Saving, Investment, and Financial Systems

Introduction

• Saving is the portion of income not spent on current consumption.
• Investment refers to spending on capital goods like equipment, buildings, and other productive assets.
• The financial system connects savers with borrowers, ensuring funds flow efficiently in the economy.

Saving vs. Investment

• Saving involves postponing consumption to provide funds for future use.
• Investment entails purchasing assets that enhance future production.
• In a closed economy, saving is equal to investment.
• Intertemporal choices emphasize balancing current consumption against future benefits.

The Role of the Financial System

• Definition: This system includes institutions that match one person's saving with another person's investment.
• The financial system provides channels like banks, stock markets, and bond markets.
• It also reduces transaction costs and improves resource allocation efficiency.

Components of the Financial System

• Financial Markets: Financial institutions through which savers can directly provide funds to borrowers.
• Financial Institutions: Entities such as banks, credit unions, and insurance companies.
• Financial Instruments: These are stocks, bonds, loans, and other contracts that vary in risk and return.

The Bond Market

• Funds are directly acquired from the public through the sale of bonds.
• Bonds: A certificate of indebtedness, outlines the borrower's obligations to the bond buyer.
• The time when the loan will be repaid is identified as bond maturity date, as well as the interest rate that the borrower will pay till maturity of loan.
• Principal is the buyers of the bond that can elect to sell to another party.

Characteristics of Bonds

• Term: Duration until the bond matures.
• Perpetuities: Never-maturing bonds that the British government has issued.
• Credit risk: Likelihood that the borrower will default on interest or principal payments.
• Default: Failure to pay.
• High-yield bonds (junk bonds): Financially shaky corporations use to raise money, and feature high interest rates.
• Bond rating agencies rate bonds from AAA (safest) to D (already in default).
• Tax treatment: How tax laws treat interest earned on bonds.
• Bonds issued by state and local governments typically have lower interest due to tax exemption.
• Inflation protection is rare except for Treasury Inflation-Protected Securities (TIPS).

The Stock Market

• Funds can be obtained by selling stock in a company.
• Stock: Claim to partial ownership in a firm.
• Equity finance is the process of raising money through the sale of stock.
• Debt finance is the sale of bonds.
• Compared to bonds, stocks pose a greater risk but provide better yields.
• A stock index is calculated by averaging the prices of a group of stocks.

Financial Intermediaries

• Financial institutions allow savers to indirectly provide funds to borrowers.
• Banks facilitate transactions by providing a medium of exchange.
• Mutual Funds: Institutions selling shares to the public and investing the revenue in a diverse portfolio of stocks and bonds.
• Mutual funds let individuals with limited funds diversify their holdings..
• Mutual funds provide ordinary people access to professional money management skills.
• Index funds: Invest in all stocks within a particular stock index, and perform slightly better than actively managed mutual funds.

Saving and Investment in the National Income Accounts

• Macroeconomists study financial markets work and how events and policies impact them.
• Important Identity: In a closed economy, S = I, where S = Y – C – G.
• Private Saving: Y – C – T.
• Public Saving: T – G.
• Budget surplus occurs if public saving is positive.
• Budget deficit occurs if public saving is not positive.

The Loanable Funds Market

• Savers supply funds, and borrowers demand funds.
• The equilibrium real interest rate balances saving and investment.
• Supply comes from household and corporate savings.
• Demand comes from businesses and government's investment needs.

Graphical Representation

• Reducing taxes on savings boosts supply.
• Reducing taxes on investment boosts demand.

Government Budget Deficit and Crowding Out

• Budget deficit occurs when government spending exceeds tax revenue.
• Shortfalls are funded by governments through bond market borrowing.
• The accumulation of past government borrowing is referred to as government debt,.
• An increase in government debt reduces the supply of loanable funds.
• Supply decreases since supply comes from national savings and when public saving decreases.
• Interest rates subsequently rise, which in turn causes a reduction in equilibrium investment.