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

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

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

 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

 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

…

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

Demand

5%

$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

 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

Loanable Funds (in billions of dollars) 0

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

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

Loanable Funds(in billions of dollars)0

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

 Change in supply of loanable funds

 Decrease in supply

 Supply curve shifts left

 New equilibrium

 Higher interest rate

 Smaller quantity of loanable funds

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

S26%

$800

1 A budget deficit decreases the supply of loanable funds

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

surplus