Investment, Saving, and the Financial System
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FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY
The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. It moves the economys scarce resources from savers to borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.
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FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY
Financial Markets
Stock Market Bond Market
Financial Intermediaries
Banks Mutual Funds
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FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY
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.
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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.
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Financial Markets 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.
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Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Banks
take deposits from people who want to save and use the deposits to make loans to people who want to borrow.
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Financial Intermediaries 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.
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THE MARKET FOR LOANABLE FUNDS
Financial markets coordinate the economys 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.
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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.
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Supply and Demand for Loanable Funds 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.
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Supply and Demand for Loanable Funds 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.
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Figure 1 The Market for Loanable Funds
Interest Rate Supply
5%
Demand
0
$1,200
Loanable Funds (in billions of dollars)
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Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment
Taxes and saving Taxes and investment Government budget deficits
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Policy 1: Saving Incentives Lower taxes for saving (such as interest income tax, capital gains tax) increase saving Guarantees for saving (FDIC) Other tax incentives to save (individual retirement accounts)
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Figure 2 An Increase in the Supply of Loanable Rate Funds
Interest Supply,S1 S2
5% 4% 2. . . . which reduces the equilibrium interest rate . . . $1,200 $1,600
1. Tax incentives for saving increase the supply of loanable funds . . . Demand
0
Loanable Funds (in billions of dollars)
3.. . . and raises the equilibrium quantity of loanable funds.
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Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.
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Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow.
Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.
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Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.
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Figure 3 An Increase in the Demand for Loanable Funds
Interest Rate Supply 1. An investment tax credit increases the demand for loanable funds . . .
6% 5% 2. . . . which raises the equilibrium interest rate . . .
D2 Demand,D1
0
$1,200
$1,400
Loanable Funds (in billions of dollars)
3. . . . and raises the equilibrium quantity of loanable funds.
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Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.
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Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out.
The deficit borrowing crowds out private borrowers who are trying to finance investments.
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Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds.
Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.
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Figure 4: The Effect of a Government Budget Deficit
Interest Rate S2 Supply,S1
6% 5% 2. . . . which raises the equilibrium interest rate . . .
1. A budget deficit decreases the supply of loanable funds . . .
Demand
0
$800
$1,200...