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Saving, Investment,and the Financial
System
Chapter 25
Copyright 2001 by Harcourt, Inc .
All rights reserved. Requests for permission to make copies of any part ofthe
work should be mailed to:Permissions Department, arcourt !ollege Publishers,
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The Financial System
The financial system consists ofinstitutions that help to match one
persons saving with another personsinvestment
It moves the economys scarceresources from savers to borrowers
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Financial Institutionsin the U.S. Economy
The financial system is ma!e up offinancial institutions that coor!inate the
actions of savers an! borrowers"inancial institutions can be groupe!into two !ifferent categories# financial
mar$ets an! financial interme!iaries
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Financial Institutionsin the U.S. Economy
"inancial %ar$ets&toc$ %ar$et
'on! %ar$et
"inancial Interme!iaries'an$s
%utual "un!s
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Financial Institutionsin the U.S. Economy
"inancial mar$ets are the institutionsthrough which savers can !irectlyprovi!e fun!s to borrowers"inancial interme!iaries are financialinstitutions through which savers can
in!irectly provi!e fun!s to borrowers
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The Bond ar!et
( bon! is a certificateof in!ebte!ness thatspecifies obligations ofthe borrower to thehol!er of the bon!
IOU
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&toc$ represents ownership in a firm an!is therefore, a claim to the profits that thefirm ma$esThe sale of stoc$ to raise money is calle!e+uity financing .
Compare! to bon!s, stoc$s offer both higherris$ an! potentially higher returns
The Stoc! ar!et
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The Stoc! ar!et
The most important stoc$ e*changes inthe nite! &tates are the -ew .or$&toc$ /*change, the (merican &toc$/*change, an! -(& (
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The Stoc! ar!et
%ost newspaper stoc$ tables provi!e thefollowing information#
rice 3of a share4
5olume 3number of shares sol!4
ivi!en! 3profits pai! to stoc$hol!ers4
rice6earnings ratio
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Financial Intermediaries#Ban!s
'an$s ta$e !eposits from people whowant to save an! use the !eposits to ma$eloans to people who want to borrow'an$s pay !epositors interest on their!eposits an! charge borrowers slightly
higher interest on their loans
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Ban!s
'an$s help create a me!ium of e*change by allowing people to write chec$s against
their !eposits( me!ium of e*changes is an item thatpeople can easily use to engage intransactions
This facilitates the purchases of goo!san! services
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Financial Intermediaries#utual Funds
( mutual fun! is an institution that sellsshares to the public an! uses the procee!sto buy a selection, or portfolio, of varioustypes of stoc$s, bon!s, or both
They allow people with small amounts of
money to easily !iversify
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$ther Financial Institutions
Cre!it unions
ension fun!sInsurance companies
7oan shar$s
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Saving and Investment in the %ationalIncome &ccounts
)ecall that 8 is both total incomein an economy an! total e*pen!itureon the economys output of goo!s an!services#
Y = C + I + G + NX
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Some Important Identities
(ssume a close! economy 9 one that!oes not engage in international tra!e#
Y = C + I + G
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Some Important Identities
-ow, subtract C an! 8 from both si!es ofthe e+uation#
Y C G =IThe left si!e of the e+uation is the totalincome in the economy after paying forconsumption an! government purchasesan! is calle! national saving , or :ustsaving (S).
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Some Important Identities
&ubstituting S for Y-C-G , the e+uationcan be written as#
S = I
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Some Important Identities
-ational saving, or saving, is e+ual to#
S = IS = Y C G
S = (Y T C) + (T G)
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'rivate Saving
rivate saving is the amount of incomethat househol!s have left after paying
their ta*es an! paying for theirconsumption
Private saving = (Y T C)
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'u(lic Saving
ublic saving is the amount of ta*revenue that the government has left
after paying for its spen!ing
Public saving = (T G)
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Surplus and )e"icit
If T>G , the government runs a bu!getsurplus because it receives more money
than it spen!sThe surplus of T-G represents publicsaving
If G>T , the government runs a bu!get!eficit because it spen!s more moneythan it receives in ta* revenue
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Saving and Investment
"or the economy as a whole, savingmust be e+ual to investment
S = I
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The ar!et "or *oana(le Funds
"inancial mar$ets coor!inate theeconomys saving an! investmentin the mar$et for loanable fun!s
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The ar!et "or *oana(le Funds
7oanable fun!s refers to all incomethat people have chosen to save an!len! out, rather than use for theirown consumption
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The supply of loanable fun!s comes frompeople who have e*tra income they want
to save an! len! outThe !eman! for loanable fun!s comesfrom househol!s an! firms that wish to
borrow to ma$e investments
Supply and )emand "or *oana(leFunds
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Supply and )emand "or *oana(le
Funds
"inancial mar$ets wor$ much li$e
other mar$ets in the economyThe e+uilibrium of the supply an! !eman!for loanable fun!s !etermines the realinterest rate
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arcourt, +nc. items and derived items copyright #-- by arcourt, +nc.Loanable Funds(in billions of0
InterestRate
Demand
Su l!
"#
$%&'00
ar!et "or *oana(le Funds...
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+overnment 'olicies That &""ectSaving and Investment
Ta*es an! saving
Ta*es an! investment8overnment bu!get !eficits
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Ta es and Saving
Ta*es on interest income substantially
re!uce the future payoff from currentsaving an!, as a result, re!uce theincentive to save
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Ta es and Saving
( ta* !ecrease increases the incentive forhousehol!s to save at any given interest
rate The supply of loanable fun!s curve shifts tothe right
The e+uilibrium interest rate !ecreasesThe +uantity !eman!e! for loanable fun!sincreases
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S
1. Tax incentivesfor savingincrease thesupply of loanablefunds...
&n Increase in the Supply o" *oana(leFunds...
Loanable Funds (in billions of
dollars)
0
InterestRate
"#
Su l!& S !
$%&'00
Demand
$%& 00
3. ...and raises the equilibrium quantity of loanablefunds.
#
2. ...which
reduces theequilibriuminterestrate...
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Ta es and Saving
If a change in ta* law encouragesgreater saving, the result will belower interest rates an! greaterinvestment
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Ta es and Investment
(n investment ta* cre!it increases theincentive to borrow
Increases the !eman! for loanable fun!s&hifts the !eman! curve to the right
)esults in a higher interest rate an! a greater
+uantity save!
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&n Increase in the )emand "or*oana(le Funds...
Loanable Funds(in billions of
dollars)
0
InterestRate
"#
$%&'00
Su l!
Demand& " !
1. An investmenttax creditincreases thedemand forloanable funds...
"
#
2. ...whichraises theequilibriuminterestrate...
$%& 003. ...and raises theequilibrium quantity of
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+overnment Budget )e"icits andSurpluses
;hen the government spen!s more than
it receives in ta* revenues, the short fallis calle! the bu!get !eficit
The accumulation of past bu!get !eficits
is calle! the government !ebt .
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+overnment Budget )e"icits andSurpluses
8overnment borrowing to finance itsbu!get !eficit re!uces the supply of
loanable fun!s available to financeinvestment by househol!s an! firms
This fall in investment is referre! to as
crow!ing outThe !eficit borrowing crow!s out privateborrowers who are trying to financeinvestments
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+overnment Budget )e"icits andSurpluses
( bu!get !eficit !ecreases the supply of
loanable fun!s &hifts the supply curve to the left
Increases the e+uilibrium interest rate
)e!uces the e+uilibrium +uantity of loanablefun!s
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S
1. A budgetde cit decreases
the supply ofloanable funds...
The E""ect o" a +overnment Budget)e"icit...
Loanable Funds(in billions of dollars)
0
InterestRate
$%&'00
Su l!& S !
Demand
"#
$*003. ...and reduces theequilibrium quantity of
2. ...whichraises theequilibrium
interestrate...
#
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+overnment Budget )e"icits andSurpluses
;hen government re!uces nationalsaving by running a !eficit, theinterest rate rises an! investment falls
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+overnment Budget )e"icits andSurpluses
( bu!get surplus increases the supply ofloanable fun!s, re!uces the interest rate,an! stimulates investment
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The U.S. +overnment )e(t
0
'0
0
0
*0
%00
% "0 % "" % 0 % " % ,0 % ," % *0 % *" % 0 '000 % "
-.S. /o ernmentdebt
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Summary
The & financial system is ma!e up offinancial institutions such as the bon!mar$et, the stoc$ mar$et, ban$s, an!
mutual fun!s(ll these institutions act to !irect theresources of househol!s who want to save
some of their income into the han!s ofhousehol!s an! firms who want to borrow
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Summary
-ational income accounting i!entitiesreveal some important relationshipsamong macroeconomic variables
In particular, in a close! economy,national saving must e+ual investment
"inancial institutions attempt to matchone persons saving with anotherpersons investment
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Summary
The interest rate is !etermine! by thesupply an! !eman! for loanable fun!s
The supply of loanable fun!s comes fromhousehol!s who want to save some oftheir income
The !eman! for loanable fun!s comesfrom househol!s an! firms who want toborrow for investment
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Summary
-ational saving e+uals private saving pluspublic saving
( government bu!get !eficit representsnegative public saving an!, therefore,re!uces national saving an! the supply ofloanable fun!s
;hen a government bu!get !eficitcrow!s out investment, it re!uces thegrowth of pro!uctivity an! 8
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8raphical)eview
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arcourt, +nc. items and derived items copyright #-- by arcourt, +nc.Loanable Funds(in billions of0
InterestRate
Demand
Su l!
"#
$%&'00
ar!et "or *oana(le Funds...
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&n Increase in the )emand "or*oana(le Funds...
Loanable Funds(in billions of
dollars)
0
InterestRate
"#
$%&'00
Su l!
Demand& " !
1. An investmenttax creditincreases thedemand forloanable funds...
"
#
2. ...whichraises theequilibriuminterestrate...
$%& 003. ...and raises theequilibrium quantity of
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