The Study of Economics

The Study of Economics

THIRD EDITION ECONOMICS and MACROECONOMICS Paul Krugman | Robin Wells Chapter 10(25) Savings, Investment Spending, and the Financial System WHAT YOU WILL LEARN IN THIS

CHAPTER The relationship between savings and investment spending Aspects of the loanable funds market, which shows how savers are matched with borrowers The purpose of the five principal types of assets: stocks, bonds, loans, real estate, and bank deposits How financial intermediaries help investors achieve diversification Some competing views of what determines stock prices and why stock

market fluctuations can be a source of macroeconomic instability Matching Up Savings and Investment Spending According to the savingsinvestment spending identity, savings and investment spending are always equal for the economy as a whole. The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending. The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue.

Matching Up Savings and Investment Spending The budget balance is the difference between tax revenue and government spending. National savings, the sum of private savings plus the budget balance, is the total amount of savings generated within the economy. Capital inflow is the net inflow of funds into a country. The SavingsInvestment Spending Identity In a simplified economy: 1) Total Income = Total spending 2) Total income = Consumption spending + Savings Meanwhile, spending consists of either consumption

spending or investment spending: 3) Total spending = Consumption spending + Investment spending Putting these together, we get: 4) Consumption spending + Savings = Consumption spending + Investment spending Subtract consumption spending from both sides, and we get: 5) Savings = Investment spending The SavingsInvestment Spending Identity In a simplified economy:

GDP = C + I + G SPrivate = GDP + TR T C SGovernment = T TR G NS = SPrivate + SGovernment = (GDP + TR T C) + (T TR G) = GDP C G Hence, I = NS. Investment spending = National savings in a closed economy. The SavingsInvestment Spending Identity (a) United States, 2007 Share

Share of GDP of GDP 25 % 20 15 10 5 0 5 Investmen 10 t spending

15 Capital inflows Budget deficit Savings Private savings (b) Japan, 2007

25 % 20 15 Private 10 savings 5 0 Capital 5 Investmen outflows 10 t spending

15 Savings Budget deficit The SavingsInvestment Spending Identity Investment spending = National savings + Capital inflow in an open economy I = SPrivate + SGovernment + (IM X) = NS + KI 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 Market for Loanable Funds The rate of return on a project is the profit earned on the project expressed as a percentage of its cost. The Demand for Loanable Funds Interes t rate

12% A B 4 Demand for loanable funds, D 0 $150 450

Quantity of loanable funds (billions of dollars) The Supply for Loanable Funds Interes t rate Supply of loanable funds, S 12% 4 0

Y X $150 450 Quantity of loanable funds (billions of dollars) Equilibrium in the Loanable Funds Market Interest rate

Projects with rate of return 8% or greater are funded. 12% Offers not accepted from lenders who demand interest rate of more than 8%. r* 8 Projects with rate of return

less than 8% are not funded. 4 0 $300 Q* Offers accepted from lenders willing to lend at interest rate of 8% or less.

Quantity of loanable funds (billions of dollars) Shifts of the Demand for Loanable Funds Factors that can cause the demand curve for loanable funds to shift include: Changes in perceived business opportunities Changes in the governments borrowing Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending. An Increase in the Demand for Loanable Funds

Interes t rate S . . . leads to a rise in the equilibrium interest rate. An increase in the demand for loanable funds . ..

r 2 r 1 D D 2 1 Quantity of loanable funds

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 United States 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. An Increase in the Supply of Loanable Funds Interes t rate S 1 S

. . . leads to a fall in the equilibrium interest rate. r r 1 2 An increase in the

supply for loanable funds . . . 2 D Quantity of loanable funds 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: changes in government policy. technological innovations that created new investment opportunities. Inflation and Interest Rates 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 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. 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. The Fisher Effect

Nominal Interest rate S 10 E 10 14% Demand for loanable funds at 0% expected

inflation 4 Supply of loanable funds at 10% expected inflation Demand for loanable funds at 10% expected inflation

Supply of loanable funds at 0% expected inflation D 10 S 0 E 0 D

0 0 Q* Quantity of loanable funds The Concept of Present Value When someone borrows money for a year, the interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender. The interest rate can be used to compare the value of a

dollar realized today with the value of a dollar realized later, because it correctly measures the cost of delaying a dollar of benefit (and the benefit of delaying a dollar of cost). The present value of $1 realized one year from now is equal to $1/(1 + r): the amount of money you must lend out today in order to have $1 in one year. It is the value to you today of $1 realized one year from now. Present Value Lets call $V the amount of money you need to lend today, at an interest rate of r in order to have $1 in two years. So if you lend $V today, you will receive $V(1 + r) in one year. And if you re-lend that sum for yet another year, you will receive $V (1 + r) (1 + r) = $V (1 + r)2 at the end of the

second year. At the end of two years, $V will be worth $V (1 + r)2 If r = 0.10, then this becomes $V (1.10)2 = $V (1.21). Present Value What is $1 realized two years in the future worth today? In order for the amount lent today, $V, to be worth $1 two years from now, it must satisfy this formula: $V (1 + r)2 = $1 If r = 0.10, $V = $1/(1 + r)2 = $1/1.21 = $0.83 The present value formula is equal to $1/(1 + r) N Net Present Value The net present value of a project is the present value of

current and future benefits minus the present value of current and future costs. The Financial System A households 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. 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 Financial System A liability is a requirement to pay income in the future. Transaction costs are the expenses of negotiating and executing a deal.

Financial risk is uncertainty about future outcomes that involve financial losses and gains. Three 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.

Providing liquid assets assets that can be quickly converted into cash (in contrast to illiquid assets, which cant). Three Tasks of a Financial System An individual can engage in diversification by investing in several different things so that the possible losses are independent events. An asset is liquid if it can be quickly converted into cash. An asset is illiquid if it cannot be quickly converted into cash. Types of Financial Assets

There are four main types of financial assets: 1) loans 2) bonds 3) stocks 4) bank deposits In addition, financial innovation has allowed the creation of a wide range of loan-backed securities. Types of Financial Assets A loan is a lending agreement between a particular lender and a particular borrower. A default occurs when a borrower fails to make payments as specified by the loan or bond contract. A loan-backed security is an asset created by pooling

individual loans and selling shares in that pool. 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. A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members. Financial Intermediaries A life insurance company sells policies that guarantee a payment to a policyholders 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. 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. An Example of a Diversified Mutual Fund Financial Fluctuations Financial market fluctuations can be a source of macroeconomic instability. Stock prices are determined by supply and demand, as well

as by the desirability of competing assets, like bonds: when the interest rate rises, stock prices generally fall and vice versa Financial Fluctuations The value of a financial asset today depends on investors beliefs about the future value or price of the asset. 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, todays equilibrium price of the asset will rise. Financial Fluctuations

If investors believe the asset will be worth less in the future, they will demand less today at any given price. Consequently, todays equilibrium price of the asset will fall. Todays stock prices will change according to changes in investors expectations about future stock prices. Financial Fluctuations Financial market fluctuations can be a source of macroeconomic instability. 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 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. It implies that fluctuations are inherently unpredictable they follow a random walk. Irrational Markets? 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. Asset Prices and Macroeconomics How do macroeconomists and policy makers deal with the fact that asset prices fluctuate a lot and that these fluctuations can have important economic effects? Should policy makers try to pop asset bubbles before they get too big? 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. Summary 2. According to the savingsinvestment 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.

Summary 3. (Cont.) 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 coststhe cost of making a deal; reducing financial riskuncertainty 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 moderately sized 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. Summary 6. (Cont.) Loan-backed 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 intermediariesinstitutions 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 in 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 such as bonds: when the interest rate rises, prices of stocks and physical assets such as real estate generally fall, and vice versa. Summary 9. (Cont.) Expectations drive the supply of and demand for assets: expectations of higher future prices push todays 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 unpredictablethey 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. Key Term

Savingsinvestment spending identity Budget surplus Budget deficit Budget balance National savings Capital inflow Loanable funds market Interest rate Present value Crowding out Fisher effect

Wealth Financial asset Physical asset Liability Transaction costs

Financial risk Diversification Liquid Illiquid Loan Default

Loan-backed securities Financial intermediary Mutual fund Pension fund Life insurance company Bank deposit Bank Efficient markets hypothesis Random walk

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