CHAPTER SLIDES BY SOLINA LINDAHL Savings, Investment Spending, and the Financial System 10(25) FOOD FOR THOUGHT…. SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING: C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S What you will learn in this chapter ▪ The relationship between savings and investment spending ▪ Aspects of the loanable funds market, which show how savers are matched with borrowers ▪ The purpose of the five principal types of financial assets: stocks, bonds, loans, real estate, and bank deposits ▪ How financial intermediaries help investors achieve diversification ▪ Some competing views of what determines asset prices and why asset market fluctuations can be a source of macroeconomic instability To Video To First Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S THE NECESSITY OF FINANCE Having a good idea isn’t enough to build a business. Entrepreneurs need funds: You have to spend money to make money. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MATCHING UP SAVINGS AND INVESTMENT SPENDING Who pays for private investment spending? In the modern economy, individuals and firms that create physical capital often do it with other people’s money. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MATCHING UP SAVINGS AND INVESTMENT SPENDING Savings–investment spending identity: savings and investment spending are always equal for the economy as a whole. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY GDP = C + I + G. Total income = total spending. Total income can go to consumer spending (C) or government purchases of goods and service (G) or be saved (S). GDP = C + G + S. Total income = consumption spending + savings. Total spending consists of either consumption spending (C + G) or investment spending (I): GDP = C + G + I. Total income = consumption spending + investment spending. Putting these equations together, we get: C+G+S=C+G+I Consumption spending = consumption spending + savings + investment spending. Subtracting (C + G) from both sides: S = I or savings = investment spending. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SAVINGS–INVESTMENT SPENDING IDENTITY Now let’s take a closer look at savings. Government can also save (or not). Budget surplus: excess of tax revenue over government spending. Budget deficit: excess of government spending over tax revenue. Budget balance: the difference between tax revenue and government spending. National savings: the sum of private savings and the budget balance (the total amount of savings generated within the economy). C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY SGovernment = T − TR − G T = the value of tax revenues and TR = the value of government transfers. SNational = SGovernment + SPrivate And since S = I has been established, we can say SNational = I National savings = investment. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE DIFFERENT KINDS OF CAPITAL It’s important to stay clear about the different kinds of capital (as explained in the previous chapter): 1. Physical capital consists of manufactured resources, such as buildings and machines. 2. Human capital is the improvement in the labor force generated by education and knowledge. 3. Financial capital is funds from savings that are available for investment spending. Back to Table of contents C OPYRIGHT 2015 W ORTH P UBLISHERS THE SAVINGS–INVESTMENT SPENDING IDENTITY IN AN OPEN ECONOMY What happens when a country sends savings to or receives savings from abroad? This affects national savings. Net capital inflow is the total flow of funds into a country minus the total flow of funds out of a country. A country with a positive net capital inflow has an extra flow of funds from abroad that can be used for investment spending. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SAVINGS–INVESTMENT SPENDING IDENTITY IN AN OPEN ECONOMY A country that spends more on imports than it earns from exports must borrow the difference from foreigners. NCI = IM − X Net capital inflow = imports − exports. Rearrange GDP = C + I + G + X − IM… to I = (GDP − C − G) + (IM − X) We know that GDP − C − G is equal to national savings, I = SNational + (IM − X) = SNational + NCI Investment spending = national savings + net capital inflow. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Capital inflow is the: a) net inflow of foreign funds plus domestic savings into an economy. b) net inflow of funds into a country, or the total inflow of foreign funds into a country minus the total outflow of domestic funds to other countries. c) total outflow of domestic funds to other countries minus the net inflow of foreign funds into a country. d) total outflow of domestic funds to other countries plus the net inflow of foreign funds into a country. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Suppose a country exports $50 million worth of goods and services, while it imports $60 million worth of goods and services. This country a. has a positive capital inflow. b. lends funds to foreigners. c. has a negative capital inflow. d. Answers (a) and (b) are both correct. e. Answers (b) and (c) are both correct. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SAVINGS–INVESTMENT SPENDING IDENTITY IN OPEN ECONOMIES The United States and Germany, 2013 (two large open economies) Sources: Bureau of Economic Analysis; OECD C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE MARKET FOR LOANABLE FUNDS On any given day, the people with money to lend are not usually the same as people who want to borrow. How are savers and borrowers brought together? Financial markets channel the savings of households to businesses that want to borrow in order to purchase capital equipment. There are many financial markets. For our purposes we’ll assume one market where savers and borrowers come together. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE MARKET FOR LOANABLE FUNDS The loanable funds market: a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders. We assume the price of loans is the (nominal) interest rate. (Again, we assume a simplified world with just one interest rate, knowing that the real world contains many interest rates according to length of loan, risk, and customers.) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE DEMAND FOR LOANABLE FUNDS The interest rate is the price of borrowing funds. Firms borrow more when the interest rate falls because more projects will earn enough to pay for themselves. Interest rate A 12% B 4 Demand for loanable funds, D 0 450 $150 C O P Y R I G H T 2 0 1 5 W O R T H P Quantity of loanable funds U B L I S (billions H E R of S dollars) Back to Table of contents PRESENT VALUE The demand for loanable funds An investment is worth making only if it generates a future return that is greater than the monetary cost of making the investment today. Present value is the amount of money needed today to receive a given amount of money at a future date given the interest rate. If you need $1,000 in a year and the interest rate on savings is r, how much do you need to put in the bank now (X)? X × (1 + r) = $1,000. Rearrange: X = $1,000/(1 + r). C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents PRESENT VALUE A firm has two potential investment projects in mind, each of which will yield $1,000 a year from now. Each project has different initial costs: One requires that the firm borrow $900 right now. The other requires that the firm borrow $950. Which of these projects is worth borrowing money to finance and undertake? Depends on the interest rate. A 10% interest rate means $1,000 is worth $909 now, so only the first project is worth it, since its initial cost ($900) is less than the present value. More projects are worth it as interest rate falls. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE SUPPLY OF LOANABLE FUNDS Interest rate Supply of loanable funds, S 12% Y 4 X $150 0 C O P Y R 450 I G H T 2 0 1 5 W O Quantity of loanable funds (billions of dollars) R T H P U B L I S H E R S Back to Table of contents THE SUPPLY OF LOANABLE FUNDS Why does the supply of loanable funds curve slope upward? More people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE EQUILIBRIUM INTEREST RATE Interest rate Only projects that are profitable at an interest rate of 8% or higher are funded. 12% S Offers not accepted from lenders who demand interest rate of more than 8%. 8 E r* Projects with rate of return less than 8% are not funded. 4 Offers accepted from lenders willing to lend at interest rate of 8% or less. D 0 $300 Quantity of loanable funds (billions of dollars) Q* C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents SHIFTS OF THE DEMAND FOR LOANABLE FUNDS Factors that can cause the demand curve for loanable funds to shift: 1. changes in perceived business opportunities 2. changes in government borrowing C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INCREASE IN THE DEMAND FOR LOANABLE FUNDS Interest rate S An increase in the demand for loanable funds . . . r2 . . . leads to a rise in the equilibrium interest rate. r1 D2 D1 Quantity of loanable C O P Y R I G H T 2 0 1 5 W O R T H P U B L Ifunds S H E R S Back to Table of contents SIDE EFFECTS OF GOVERNMENT BORROWING? Crowding out occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending. Crowding out is not a concern in a depressed economy; rather, increased government spending raises income (and private savings). C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents SHIFTS OF THE SUPPLY OF LOANABLE FUNDS Factors that can cause the supply curve for loanable funds to shift include: 1. changes in private savings behavior. 2. changes in net capital inflows. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents AN INCREASE IN THE SUPPLY OF LOANABLE FUNDS Interest rate S1 S2 r1 . . . leads to a fall in the equilibrium interest rate. An increase in the supply of loanable funds . . . r2 D C O P Y R I G H T 2 0 1 5 W O R T H P U Quantity of loanable funds B L I S H E R S Back to Table of contents 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. Major changes in interest rates have been driven by many factors, including: ▪ changes in government policy. ▪ technological innovations that created new investment opportunities. But most important, people’s expectations about future inflation. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INFLATION AND INTEREST RATES Real interest rate = nominal interest rate – inflation rate. The true cost of borrowing (and payoff to lending) is the real interest rate. But neither lenders nor borrowers know what inflation will be, so loan contracts specify a nominal interest rate. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION If the yearly nominal interest rate on a savings account is 5% and the rate of inflation over the same period is 2%, what is the real interest rate? a) 5% b) 2% c) 7% d) 3% To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE FISHER EFFECT According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged. If the tide rises, these boats will still float on the surface. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE FISHER EFFECT The expected real interest rate is unaffected by changes in expected future inflation. Supply of loanable funds at 10% expected inflation Demand for loanable funds at 10% expected inflation Nominal Interest rate S10 E10 14% Supply of loanable funds at 0% expected inflation Demand for loanable funds at 0% expected inflation 4 D10 S0 E0 D0 0 C O P Y R I G H T 2 0 1 5 W Q* O R T H P Quantity funds B L I S of H Eloanable R S U Back to Table of contents ECONOMICS IN ACTION 60 YEARS OF U.S. INTEREST RATES C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: DISCUSS With a partner, answer the following: Suppose that expected inflation rises from 3% to 6%. a) How will the real interest rate be affected by this change? b) How will the nominal interest rate be affected by this change? c) What will happen to the equilibrium quantity of loanable funds? To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE FINANCIAL SYSTEM Most economies have some sort of financial system to handle household wealth and make loans. Wealth is the value of a household’s accumulated savings. 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. A liability is a requirement to pay income in the future. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE NEED FOR A SOUND FINANCIAL SYSTEM A well-functioning financial system is a critical ingredient in achieving longrun growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THREE TASKS OF A FINANCIAL SYSTEM Task 1: reducing transaction costs Transaction costs: the expenses of negotiating and executing a deal. Task 2: reducing risk Financial risk: uncertainty about future outcomes that involve financial losses or gains. Diversification: investing in several assets with unrelated, or independent, risks; reduces risk. Task 3: providing liquidity Liquidity: a measure of how quickly an asset can be converted into cash with relatively little loss of value. If it can be converted quickly, it’s liquid; if not, illiquid. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Which of the following assets is most liquid? a) a home with a market value of $300,000 b) a checking account balance of $1,000 c) a three-carat diamond engagement ring d) a rare edition of an out-of-print book To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Financial markets provide a means for: a) reducing risk for borrowers and lenders. b) reducing transaction costs for borrowers and lenders. c) enhancing liquidity for borrowers and lenders. d) Answers (a), (b), and (c) are all correct. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents TYPES OF FINANCIAL ASSETS Bond: an IOU issued by the borrower, usually with a set interest and maturity date A concern for investors is the possibility of default (failure of a borrower to make payments as specified) More risky bonds carry higher interest rates Loan-backed securities: assets created by pooling individual loans and selling shares in that pool (a process called securitization) With so many loans packaged together, it can be difficult to assess the true quality of the asset, as in the financial crisis of 2008. Stock: a share in the ownership of a company C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents FINANCIAL INTERMEDIARIES Financial intermediary: an institution that transforms the funds it gathers from many individuals into financial assets. mutual funds pension funds and life insurance companies banks C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents WHAT HAPPENS WHEN INTERMEDIATION FAILS? When large banks fail, they can take down the economy. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MUTUAL FUNDS It’s hard for people without large amounts of money to build a diversified portfolio. The solution is mutual funds. Mutual fund: financial intermediary that builds a stock portfolio and resells shares of this portfolio to individual investors. Fidelity Spartan 500 Index Fund top holdings (as of November 2014) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents PENSION FUNDS AND LIFE INSURANCE COMPANIES Pension fund: a type of mutual fund that holds assets to provide retirement income to its members. Life insurance company: sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents BANKS Bank: a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers who don’t want to use the stock or bond markets. Bank deposit: a financial asset (a claim on the bank’s cash) owned by the depositor—and a liability of the bank that holds it. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents BONDS VERSUS BANKS Is it the increased appetite for risk that causes U.S. companies to issue a lot more bonds than their European counterparts? C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents BANKS AND THE SOUTH KOREAN MIRACLE In 1965 the South Korean government reformed the country’s banks and increased interest rates to a level that was attractive to savers. Over the next five years bank deposits increased seven-fold, and businesses launched a great investment spending boom. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents FINANCIAL FLUCTUATIONS A healthy financial system is essential; when it fails, it causes instability. What causes asset price fluctuations? the demand for stocks the demand for other assets asset price expectations C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents HOW NOW, DOW JONES? Stock indexes: what and why? Dow Jones Industrial Average, S&P 500, and NASDAQ are averages of a group of stocks. Each index gives investors a quick view of how different sectors are doing (or rather, how investors expect them to do in the future). C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ARE STOCK MARKETS EFFICIENT? According to the efficient markets hypothesis, asset prices embody all publicly available information. Implications: At any time stock prices are fairly valued: They reflect all available information about fundamentals. The prices of stocks and other assets should change only in response to new information about the underlying fundamentals—and should move in a random walk (a “random walk” is the movement over time of an unpredictable variable.) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents BEHAVIORAL FINANCE Behavioral economics (and its subfield in finance) study how people make (predictable) mistakes in their decisions. Investors depart from rationality in systematic ways: Overconfidence: having misguided faith that they are able to spot a winning stock. Loss aversion: being unwilling to sell an unprofitable asset and accept the loss. Herd mentality: buying an asset when its price has already been driven high and selling it when its price has already been driven low. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents WHAT HAPPENS WHEN INTERMEDIATION FAILS? Bank failures and panics Systemic problems usually lead to large-scale economic crises. During the Depression, between 1929 and 1933: 11,000 banks (almost half of U.S. banks) failed. Ripple effects: Businesses could not get working capital. Many people lost their life savings, resulting in lower spending. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION THE GREAT AMERICAN HOUSING BUBBLE Policymakers didn’t worry about the massive rise in home values until it began to cause economic slowdown. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: APPLICATION VIDEO Richard Thaler, (Professor, The University of Chicago Booth School of Business): “We failed to learn from the hedge fund failures of the late ’90s.” His message here to overconfident risk managers: There’s more risk out there than you think. (2:02 minutes) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: BUSINESS CASE Grameen Bank: Banking Against Poverty Mohammed Yunus pioneered microcreditproviding small loans to people who are poor. The loans are
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