Chapter 10. Savings and Investment
Chapter 10. Savings and Investment
Link to syllabus
The discussion about the Financial
System (pp. 291-304) might have been
a bit shorter, but it is very important
material in today’s world.
Savings/investment identity [accounting identity] [two versions]
Start out ignoring government and foreign trade.
Total Income = Consumption + Savings
Expenditures = Consumption + Investment
In equilibrium, Income = Expenditures,
So, Savings = Investment (p. 277)
Key Keynesian insight: savers and investors are different people, and are
affected by different economic factors. Consumption/saving affected
by income, ‘future plans,’ perhaps interest rates. Business investors
look at profitability.
Different in classical times. (Henry Ford)
With government and foreign trade, we have budget surplus/deficit and
capital inflows adding to savings. (Note: cap inflows = Imp-Exp)
Income = C + Savings + Taxes + Imports
Expenditure = C + Investment + Gov’t + Exports
So, Invest = Savingsperson + (Taxes-Gov’t) + (Imports – Exports)
Or Invest = Savingspersonal + (Taxes-Gov’t) + capital inflows.
(Personal savings, govn’t savings, foreign savings)
Savings-Investment Identity: US and Japan Fig.10-1, p.260
Shows how capital inflows (or outflows) combine with private
savings to finance domestic investment.
Savings-Investment Identity: US and
Japan Fig.10-1, p. 279
Shows how capital inflows (or outflows)
combine with private savings to finance
domestic investment. Japan has trade
surplus, we have a deficit. They have a
gov’t deficit, as does US.
2
Global Data: Savings Rates, 2007. p. 261
U.S. has relatively low savings rates.
Global Data: Savings Rates, 2007. p. 286
US has low savings rate. Important
because Savings-investment are
important to growth.
The Loanable Funds Market
Explain what is meant by loanable funds. Contrast modern-corporative
model with old-style version. Mention also that corporations still
finance some of their investments with retained earnings. Mention
venture capitalists.
The Demand for Loanable Funds. Fig 10-2, p. 281
Depends on:
Opportunities for business investments
Financing of government deficits
The Supply of Loanable Funds. Fig 10-3 p. 264
Depends on:
Individuals’ savings habits
International loans
Equilibrium in the Loanable Funds Market. Fig 10-4 p. 264
The Demand for Loanable Funds. Fig
10-2, p. 281
Depends on perceived business
opportunities, and government
borrowing.
Supply of Loanable Funds. Fig 10-3 p.
283
Depends on private savings behavior,
capital inflows.
Both also depend on expectations.
Equilibrium in the Loanable Funds
Market. Fig 10-4 p. 284
3
An Increase in the Demand for Loanable Funds. Fig. 10-5 p. 286.
Standard example; increased government deficit, financed internally
An Increase in the Demand for
Loanable Funds. Fig. 10-5 p. 286.
Standard example; increased
government deficit, financed internally.
Called Crowding out. (p. 286)
May not be important if Y increases
An Increase in the Supply of Loanable Funds. Fig 10-6 p. 287
An Increase in the Supply of Loanable
Funds. Fig 10-6 p. 287.
Example: people decide to save more, consume less.
Example: people decide to save more,
consume less. Bernanke talked about
increased foreign savings.
Does inflation affect nominal interest rates?
Recall: Real interest rate = Nominal interest rate – Inflation (p. 287).
Maybe these should be done in terms of nominal rates (?).
The Fisher Effect asserts that an increase in expected inflation increases
nominal interest rates, leaving real rate constant.
The Fisher Effect. Figure 10-7 p. 268.
The Fisher Effect. Figure 10-7 p. 289.
Suppose everybody expects inflation to
grow by 10%. Then nominal i rises by
10%, and real rates stay constant.
(How a change in expected inflation increases the nominal interest
rate).
Irving Fisher, 1867-1947
4
Changes in US Interest Rates, Figure 10-8 p. 269
Illustrates that sometimes interest rates are increased by expected
inflation, and other times other factors dominate.
Changes in US Interest Rates, Figure 108 p. 290.
Major changes in r was change in D,
caused by change in investments.
Suggests Fisher Effect is not major
determinant, because demand for
investments changed.
Discussion about stocks and bonds. Returns – interest, dividends, more
risk with dividends, so they pay more. Prices of stocks reflect
expectations about future performance.
Detour on capital gains. Stock price indexes (DJ, S&P, NASDAQ etc.)
Buying on margin.
Main financial institution is bank; also pension funds, mutual funds.
Hedge funds are very speculative.
Financial Deregulation of 1980s. (inter-state banking, interest on
checking accounts, non-bank banking, banks expand services to
stocks, insurance, etc. Eliminate difference between S&Ls and
commercial banks (level the playing field). Insufficient regulation.
Cut short careers of Dan Riegle, Alan Cranston, Dennis
DeConcini. John Glenn and John McCain unscathed. Cost
taxpayers ~$150 b, over several years.
Why deregulation? Ideology, technology. Are markets efficient, or
irrational? Mentions Greenspan’s acknowledgement of ‘irrational
exhuberence’ – some “froth” in the market.
Recent crisis has its causes in deregulation, most visibly loan backed
securities (securitization). Home Mortgages. Also, insurers, and the
desire by politicians of both parties to extend mortgages to lower
income people. Response was Dodd-Frank Bill.
The US Housing Bubble. Fig 10-10 p. 281
The US Housing Bubble. Fig 10-9 p. 303