Investment Spending Identity

In a simplified private economy:
(1) Total Income = Total Spending
(2) Total income = C + S

Spending consists of either consumption spending or
investment spending:
(3) Total spending = C + I

Putting these together, we get:
(4) C + S = C + I

Subtract consumption spending from both sides, and
we get:
(5) S = I
PITFALLS
Investment versus investment spending


When macroeconomists use the term investment spending,
they almost always mean “spending on new physical capital.”
This can be confusing, because in ordinary life we often say
that someone who buys stocks or purchases an existing
building is “investing.”
The important point to keep in mind is that only spending that
adds to the economy’s stock of physical capital is
“investment spending.” In contrast, the act of purchasing an
asset such as a share of stock, a bond, or existing real estate is
“making an investment” or better yet a “portfolio decision”.
The Savings–Investment Spending Identity

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
In an open economy, foreigners can also put funds
into a country, which is called a capital inflow (KI).
If saving in a country is not high enough for the
amount of investment spending in an economy,
foreigners can put their savings into that country (if the
rate of return is good enough).
When they do this the country that receives the capital
inflow will always run a trade deficit.
Therefore, a trade deficit is a rough measure of a net
capital inflow.
The next slide shows this in symbols.
The Savings–Investment Spending Identity
Private Saving:
SP = GDP + TR − T − C
Government Saving: SG = T − TR − G
National Saving: NS = SP + SG =
(GDP + TR − T − C) + (T − TR − G) = GDP − C − G.
 In an open economy: GDP = C + I + G + X – IM so
NS = GDP – C – G = I + X – IM.
 Therefore, NS = I + X – IM or: I = NS + (IM – X)



IM – X is the trade deficit, which is the measure of a
capital inflow (that is how foreigners earn income to
save in another country)
Investment spending = National savings + Capital
inflow in an open economy
I = NS + KI or I = SP + SG + KI
The Savings–Investment Spending Identity
Share
of GDP
25%
Share
of GDP
25%
(a) United
States
20
15
10
5
0
Investment
–5
spending
Budget
deficit
–10
Capital
inflows
20
Private
savings
10
(b) Japan
15
Private
savings
5
0
Savings
–15
Investment Capital
–5
spending outflows
–10
–15
Budget
deficit
Savings
Japanese investment spending
U.S. investment spending in
2007 = equal to 18.8% of GDP in 2007 = 23.8% of GDP.
Financed by a combination of
private savings (15.7% of GDP)
and capital inflows (5.2% of
GDP), which were partially
offset by a budget deficit
(−1.6% of GDP).
Source: Bureau of Economic Analysis; OECD.
It was financed by a higher
level of private savings as a
percentage of GDP (32.1%),
which was offset by both a
capital outflow (−4.9% of GDP)
and a relatively high budget
deficit (−3.4% of GDP).
PITFALLS
The different kinds of capital





It’s important to understand clearly the three different kinds of
capital: physical capital, human capital, and financial capital.
Physical capital consists of manufactured resources such as
buildings and machines.
Human capital is the improvement in the labor force generated
by education and knowledge.
Financial capital is funds from savings that are available for
investment spending.
So a country that has a positive capital inflow is experiencing a
flow of funds into the country from abroad that can be used for
investment spending.
FOR INQUIRING MINDS
Who Enforces the Accounting?


The savings–investment spending identity is a fact of
accounting. By definition, savings equals investment spending
for the economy as a whole. But who enforces the arithmetic?
The short answer is that actual and desired investment
spending aren’t always equal.




Suppose that households suddenly decide to save more by
spending less.
The immediate effect will be that unsold goods pile up. And this
increase in inventory counts as investment spending, albeit
unintended.
So the savings–investment spending identity still holds.
Similarly, if households suddenly decide to save less and spend
more, inventories will drop—and this will be counted as
negative investment spending.
The Market for Loanable Funds


The loanable funds market is a hypothetical market
that examines the market outcome of the demand for
funds generated by borrowers and the supply of funds
provided by lenders.
The interest rate is the price, calculated as a
percentage of the amount borrowed, charged by the
lender to a borrower for the use of their savings for
one year.

The interest rate is what determines the allocation of
savings in the loanable funds market
The Market for Loanable Funds



From chapter 11 we determined that a business firm
will purchase a capital goods project if the
rate of return >= interest rate.
The rate of return on a project is the profit earned on
the project expressed as a percentage of its cost.
There are usually more projects at lower rates of return
than at higher rates of return.
 So as interest rates decline, more projects become
profitable and more investment spending is done.
Therefore, the demand for loanable funds will be
downward sloping.
The Demand for Loanable Funds
Interest rate
12
10
A
8
6
4
2
B
Factors that can cause the demand
curve for loanable funds to shift
include:
1. Changes in perceived
business opportunities
Changes in technology,
investment tax credits, “animal
spirits”
2. Changes in the
government’s borrowing
Demand for loanable funds
0
$150
$550
Quantity of loanable funds ($ billions)
The demand curve for loanable funds slopes downward: the lower
the interest rate, the greater the quantity of loanable funds
demanded
The Supply of Loanable Funds

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
Savers make a sacrifice of current consumption, that
is their opportunity cost.
Interest earned on their saving is the reward for
sacrificing current consumption; that is they get
greater future consumption.
So we would expect that the higher the interest rate
the more households would be willing to sacrifice
current consumption, that is they would save more.
Therefore, the supply of loanable funds will be upward
sloping.
The Supply for Loanable Funds
Interest rate
Supply of
loanable funds
12
10
B
8
6
4
A
2
0
$100
Factors that can cause the supply of
loanable funds to shift include:
1. Changes in private savings
behavior
2. Changes in capital inflows
$450
Quantity of loanable funds ($ billions)
The supply curve for loanable funds slopes upward: the higher
the interest rate, the greater the quantity of loanable funds
supplied.
Shifts of the Supply for Loanable Funds

Factors that can cause the supply of loanable funds
to shift include:


Changes in private savings behavior: Between
2000 and 2006 rising home prices in the United States
made many homeowners feel richer, making them
willing to spend more and save less This shifted the
supply of loanable funds to the left.
Changes in capital inflows: The U.S. has received
large capital inflows in recent years, with much of the
money coming from China and the Middle East. Those
inflows helped fuel a big increase in residential
investment spending from 2003 to 2006. As a result of
the worldwide slump, those inflows began to trail off in
2008.
Equilibrium in the Loanable Funds Market
Interest rate Projects with rate of return
6% or greater are funded.
12
S
10
8
r* 6
Offers not accepted from
lenders (to borrowers) who
demand interest rate of more
than 6%.
Projects with rate of return
less than 6% are not funded.
E
4
2
0
Offers accepted from
lenders (to borrowers) willing
D
Q*
to lend at interest rate of 6% or
less.
$400
Quantity of loanable funds ($ billions)
At the equilibrium interest rate, the quantity of loanable funds
supplied equals the quantity of loanable funds demanded.
Here, the equilibrium interest rate is 6%, with $400 billion of funds
lent and borrowed.
An Increase in the Demand for Loanable Funds
Interest rate
..
. leads to
a rise in the
equilibrium
interest rate.
If the quantity of funds demanded by borrowers rises at
any given interest rate, the demand for loanable funds
shifts rightward from D1 to D2
S1
E2
r2
r1
An increase
in the demand
for loanable
funds . . .
E
1
D2
D1
Q1
Q2
Quantity of loanable funds ($ billions)
Crowding
out occurs when a government deficit drives up the
interest rate and leads to reduced investment spending.
An Increase in the Supply for Loanable Funds
Interest rate
. leads to
a fall in the
equilibrium
interest rate.
An increase
in the
supply of
loanable
funds . . .
..
S1
S2
E1
r1
E2
r2
D1
Q1
Q2
Quantity of loanable funds ($ billions)
If the quantity of funds supplied by lenders rises at any given
interest rate, the supply of loanable funds shifts rightward from S1
to S2
Inflation and Interest Rates


Anything that shifts either the supply of loanable funds
curve or the demand for loanable funds curve changes the
interest rate.
Historically, major changes in interest rates have been
driven by many factors, including:


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
Changes in government policy, such as incentives to invest
or increases and decreases in budget deficits.
Technological innovations that created new investment
opportunities.
However, arguably the most important factor affecting
interest rates over time is changing expectations about
future inflation.
This shifts both the supply and the demand for loanable
funds.
This is the reason, for example, that interest rates today
are much lower than they were in the late 1970s and early
1980s.
Inflation and Interest Rates
Real interest rate = nominal interest rate - expected inflation rate


In the real world neither borrowers nor lenders know
what the future inflation rate will be when they make a
deal.
Actual loan contracts, therefore, specify a nominal
interest rate rather than a real interest rate.
Nominal interest rate = real interest rate + expected inflation rate

According to the Fisher effect, an increase in
expected future inflation drives up the nominal interest
rate, leaving the expected real interest rate
unchanged.
The Fisher Effect
Nominal Interest rate
14
4
D0 and S0 are the
demand and supply
curves for loanable funds
when the expected future
inflation rate is 0%.
S10
E10
S0
E0
D10
An increase in expected
future inflation pushes both
the demand and supply
curves upward by 1 % for
every 1 % increase in
expected future inflation
D0
Q1
Quantity of loanable funds ($ billions)
The expected real interest rate remains at 4%, and the equilibrium
quantity of loanable funds also remains unchanged.
►ECONOMICS IN ACTION
Changes in the U.S. Interest Rates Over Time
(b) Changes in Expected Rate of Return on
Investment Spending and Interest Rates
(a) Changes in Expected
Inflation and Interest Rates
10-Year
Treasury
constant
maturity rate,
inflation rate
10-Year
Treasury
constant
maturity rate
During 1998–2008, expectations of
future inflation were relatively
constant, but the interest rate first
rose and then fell sharply
16%
7%
14
12
6
10
8
5
6
4
4
2
3
1958
1970
1980
1990
2000
2008
Year
1998
2000
2002
2004
2006
2008
Year
High current inflation leads to expectations of high future inflation,
which results in a rise in the interest rate.
The Financial System: Definitions



A household’s wealth is the value of its accumulated
savings.
A financial asset is a paper claim that entitles the
buyer to future income from the seller. This takes
place in financial markets
A physical asset is a claim on a tangible object that
gives the owner the right to dispose of the object as he
or she wishes.


The purchase of a preexisting asset is called investing,
while to spend funds to add to the capital stock (a new
capital good) is referred to as investment spending.
A liability is a requirement to pay income in the future.



Wealth = Value of Assets – Value of Liabilities
An asset to one person or financial institution is a
liability to another.
A loan is an asset to a bank, but a liability to a firm.
The Financial System: Definitions

Transaction costs are the expenses of negotiating
and executing a deal.


These can include brokerage fees, loads for mutual
funds, time it takes to go to a bank.
Financial risk is uncertainty about future outcomes
that involve financial losses and gains.

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

Some assets are riskier than others.
Some participants want to reduce this risk and some
are willing to take on more risk – for a price.
Most people are risk averse – don’t like risk unless
given suitable compensation – higher expected returns.
Risk averse individuals are willing to compensate others
who take on risk they don’t.
Risk-Averse Attitudes Toward Gain and Loss
Change in
individual
welfare
(a) Typical Individual
Welfare gain from
gaining $1,000
Change in
individual
welfare
$1,000
$1,000
0
0
Welfare loss from
losing $1,000
–1,200
(b) Wealthy Individual
Welfare gain from
gaining $1,000
Welfare loss from
losing $1,000
–2,000
Differences in wealth lead to differences in attitudes toward risk.
The typical individual represented in panel (a) experiences a
$1,000 loss as a much more significant hardship than the wealthy
individual represented in panel (b).
This reflects the fact that wealthy individuals, although still riskaverse, tend to be more tolerant of risk than individuals of modest
means.
Three Tasks of a Financial System

Reducing transaction costs ─ the cost of making a deal.


By specializing and doing may similar types of
transactions financial institutions can take advantage of
economies of scale and lower transactions cost.
Reducing financial risk – uncertain outcomes gains/losses

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

Limited liability with corporations means you can only
lose what you put into that business.
Sell stock to others who are willing to take some of the
risk for you in exchange for expected profit.
An individual can engage in diversification by
investing in several different things so that the possible
losses are independent events.
Mutual funds or exchange traded funds do this for you.
Banks offer products where you are guaranteed not to
lose any principal over time.
Reducing Financial Risk
Risk Sharing – A borrower can transfer risk to many different
savers
Saver A
Financial Asset
Saver B
issued by a
corporation
Saver C
Risk Diversification - by purchasing financial assets from
many different borrowers (who face separate types of risks)
a saver can stabilize returns.
Asset A from Corporation 1
Portfolio of
a Saver
Asset B from Corporation 2
Asset C from Corporation 3
Three Tasks of a Financial System

Providing liquid assets

An asset is liquid if it can be quickly converted into
cash without a great loss of value.




The greater the number of participants in a given market
for an asset the greater the liquidity.
An asset is illiquid if it cannot be quickly converted into
cash or it loses a large amount of it’s value if it has to be
sold for cash quickly.
Risk and illiquidity go together. Illiquid assets have
greater risk.
Cash and their equivalents are the ultimate in liquidity.
The financial system provide a continuum of liquid to
illiquid assets.
Types of Financial Assets


There are four main types of financial assets:
Loans




a lending agreement between a particular lender and a
particular borrower. Car loans and Mortgages are
examples.
Somewhat high transactions costs
A default occurs when a borrower fails to make
payments as specified by the loan or bond contract.
Bonds




an IOU issued by a borrower to many buyers
Pays periodic interest and principal at maturity
Somewhat high transactions costs since have to
investigate the company. Bond rating agencies can
help with that.
Easier to resell than loans, more liquid than loans
Types of Financial Assets

A Loan-backed security is an asset created by
pooling individual loans and selling shares in that pool.



Stocks



This is called securitization.
Any pool of assets can work, but the most common are
mortgage backed securities, which have been aided by
the government is establishing a market
Represent ownership in a corporation. Reduces risk of
ownership.
Entitles owner to future profit of firm. If firm goes
bankrupt the value of a stock is $0
Bank deposits


is a claim on a bank that obliges the bank to give the
depositor his or her cash when demanded.
Checking accounts, savings accounts, certificate of
deposits. Safe, liquid assets that have low return.
Financial Intermediaries


A Financial intermediary is an institution that
transforms the funds it gathers from many individuals
into financial assets.
A mutual fund is a financial intermediary that creates
a stock portfolio and then resells shares of this
portfolio to individual investors.


There are many types of mutual funds that hold more
than just stocks. Some hold only very safe government
bonds, other hold real estate, gold, other much riskier
assets
A pension fund is a type of mutual fund that holds
assets in order to provide retirement income to its
members.


These are for defined benefit plans
Often referred to an institutional investors
Financial Intermediaries

A life insurance company sells policies that
guarantee a payment to a policyholder’s beneficiaries
when the policyholder dies.


This reduce risk to the policyholders family and some
policies can act like a savings account.
A bank is a financial intermediary that provides liquid
assets in the form of bank deposits to lenders and
uses those funds to finance the illiquid investments or
investment spending needs of borrowers.



A bank lends most of it’s deposit in order to earn profit.
It borrows short term and lends long term so it can have
a cash flow problem (only if all depositor try to take their
funds out at the same time).
Deposit insurance from the FDIC helps with this
potential problem.
Financial Fluctuations


Financial market fluctuations can be a source of
macroeconomic instability.
Stock prices are determined by supply and demand as
well as the desirability of competing assets, like
bonds:




A stock price is a reflection of what investor’ believe
about expected profits of that company.
If investors believe that it will be worth more in the
future, they will demand more of the asset today at any
given price.
Consequently, today’s equilibrium price of the asset will
rise.
When the interest rate rises, stock prices generally fall
and vice versa since interest on a bond is more of a
“sure thing” than expected profits.
Financial Fluctuations

A single family home or condo is an illiquid asset.





The owner pays a “rent” to themselves.
The price of a house depends on what house buyers
believe about the future “rents” of housing.
If expected “rent” rises or house prices are expected
to rise in the future, this increases demand for
housing and prices rise today.
Interest rates, income, and the prices of competing
assets also have an influence on demand.
If interest rates rise, mortgages are more expensive
and demand will fall and so will house prices.
FOR INQUIRING MINDS
How Now, Dow Jones?



Financial news reports often lead with the day’s stock market
action, as measured by changes in the Dow Jones Industrial
Average, the S&P 500, and the NASDAQ. All three are stock
market indices. Like the consumer price index, they are
numbers constructed as a summary of average prices.
The Dow, created by the financial analysis company Dow
Jones, is an index of the prices of stock in 30 leading
companies, The S&P 500 is an index of 500 companies,
created by Standard and Poor’s. The NASDAQ is compiled by
the National Association of Securities Dealers.
The movement in an index gives investors a quick, snapshot
view of how stocks from certain sectors of the economy are
doing.
Financial Fluctuations: Asset price expectations



There are two principal competing views about how
asset price expectations are determined.
One view, which comes from traditional economic
analysis, emphasizes the rational reasons why
expectations should change.
The other, widely held by market participants and also
supported by some economists, emphasizes the
irrationality of market participants.
Financial Fluctuations: Asset price expectations


One view of how expectations are formed is the
efficient markets hypothesis, which holds that the
prices of financial assets embody all publicly available
information.
Investors looks at fundamentals:




Consumer buying habits, tax policy, cost of production,
management, etc.
Any new “news” about a company will change the price
of the stock.
It implies that fluctuations are inherently unpredictable
on a daily basis—they follow a random walk.
It also implies that it is very difficult to beat the
“market” on a regular basis.
Irrational Markets?

Many market participants and some economists
believe that, based on actual evidence, financial
markets are not as rational as the efficient markets
hypothesis claims.






This would mean you could use technical means to
figure out stock prices.
Using charts, moving averages, patterns, to evaluate
stock price.
It is more likely to happen in illiquid markets.
This could lead to “bubbles”.
There is some evidence that stock price fluctuations
are too great to be driven by fundamentals alone.
However, you can always get lucky once, but it is still
very difficult to beat the market over long periods of
time since investors will exploit any pattern to earn
profit.
►ECONOMICS IN ACTION
The Great American Housing Bubble




Between 2000 and 2006, there was a huge increase in
the price of houses in America. A number of
economists argued that this price increase was
excessive—that it was a “bubble”.
Yet there were also a number of economists who
argued that the rise in housing prices was completely
justified.
They pointed, in particular, to the fact that interest
rates were unusually low in the years of rapid price
increases.
They argued that low interest rates combined with
other factors, such as growing population, explained
the surge in prices.
►ECONOMICS IN ACTION
The Great American Housing Bubble




Alan Greenspan, the chairman of the Federal
Reserve, conceded in 2005 that there might be some
“froth” in the markets but denied that there was any
national bubble.
Unfortunately, it turned out that the skeptics were right.
Greenspan himself would later concede that there
had, in fact, been a huge national bubble.
In 2006, as home prices began to level off, it became
apparent that many buyers had held unrealistic
expectations about future prices.
Home prices began falling, and the demand for
housing fell drastically.
►ECONOMICS IN ACTION
The Great American Housing
Bubble
New
Index
(2000 = 100)
single-family
houses sold
(thousands)
220
200
1,400
180
1,200
160
140
1,000
120
800
100
600
80
2000
2002
2004
2006
2008
Year
There was a large run-up in home
prices after 2000, which some
economists argued was not justified
by fundamentals.
By 2007 it was clear that there had
indeed been a bubble driven by
unrealistic expectations about future
prices.
2000
2002
2004
2006
2008
Year
When expectations of rising prices
turned into expectations of falling prices,
the demand for homes slumped.
SUMMARY
1. Investment in physical capital is necessary for long-run
economic growth. So in order for an economy to grow, it
must channel savings into investment spending.
2. According to the savings–investment spending identity,
savings and investment spending are always equal for the
economy as a whole. The government is a source of
savings when it runs a positive budget balance or budget
surplus; it is a source of dissavings when it runs a
negative budget balance or budget deficit. In a closed
economy, savings is equal to national savings, the sum of
private savings plus the budget balance. In an open
economy, savings is equal to national savings plus capital
inflow of foreign savings. When a capital outflow, or
negative capital inflow, occurs, some portion of national
savings is funding investment spending in other countries.
SUMMARY
3. The hypothetical loanable funds market shows how loans
from savers are allocated among borrowers with
investment spending projects. In equilibrium, only those
projects with a rate of return greater than or equal to the
equilibrium interest rate will be funded. By showing how
gains from trade between lenders and borrowers are
maximized, the loanable funds market shows why a well
functioning financial system leads to greater long-run
economic growth. Government budget deficits can raise
the interest rate and can lead to crowding out of
investment spending. Changes in perceived business
opportunities and in government borrowing shift the
demand curve for loanable funds; changes in private
savings and capital inflows shift the supply curve.
SUMMARY
4. Because neither borrowers nor lenders can know the future
inflation rate, loans specify a nominal interest rate rather
than a real interest rate. For a given expected future inflation
rate, shifts of the demand and supply curves of loanable
funds result in changes in the underlying real interest rate,
leading to changes in the nominal interest rate. According to
the Fisher effect, an increase in expected future inflation
raises the nominal interest rate one-to-one so that the
expected real interest rate remains unchanged.
SUMMARY
5. Households invest their current savings or wealth by
purchasing assets. Assets come in the form of either a
financial asset or a physical asset. A financial asset is
also a liability from the point of view of its seller. There are
four main types of financial assets: loans, bonds, stocks,
and bank deposits. Each of them serves a different
purpose in addressing the three fundamental tasks of a
financial system: reducing transaction costs—the cost of
making a deal; reducing financial risk—uncertainty about
future outcomes that involves financial gains and losses;
and providing liquid assets— assets that can be quickly
converted into cash without much loss of value (in contrast
to illiquid assets, which are not easily converted).
SUMMARY
6. Although many small and moderate-size borrowers use
bank loans to fund investment spending, larger companies
typically issue bonds. Bonds with a higher risk of default
must typically pay a higher interest rate. Business owners
reduce their risk by selling stock. Although stocks usually
generate a higher return than bonds, investors typically wish
to reduce their risk by engaging in diversification, owning a
wide range of assets whose returns are based on unrelated,
or independent, events. Most people are risk-averse. Loanbacked securities, a recent innovation, are assets created
by pooling individual loans and selling shares of that pool to
investors. Because they are more diversified and more
liquid than individual loans, trading on financial markets like
bonds, they are preferred by investors. It can be difficult,
however, to assess their quality.
SUMMARY
7. Financial intermediaries—institutions such as mutual
funds, pension funds, life insurance companies, and
banks—are critical components of the financial system.
Mutual funds and pension funds allow small investors to
diversify, and life insurance companies reduce risk.
8. A bank allows individuals to hold liquid bank deposits that
are then used to finance illiquid loans. Banks can perform
this mismatch because on average only a small fraction of
depositors withdraw their savings at any one time. Banks
are a key ingredient of long-run economic growth.
SUMMARY
9. Asset market fluctuations can be a source of short-run
macroeconomic instability. Asset prices are determined by
supply and demand as well as by the desirability of
competing assets, like bonds: when the interest rate rises,
prices of stocks and physical assets such as real estate
generally fall, and vice versa. Expectations drive the supply
of and demand for assets: expectations of higher future
prices push today’s asset prices higher, and expectations of
lower future prices drive them lower. One view of how
expectations are formed is the efficient markets
hypothesis, which holds that the prices of assets embody
all publicly available information. It implies that fluctuations
are inherently unpredictable—they follow a random walk.
SUMMARY
10.Many market participants and economists believe that,
based on actual evidence, financial markets are not as
rational as the efficient markets hypothesis claims. Such
evidence includes the fact that stock price fluctuations are
too great to be driven by fundamentals alone. Policy makers
assume neither that markets always behave rationally nor
that they can outsmart them.