Parkin-Bade Chapter 29 - University Of Marylandterpconnect.umd.edu/~jneri/Econ201/files/Chapter 7 Lecture... · At 7 percent a year, there is a surplus of funds and the real interest

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Chapter 7 SAVING, INVESTMENT

and FINIANCE

• Describe financial markets

• Explain how financial markets channel

saving to investment

• Explain how governments impact

financial markets

Income not spent is saved. Where do

those dollars go?

Financial Institutions and Financial Markets

Important Concepts

Distinguish between -

Physical capital and financial capital

Finance and money

Physical Capital: machines, tools, buildings,

computer systems and other items that have been

produced in the past and that are used today to

produce goods and services.

Financial capital: The funds that firms use to buy

physical capital – bank loans, stocks, bonds, called

financial instruments.

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Important Concepts

Finance looks at how households and firms use

financial instruments (loans, stocks, bonds) and

how they manage the risks that associated with

this activity.

The study of money looks at how households

and firms use money, how much of it they hold,

how banks create money, and how its quantity of

money influences the economy.

We talk a lot about Money in Chapter 8.


More Concepts

Investment and Capital

Gross investment is the total amount spent on purchases

of new physical capital and on replacing depreciated

capital.

Depreciation is the decrease in the quantity of physical

capital that results from wear and tear and obsolescence.

Net investment is the change in the quantity of capital.

Net investment = Gross investment Depreciation.

Capital and Investment

Example - assume 6% depreciation:

1/1/2011: an economy has $500 billion worth of

capital

during 2011: gross investment = $60 billion

1/1/2012: economy will have $530 billion worth

of capital

$530 = $500 + ($60 – $30)

What is the value of net investment?

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Economist Distinguish between Stocks

and Flows

A flow is a quantity measured per unit of time.

E.g., “U.S. investment was $2.5 trillion during

2009.”

Flow Stock

A stock is a

quantity measured

at a point in time.

E.g.,

“The U.S. capital

stock was $26 trillion

on January 1, 2009.”

Stocks vs. Flows - examples

the govt budget

deficit the govt debt

dollars added to your

credit card this

month

balance on your

credit card

a person’s

annual saving a person’s wealth

flow stock


More Concepts

Wealth and Saving

• Wealth is the value of all the things that

people own – it is a stock.

• Saving is the amount of income that is not

paid in taxes or spent on consumption of

goods and services – it is a flow.

• Saving increases wealth.

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• Wealth also increases when the market

value of assets rise - called capital gains

- and decreases when the market value

of assets falls - called capital losses.

• Buy and house for $300,000 and sell for

$500,000. The capital gain is $200,000.


More Concepts

Markets for Financial Capital

Saving is the source of funds used to finance

investment.

These funds are supplied and demanded in

three types of financial markets:

Loan market

Bond market

Stock market

• Business borrows from a bank to buy a new

computer system.

• You borrow from a bank to buy a car

• Households borrow to buy a home – called

a mortgage loan.

• These are examples of financing called

loans that take place in the loan markets.

• Loans are legal contracts.

Loans and Loan Markets

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• A bond is a promise by a borrower to make

specified payments on specified dates.

• Bonds are issued by corporations and

governments.

• The buyer of a bond is a lender and the

seller of the bond is a borrower.

• Bonds are legal contracts.

• Notice that loans and bonds are promises.

Bonds and Bond Markets

• A certificate of ownership and claim on

firm’s profits.

• Traded in stock markets.

Stocks and Stock Markets

Financial Institutions

• A financial institution is a firm that operates in the

markets for financial capital.

• Key financial institutions are:

• Commercial banks

• Insurance companies

• Mutual funds

• Pension funds

• The Federal Reserve

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Solvency and Insolvency

A financial institution’s net worth is the total market value

of its assets lent minus the market value of what it has

borrowed.

Net worth = Assets – Liabilities

If net worth is positive, the institution is solvent and can

remain in business.

But if net worth is negative, the institution is insolvent and

will go out of business.

$1,000 $900

Assets

(Funds lent)

Liabilities

(Funds borrowed)

Net Worth $100

Illiquidity

A financial institution can be solvent but illiquid.

This can happen if the institution borrows short-term and

makes long-term investments.


Interest Rates and Asset Prices

• The interest rate on a financial asset is the

interest received expressed as a percentage

of the price of the asset.

• For example, if the price of the asset is $50

and the interest received is $5, then the

interest rate is 10 percent:

$5

$50 = 0.10 or 10%

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Interest Rates and Asset Prices

• If the asset price rises (say to $100), other things

remaining the same, the interest rate falls to 5

percent.

$5

$100 = .05 or 5%.

• If the asset price falls (say to $20), other things

remaining the same, the interest rate rises to 25

percent.

Interest rates and asset prices are inversely related

The Loanable Funds Market

Where interest rates are determined

The market for funds that finance investment.

Y = national income

Y is either consumed (C), saved (S) or taxed (T):

Y = C + S + T

We know from Chapter 4:

Y = C + I + G + X – M

We get: C + S + T = C + I + G + X – M

Solve for I:

I = S + (T - G) + (M - X)


I = S + (T - G) + (M - X)

This equation tells us that funds that finance

investment (I) come from three sources:

1. Household saving (S), called private saving.

2. Government budget surplus (T – G), called public

saving.

NOTE: S + (T- G) is called national saving.

3. Borrowing from the rest of the world (M – X).

National saving plus foreign borrowing

finance domestic investment.

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The interest rate determined in the loanable

funds market is the Real Interest Rate

The nominal interest rate is the number of dollars that a

borrower pays and a lender receives in interest in a year

expressed as a percentage of the number of dollars

borrowed and lent.

In our example, the annual interest paid on a $50 loan is

$5, the nominal interest rate is 10 percent per year.

Nominal and Real Interest Rates

The real interest rate is the nominal interest rate adjusted

to remove the effects of inflation on the purchasing power

of money.

The real interest rate is approximately equal to the nominal

interest rate minus the inflation rate.

real interest rate = nominal interest rate – inflation

For example, if the nominal interest rate is 5 percent a

year and the inflation rate is 2 percent a year, the real

interest rate is 3 percent a year.

3% = 5% - 2%

Example:

I borrow $100 from a lender and agree to

pay $105 after one year:

Loan amount = $100

Interest payment = $5

Nominal Interest rate = $5/ $100 = 5%

The lender has $105 at the end of the year.

Suppose inflation is 2%. What cost $100 a

year earlier now cost $102.

The lender’s purchasing power increases by

$3 not $5.

The real interest rate is 5% - %2 = 3%

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More on the Costs of Inflation

• The real interest rate represents:

• the increase in purchasing power to the lender

• the real cost of the loan to the borrower.

• If borrowers and lenders know the rate of

inflation, they know the real cost and

purchasing power of the loan

• Unexpected inflation shifts purchasing power

between lenders and borrowers.

More on the Costs of Inflation

1) Inflation rate higher than expected

• Harms those awaiting payment (lenders)

• Benefits the payers (borrowers)

• I lend money at 5% expecting 2% inflation

• I expect a real return of 3%

• If inflation turns out to be 4%, my actual real return is 1%

2) Inflation rate lower than expected

• Harms the payers (borrowers)

• Benefits those awaiting payment (lenders)

• If inflation turns out to be 1%, my actual return as a

lender is 4%.


• The market for loanable funds determines the

real interest rate, the quantity of funds loaned,

saving, and investment.

• We’ll start by ignoring the government (T – G)

and the rest of the world (M – X).

• In this case, the only source of loanable funds

is private saving (S).

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The Demand for Loanable Funds

• The quantity of loanable funds demanded (how much

business firms want to borrow) depends on

1. The real interest rate

2. Expected profit

Demand for Loanable Funds Curve

• The demand for loanable funds curve is the relationship

between the quantity of loanable funds demanded and the

real interest rate when all other influences on borrowing

plans remain the same.

• Business investment (I) is the main item that makes up the

demand for loanable funds.


Demand for loanable

funds curve.

A rise in the real interest

rate decreases the

quantity of loanable funds

demanded.

A fall in the real interest

rate increases the quantity

of loanable funds

demanded.


Changes in the Demand for Loanable Funds

• When the expected profit changes, the demand for

loanable funds changes.

• The greater the expected profit from investment,

investment increases and the demand for loanable

fund increases. The DLF curve shifts to the right.

• The lower the expected profit from investment,

investment decreases and the demand for loanable

fund decreases. The DLF curve shifts to the left.

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Change in the Demand for Loanable Funds

Loanable Funds

Real

Interest

Rate

DLF1 DLF2

DLF3


The Supply of Loanable Funds

The quantity of loanable funds supplied (household

saving) depends on

1. The real interest rate

2. Disposable income

3. Expected future income

4. Wealth

5. Default risk – this is the probability the lender will not be

repaid.


The Supply of Loanable Funds Curve

• The supply of loanable funds is the relationship

between the quantity of loanable funds supplied

and the real interest rate when all other

influences on lending plans remain the same.

• For now we focus just on private saving (S).

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As the real interest rate

increases, households

save more, the quantity of

loanable funds supplied

increases.

A fall in the real interest

rate decreases the

quantity of loanable funds

supplied as households

save less.

Changes in the Supply of Loanable Fund

• A change in disposable income, expected future

income, wealth, or default risk changes the supply

of loanable funds.

• Household saving and the supply of loanable funds

will increase when -

• There is an increase in disposable income,

• There is a decrease in expected future income,

• There is a decrease in wealth (e.g., loss in the stock market

or real estate),

• There is a decrease in default risk

Change in the Supply of Loanable Funds

Loanable Funds

Real

Interest

Rate

SLF1 SLF2

SLF3

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Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real

interest rate at which the quantity of loanable funds

demanded equals the quantity of loanable funds supplied.

This figure illustrates the

loanable funds market.

At 7 percent a year, there is a

surplus of funds and the real

interest rate falls – households

save more than business firms

want to borrow.

At 5 percent a year, there is a

shortage of funds and the real

interest rate rises.

Equilibrium occurs at a real

interest rate of 6 percent a

year.


E

• An increase in expected

profits increases DLF.

• DLF shifts to the right.

• The real interest rate

rises.

• With higher real interest

rates, household saving

increases and quantity of

loanable funds supplied

increases movement from

E to F.

What Happens When Things Change?

Increase in Demand for Loanable Funds

E

F

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• If one of the influences on

saving changes and saving

increases, the supply of

funds increases.

• (recall the influences that

will increase supply?)

• The real interest rate falls.

• Investment increases.

Increase in the Supply of Loanable Funds

E

F


Long-run changes in Demand and Supply

The book states on p. 171 that in the long-run both supply and

demand for loanable funds tend to increase over time at

similar pace: “the real interest rate has no trend.”

Let’s look at what has been going on:

https://fred.stlouisfed.org/series/WFII10

Now Add the Government to the Loanable

Funds Market

Government enters the loanable funds market when it has a

budget surplus or deficit.

Budget = Tax revenues (T) minus Government spending (G).

= T - G

A government budget surplus (T>G) increases the supply of

funds.

A government budget deficit (T<G) increases the demand

for funds.



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Note: PSLF is Private Supply of

Loanable Funds – household saving (S)

• The budget surplus of $1

trillion increases supply of

funds $1trillion at each

interest rate.

• The real interest rate falls.

• Two things happen:

• Private saving decreases -

in this example by $0.5

trillion to $1.5 trillion.

• Investment increases – in

this example by $0.5 trillion

to $2.5 trillion.

Government in the Loanable Funds Market:

Budget Surplus of $1.0 Trillion

E

F H

Note: PSLF is Private Demand for

Loanable Funds – business investment

(I)

A budget deficit increases

demand for funds by $1trillion

at each interest rate.

The real interest rate rises.

Two things happen:

• Private saving increases - to

by $0.5 trillion to $2.5

• Investment decreases - is

crowded out – as the real

interest rate rises. I falls to by

$0.5 trillion to $1.5 trillion.

Government in the Loanable Funds Market:

Budget Deficit of $1 Trillion

The Crowding Out Effect

•The tendency for government budget

deficits to raise real interest rates and

decrease private spending – both C and I.

•Public spending crowds-out private

spending.

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A budget deficit increases the

demand for funds.

Budget deficits today means taxes

must rise in the future and

disposable income will be lower.

“Rational”, forward looking

taxpayers increase saving today,

which increases the supply of

funds.

Increased private saving finances

the deficit.

In the extreme, crowding-out is

avoided - the real interest rate

does not rise and investment does

not fall.

The Ricardo–Barro Effect

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Parkin-Bade Chapter 29 - University Of Marylandterpconnect.umd.edu/~jneri/Econ201/files/Chapter 7 Lecture... · At 7 percent a year, there is a surplus of funds and the real interest