Saving, investment and financial system (KINH tế vĩ mô 1)

Chapter - Saving, investment and financial system Content I Financial system in the economy II Saving and investment in National Income Account III The market for loanable funds I Financial system in the economy Financial system: Group of institutions in the economy that help match one person’s saving with another person’s investment Indirect channel Capital Lenders - Households - Firms - Government - Foreign entities Capital Financial intermediary Financial system Capital Financial market Direct channel Capital Borrowers - Households - Firms - Government - Foreign entities I Financial system in the economy + Direct channel: Financial markets where savers can directly  provide funds to borrowers + Indirect channel: Financial intermediaries where savers can  indirectly provide funds to borrowers Why we need indirect channel  Decreasing transaction cost  Decreasing cost derived from asymmetric information  Avoiding free driver issue I Financial system in the economy Financial institutions + Direct channel: i) The bond market  Bond is the certificate of indebtedness  Firms raise money by selling bond (loan finance)  Properties of bond: Time of maturity - at which the loan will be repaid; Rate of interest; Principal amount borrowed; Term - length of time until maturity  Interest rate of bond depends on Credit risk of borrowers and term length  Bond interest and its price: negative relationship (apply: how tax treatment affects bond interest) I Financial system in the economy Financial institutions + Direct channel: ii) The stock market  Stock is the claim to partial ownership in a firm  Firms raise money by selling stock (equity finance)  Stock is traded in organized stock exchanges  Stock index is an average of a group of stock prices, which sensitively indicates market conditions  Stock prices: demand and supply principle … I Financial system in the economy Financial Institutions + Indirect channel: i) Banks:  Take in deposits from savers (banks pay interest) and make loans to borrowers (banks charge interest)  Facilitate purchasing of goods and services by creating Checks/ATM card – medium of exchange ii) Mutual funds:  Institution that sells shares to the public  Uses the proceeds to buy a portfolio of stocks and bonds  Advantages: Diversification and Access to professional money managers Disadvantages: Moderate profit and Asymmetric information … II Saving and investment in National Income Account Some important identities Gross domestic product (GDP) or (Y)  represents Total income and   Total expenditure as well  As we know Y = C + I + G + NX With closed economy NX = 0, with open economy NX ≠ 0 National saving (S) is the total income in the economy that remains  after paying for consumption and tax (if exist) We now consider closed economy:  Y = C + I + G + S = Y – C – G (by definition),  I = Y – C – G (by national income  account) → S = I + S = (Y – T – C) + (T – G)  while T = taxes minus transfer payments (net tax) II Saving and investment in National Income Account Some important identities Private saving (Sp), Y – T – C Income that households have left after paying for taxes and consumption Public saving (Sg), T – G Tax revenue that the government has left after paying for its spending + Budget surplus: T – G > (Excess of tax revenue over government spending) + Budget deficit: T – G < (Shortfall of tax revenue from government spending) Therefore Sp + Sg = I or Sp +(T – G) = I or (Sp – I) + T = G government spending funded by tax collection and net capital from private sector II Saving and investment in National Income Account Other identities (for Open economy) We now consider open economy Y = C + I + G + NX Similarly, we have S = Y – C – G, I + NX = Y – C – G → S = I + NX or Sp + Sg = I + NX, Sp + (T – G) = I + (X – M) or (Sp – I) + (M – X) = G – T budget deficit funded by net capital from private sector and net foreign inflow We also have NX = NFI (net foreign investment) therefore S = I + NFI or S + NDI = I (NDI net domestic investment = NFI) III The Market for Loanable Funds What is the market for loanable funds? It is the market for Those who want to save supply funds and Those who want to borrow to invest demand fund Assumptions One interest rate that reflects Return to saving and Cost of borrowing Single financial market Building the market: Supply and demand of loanable funds Source of the supply of loanable funds: Saving Source of the demand for loanable funds: Investment Price of a loan = real interest rate  Borrowers pay for a loan  Lenders receive on their saving 11 III The Market for Loanable Funds Building the market: Supply and demand of loanable funds As interest rate rises Quantity demanded declines Quantity supplied increases Demand curve Slopes downward Supply curve Slopes upward 12 The market for loanable funds Interest Rate Supply 5% Demand $1,200 Loanable Funds (in billions of dollars) The interest rate in the economy adjusts to balance the supply and demand for loanable funds The supply of loanable funds comes from national saving, including both private saving and public saving The demand for loanable funds comes from firms and households that want to borrow for purposes of investment Here the equilibrium interest rate is percent, and $1,200 billion of loanable funds are supplied and demanded III The Market for Loanable Funds Policies affecting loanable funds Policy 1: saving incentives E.g Shelter some saving from taxation Affect supply of loanable funds Increase in supply Supply curve shifts right New equilibrium Lower interest rate Higher quantity of loanable funds Greater investment 14 Saving incentives increase the supply of loanable funds Interest Rate Supply, S1 S2 Tax incentives for saving increase the supply of loanable funds 5% 4% Which reduces the equilibrium interest rate Demand $1,200 $1,600 Loanable Funds (in billions of dollars) and raises the equilibrium quantity of loanable funds A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S1 to S2 As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment Here the equilibrium interest rate falls from percent to percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion The Market for Loanable Funds Policies affecting loanable funds Policy 2: investment incentives E.g Investment tax credit Affect demand for loanable funds Increase in demand Demand curve shifts right New equilibrium Higher interest rate Higher quantity of loanable funds Greater saving 16 Investment incentives increase the demand for loanable funds Interest Rate Supply An investment tax credit increases the demand for loanable funds 6% 5% which raises the equilibrium interest rate D2 Demand, D1 Loanable Funds (in billions of dollars) and raises the equilibrium quantity of loanable funds If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving Here, when the demand curve shifts from D to D2, the equilibrium interest rate rises from percent to percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion $1,200 $1,400 The Market for Loanable Fundsaffecting loanable funds Policies 18 Policy 3: government budget deficits and surpluses Government - starts with balanced budget E.g Then starts running a budget deficit by increasing spending or decreasing tax Change in supply of loanable funds Decrease in supply Supply curve shifts left New equilibrium Higher interest rate Smaller quantity of loanable funds The effect of a government budget deficit Interest Rate S2 6% Supply, S1 A budget deficit decreases the supply of loanable funds 5% which raises the equilibrium interest rate Demand Loanable Funds (in billions of dollars) and reduces the equilibrium quantity of loanable funds When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving The supply of loanable funds decreases, and the equilibrium interest rate rises Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from percent to percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion $800 $1,200 III The Market for Loanable Funds Policies affecting loanable funds Policy 3: government budget deficits and surpluses Government - budget deficit Interest rate rises Investment falls Crowding out effect Decrease in investment Results from government borrowing (Analyze the situation when government runs budget surplus) 20 Key concepts  Financial system  Financial market  Financial intermediary  Bond market, stock market  Investment saving identity  Loanable fund market  Budget deficit, budget balance, budget surplus  Crowding – out effect ...Content I Financial system in the economy II Saving and investment in National Income Account III The market for loanable funds I Financial system in the economy ? ?Financial system: Group... Stock prices: demand and supply principle … I Financial system in the economy ? ?Financial Institutions + Indirect channel: i) Banks:  Take in deposits from savers (banks pay interest) and make loans... Credit risk of borrowers and term length  Bond interest and its price: negative relationship (apply: how tax treatment affects bond interest) I Financial system in the economy ? ?Financial institutions