Kinh tế vĩ mô Chap 4

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 b

Mentor Pham Xuan Truong

truongpx@ftu.edu.vn

Chapter 4 Saving, investment

and financial system

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

Financial system

+ 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

 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

 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

…

I Financial system in the

economy

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)

Some important identities

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)

II Saving and investment in National Income Account

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

The market for loanable funds

Interest

Rate

Loanable Funds (in billions of dollars) 0

Supply

Demand5%

$1,200

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 5 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

14

Saving incentives increase the supply of

loanable funds

Interest

Rate

Loanable Funds (in billions of dollars) 0

Supply, S1

Demand5%

$1,200

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 5 percent to

4 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

16

Investment incentives increase the demand for loanable funds

Interest

Rate

Loanable Funds(in billions of dollars)0

Supply

Demand, D15%

$1,200

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 D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion

D26%

$1,400

1 An investment tax credit increases the demand for loanable funds

The Market for Loanable

Funds

Policies affecting loanable funds

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

18

The effect of a government budget deficit

Interest

Rate

Loanable Funds(in billions of dollars)0

Supply, S1

Demand5%

$1,200

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 5 percent to 6 percent, and the equilibrium

quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion

3 and reduces the equilibrium quantity of loanable funds

2 which

raises the

equilibrium

interest rate

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