Chapter 5 - Finance, Saving and Investment PDF

MGT 4073/CFB 1133 MACROECONOMICS CHAPTER 5: Finance, Saving and Investment  CHAPTER 5: FINANCE, SAVING AND INVESTMENT At the end of this chapter, you should be able to: Interpret the concept of financial system. Des...

MGT 4073/CFB 1133 MACROECONOMICS CHAPTER 5: Finance, Saving and Investment  CHAPTER 5: FINANCE, SAVING AND INVESTMENT At the end of this chapter, you should be able to: Interpret the concept of financial system. Describe the meaning of saving and investment. State and explain injection and leakages.  THE FINANCIAL SYSTEM The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers.  FINANCIAL INSTITUTIONS The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.  FINANCIAL INSTITUTIONS(cont.) Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds  FINANCIAL INSTITUTIONS(cont.) Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.  Financial Markets The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt.  Financial Markets (cont.) The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.  Financial Markets (cont.) Most newspaper stock tables provide the following information: Price (of a share) Volume (number of shares sold) Dividend (profits paid to stockholders) Price-earnings ratio  Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.  Financial Intermediaries (cont.) Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.  Financial Intermediaries (cont.) Banks Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchanges is an item that people can easily use to engage in transactions. This facilitates the purchases of goods and services.  Financial Intermediaries (cont.) Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.  Financial Intermediaries (cont.) Banks Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchanges is an item that people can easily use to engage in transactions. This facilitates the purchases of goods and services.  Financial Intermediaries (cont.) Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify.  Financial Intermediaries (cont.) Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks  SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX  Some Important Identities Assume a closed economy – one that does not engage in international trade: Y=C+I+G  Some Important Identities Now, subtract C and G from both sides of the equation: Y – C – G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).  Some Important Identities Substituting S for Y - C - G, the equation can be written as: S=I  Some Important Identities National saving, or saving, is equal to: S=I S=Y–C–G S = (Y – T – C) + (T – G)  The Meaning of Saving and Investment (cont.) National Saving National saving is the total income in the economy that remains after paying for consumption and government purchases. Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C)  The Meaning of Saving and Investment (cont.) Public Saving Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)  The Meaning of Saving and Investment (cont.) Surplus and Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.  The Meaning of Saving and Investment (cont.) For the economy as a whole, saving must be equal to investment. S=I  THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.  Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments. The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate.  Supply and Demand for Loanable Funds (cont.) Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate. Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits LEAKAGE AND INJECTION  LEAKAGE AND INJECTION (cont.) LEAKAGE INJECTION SAVINGS (S) INVESTMENTS (I) TAXES (T) GOVERNMENT SPENDING (G) IMPORTS (M) EXPORTS (E)  LEAKAGE AND INJECTION (cont.) Leakage means withdrawal from the flow. When households and firms save part of their incomes it constitutes leakage. They may be in form of savings, tax payments, and imports. Leakages reduce the flow of income. Injection means introduction of income into the flow. When households and firms borrow the savings, they constitute injections. Injections increase the flow of income. Injections can take the forms of investment, government spending and exports.  The state of equilibrium In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as: Savings + Taxes + Imports = Investment + Government Spending + Exports S + T + M ≠ I + G + X  The state of equilibrium (cont.) If the state of the sum of total leakages does not equal the sum of total injections it will result in disequilibrium. Disequilibrium can be shown as: Savings + Taxes + Imports ≠ Investment + Government Spending + Exports S+T+M≠I+G+X END OF CHAPTER 5 THANK YOU